INSTINET GROUP INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

COMMISSION FILE NUMBER 000-32717

INSTINET GROUP INCORPORATED
(Exact Name of Registrant as Specified in Its Charter)

DELAWARE 13-4134098
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)

3 TIMES SQUARE 10036
NEW YORK, NY (Zip Code)
(Address of Principal Executive Offices)

212-310-9500
(Registrant's Telephone Number, Including Area Code)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment of this
Form 10-K. [ ]

The number of shares of Common Stock outstanding as of March 20, 2002 was
248,738,970 shares. As of March 20, 2002, the aggregate market value of voting
stock held by non-affiliates of the registrant was approximately $272,356,973,
based upon the Nasdaq National Market closing price for such shares on that
date. For purposes of this calculation, the Registrant has assumed that its
directors and executive officers are affiliates.

Portions of the Instinet Group Incorporated Proxy Statement for the 2002
Annual Meeting of Stockholders are incorporated by reference in Part III hereof.

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INSTINET GROUP INCORPORATED

ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

TABLE OF CONTENTS

Unless otherwise indicated or the context otherwise requires, references to
the "company," "we," "us," and "our" mean Instinet Group Incorporated and its
subsidiaries.

We have made forward-looking statements in this Annual Report on Form 10-K
for 2001, including in the sections entitled Business, Certain Factors that May
Affect Our Business, Management's Discussion and Analysis of Financial Condition
and Results of Operations and Quantitative and Qualitative Disclosures about
Market Risk, that are based on our management's beliefs and assumptions and on
information currently available to our management. Forward-looking statements
include information concerning our possible or assumed future results of
operations, business strategies, financing plans, competitive position,
potential growth opportunities and the effects of competition and regulation.
Forward-looking statements include all statements that are not historical facts.
You can identify these statements by the use of forward-looking terminology,
such as the words believes, expects, anticipates, intends, plans, estimates, may
or might or other similar expressions.

Forward-looking statements involve significant risks, uncertainties and
assumptions. Although we believe that the expectations reflected in the
forward-looking statements are reasonable, actual results may differ materially
from those expressed in these forward-looking statements. You should not put
undue reliance on any forward-looking statements. You should understand that
many important factors, in addition to those discussed in the section entitled
Certain Factors that May Affect Our Business and elsewhere in this annual
report, could cause our results to differ materially from those expressed or
suggested in forward-looking statements.

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PART I

ITEM 1. BUSINESS

INTRODUCTION

We are the largest global electronic agency securities broker and have been
providing investors with electronic trading solutions for more than 30 years.
Our services enable buyers and sellers worldwide to trade securities directly
and anonymously with each other, gain price improvement for their trades and
lower their overall trading costs. Through our electronic platforms, our
customers also can access over 40 securities markets throughout the world,
including Nasdaq, the NYSE, and stock exchanges in Frankfurt, Hong Kong, London,
Paris, Sydney, Tokyo, Toronto and Zurich. We also provide our customers with
access to research generated by us and by third parties, as well as various
informational and decision-making tools. Our customers primarily consist of
institutional investors, such as mutual funds, pension funds, insurance
companies and hedge funds, as well as broker-dealers. Our revenues consist
primarily of transaction fees generated by our securities brokerage and related
services. In 2001, we had revenues of $1.5 billion and earned net income of
$144.8 million.

Our global electronic agency securities brokerage business centers almost
exclusively on serving the needs of institutional investors and broker-dealers
in the global markets for equity securities. In the United States, our customers
include approximately 1,000 institutional investors and 720 broker-dealers as of
December 31, 2001. We have operations in Europe and Asia, where we had
approximately 900 customers as of December 31, 2001, and are continuing to grow
our global presence. During 2001, our customers used our systems to execute
106.0 million transactions globally, of which 98.3 million transactions were in
U.S. equity securities. Those U.S. transactions represented approximately 65.9
billion shares of Nasdaq-quoted stocks and 11.0 billion shares of U.S.
exchange-listed stocks. More than 80% of our customers' transactions in U.S.
equity securities using our electronic trading systems were executed within our
internal liquidity pool. We also offer our customers technology (known as
order-routing technology) that directs their equity securities transactions to
either our own liquidity pool or one of the various markets to which we are
connected to obtain better execution. . In addition to our core execution
services, we offer our customers services that enhance their ability to achieve
their trading objectives, including extended hours trading, crossing services,
block trading and portfolio trading, as well as global clearing and settlement
of trades. We are also one of the largest independent providers of research and
other brokerage services through soft dollar or other similar arrangements.

We have built our business on a model that incorporates the following four
core values:

- Independence and Neutrality -- As an agency broker, we do not trade
securities for our own account or maintain inventories of securities for
sale. As a result, unlike exchange specialists, market makers and other
market participants that trade for their own account, we have no direct
interest in, or in maintaining, the trading spread (the difference between
the price offered by a buyer and that asked by a seller) in the Nasdaq
market or on an exchange. We avoid conflicts with our customers that
interfere with their obtaining better pricing for their trades.

- Anonymity -- Our systems do not require the identity of the ultimate
buyer or seller to be disclosed to the counterparty or other market
participants at any point in the trading process. We believe that
anonymous trading can reduce the potential market impact of large
transactions and transactions by certain investors whose trading activity,
if known, may be more likely to influence other market activity, and may
contribute to improved pricing for our customers.

- Equal and Direct Access -- We provide all of our customers, without
regard to their size or volume of trading, with equal and direct access to
markets. Direct market access can increase the speed at which trades are
executed and level the playing field among market participants. This
enhanced market access also allows our customers to have available
real-time information on the demand for and supply of one or more
securities, a concept commonly referred to as transparency.

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- Customer Empowerment -- We use and develop, and may acquire, technology
to empower our customers to achieve their trading objectives. Our trading
services and tools give our customers flexibility in choosing their level
of direct participation in carrying out their trades.

As a result of these core values, we believe that we provide our customers
with valuable benefits that help them achieve their trading objectives at
reduced costs and with greater speed and efficiency.

While our global institutional equities business continues to be our core
business, we have developed several other services. Our global electronic
platform for trading fixed income securities provided brokerage and execution
services to approximately 115 banks and broker-dealers as of December 31, 2001.
We also provide correspondent clearing services to a few securities brokers in
the United States.

In an effort to expand the scope of our business and complement our
existing services, in recent years, we have acquired a number of companies. In
October 1999, we acquired Montag Popper & Partner GmbH, a German fixed income
voice broker. In February 2000, we acquired Lynch, Jones & Ryan, a leading
provider of specialized brokerage, research and commission recapture services to
pension plan sponsors and managers. In October 2001, we acquired ProTrader
Group, L.P., a provider of advanced trading technologies and electronic
brokerage services.

We were founded in 1969 and, although continuously headquartered in New
York since then, were a wholly owned subsidiary of Reuters Group PLC from May
1987 until our initial public offering in May 2001. Reuters currently owns
approximately 83.3% of our outstanding common stock. We opened a London office
in 1988 and currently also have offices in Frankfurt, Hong Kong, Paris, Tokyo,
Toronto and Zurich.

INDUSTRY BACKGROUND

GROWTH IN EQUITY TRADING VOLUME

Over the past decade, the volume of trading in the world's major stock
markets has grown dramatically. For example, from January 1, 1991 to December
31, 2001, average daily trading volume in the Nasdaq market increased at a
compound annual rate of 25% from 162.9 million shares to 1.9 billion shares,
while on U.S. exchanges, average daily trading volume increased at a compound
annual rate of 20%, from 189.0 million shares to 1.5 billion shares. In 2001,
this growth rate has slowed and there was significant volatility in the U.S.
markets over the year.

This overall growth in volumes over the past decade was due to a number of
factors, including strong economic conditions and increased issuances of equity
securities in the United States and record high returns in U.S. equity markets
through much of the period. Favorable market conditions had increasingly allowed
companies to raise capital through initial public offerings, resulting in
significant growth in the overall NYSE and Nasdaq market capitalization from
approximately $3.7 trillion and $521.4 billion, respectively, as of December 31,
1991 to approximately $11.7 trillion and $2.9 trillion, respectively, as of
December 31, 2001, despite a decrease in the overall NYSE and Nasdaq market
capitalization from 2000 to 2001. Increased personal wealth and disposable
income, greater availability of self-directed investment programs (including
employer-sponsored programs) and a trend towards more self-directed individual
investing had all contributed to increased public interest in investing in
equity securities. This trend resulted in a greater allocation of investment
funds to equity securities which increased trading volume. In addition,
technological innovation, including the emergence of the Internet and market
acceptance of electronic brokers, reduced transaction costs and further
stimulated trading activity. The decline in the growth rate and volatility of
U.S. market volumes in 2001 was due to a number of factors including a weakened
and uncertain economic climate (which was exacerbated by the events of September
11th), reduced capital raising activities and increased unemployment rates.

The overall growth in non-U.S. markets has paralleled that of the U.S.
markets in the past decade and continues to grow. From January 1, 1996 to
December 31, 2001, average daily trading volume on the London Stock Exchange
increased from 870.2 million shares to 2.3 billion shares, and on the Tokyo
Stock Exchange from approximately 405 million shares to 829 million shares. A
number of factors have contributed to this growth, including increased
availability of market information, a growing trend toward public (rather than
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governmental) ownership of companies in Europe and Asia, greater access to
equity investing and advances in trading technology. Additionally, growing
interest in the opportunities available in global markets, as well as a
heightened focus on diversification, have also resulted in increased
cross-border trading.

