KCG 2016 Annual Report
We undertake actions or abandon ideas depending on their ability to contribute to our present and future happiness. We acquire goods and pay for services, constantly calculating whether our need for them justifies their expense. We conceive and structure frameworks for free and fair exchanges to help us determine, on a market-wide scale, how much any individual item should cost.
At KCG, we do the same, only on a much larger scale. As a firm, we collectively work to identify and demonstrate value in the global capital markets.
To do that, we draw together individuals with deep, specialized experience in trading, technology, and mathematics and challenge them to address complex issues for the benefit of market participants.
We assist clients in deploying capital efficiently, fulfilling best execution mandates for retail and institutional investors and enhancing their trading operations.
And we help markets function more efficiently through better price discovery, deeper liquidity, tighter spreads, and lower trading costs.
Today, KCG plays a critical role in the global capital markets, with leading banks, brokers, and asset managers relying on the firm’s sophisticated execution services. And while our book value per share has steadily increased in part as a reflection of that, we still have much more work left to do to create significant value for our stockholders.
We’re reengineering the firm’s trading architecture to transform operations. Additionally, by aggressively reducing shares outstanding, we’ve created the potential for greater earnings leverage for stockholders going forward.
That’s just the beginning. As we refine and enhance capabilities, we see an opportunity to emerge even stronger: as a trading firm unlike any other and an asset positioned to realize its full potential.
For more on strategic, operational, and financial matters, go to www.kcg.com/ir/a-primer-on-kcg.
March 7, 2017
Dear KCG Stockholder,
In 2016, KCG continued to advance a number of strategic and operational initiatives. Financial results, however, remained volatile.
KCG teams posted gains in critical markets including the retail equity and bond markets, institutional algorithmic execution, and exchange-traded funds (ETFs).
Market share of retail SEC Rule 605 U.S. equity share volume rose to 29.0 percent for the full year.*
Market share of interdealer corporate bond transactions in retail-size lots under 250 bonds rose to 19.9 percent for the full year while municipals rose to 10.0 percent for the same period.†
Algorithmic execution U.S. equity share volume from the 25 largest U.S. asset managers rose 28.2 percent year over year.‡ KCG market share of U.S. ETF market volume rose to 13.4 percent for the full year.§
During the course of the year, we rationalized elements of the firm. We sold KCG’s Designated Market Maker (DMM) unit at the NYSE, monetized the firm’s investment in Bats Global Markets, Inc. earlier than expected, and acquired Stockholm-based broker Neonet Securities AB to accelerate our growth strategy in Europe. After a great deal of planning, we consolidated offices in the metropolitan New York City area into new corporate headquarters in the Financial District, joining employees together in one location and reducing total occupied space. And, after a great deal more planning, we initiated a reengineering of the trading architecture.
The reengineering is central to improving KCG’s performance. Operating fewer, better trading systems will allow us to reduce the cost structure and create greater scale. The benefits of maintaining a low expense base are self-evident. Greater scale makes it easier to build out or hire new trading teams. The dual intended effect is to provide for margin expansion by generating new and greater revenues while keeping additive costs to a minimum.
KCG’s financial results for 2016 were disappointing for the stark mid-year divergence in earnings. After a strong start to the year, net revenues declined 41 percent from the first to the second half of 2016 due to the decline in realized intraday volatility in U.S. equities, lower market volumes across asset classes, and a difficult environment for quantitative trading strategies in the period leading up to the U.S. presidential election. The factors disproportionately affected market making in global equities, fixed income and currencies as evident in the results from trading revenues.
The decline in revenues from non-U.S. equity market making is a particular concern. After a review, we shuttered KCG’s principal trading as a market maker in corporate bonds and continue to assess certain other products. We nonetheless believe there is a growing role for financial intermediaries in a range of products with meaningful growth potential. Additionally, the reengineering will potentially improve margins in market making across products.
In terms of expenses, we made further progress in reducing compensation and benefits. The ratio of compensation to net revenues declined to 42.2 percent in 2016 from 48.5 percent in 2015. The decrease is due in part to a reduction in headcount to 952 at year-end 2016 from 1,006 at year-end 2015. Although we expect certain expenses to rise in 2017—specifically communications and data processing and depreciation and amortization—reducing the cost structure remains an imperative.
KCG’s overall financial condition is strong. At year end, KCG held cash and cash equivalents of $632.2 million on the balance sheet and more than 97 percent of all assets measured at fair value were classified as Level 1 assets. During the year, we repurchased $364.7 million in KCG common stock and warrants and, in the process, reduced KCG shares outstanding by 25.5 percent to 67.2 million, including restricted stock units.
With the 45.0 percent reduction in KCG common stock since the merger, we’ve created the potential for greater earnings leverage going forward.
At the current number of shares outstanding, each $25.0 million in net income equates to $0.37 in earnings per share, provided that future share repurchases offset any dilution resulting from the exercise of KCG warrants and stock options. We’re concentrating on ramping up KCG’s earnings power as we move beyond the reengineering of the trading architecture and seek to attain greater balance among market making and agency trading, provided reasonable market conditions.
Further to that, the priorities we’ve set for KCG in 2017 are straightforward.
First, consolidate gains in critical markets. KCG is an important partner to banks, brokers, and asset managers. In addition, we provide supplemental liquidity on all major exchanges. We’re determined to further recent gains made in terms of market share and trade volumes as well as push the development of other still nascent efforts to grow revenues.
Second, reengineer the trading architecture. Parallel efforts are directed at data and simulations, client-facing trading, street-facing trading, and the post-trade environment. Executed methodically through to completion, we expect the initiative to fundamentally transform KCG’s operations by consolidating systems and processes, reducing complexity, and increasing speed to the market.
