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October 14, 2008

Deal Gives ECN a Way Forward

By Nina Mehta

Direct Edge's planned acquisition of the ISE Stock Exchange is expected to accelerate the ECN's bid to become a stock exchange. It does this by providing technology and regulatory know-how to the ECN operator. But the deal is also designed to maintain the critical role of Direct Edge's major broker-dealer owners.

"A big part of Direct Edge's success to date is that Knight, Citadel and Goldman Sachs are incentivized, high-value strategic partners, and we wanted to continue that," said William O'Brien, CEO of Direct Edge. About 40 percent of Direct Edge's executed volume comes from its three owners.

Each of those brokers will own 19.9 percent of the company when the deal is completed, the maximum stake allowed for broker-dealer owners of an exchange. The acquisition, announced in August, is expected to close within the next couple of months, subject to Securities and Exchange Commission approval.

The International Securities Exchange, which owns 51 percent of the ISE Stock Exchange, will own 31.5 percent of Direct Edge once the deal closes. The ISE also invested $123 million as part of the deal. The majority of that went to Direct Edge, but a portion was used to acquire some of the ownership stake of Knight Capital Group, Citadel Derivatives Group and Goldman Sachs.

The ISE Stock Exchange's other owners will get only a small piece of the action at Direct Edge. Eight of the group of 10 broker-dealers that currently owns 49 percent of the exchange will get a cumulative 8.8 percent of Direct Edge (the other two are Knight and Citadel).

Acquiring the ISE Stock Exchange will not give Direct Edge's two ECN markets exchange status. Direct Edge still plans to file for a pair of exchange licenses. Until it receives those licenses from the SEC, it will operate the ISE Stock Exchange as a separate market, with EDGA and EDGX quoting to the ISE Stock Exchange, instead of the National Stock Exchange.

O'Brien said he expects Direct Edge to boost its matched market share to double digits within 18 months of receiving exchange licenses. Direct Edge's matched market share in August was 5.7 percent, up from 1.9 percent in August 2007. The ISE Stock Exchange's matched market share is around 1 percent.

Direct Edge's matched market share will jump, O'Brien said, because Direct Edge, like BATS, has a "clear path to get to exchange status on its own terms and backed by quality players." BATS won SEC approval to operate as an exchange in August.

After Direct Edge secures its exchange licenses, the ISE equities market will be shuttered, with its volume moved over to Direct Edge's markets. Gary Katz, president and CEO of the ISE, told reporters in August that the ISE's equities license would be decommissioned. "We have no plans of restarting another stock exchange business to compete with our very large investment in Direct Edge," he said.

For the ISE, this deal enables the exchange to wind down its equities market, which hasn't amassed sufficient flow to compete with the dominant players, and instead become the biggest shareholder in a fast-growing market. Andrew Brenner, head of the ISE Stock Exchange, acknowledged that "building market share in a very competitive environment is difficult." The current deal "makes sense for both the ISE and Direct Edge," he said. "We're proud of the technology we built, and they're proud of the order flow they've established. We're sure that the combination, which will integrate the best of what each platform offers, will be successful going forward."

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