U.S. MARKET STRUCTURE

Until 1968, stock markets operated primarily in a physical
environment -- on a trading floor -- through an auction conducted by open
outcry. The NYSE continues to operate an auction system on a physical trading
floor, with orders for each listed stock being routed on the floor of the
exchange, either electronically or physically, to a designated dealer, known as
a specialist. In 1971, the Nasdaq system, a new electronic marketplace without a
physical trading floor, was introduced as an outgrowth of the traditional and
inefficient telephone-based over-the-counter market. Nasdaq dealers, known as
market makers, are linked together via a screen-based electronic communications
system, known as the Nasdaq quote montage.

While both of these trading markets have accommodated historical trading
patterns and volumes, they have substantial shortcomings, the most significant
of which is limited access. Neither market enables buyers and sellers to deal
directly with each other. Instead, trading is conducted indirectly through
intermediaries -- the specialists, in the case of the NYSE, and the market
makers, in the case of Nasdaq. Access to these intermediaries is further
restricted. For example, in the case of the NYSE, only a member owning a "seat"
on the exchange (or a brokerage firm to which that member has granted the use of
his seat) may trade with or through a specialist. Until 1997, when the SEC
adopted its Nasdaq order handling rules, only market makers had access to the
Nasdaq quote montage. In some cases, investors access a NYSE member firm or
Nasdaq market maker through the intervention of yet another securities brokerage
firm. Indirect access reduces the speed with which a desired trade is executed.
In some cases, this delay may prevent an investor from trading at the last
published price of which the investor had knowledge when placing an order for
the trade. In addition, an investor with indirect access often has more limited
pricing information than others with direct access (such as market makers or the
specialists). An SEC report issued in January 2001 determined that indirect
access and market fragmentation were primary causes for the longer execution
times and significantly larger effective and realized spreads in Nasdaq-quoted
stocks than those in NYSE-listed stocks. Market fragmentation refers to a market
environment in which prices are determined and orders are executed in a number
of different places (physical or electronic) rather than a single place.

Other shortcomings are also apparent. Paper or telephone-based trading,
which continues to be used where access to electronic systems is limited, also
reduces the speed of execution and increases potential for errors and disputes.
These factors lead to increased costs and market and execution risk for both
broker-dealers and traders. Sophisticated trading strategies, such as those
involving the execution of trades in more than one security or using multiple
types of financial instruments, are particularly difficult to accomplish without
rapid, direct and anonymous electronic market access.

Regulatory and technological developments over the past five years have led
to gradual increases in competition for trading shares that are listed on the
NYSE or quoted on Nasdaq. Alternative methods of trading NYSE-listed stocks by
non-NYSE members without recourse to the exchange trading floor -- the so-
called third market -- have emerged alongside the traditional structure of the
NYSE. Off-exchange trading by all broker-dealers, including NYSE members and
member firms, has been permitted in those stocks listed or traded on the NYSE
after April 26, 1979. In May 2000, the NYSE rescinded its Rule 390, which had
required all NYSE members and member firms to execute transactions in stocks
listed or traded on or before April 26, 1979, only on the floor of the NYSE,
subject to some exceptions. Because these stocks accounted for approximately 50%
of average daily trading volume in 2001, the abolition of Rule 390 may
eventually lead to increased competition in trading NYSE-listed stocks that were
previously subject to the rule. See also "-- Regulation."

Competition has also developed for trading in Nasdaq-quoted stocks. Most
significantly, in 1997, the SEC's order handling rules for market makers and
exchange specialists took effect. These rules provided a specified role for
ECNs, or electronic systems that widely disseminate to third parties orders
entered into them by a market maker or specialist and permit execution of those
orders against each other. The order handling

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rules deal specifically with the processing of limit orders, which are orders
with an associated limit price above which a buyer, or below which a seller,
will not trade. In particular, the rules prohibit a market maker or exchange
specialist from displaying its own limit order for a security through an ECN at
a more favorable price than its published quote unless the ECN publishes its
best-priced market maker and exchange specialist orders in that security and
permits execution against those orders through Nasdaq. Similarly, a market maker
that receives a limit order better than its own published quote, must generally
either execute the order, incorporate the limit order price into its published
quote or pass the order on to an ECN for public display and execution access.

The emergence of ECNs and later ATSs -- a term that refers generally to all
systems, including ECNs, that bring together the orders of buyers and sellers of
securities through automated means -- has provided efficient means of access to
market centers and has resulted in a shift in liquidity, or trading activity,
from the major established market centers to the ATSs. According to Nasdaq, ECNs
alone accounted for 30.9% of the total Nasdaq trade volume in 2001.

Following the adoption of the order handling rules, in 1998 the SEC adopted
Regulation ATS, which regulates the operation of ATSs (including all recognized
ECNs) registered as broker-dealers. ATSs may register as national securities
exchanges. To date, two ATSs have applications pending for exchange status, and
one ATS has already been approved to serve as a facility of an exchange. With
exchange status, an ATS gains direct access to the National Market System and
the Intermarket Trading System, enabling it to publicly display orders in U.S.
exchange-listed stocks and make those orders available for execution. As an
exchange, an ATS also becomes a self-regulatory organization, no longer subject
to NASD regulation.

Recently, the NASD has implemented or proposed a number of rule changes for
the Nasdaq market that move Nasdaq from a quote-driven display system to an
order-driven execution system that will directly compete with ECNs. First, in
part as a reaction to the growing competitive pressures from ECNs, in July 2001,
the NASD implemented SuperSoes as its new platform for the trading of the most
widely held Nasdaq-quoted stocks (Nasdaq National Market stocks). SuperSoes
substantially expanded the functionality of SOES -- Nasdaq's existing small
order execution system available only for small orders from public
customers -- by incorporating many features common among ECNs, as well as
improving the speed of order execution. In addition, unlike SOES, SuperSoes may
be used by market makers when trading for their own accounts. Full participation
in SuperSoes is mandatory for all market makers in any SuperSoes-eligible
securities in which they make markets. We believe a number of SuperSoes'
features disadvantage ECNs with significant internal liquidity pools, so that
only one ECN to date has chosen to participate in SuperSoes both for order-entry
and for display of its best-priced orders in the Nasdaq market ("full"
participation), with the remainder choosing instead order-entry only
participation. Without full participation in SuperSoes, ECNs must rely on
SelectNet to display and provide access to their customers' orders in the Nasdaq
market. (SelectNet is an older order delivery and negotiation system that
electronically facilitates, but does not automatically provide, order
executions.) In addition, SuperSoes' pricing structure is disadvantageous to
order-entry only participants. SuperSoes, in light of its features and
functionality, may have shifted, and may continue to shift, some order flow away
from ECNs.

Second, on January 10, 2001, the SEC approved the NASD's rules changes
creating a new trading platform for the Nasdaq market, known as SuperMontage.
These new rules will significantly change the way the Nasdaq market operates,
including changing the information displayed on, and the method of operation of,
the Nasdaq quote montage. The new structure will combine a computer display
containing more bid and offer information about trading interest in individual
Nasdaq-quoted stocks than is currently displayed, together with new rules
establishing the execution priority of quotes and orders submitted to Nasdaq.
Nasdaq has announced that it expects to implement this structure beginning
around the third quarter of 2002. The NASD rules as approved by the SEC were
significantly modified, and we believe improved, from the proposals previously
submitted by the NASD. The SEC conditioned its approval of the SuperMontage
proposal on the NASD establishing an alternative facility that market makers and
ECNs can use to meet their order display obligations. The SEC is also
considering making non-exclusive Nasdaq's role as a collector and distributor of
data (known as a securities information processor) regarding quotations in
Nasdaq-quoted stocks. Nasdaq's current role as the exclusive information
processor gives it financial and other competitive advantages.
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In addition, Nasdaq is in the process of becoming a for-profit exchange,
independent from the NASD. On March 15, 2001, Nasdaq submitted its application
for registration as a national securities exchange to the SEC. By operating as
an exchange with SuperMontage as its trading platform, Nasdaq is continuing to
evolve as a direct competitor of ATSs. Nasdaq is currently considering the fee
structure it would introduce as an independent, for-profit exchange. We are
unable to predict what fee changes Nasdaq might propose or eventually implement,
but Nasdaq's fee structure may have a significant impact on the competitive
landscape for ECNs.

