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WIKI ANALYSIS
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The Investment Technology Group (NYSE: ITG) sells securities trading and analytical software to its clients - usually hedge funds, investment banks, and large brokers.[1][2] Instead of customers contacting brokers to make stock or bond trades, ITG's software lets hedge funds trade themselves. The software is specifically designed to plug into hedge funds' automatic trading algorithms and execute trades at the behest of the funds' software. [3] The firm earns 85% of its revenue through transaction fees and commissions on its customers' trades. ITG's revenue grew by nearly 22% in 2007, thanks to increased commissions from boosted volumes traded.[4]
One of ITG's services involves helping clients access "dark pools", or private trading markets hidden from the public that are designed for liquidity. These pools specifically help investors make block (large) trades outside of traditional markets in order to keep the trade private - trading such quantities of shares on public markets like Nasdaq or NYSE might draw attention, and lead competitors to "front run" the funds' trades, or profit by either buying before the fund finished buying or selling before it finished selling. Because of ITG's client base - hedge funds making massive bets with larger numbers of shares - ITG's dark pools program "POSIT" accounted for 1.5% of the stock shares traded in the U.S. in 2007.[5]
Like most financial companies, interest rates play a key role in ITG operations. In this case, rising interest rates hurt the business as the investing, spending and trading activity of their customers--hedge funds and investment banks (large borrowers)-- move inversely with interest rates. Second, activity in dark pools is on the rise, and ITG stands to benefit as a company that helps clients access such liquidity. Also, limited barriers to entry of the investment technology/brokerage industry helps ITG to compete against traditional powerhouses (NYSE and NASDAQ) with niche products like POSIT. The Group's main competitors offer technology similar to POSIT, which assists customers in making block trades in dark pools. Such programs include the Nyfix Millennium, Pipeline, and Liquidnet.
Corporate Overview As an alternative broker, ITG offers products to simplify and streamline the trading process. One of its main products is POSIT, which manages anonymous block trading. Large buy or sell offers can dramatically shift prices on trading markets. Through POSIT, clients can make big trading offers without releasing any information about the bid. Also, the program maximizes liquidity by providing up-to-date electronic pricing information, allowing trades to be made within pricing spreads. Though launched in the US in 1989, ITG continues to expand its services internationally with POSIT openings in Europe in 1998 and Hong Kong in 2002.[7] POSIT remains a key alternative trading product in the markets, accounting for a 45 million average daily volume in 2Q2008.[8]
ITG revenue and net income reached all time highs over FY2007, thanks to strong industry-wide increases in volume traded. In fact, over FY2007, market volumes for NASDAQ and NYSE increased by 7% and 34% respectively while ITG's expanded by 28%.[4] For 1Q2008, average daily volumes reached a record high 225 million, an increase of 18%, boosting commissions revenue.[9] POSIT volumes also increased by 38% over 4Q2007.[9]
However, 2Q2008 saw ITG revenue ($180 million) rise 3% from 2Q2007 but slip $17 million dollars from the first quarter. Net income dropped 5% from a year ago to 25.7 million. Two key factors caused the slide. First, ITG costs for international operations steeply rose.[3] Also, expenses for data processing and occupancy, costs for which ITG earns no net income, grew faster than revenue.[3]
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Business Segments ITG has hit new revenue all-time highs in the past five years and the past three years have seen net income records as well. The company showed revenue growth of 28% average from 2004-2007.[3]
Key Trends and Forces
Interest rate increases hurt ITG business Interest Rates play a key role in ITG operations. In fiscal years 2006 and 2007, the company had $240.9 and $318.2 million[14], respectively, in interest-rate sensitive investments. In its acquisition of Macgregor and Plexus in 2006, the firm borrowed $200 million[14]. On this loan, ITG hedged against interest rate increases by freezing rates at a little over 5%[14] Rising interest rates reduce borrowing, consumer spending, and investment, especially with investment banks and hedge funds who borrow frequently and in large amounts. When these firms reduce their leverage, spending, and trading, brokerage firms like ITG are hit.
Increases in block trading/dark pool activity benefit ITG operations As of FY2007, ITG's POSIT holds the top spot for block trading algorithm by sheer volume traded. Dark pools account for around 10% of daily US trading volume[15] and is on the rise. As buy-sell spreads get smaller and smaller, the efficiencies of electronic and private trading accordingly increase. Not only do the anonymous and private trading offered by dark pools benefit clients, but the efficiency of increased liquidity allows customers to make small and large trades efficiently. In fact, by 2011, dark pool trading is expected to increase by 4% to 14%[5] as the pools continue to grow. Such growth can only benefit ITG, as POSIT and their other programs top the industry.
Limited barriers of entry to investment technology/brokerage industry benefits ITG Two companies dominate the brokerage and trading industry, the NASDAQ and the NYSE. However, because the industry is not heavily regulated save for minimum credit and insurance, smaller companies are better able to compete with the big two. Though ITG cost-per-transaction (cpt) information was not available, such competition has driven down cpts for rivals, leading to $ 0.002 and $ 0.00025 for NASDAQ and NYSE respectively.[16] However, the lower barriers to entry combined with the two dominant firms have opened the door for niche brokerage and trading companies. In fact, should buy-sell spreads on markets slim, customers may shift to companies who offer innovative and efficient products, like ITG's POSIT. Even though cpts may be more expensive with the smaller firms, products like POSIT allow clients to make more money through techniques such as anonymous block trading. In general, firms like ITG profit through limited barriers to entry combined with innovative brokerage and trading products.
Competition
ITG's main competition comes from opposing electronic trading programs created by companies worldwide, including the Nyfix Millennium, Liquidnet, and Pipeline.
References



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