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September 10, 2007

Direct Edge Gets New Investors

By James Ramage

Direct Edge ECN is expected to garner more order flow following recent deals by Knight Capital Group to reduce its ownership in the ECN. Any fears competing market makers might once have had about routing orders through an ECN owned by one of the Street's largest market-making firms should be lessened considerably, Knight's competitors say.

"I would expect that [independence] does help to alleviate any concerns that way," says Steve Swanson, chief executive officer and president of automated wholesale market maker ATD, as well as a Direct Edge user and Knight competitor.

In the past two months, Knight has sold large portions of subsidiary Direct Edge to both Citadel and Goldman Sachs. Citadel has since said it would increase its stake. Knight would not disclose any details of the transactions. But it says it will own less than 50 percent of Direct Edge when the Goldman portion closes, making the ECN an independent entity. Other firms have shown an interest in buying into Direct Edge, and landing more partners fits Knight's plans, according to Tom Joyce, Knight's chairman and chief executive officer. "We would be willing to dilute further, under the right circumstances," he says. "With the right partners supporting it, singular ownership will be trumped by a strong consortium every time."

Strong partnerships with investment banking giant Goldman Sachs and wholesale market makers Citadel Derivatives Group should help Direct Edge's business base grow, Swanson says. Direct Edge should be able to draw upon that base and encourage those partners to send business its way, increase its overall volume and subsequently attract more order flow. The ECN's recent average daily matched share volume has been about 150 million. It trails its chief competitors, Nasdaq and BATS, at 2.21 billion and 470 million, respectively.

The ECN's independence is important because of an existing perception that the Direct Edge connection to Knight has hindered the ECN's growth. Market makers, the thinking goes, wouldn't want to support a competitor. Also, traders may have been apprehensive about trading against orders that might come from Knight's well-informed trading desk. "We're not blind to the dynamics of the market, obviously," Joyce says. "And we know some of our competitors were using the fact that Knight owned it in its entirety against us as a selling point, and made representations that, because Knight owned it singularly, it was a less attractive destination. We, of course, completely disagreed with that and ran it as an independent destination."

But the fact that Direct Edge is now a consortium removes that argument and positions the ECN for more rapid growth, Joyce says.

Knight established Direct Edge ECN-after buying the Attain ECN-in 2005 to reduce its own ECN expenses and to have an alternative to what the company perceived was a threatening, cost-raising oligopoly in the newly public New York Stock Exchange and Nasdaq. "We ran it to be a low-cost industry utility," Joyce says. This worked for a time, as owning and controlling the ECN allowed Knight to drive volume to Direct Edge and create momentum, Joyce adds. But Knight judged that a consortium presented advantages.

Citadel agreed, and furthermore liked what it saw in Direct Edge's valuation, technology and position in the market, says Neil Fitzpatrick, chief operating officer for Citadel Execution Services. And the ECN has the means to draw market makers, he says. "If the technology is sound, if the liquidity and the user experience is there, and the price is right," Fitzpatrick says, "they will come."