The SEC has noted that even if Nasdaq gains status as an exchange, the NASD
will continue to be required to collect bids, offers and quotation sizes for
parties seeking to trade U.S. exchange-listed stocks -- which would then include
Nasdaq stocks -- other than on an exchange. As a result, the SEC has indicated
that the NASD must have an alternative display facility (ADF) operational by the
time Nasdaq is granted exchange status. Accordingly, on December 7, 2001, the
NASD submitted to the SEC proposed changes to the NASD's rules to reflect
Nasdaq's anticipated approval as an exchange, its resultant separation from the
NASD and the creation of an ADF. The NASD has indicated that in creating the
ADF, it intends to provide a facility that will display quotes and collect trade
data, while keeping its obligations to operate a market to a minimum. Other than
providing access to the Intermarket Trading System -- a system that links market
centers that trade U.S. exchange listed equity securities, the NASD's proposed
ADF would not provide for order execution or routing services, so that ADF
market participants themselves would be required to provide NASD member
broker-dealers with electronic access, either directly or indirectly, to their
quotations. It is unclear when and in what form the ADF might be implemented and
whether the ADF, as currently contemplated, would prove to be a viable
marketplace. For a further discussion of SuperSoes, SuperMontage and the NASD's
proposed ADF, see "-- Regulation" and "Certain Factors that May Affect Our
Business -- We Operate in a Highly Regulated Industry and Regulatory Changes
Could Adversely Affect Our Business."

The introduction of decimalization in April 2001 -- the quoting of stock
prices in dollars and cents rather than in dollars and fractions of a dollar
(such as 1/8 or 1/16) -- has also had an impact on the U.S. securities markets
and increased competition for ATSs. Decimalization may assist investors in
obtaining price improvement because improvement in smaller increments is
possible. Because decimalization narrows the average trading spreads, it has had
a significant negative impact on the profitability of traditional broker-
dealers. As a result, some market makers are moving from a business model in
which they trade as principal for their own account to an agency business model.
The SEC's recently expanded interpretation of Section 28(e) of the Exchange Act
allowing institutional investors to obtain soft dollar credits from certain
transactions executed through broker-dealers on a "riskless" principal basis,
rather than only on an agency basis, may further encourage this trend.
Decimalization has also caused traditional broker-dealers to execute their
customers' orders internally rather than route them to external market centers
for execution, because the additional price risk they incur to fill orders
internally has decreased to as little as a penny a share.

IMPACT OF TECHNOLOGICAL DEVELOPMENTS

Innovations in technology, particularly the growth of the Internet, have
increased the speed of communications and the availability of information,
facilitated the globalization of commerce, and simultaneously decreased the cost
of electronic commerce. New methods have developed to enable institutional
investors to access and participate in the equity securities markets more easily
and less expensively. Electronic markets have substantially reduced the need for
intermediation, such as by NYSE members and NYSE specialists or Nasdaq market
makers, because direct access is effectively unlimited and technology enhances
the ability to determine the best price at which a trade can be executed. These
developments, combined with the regulatory changes discussed above that allowed
for the emergence of ATSs, have led to dramatic growth in electronic trading and
provide us with significant opportunities.

Technological developments have also affected investing by individuals.
Technological advances have created new and inexpensive means for individual
investors to access markets directly on-line. As technology continues to improve
and regulatory and customer scrutiny of execution and trading services
intensifies, we believe that individual investors will increasingly demand
institutional-quality services.

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INTERNATIONAL SECURITIES MARKETS

Until the early 1990s, equity markets outside the United States were
generally less developed than those in the United States, with relatively low
trading volumes and less advanced trading systems. Thereafter, technological and
regulatory changes, other competitive pressures, and increased globalization
contributed to increasing trading activity and major structural changes in the
established European exchanges, which generally moved to an electronic model. In
this model, an electronic system receives and matches orders that are routed
through the system. Intermediaries provide execution services to their customers
primarily by providing connectivity to the exchange system. In addition, in
Europe there has been an increasing trend towards consolidation of exchanges,
encouraged by technology and the adoption of the euro. We believe that while
economic and financial difficulties and disruptions in Asia since 1997 have made
trends in Asian securities markets less predictable, similar competitive,
demographic and technological developments will lead over time to an evolution
in Asia comparable to that in Europe over the last decade.

FIXED INCOME MARKETS

The markets for fixed income securities are among the largest in the world.
According to the Bank for International Settlements quarterly review issued in
December 2001, approximately $29.5 trillion of fixed income securities were
outstanding as of June 30, 2001, representing $14.8 trillion of U.S. fixed
income securities and $14.7 trillion of non-U.S. fixed income securities. In
addition, approximately $300 billion of U.S. government securities are traded
among primary dealers and investors each day. In Europe, the introduction of the
euro has created a single fixed income securities market which, together with
the United States and Japan, make up the three largest markets in the world in
terms of size.

The fixed income markets are far less transparent than the equity markets.
Less information is available to investors regarding supply and demand, pricing
and trading volume. General acceptance of electronic fixed income trading
platforms has varied considerably across the markets and among the different
fixed income instruments.

OUR COMPETITIVE STRENGTHS

WE ARE A MARKET LEADER WITH STRONG BRAND AWARENESS

We pioneered an electronic screen-based trading system and have been
providing investors with electronic trading solutions for more than 30 years. We
have been a market leader in the trading of Nasdaq-quoted stocks for many years
and accounted for 14.0% of the total trading volume in that market in 2001. For
an explanation of how we calculate our trading volumes, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations -- Key
Statistical Information -- Nasdaq Volume Calculations." Our substantial share
trading volume, particularly in Nasdaq-quoted stocks, attracts significant
customer attention and order flow. CNBC and CNNfn broadcast live daily from our
sales trading centers in the pre-and post-market hours. As a result, we have
strong name and brand recognition among institutional investors.

WE DELIVER COMPELLING BENEFITS TO OUR CUSTOMERS

We believe that our core values of independence and neutrality, anonymity,
equal and direct access and customer empowerment enable our customers to obtain
superior execution of their trades, including better pricing and reduced
transaction costs than are generally achievable using traditional trading
channels. For example, we believe that one of the biggest concerns of
institutional investors in securities trading today is the market impact of the
disclosure of their identity and trading intentions. Customers, therefore, often
seek to break up orders to hide their overall intentions, but if the market
becomes aware of a large investor seeking to sell securities, the price of those
securities may drop before the investor's position can be fully liquidated.
Similarly, market awareness of a large investor seeking to buy a large amount of
securities may result in an increase in the price of the securities before the
order can be fully executed. By allowing our customers to trade directly but
anonymously, we reduce the potential for this market impact, which we believe
can result in better pricing for the customer.
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We believe that we allow our customers to obtain significant price
improvement and reduced transaction costs in executing their trades. In a report
published in January 2002 based on data for the 12 months ended September 30,
2001, Plexus Group, an independent market research group, ranked Instinet first
in execution quality in Nasdaq-listed stocks when compared to a universe of the
12 most-active full-service brokers for which Plexus has data. Instinet also
tied for first in execution quality in U.S. exchange-listed stocks when compared
to the same universe of brokers.

WE OFFER A BROAD RANGE OF SERVICES

As an electronic agency broker, in addition to trade execution, we offer
our customers a wide variety of other services. Companies acting solely as ECNs
are generally limited to small order electronic execution and order routing. Our
broader business model extends beyond these functions, and we provide service
offerings tailored to our customers' diverse trading needs. These service
offerings include a variety of trading services, research, and clearing and
settlement, all of which add value for our customers. For example, we provide
services such as:

- simultaneous execution of multiple orders of securities (known as
portfolio trading);

- trading of large orders (referred to as block trading);

- automatically matching orders at specified levels (known as crossing);

- extended hours trading;

- technical assistance to customers in inputting orders; and

- managing the execution of orders for customers over time (often referred
to as working orders).

We also are one of the largest global independent providers of research and
other brokerage services through soft dollars or other similar arrangements.

WE OPERATE GLOBALLY

Our customers use our systems to trade securities in over 30 non-U.S.
securities markets, and we are members of 9 non-U.S. exchanges. As of December
31, 2001, approximately 750 customers in Europe and approximately 150 customers
in Asia had access to the INSTINET(R) trading system. The number of transactions
in non-U.S. equity securities executed through our systems has grown from
approximately 0.3 million transactions in 1996 to 7.7 million transactions in
2001.

In addition, we are a substantial independent provider of research and
other brokerage services through soft dollar and similar arrangements outside
the United States, and we offer a fixed income platform in Europe. We led, and
are the largest investor in, the consortium that owns 38.9% of virt-x, an
electronic order-driven equities market for pan-European securities.

WE HAVE A PROVEN ABILITY TO INNOVATE AND ADAPT

Throughout our 30-year history, we have been an innovator in using
technology to enhance securities trading, have seized market opportunities and
have adapted to numerous changes in our operating and regulatory environment
while continuing to grow. Some of our most significant developments include the
following:

- At a time when most investors were paying fixed commissions to trade in
NYSE-listed stocks, we pioneered an electronic screen-based trading
system that allowed customers to trade without paying fixed commissions.

- After the abolition of fixed commissions in 1975 placed significant price
pressure on our business, we established the first service to display
real-time information showing NYSE and regional exchange quotes together
on an electronic screen and provided our customers direct access to trade
NYSE-listed or regional exchange-listed stocks through the regional
exchanges.

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- In 1984, we created an electronic marketplace in which market makers and
institutional investors could trade directly among themselves and obtain
automated execution of trades inside the publicly quoted spreads for
those stocks. In 1989, we enhanced this service by enabling our customers
to interact and trade anonymously on our system.