Third, seek to continue the capital return program. In considering all the potential uses of cash—debt reduction, share repurchases, investments, acquisitions and dividends—the most attractive remains share repurchases given the minimal investment required to develop new efforts and recent trading range of KCG common stock relative to tangible book value. KCG generates roughly $32 to $36 million per quarter in free cash flow, excluding one-time gains and losses.
Among the new regulations we’re watching that may affect the firm, a number are generally agreeable to the KCG model.
Last year, the SEC approved a new rule requiring FINRA members to report transactions in U.S. Treasuries to the industry organization’s Trade Reporting and Compliance Engine (TRACE). While the data will be available only to regulators, we believe the rule to be an initial step toward greater pre- and post-trade transparency for all market participants in the world’s most traded financial instrument.
The Markets in Financial Instruments Directive (MiFID) II contains rules targeting inducements that can potentially deter a firm from acting in the best interests of clients. Included are provisions requiring the separation, or unbundling, of trade commissions from investment research, which will place a greater emphasis on best execution among institutional investors. MiFID II is scheduled to become effective in January 2018.
In addition, the SEC proposed amendments to Rule 605 of Regulation NMS to expand disclosure of standardized data on trade execution to institutional client orders. At present, requirements for disclosure of best execution measures apply only to retail client orders. The proposed amendments call for quarterly disclosure of metrics on institutional orders on an aggregated basis as well as in response to client requests.
At the formation of KCG, we set out to build a firm that would be a leading provider of liquidity and execution services to investors around the world. As we have been building this firm, we have made every effort to return excess cash to stockholders through stock repurchases, which improve tangible book per share and which is expected to improve stockholder leverage when the effort to reengineer the trading architecture is complete. Until this effort is complete and our returns are in the double digits, we will not lose focus on creating shareholder value through aggressively returning capital whenever possible.
We appreciate your continued support and look forward to providing regular updates on progress during the year.
Chief Executive Officer
*Messrs. Kern and Morris are not standing for re-election to the Board of Directors and, as a result, their respective terms will expire upon the election of directors at the KCG 2017 Annual Meeting of Stockholders.
KCG is a leading independent securities firm offering investors a range of services designed to address trading needs across asset classes, product types, and time zones. The firm combines advanced technology with specialized client service across market making, agency execution, and venues and also engages in principal trading via exchange-based market making. KCG has multiple access points to trade global equities, fixed income, options, currencies, and commodities via voice or automated execution. www.kcg.com
KCG Holdings, Inc. provides its offerings through its Market Making, Global Execution Services, and Corporate and Other operating segments. Securities and services are primarily offered by its regulated broker-dealer subsidiary duly registered with, and a member of, the Securities and Exchange Commission (SEC), the Securities Investor Protection Corporation and certain national, regional and foreign exchanges and self-regulatory organizations. For 2016, the Company’s material domestic regulated broker-dealer entity was KCG Americas LLC. Securities and services were also provided by the following entities: GETCO, LLC and Knight Quantitative Trading, LLC. The Company’s material international regulated broker-dealer entity was KCG Europe Limited, authorized and regulated by the FCA.
Unless the context otherwise requires, “KCG,” the “Company,” “We,” or “Our” shall mean KCG Holdings, Inc. and its consolidated subsidiaries.
Certain statements contained in this Annual Report may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are typically identified by words such as “believe,” “expect,” “anticipate,” “intend,” “target,” “estimate,” “continue,” “positions,” “prospects,” or “potential,” by future conditional verbs such as “will,” “would,” “should,” “could” or “may,” or by variations of such words or similar expressions. These “forward looking statements” are not historical facts and are based on current expectations, estimates and projections about KCG's industry, management's beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Any forward-looking statement contained herein speaks only as of the date on which it is made. Accordingly, readers are cautioned that any such forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict including, without limitation, risks associated with: (i) the inability to manage trading strategy performance and grow revenue and earnings; (ii) the receipt of additional payments from the sale of KCG Hotspot that are subject to certain contingencies; (iii) changes in market structure, legislative, regulatory or financial reporting rules, including the increased focus by Congress, federal and state regulators, the self-regulatory organization and the media on market structure issues, and in particular, the scrutiny of high frequency trading, best execution, internalization, alternative trading systems, market fragmentation, colocation, access to market data feeds, and remuneration arrangements such as payment for order flow and exchange fee structures; (iv) past or future changes to KCG's organizational structure and management; (v) KCG's ability to develop competitive new products and services in a timely manner and the acceptance of such products and services by KCG's customers and potential customers; (vi) KCG's ability to keep up with technological changes; (vii) KCG's ability to effectively identify and manage market risk, operational and technology risk, cybersecurity risk, legal risk, liquidity risk, reputational risk, counterparty and credit risk, international risk, regulatory risk, and compliance risk; (viii) the cost and other effects of material contingencies, including litigation contingencies, and any adverse judicial, administrative or arbitral rulings or proceedings; (ix) the effects of increased competition and KCG's ability to maintain and expand market share; and (x) the relocation of KCG's global headquarters from Jersey City, NJ to New York, NY and the migration of its Jersey City, NJ data center operations to other commercial data centers and colocations. The list above is not exhaustive. Because forward looking statements involve risks and uncertainties, the actual results and performance of KCG may materially differ from the results expressed or implied by such statements. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Unless otherwise required by law, KCG also disclaims any obligation to update its view of any such risks or uncertainties or to announce publicly the result of any revisions to the forward-looking statements made herein. Readers should carefully review the risks and uncertainties disclosed in KCG’s reports with the SEC, including those detailed in "Risk Factors" in Part I, Item 1A and elsewhere in the Annual Report on Form 10-K for the year ended December 31, 2016, and in other reports or documents KCG files with, or furnishes to, the SEC from time to time.
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