- In the late 1990s, we adapted to cost and pricing pressures in our
equities business, to the introduction of the SEC's order handling rules,
which substantially changed activity for Nasdaq participants, and to the
adoption by the SEC of Regulation ATS, which imposed new requirements on
our activities. We enhanced and modified our services, lowered our prices
and changed our cost structure to adjust to these changes in our
operating environment.

- In response to the increasing volumes in cross-border trading and the
fragmentation of securities markets, we offered our customers ways to
access multiple liquidity pools. We introduced the first integrated
electronic trading platform to permit direct electronic access to
equities markets across Europe, together with facilities to negotiate and
trade directly and anonymously with other customers.

- We introduced one of the first order management tools that allowed
customers to manage, deliver and execute baskets of securities in the
Nasdaq market. We also introduced tools that allow customers to use our
technology to enter alternative pricing for trades (commonly referred to
as discretionary pricing) or for alternative trade sizes (commonly
referred to as reserve book features), which had in the past required a
high degree of manual intervention.

- We have been an innovator in developing extended hours trading and
crossing capabilities starting in 1995 and 1986, respectively. These new
services responded to globalization and continuous availability of
information about markets and issuers, and the resulting demand by
investors to trade equity securities after traditional exchanges and
markets are closed.

WE HAVE AN ESTABLISHED TECHNOLOGY INFRASTRUCTURE

We developed one of the earliest electronic businesses in any field of
commerce and introduced the first screen-based system through which
institutional investors could trade Nasdaq-quoted stocks directly with each
other. Our technology enables all of our customers to access the liquidity pool
within our own electronic trading system in order to trade these securities with
one another. In addition, our customers can use our electronic platforms to
connect to other markets in order to trade indirectly with other participants in
those markets. We believe that our ability to use technology effectively to
improve our services has been a key component in the development of our
business.

OUR STRATEGY

We are focused on using technology to deliver services that empower our
customers to reduce their total transaction costs, gain price improvement on
their trades and better achieve their trading objectives. Our objective is to
take advantage of growth opportunities that are arising in the securities
industry as a result of changing technology, regulation and market demands. We
believe that our strong global competitive position, breadth and scale of
operations, unique business model, and proven ability to innovate and use
technology give us an advantage in this pursuit. We also continue to explore
ways to take advantage of the synergies between us and Reuters, as well as our
respective capabilities, as part of our effort to provide value-added products
and services to our customers in a cost effective manner.

The principal elements of our strategy include the following:

Extend our global brokerage offering. We intend to continue to develop our
global agency brokerage business by aligning our existing resources and focusing
our initiatives on developing products and services tailored to our various
customer categories, based upon our customers' specific needs and their diverse
business models. These services include portfolio trading, block trading,
crossing, enhanced technology and research. We believe these services will
enable our customers to improve their execution performance. We are also
increasing our focus on our soft dollar and plan sponsor service programs, as
part of our efforts to enhance our global brokerage offering.
9

We believe that international markets offer a significant growth
opportunity for our institutional equities business. We are expanding our
European equities business, introducing services that add value for our
customers, while managing our costs to allow us to respond to anticipated future
pricing pressure. We are also continuing to develop our Asian institutional
equities business. In addition, international markets present high potential
growth for our fixed income business. We are continuing to focus our fixed
income securities activities on the specific needs of our existing customer
base. We are also exploring possible alliances and expansion opportunities in
the United States, Europe and Asia to further develop our customer base and our
capabilities for fixed income trading. For example, we are currently negotiating
with two major banks that, subject to the signing of definitive agreements, we
expect will provide liquidity and product support to our fixed income
activities. In return, the banks would have the right to acquire an ownership
stake in the fixed income broker-dealer operations that are presently 100% owned
by us. We are also continuing to evaluate our fixed income business and explore
various strategic options.

Maintain and expand our Nasdaq liquidity pool. At the same time we
continue to develop our global agency brokerage business, we intend to maintain
and expand our Nasdaq liquidity pool. Recently, we have experienced a decline in
our Nasdaq market share, primarily due to lower volumes from our broker-dealer
customers. As a result, in September 2001, we reduced our pricing, implementing
a new pricing schedule for our U.S. broker-dealer customers, and adjusted
certain pre-set volume levels at which we offer those customers lower per share
transaction fees and also established a pilot program to test pricing incentives
for liquidity providers. In March 2002, we aggressively reduced pricing,
implementing a new pricing plan to offer further pricing incentives to our U.S.
broker-dealer customers, reducing prices paid by broker-dealers trading
Nasdaq-quoted stocks by approximately 60% and simplifying the pricing schedule
by adjusting certain pre-set volume levels at which we offer those customers
lower per share transaction fees. We expect these pricing initiatives will
result in better executions for all of our customers. In anticipation of the
impact of price reductions on our revenue from U.S. broker-dealer customers, we
have taken action to reduce costs, including the cutback of staff levels in a
number of areas, and we continue to evaluate further cost initiatives. We are
also continuing to improve our integration with our customers' trading systems.
We expect that focusing on increasing liquidity, improving system and network
efficiencies and implementing our cost reduction program will enable us to
maintain and expand our Nasdaq liquidity pool.

Continue to enhance our technology. We plan to continue to improve our
technology by offering new trading products and functionality both to provide
improved services and to contain costs. Recently, we introduced smart
order-routing technology for trading in Nasdaq-quoted stocks, which provides our
customers with enhanced order execution capabilities. We are also developing a
new, more flexible platform for our communications with, and connections to, our
customers. We have introduced new trading functionality to improve our
customers' performance and efficiency when executing large, complex orders. In
addition, we have developed and are currently testing two new products to
enhance execution quality, both in U.S. equities and in overseas markets, and to
improve our customers' investment and trading performance. The first product,
based on the technology we acquired through our acquisition of ProTrader, is a
trading application, aimed primarily at active fund managers and hedge funds,
which will enable us to enhance our customer interface and order-routing
technology. The second product is a new program trading application that we have
developed in conjunction with passive and quantitative fund managers in the
United States and Europe which will enhance our customers' ability to execute
transactions involving multiple stocks, such as baskets and portfolios of
stocks -- commonly referred to as portfolio trade transactions -- in global
markets.

Pursue select acquisitions and strategic alliances. We plan to continue to
supplement our internal growth through select acquisitions of businesses or
technologies that will enable us to strengthen our current businesses, enter new
markets, provide services that we do not currently offer or advance our
technology. We will also continue to enter into strategic alliances and make
further strategic investments in companies that we believe are well-positioned
to capitalize on potential changes in the industry. As a result, we engage in
discussions on a regular basis regarding various types of transactions,
including possible acquisitions or investments, some of which could be material
to us. We may agree to pay the consideration in connection with a transaction in
cash, our securities or some combination of the two. Some acquisition
transactions that involve our securities could have a dilutive effect on our
earnings per share. It is also possible that the number

10

of shares of our common stock that may be issued in connection with a
transaction could constitute a material portion of our then outstanding common
stock not held by Reuters, even if not material compared to the total amount of
common stock outstanding. See "Certain Factors that May Affect Our
Business -- Future Sales of Our Shares Could Adversely Affect the Market Price
of Our Common Stock." At present, we have no agreements or understandings for
any material acquisitions or investments.

OUR BUSINESS

OUR GLOBAL INSTITUTIONAL EQUITIES BUSINESS

We offer our customers a broad range of trade, execution and ancillary
services, enabling them to trade equity securities directly with each other
through our platform, as well as with other investors in over 40 securities
markets throughout the world. The size, nature and geographic distribution of
our customers have generated a distinct pool of liquidity on our electronic
platform. We also offer our customers order-routing technology that directs
their equity transactions among the various markets to which we are connected to
obtain better execution. On a worldwide basis, in 2001, our customers used our
platform to complete a total of 106.0 million transactions, representing an
average of approximately 427,500 transactions each trading day.

We are one of the largest ATSs participating in Nasdaq. We accounted for
14.0% of the total trading volume in Nasdaq-quoted stocks during 2001 (although
that figure fluctuated significantly during the year). Our average daily trading
volume in Nasdaq-quoted stocks has increased at a compound annual rate of 25%
from 85.7 million shares in 1996 to 265.7 million shares in 2001. For an
explanation of how we calculate our Nasdaq trading volumes, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations -- Key
Statistical Information -- Nasdaq Volume Calculations."

Our share of the total trading volume in U.S. exchange-listed stocks has
increased from 1.8% in 1996 to 3.1% in 2001. Our average daily trading volume in
U.S. exchange-listed stocks increased during that period at a compound annual
rate of 39% from 8.7 million shares in 1996 to 44.4 million shares in 2001. Our
transactions in non-U.S. stocks during that period increased from approximately
0.3 million transactions in 1996 to 7.7 million transactions in 2001,
representing a compound annual growth rate of 95%.

Customers

Institutional investors (including mutual funds, hedge funds, pension
funds, banks, insurance companies and investment portfolio managers) and market
professionals (broker-dealers, including Nasdaq market makers) are the core of
our customer base. We provide our equities trading services to approximately
2,600 customers, of which approximately 750 are in Europe and 150 are in Asia.
In the United States, our customers include approximately 1,000 institutional
investors and 720 broker-dealers.

Our customers fall into the following broad categories:

Institutional Investors:

- ACTIVE INSTITUTIONS, which generally include mutual funds and asset
managers that make stock specific equity investment decisions based on
fundamental company research;

- PASSIVE AND QUANTITATIVE INSTITUTIONS, which include mutual funds and
asset managers with a passive or quantitative approach to investing;

- PLAN SPONSORS, which generally include pension fund managers; and

- HEDGE FUNDS.

11

Market Professionals:

- MARKET MAKERS, which include broker-dealers and agency traders;

- DIRECT ACCESS, which includes smaller institutions and professional
non-institutional traders who seek to manage their own trading activity
by accessing the markets directly instead of through market professionals
or institutional investors; and

- PROGRAM DRIVEN TRADERS, which include customers who execute a variety of
arbitrage strategies and use automated computer processes to trade.

We have developed and are continuing to develop product and service
offerings tailored to these customer categories, based upon their specific
needs. Due to the diverse business models of our customers, some of our
customers may fall into several of these categories. In this case, we provide
our tailored services to each aspect of the customer's business model, rather
than assigning the customer to one particular category. We believe that by
offering our customers a tailored package of value-added services and
functionality, together with anonymous trading, access to our liquidity pool and
connections to other trading platforms, we can enhance our customers' ability to
achieve their trading objectives in this complex economic environment.

Services

We offer our customers a broad range of trade execution and other services
including the following:

Core Execution Services. We enable our customers to view market
information and execute trades directly with each other over our electronic
platform, and to trade with other investors in over 40 securities markets
worldwide. Direct trading between our customers over our platform creates a deep
liquidity pool, in particular for Nasdaq-quoted stocks and exchange-traded funds
(an index fund representing a basket of stocks that trades on the exchange, with
pricing throughout the day). Customers can also access market makers or other
ECNs through us using our smart order-routing technology. Our recently
introduced automated market interaction system automatically routes our
customers' transactions in Nasdaq-quoted stocks to either our own liquidity pool
or one of the various markets to which we are connected to obtain better
execution.

In the case of stocks listed on the NYSE or any other exchange, we
primarily provide connections to the exchange and, in the case of the NYSE, the
specialist for each listed stock, although our customers can trade directly with
each other over our platform.

For non-U.S. securities that are not traded in U.S. markets, although our
customers can trade directly with each other over our platform, we primarily
provide direct connections to the principal non-U.S. exchanges on which those
securities are listed. We are members of 9 non-U.S. exchanges and provide our
customers with direct access to those exchanges to execute their trades. For
more than 20 additional non-U.S. markets, we provide access through local
exchange members, with which some of whom we have clearing arrangements.

Negotiating Orders. Our technology allows our customers to communicate
anonymously both with all customers and with specific customers who have placed
an order. As a result, customers can determine whether there is interest by
another customer in a potential transaction and negotiate the volume and price
of that transaction, all directly and anonymously through our system, without
requiring any intermediation from anyone or displaying any of the communications
or negotiations to other customers. This capability facilitates the execution of
large orders and also allows customers to manage the delivery and execution of
their orders by themselves to minimize the market impact of a large order and
obtain price improvement. We have recently introduced new trading functionality
to improve our customers' performance and efficiency when executing these large,
complex orders.

Sales Trading Assistance. We have a dedicated group of sales and trading
professionals who provide our customers with various types of sales and trading
assistance. They provide technical assistance in the use of our screen-based
trading system. Customers can also place orders by telephone with our sales and
trading professionals, who enter the orders into our system on the customers'
behalf. These professionals can also work orders to manage the execution of a
large order over time for a customer to attempt to reduce the market
12

impact and achieve price improvement. For example, they may divide a large order
into a series of smaller orders that are entered over a period of time, possibly
at different prices. In addition, a dedicated team of sales and trading
professionals is available to assist our customers with their portfolio trading.

As of December 31, 2001, we had 344 sales and trading professionals, of
which 184 were located in North America, 124 in Europe and 36 in Asia. In
Europe, for those areas where we do not have a local presence, our sales traders
in London are responsible for providing brokerage services to those customers
and coverage of those markets. Recently, we streamlined our local presence
coverage in Europe, centralizing more of our European brokerage services in
London. London also has a specialized desk to service European portfolio
traders. In Asia, we provide coverage of our Japanese customers and the Japanese
market through our Tokyo office, with the remainder of Asia and Australia
serviced through our Hong Kong office. We also have coverage in each of our
offices in the United States, Canada, Europe and Asia to assist customers who
wish to place orders in a different region (for example, a European
institutional investor seeking to trade a U.S. or Japanese equity security).
These cross-region trades are also covered by our sales and trading
professionals for that market, thereby affording our customers in other regions
access to local market expertise. Because we have offices worldwide, we also are
able to provide sales and trading assistance to our customers 24 hours a day
without requiring additional sales and trading professionals to be staffed in
any one office on a continuous basis throughout the day.

Extended Hours Trading. Our customers can input orders for a security and
execute the trade with other customers in our liquidity pool before, during and
after normal market hours. This service has allowed us to expand globally to
include customers and markets in Europe and Asia, whose trading hours do not
coincide with those in the United States. It also permits us to make the
liquidity pool generated by our customers available on a 24-hour basis. Extended
hours trading has been a particularly important innovation for our customers
when material information about a market or company is released or reported
after that market or the principal market for that company's securities is
closed. When a pre- or post-market, price-moving event occurs, market
participants can interact directly at their election to discover a price, which
could be significantly different from the closing price, at which they can trade
following dissemination of news regarding the event. For example, after Adelphia
Communications Corp. announced raising a gross $1.5 billion from offerings of
common stock and securities on January 16, 2002, 7.5 million Adelphia shares
traded through our system between the close on January 15, 2002 and the open on
January 16, 2002. This represented approximately 197% of average daily trading
volume of Adelphia common stock during the prior 90-day period.

Crossing. Through our GLOBAL INSTINET CROSSING(TM), we enable customers to
enter buy or sell orders in U.S. traded securities for execution in a "crossing
session." In a crossing session, we electronically aggregate all orders to buy
or sell at a pre-specified time; match (or "cross") them with other orders to
sell or buy, respectively, and automatically execute them at a pre- determined
benchmark price. A crossing trade will be executed only if there is a
counterparty for that order (or portion of an order). Our crossing service
provides an electronic platform with enhanced liquidity for block trades and
better pricing outside regular trading hours than traditional brokerage or other
intermediaries might provide, together with the reduced trading risk of a
pre-determined benchmark price. We have two crossing sessions each trading day,
both of which occur outside of regular trading hours, the more significant of
which is in the evening. Following the close of the market each day, we have one
crossing session for orders priced at that day's closing price. On average in
2001, during each evening crossing session we received buy and sell orders from
370 customers for approximately 107 million shares of which trades were executed
for approximately 10 million shares. Before the market opens, we have another
crossing session using the volume-weighted average price for that trading day.
In addition, we now offer our customers access to a crossing system for Japanese
equity securities through JapanCross Securities Co., Ltd., our 50-50 joint
venture with Nikko Salomon Smith Barney Ltd. JapanCross, which began operating
in November 2001, enables customers worldwide to enter orders to buy or sell
Japanese equity securities in a pre-market crossing session at the
volume-weighted average price for that trading day.

Portfolio Trading. Our trading services also include portfolio trading,
which allows a customer to execute multiple orders in a number of different
securities simultaneously, including both orders to buy and sell shares of stock
as well as securities that are based on an index or basket of stocks. This
portfolio trading
13

capability, combined with our global access, also enables our customers to
manage and execute portfolios of securities denominated in a number of different
currencies. Our Trading Research Group provides portfolio managers and traders
with tools that track and evaluate trading costs by strategy, broker, market or
stock. We are also continuing to further develop technology to enhance our
client's ability to implement their trade strategies on a global basis. We are
currently testing a new program trading application that has been developed in
conjunction with passive and quantitative fund managers in the United States and
Europe, which will enhance our customers' ability to execute portfolio trade
transactions. This new trading application will continue to use our existing
execution, smart order-routing and clearing capabilities, as well as Reuters
market data infrastructure. In addition, our system will allow for interaction
between multiple traders at one customer site, the automation of trading using
algorithms created by the customer, customization of the interface by the
customer and integration with other systems commonly used by these customers. We
believe these features will help our customers to manage their order flow in a
more efficient manner. We anticipate deploying this new product to our customers
during the third quarter of this year.

Enhanced Customer Interface (Portal). Based upon the technology we
acquired through our acquisition of ProTrader, we have developed a trading
application that will enable us to enhance our customer interface and
order-routing technology. This new trading application will continue to use our
existing infrastructure while giving our customers a broader view and broader
access to multiple markets. Our customers will now have the ability to view
information for a single stock in multiple markets, increasing their ability to
execute their orders in multiple markets for better execution. We believe this
enhanced functionality will help our customers to manage their order flow in a
more efficient manner. We anticipate deploying this new product to our customers
during the second quarter of this year.

Soft Dollar Program. Institutional investors often allocate a portion of
their gross brokerage transaction fees for the purchase of proprietary and
independent third-party research products, as well as other brokerage services.
The amounts so allocated for those purposes are commonly referred to as soft
dollar revenues. We are one of the largest independent providers of research and
other brokerage services through soft dollar or other similar arrangements and
have offered soft dollar programs for over 15 years. We offer soft dollar
programs in order to increase the amount of business our institutional customers
conduct through us, thereby increasing our transaction volumes and the depth of
our liquidity pool. We are currently increasing our focus on these programs, as
part of our efforts to enhance our global brokerage offering and maintain and
expand our liquidity pool. In particular, we are developing tailored packages of
independent third-party research products for our various customer categories.

In 2001, more than one-third of our customers obtained proprietary and
third-party research services from us on a soft dollar basis. The portion of our
transaction fee revenue representing soft dollar revenues is offset
dollar-for-dollar by expenses we incur in paying for research from independent
third parties. We made $154.4 million in soft dollar payments to independent
research providers on behalf of our customers in 2001.

Research. Consistent with our agency brokerage approach, we believe our
clients can benefit from greater availability of research provided by
independent research providers who have no actual or potential conflicts of
interest with respect to the companies they analyze. In addition to the
independent third-party research that we provide to our customers through our
soft dollar programs (described above), we also offer proprietary research tools
and services, including those of our subsidiary, Lynch, Jones & Ryan, as well as
co-branded research. Our customers, primarily institutional investors, generally
use soft dollars or other similar arrangements to pay for these products and
services as well.

Our proprietary research is designed to enable our clients to design
efficient portfolio and trading strategies. Our proprietary research tools and
services for our customers include the following:

- INVESTMENT STRATEGY GROUP produces quantitative research, in the form of
both models and customized analysis, as well as general market
commentary.

- TECHNICAL ANALYSIS GROUP produces packaged and customized technical
analysis, as well as daily market commentary.

14

- REDBOOK publishes fundamental research on retail and related sectors. Its
REDBOOK RETAIL SALES AVERAGE is recognized as a leading indicator of
economic activity.

- THE GREAT LAKES REVIEW focuses on uncovering stock opportunities among
lesser-known companies in the Midwest.

In September 2001, we sold our Research and Analytics (R&A) product, an
integrated equity workstation that provides users with real-time quotes and news
as well as advanced analytics, to Reuters. The sale of R&A has enabled us to
focus on our core service offerings and reduce our costs associated with
providing the R&A product to our customers. We can continue to make available
soft-dollar payment options to our customers in connection with their use of the
R&A product.

Our co-branded research focuses on several different aspects of specific
industries and these research products include market studies, surveys and
detailed industry and company analysis. We are continuing to explore additional
co-branding relationships with other established research providers that have
expertise in specific sectors, products or companies.

Plan Sponsor Services. As part of our transactional services to pension
plans and other funds through their sponsors, such as corporations, unions,
state and local governments, endowments and foundations, we enable pension plan
and other fund sponsors to recapture a portion of the gross transaction fees
that the fund managers pay us. As of December 31, 2001, we provided these
services to approximately 1,200 pension plans and other funds. In addition, we
provide our plan sponsor customers with services that assist them when they
transfer from one money manager to another. For example, our crossing, portfolio
trading and trading research services can help these customers manage this
transition.

ProTrader. Through our recently acquired ProTrader subsidiary, we provide
advanced trading technologies and electronic brokerage services primarily to
professional non-institutional traders, active fund managers and hedge funds.

OUR FIXED INCOME SECURITIES BUSINESS

We offer dealers and market makers in the United States and Europe a
platform for trading primarily U.S. and European bonds. We offer approximately
270 U.S. government bonds, 30 U.S. federal agency bonds, 260 euro-denominated
government bonds, 20 Eurobonds and 290 German mortgage bond (Pfandbriefe)
products, as of December 31, 2001. Our subsidiary, Montag Popper, a German fixed
income broker, provides us with a presence in an important market in Europe. In
addition, we are exploring possible alliances and expansion opportunities in the
United States, Europe and Asia to further develop our capabilities for fixed
income trading. We are also continuing to evaluate our fixed income business and
explore various strategic options.

Customers

As of December 31, 2001, our fixed income business had over 115 customers,
with over 35 in the United States (including 23 of the 24 primary dealers in
U.S. government securities) and over 80 in Europe, representing a total of
approximately 1,000 traders.

Services

We perform the same trading role for our fixed income customers as for our
equities customers, with an electronic fixed income trading platform that
operates separately from our equities platform and that permits similar direct
access, anonymous trading and the opportunity for reduced transaction costs. Our
fixed income platform is available to customers in both the United States and
Europe. We support our electronic trading capability with broker desks staffed
with sales and trading professionals based in New York, London, Paris and
Frankfurt. We offer simultaneous communication of trade execution data to our
customer's trading desks and clearing and settlement information to their
middle- and back-offices, commonly referred to as "straight-through processing."
Straight-through processing can reduce costs and errors associated with our
customers' manual keyboard entry of execution data into their recordkeeping,
risk management and settlement systems.
15

Our customers can access our platform using either our graphical user interface
or our application program interface (API). The API can be integrated with our
customers' order management system or trading engine, allowing our customers
greater ease in submitting their orders electronically. When we introduced the
API, we also enhanced the capacity and performance of our fixed income platform,
which gives us the ability to manage increasing order flows and trade volumes
from our customers.

In addition to trading in single instruments, we enable our customers to
execute swaps in U.S. government securities and spread trades in
euro-denominated government bonds (both of which are the simultaneous purchase
of one bond and sale of another bond to take advantage of expected relative
changes in bond yields). We also offer basis trading (joint trading of a bond
together with a number of futures contracts, which is generally used to
neutralize market risk) in the United States and Europe.

OUR CORRESPONDENT CLEARING BUSINESS

We provide correspondent clearing services to a few securities brokers in
the United States. We offer transaction processing, clearing and settlement of
trades, recordkeeping and financing to our correspondent customers, as well as
various products and services oriented toward the institutional investor
community.

CLEARING AND SETTLEMENT OPERATIONS

We provide clearing and settlement services in nearly all of the markets in
which we execute trades for customers. Our clearing and settlement operations
are similar in design and function to other clearing brokers. We self-clear
through our subsidiary, Instinet Clearing Services (ICS), which uses our
proprietary CLEARING INFORMATION SYSTEM(TM) (CIS) to handle customer ticketing,
processing of allocations and communications with industry clearing agents,
depositories and books and records processing providers. For processing of books
and records, ICS uses Automatic Data Processing, Inc. (ADP) in the United
States, Nomura Institute's I-Star system in Japan and ACT Fiscal for all other
non-U.S. business. We also clear and settle for customers who have a contract
with ICS. With respect to these trades, we are responsible for a variety of
activities that take place after a securities trade has been executed, including
confirmation of trades before settlement, submitting executed transaction
information to industry clearing and settlement utilities, managing failed
trades, communicating trade and settlement data including allocations to
customers, management of corporate actions and updating and maintaining
Instinet's books and records.

STRATEGIC ALLIANCES AND INVESTMENTS

To enhance our core service offerings in our global electronic agency
securities business, we have made a number of strategic investments in companies
with operations or technology that we believe will enable investors and issuers
to better achieve their trading objectives. During the past three years, we have
acquired beneficial ownership interests in the following companies:

- 13.8% of TP GROUP LDC, a consortium that owns 38.9% of virt-x, an
electronic order-driven equities market for pan-European securities.

- 7.8% of W.R. HAMBRECHT + CO., INC., a U.S.-based investment banking firm
that enables issuers to conduct auction-based securities offerings via
the Internet through its OPENIPO(R). In addition, we have an option to
buy additional shares in the event WR Hambrecht becomes a publicly-traded
company.

- 9.6% of the voting interest of ARCHIPELAGO HOLDINGS, LLC, the parent
company of an ECN that has received approval for registration as a U.S.
stock exchange. In March 2002, Archipelago, LLC merged with REDIBook ECN
LLC, another ECN. We beneficially own approximately 4.8% of the voting
interest of the surviving entity.

- 48.5% of VENCAST, INC., a U.S.-based company that offers opportunities
for capital raising by, and investing in equity securities of, private
companies via the Internet.

16

- 47.9% of TRADEWARE S.A., a European-based provider of integrated order
routing solutions to broker-dealers in Europe. We also have warrants,
exercisable after October 1, 2002, that if fully exercised, would
increase our beneficial ownership to 57.3%.

- 12.8% of STARMINE INC., a U.S.-based provider of independent ratings of
Wall Street equity analysts.

EXCHANGE MEMBERSHIPS

Overall, we are a member of 18 exchanges in North America, Europe and Asia,
and we continue to develop our direct connections to non-U.S. exchanges. The
following chart shows our various exchange memberships:

EXCHANGE MEMBERSHIPS

- ---------------

(1) On October 25, 2001, the SEC approved the merger of the equities division of
the Pacific Exchange with Archipelago, LLC to create a fully electronic
national securities exchange under the name Archipelago Exchange (ArcaEx).
In March 2002, Archipelago merged with REDIBook, another ECN.

(2) The Paris, Amsterdam and Brussels Stock Exchanges merged on September 22,
2000 to form Euronext N.V. On February 6, 2002, Lisbon Stock Exchange also
joined Euronext. We currently provide customers with access to Euronext for
trades in French and Dutch stocks.

MARKETING AND COMMUNICATIONS

Our marketing and communications strategy is focused on three goals:

- strengthening corporate brand awareness;

- attracting new customers; and

- retaining our existing customers and cross-selling value-added services
to them.

We pursue these goals through a combination of marketing communications
through media (for example, in exchange for information about our extended hours
liquidity pool, CNBC and CNNfn broadcast live daily segments from our trading
floor in the pre- and post-market hours explaining market activity), print and
broadcast advertising, interactive marketing on our own Internet website and
other on-line channels, sponsorship of customer events, direct one-on-one
marketing, traditional public relations, a variety of alliances and co-marketing
programs and the production of client premiums and promotional items. Through
our website, prospective customers can get detailed information on our services,
as well as news about us and our market environment. We also distribute Instinet
Research's proprietary reports to a variety of journalists. We design our
advertising campaigns and other communications activities to educate the
marketplace regarding the nature of our agency brokerage business and our
services.

17

OUR TECHNOLOGY AND INTELLECTUAL PROPERTY

TECHNOLOGY

Our sophisticated and proprietary technology connects us to our customers,
automates traditionally labor-intensive securities transactions, provides us
with a platform to support our operations, and is an important part of our
compliance activities. We believe that our ability to use technology effectively
to expand and enhance our services has been a key component in the development
of our business.

Our systems provide customers with efficient service and have a proven
track record of adaptability as usage has increased and service and product
offerings have expanded. Our systems are designed to be interoperable and
flexible. For example, our core matching systems use an architecture that allows
us to independently develop and evolve the functionality of the systems in
different areas as business needs and opportunities demand.

To enhance the capacity and reliability of our systems, we have two core
data centers located in Jersey City, New Jersey and Bedford, Massachusetts,
which support our client connectivity, as well as our trading and execution
systems, clearing and settlement operations and customer interfaces. These two
data centers provide redundancy for our critical applications, systems and
services, allowing us to continue to operate from either site should the other
site fail. Prior to September 11, 2001, we had three core data centers; however,
as a result of the September 11th terrorist attacks, we lost one of them, which
had been located in the World Trade Center. If one of our two remaining data
centers were to be damaged, disabled or otherwise fail or experience
difficulties, it may be more difficult for us to continue operating without
disruption to our services. In order to mitigate this risk, we are installing
additional power, telecommunications and hardware at our remaining two core data
centers in order to replace the functionality and capabilities that the World
Trade Center facility provided. Our goal is to be able to support our client
connectivity and critical systems and services from these two facilities, with
each one being able to provide independent support. We also have two subsidiary
data centers and distribution points in London serving European clients.

Our central order matching engines for our institutional equities trading
platform, including our crossing services, and fixed income platform, which
provide order management functions, use sophisticated technologies including
Linux, Sun Enterprise Servers, Tibco's Rendezvous and Java and Enterprise Java
Beans (EJB).

Currently, our customers can access our trading systems through INSTINET(R)
display screens, direct links to our systems from those of our customers using
the FIX or other protocols, or our proprietary software. Most of the methods of
connecting to our trading systems are by means of dedicated networks provided by
Radianz. We are currently seeking to develop technology that will allow us to
replace our proprietary systems of communications and connectivity with an
Internet-based system that will shift communications and connectivity
requirements to our customers.

In the future, we expect to continue to make significant investments in
systems technology to upgrade services for the development of our business.

In order to deal with increasing demands on our execution and clearing
capacity in our equity securities trading system due to greater service levels
and external circumstances such as decimalization, we have a team of employees
dedicated to managing our capacity. We believe that it will be important not
only to add capacity in the future, but to make this capacity more flexible to
handle the complexity of changing circumstances. We have a test network to
simulate complex system trading scenarios and to carry out various performance
tests on our capacity. In addition, we have other ongoing capacity projects
relating to clearing and other areas.

INTELLECTUAL PROPERTY

To protect our proprietary technology and intellectual property rights, we
rely primarily on patent, copyright, trade secret and trademark law. We
principally use material, software and technology that we have developed and
that are protected by our own intellectual property rights. However, we also use
software, as well as other material and technology that is protected primarily
by intellectual property rights belonging to third parties. We have taken
measures to register and protect our tradename, logos, trademarks and service

18

marks both in the United States and in various countries throughout the world.
Notwithstanding the precautions we take to protect our intellectual property
rights, it is possible that third parties may copy or otherwise obtain and use
our proprietary technology without authorization or otherwise infringe on our
proprietary rights.

COMPETITION

The financial services industry generally, and the securities brokerage
business in which we engage in particular, is very competitive, and we expect
competition to intensify in the future. We expect to face competition from a
number of different sources varying in size, business objectives and strategy.
In our various businesses, we compete with the following entities and types of
entities, among others:

- market makers and other traditional broker-dealers (including many of our
own customers) acting as agent or principal;

- traditional and electronic trading methods in use on U.S. and
international exchanges, including NYSE specialists and the electronic
matching systems of international exchanges;

- Nasdaq's trading services that enable NASD members to trade
electronically in Nasdaq-quoted stocks, such as SelectNet, SuperSoes and
the planned SuperMontage structure;

- the NYSE's Institutional XPress(TM), NYSE Openbook(TM) and NYSE
Direct(TM) products;

- ECNs, ATSs, electronic brokers and other electronic trading systems,
including but not limited to Bloomberg Tradebook, the Island ECN, eSpeed
and Archipelago (in March 2002, Archipelago merged with REDIBook);

- automated trade execution services developed by third party vendors for
commercialization in a wide range of financial products markets;

- trading system software companies; and

- consortia comprised of leading financial institutions and service
providers, such as BrokerTec Global LLC and EuroMTS.

In our institutional equity securities business, we compete on the basis of
a number of factors, including:

- total transaction cost;

- amount and frequency of price improvement;

- the depth and breadth of our liquidity pool;

- our speed and quality of connectivity to other trading markets;

- anonymity, attributable to customer orders;

- reputation; and

- the quality and availability of our value-added brokerage and research
services.

We have experienced intense price competition in our equity securities
business in recent years. We believe that the downward pressure on prices will
continue as a result of the following factors:

- continuing advances in technology;

- price competition;

- increased customer awareness and regulatory scrutiny of execution costs;
and

- continuing unbundling of financial services.

To maintain our customer base and attempt to counter this pressure, we have
aggressively reduced pricing for our broker-dealer customers. In addition, we
seek to continue to innovate and use technology on a global

19

basis to reduce costs; increase customer awareness of the value of price
improvement and the benefits we provide as a result of our core values of
independence and neutrality, anonymity, equal and direct access and customer
empowerment; provide value-added brokerage and other services, tailored for our
various types of customers, and maintain and expand our Nasdaq liquidity pool
and the related benefits.

In our fixed income business, we face competition from traditional
broker-dealers, electronic brokers, ATSs and other electronic trading systems,
and also from other competitors and potential competitors referred to above. We
compete on the basis of a number of factors, including:

- our business model that offers value-added services, such as broker desk
support;

- speed and quality of connectivity to customers; and

- quality, cost and speed of execution.

In our correspondent clearing business, we face competition from
traditional clearing firms. Our main competitive factors are price competition
and quality of execution.

Many of the financial service providers with which we compete are
substantially larger than we are and have substantially greater financial,
technical, marketing and other resources. Outside the United States, in addition
to our U.S. competitors with international capabilities, we compete with banks
and other financial institutions that are well-capitalized and larger than we
are and may have long-standing, well-established and, in some cases, dominant
positions in their trading markets.

Competition may intensify for the following principal reasons:

- As the profitability of broker-dealers has come under significant
pressure due to the general economic downturn, as well as the impact of
decimalization, they have increasingly focused on price in their
selection of trading services. If this trend continues, the price
competition we have experienced in recent years, and in particular in the
fourth quarter of 2001 and into 2002, will likely persist.

- Commercial banks and other financial institutions have expanded their
product offerings to include many of the financial services traditionally
provided by broker-dealers. We expect competition from commercial banks
to increase as a result of regulatory initiatives in the United States to
remove or relax restrictions on combining commercial banks and other
types of financial service providers.

- Consolidations and alliances among broker-dealers and ECNs and between
commercial banks and broker-dealers have resulted, and we believe will
continue to result, in increasingly large and well-capitalized financial
service providers. Consolidation has occurred between multi-service
financial institutions and market makers (including exchange specialists)
that could result in better capitalized market makers that compete
directly with us and our agency brokerage model.

- ECNs who apply for and receive status as securities exchanges under
Regulation ATS will be able to benefit from direct connectivity to the
Intermarket Trading System. As a result, these ECNs will have a
competitive advantage over us in attracting business in U.S.
exchange-listed stocks. In addition, there may be other potential
competitive advantages associated with securities exchange status. One
ECN, Archipelago, has already been approved to serve as a facility of a
U.S. stock exchange.

- Nasdaq and the NYSE have announced plans to become for-profit entities
(and Nasdaq has applied to become a national securities exchange) and to
introduce services in order to attract order flow and trading volume.
Implementation of these plans would put them in direct competition with
us for order flow, liquidity and trading commissions.

- Multi-service competitors are able to cross-subsidize their agency
brokerage and market making activities, with which we directly compete,
with their revenues and profits from their other activities in which we
do not engage, such as principal trading and investment banking.

- As a result of decimalization, some market makers are moving from a
business model in which they trade as principal for their own account to
an agency business model in which they charge commissions rather than
profit from the "bid-ask" spread. The SEC's recently expanded
interpretation of
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Section 28(e) of the Exchange Act allowing institutional investors to
obtain soft dollar credits from certain transactions executed through
broker-dealers on a "riskless" principal basis, rather than only on an
agency basis, may further encourage this trend. These developments may
increase our competition, particularly in the provision of soft dollar
programs.

- Regulatory changes, such as NASD and Nasdaq rule changes, have altered,
and may continue to alter, the competitive landscape in which we operate.
Sometimes these changes give our competitors competitive advantages over
us. See "-- Industry Background" and "-- Regulation."

- Increased profit levels in the financial services industry have
strengthened many of our existing competitors and attracted new
competitors to that industry.

- New competitors have emerged, including companies who provide use of
order routers or similar technology, that may not need to have any
securities industry experience and potentially may compete against us
effectively with lower overhead costs. Some of these competitors may also
be better positioned than we are to exploit recent developments in
Internet-related technology and to build more attractive or flexible
competing products that could capture some of our business.

- A variety of existing companies may seek to expand their own businesses
to compete against us because of the ongoing growth of the securities
markets, the relationships between information and trading, and the
importance of technology in creating efficient trading systems. These
potential competitors could include companies that provide trading
services for products and services other than securities, software
companies, information and media companies, and other companies that are
not currently in the securities business.

We compete with Nasdaq as a trading venue for Nasdaq-quoted stocks. We own
an equity interest of less than 1% in Nasdaq. The NASD regulates the activities
of our U.S. broker-dealer subsidiaries through its own subsidiary, NASDR, and
also operates and regulates Nasdaq. The NASD is thus able to propose, and often
obtain, SEC approval of rule changes that we believe can be to Nasdaq's
competitive benefit as a securities marketplace and our competitive
disadvantage. In addition, we are required to provide quotation data to Nasdaq
in its current role as an exclusive securities information processor, and Nasdaq
then collects a fee from market participants to whom it disseminates these data.
The SEC conditioned its approval of the SuperMontage proposal on January 10,
2001 on the NASD establishing an alternative facility that market makers and
ECNs can use to meet their order display obligations. The SEC is also moving
toward making Nasdaq's role as a securities information processor non-exclusive
in the future, Nasdaq's current exclusive role provides it financial and other
competitive advantages. See "-- Industry Background" and "-- Regulation."

On December 7, 2001, the NASD submitted to the SEC proposed changes to the
NASD's rules to reflect Nasdaq's anticipated approval as an exchange, its
resultant separation from the NASD and the creation of an alternative display
facility to display quotations and collect trade data for parties (such as ECNs)
trading outside a registered securities exchange. Other than providing access to
the Intermarket Trading System, the NASD's proposed ADF would not provide for
order execution or routing services, so that ADF market participants themselves
would be required to provide NASD member broker-dealers with electronic access,
either directly or indirectly, to their quotations. It is unclear when and in
what form the ADF might be implemented and whether the ADF, as currently
contemplated, would prove to be a viable marketplace. We are unable to predict
accurately at this time the impact the NASD's proposed ADF would have on our
business.

For a further discussion of the risks relating to our competitive
environment, see "Certain Factors that May Affect Our Business -- We Face
Substantial Competition That Could Reduce Our Market Share and Harm Our
Financial Performance."

REGULATION

As a securities broker, an ATS, an ECN and an operator of a clearing
business for our own customers and third parties, we are subject to extensive
regulation in the United States and in certain other jurisdictions in which we
operate. This regulatory framework generally applies directly to our affiliates
that are registered or
21

licensed in the various jurisdictions. Instinet Corporation, Instinet Clearing
Services, Inc., Instinet Fixed Income Inc., Lynch, Jones & Ryan, Inc. and
ProTrader Securities, Limited Partnership are each registered as broker-dealers
with, and are subject to regulation by, the SEC and other entities, as described
below.

The purpose of these regulations is to generally safeguard the integrity of
the markets and to protect the interests of investors participating in those
markets, rather than the interests of securities firms or their creditors or
stockholders. As a result, these regulations cannot be expected to protect or
further the interests of our company and may have the effect of limiting or
curtailing our activities, including activities that might be profitable.
Furthermore, additional rule-making or the initiation of proceedings could
adversely affect our business, financial results and condition, prospects and
reputation.

Regulation covers all aspects of our brokerage business, including:

- registration of offices and personnel;

- conduct of personnel;

- acceptance, execution, clearing and settlement of customer orders;

- trading practices;

- record keeping;

- capital structure;

- sales practices and advertising; and

- handling of customer funds and securities and supervision of accounts in
connection with our wholesale business.

In addition, our business may be significantly affected by regulation that
extends to the structure of the markets for equities securities.

The various governmental authorities and industry self-regulatory
organizations that supervise and regulate us generally have broad enforcement
powers. If we fail to remain in regulatory compliance, we could be censored or
fined. Alternatively, regulators could issue cease-and-desist orders against us,
prohibit us from engaging in some of our businesses, or suspend or expel us or
any of our officers or employees from the securities industry. We face the risk
of significant intervention by regulatory authorities, including extensive
examination and surveillance activity. In the case of non-compliance or alleged
non-compliance with regulations, we could be subject to investigations and
judicial or administrative proceedings that may result in substantial penalties.
In the case of non-compliance, we could also, in some situations, be subject to
civil lawsuits, by customers, in some cases for substantial damages. Our ability
to comply with all applicable laws and rules is largely dependent on our
establishment and maintenance of compliance, audit and reporting systems, as
well as our ability to attract and retain qualified compliance and other
personnel.

OUR U.S. ACTIVITIES

The securities industry in the United States is subject to extensive
regulation under both federal and state laws. The SEC is the federal agency
responsible for the administration of the federal securities laws. Our U.S.
brokerage, clearing and fixed income brokerage subsidiaries are registered with
the SEC as broker-dealers, and our primary brokerage subsidiary is also
registered with the SEC as an investment advisor. Much of the regulation of
broker-dealers has been delegated by the SEC to self-regulatory organizations,
including the NASD, which has been designated by the SEC as our principal
regulator. The NASD adopts rules (subject to approval by the SEC) that regulate
the broker-dealer industry and govern the market structure of Nasdaq. These
rules regulate the conduct of our U.S. broker-dealer subsidiaries and their
activities in Nasdaq-quoted stocks. The NASD, through its subsidiary, NASDR,
also conducts periodic examinations of the operations of those subsidiaries. Our
U.S. broker-dealer and clearing subsidiaries also are registered as
broker-dealers in a number of states and are subject to regulation by state
securities administrators in states in which they conduct

22

business. Instinet Clearing Services, Inc., Lynch, Jones & Ryan and ProTrader
Securities, Limited Partnership are also subject to regulation by the regional
exchanges of which they are members.

In addition, our U.S. broker-dealer subsidiaries are members of the
Securities Investor Protection Corporation (SIPC). SIPC provides certain
protection for customers' accounts in the event of the liquidation of a
broker-dealer. SIPC is funded through assessments on registered broker-dealers,
including us.

This regulatory environment is also subject to change. Our business,
financial condition and operating results may be adversely affected as a result
of new or revised regulations or rules imposed by the SEC, other U.S. regulatory
authorities or self-regulatory organizations, such as the NASD. Our business,
financial condition and operating results also may be adversely affected by
changes in the interpretation or enforcement of existing laws and rules by the
SEC, other regulatory authorities and self-regulatory organizations.

Over the last five years, the SEC and the NASD have proposed a number of
regulatory changes in an effort to shape or respond to developments in the
securities markets and market structure that have resulted from advances in
technology and the growth of electronic trading. Because a substantial part of
our business involves electronic trading and relies heavily on technological
advances, these proposals may have a direct and substantial impact on us.

The Order Handling Rules

Starting in 1994, the SEC and the U.S. Department of Justice conducted
anti-trust investigations of the NASD and the Nasdaq market, including the
market makers, addressing concerns of fraud, price fixing and collusion. In
December 1997, 30 major brokerage firms and the Department of Justice entered
into a settlement of these anti-trust proceedings. In a report discussing
deficiencies in the NASD's oversight of the Nasdaq market and the NASD's failure
to enforce broker-dealer compliance with NASD rules and the requirements of the
federal securities laws, the SEC specifically noted that we were not a subject
of the Department of Justice investigation or the SEC report. In response to the
findings of these investigations and consistent with the recommendations in the
SEC Market 2000 Report issued in 1994, the SEC adopted the order handling rules
for market makers and exchange specialists in 1996. These rules took effect with
respect to Nasdaq-quoted stocks in 1997.

The order handling rules prohibit a market maker or exchange specialist
from displaying a limit order for a security through an ECN that is better than
its published quote unless the ECN publishes its best-priced market maker and
exchange specialist orders in that security and permits execution against those
orders through Nasdaq. Similarly, a market maker that receives a limit order
better than its own published quote, must generally either execute the order,
incorporate the limit order price into its published quote or pass the order on
to an ECN for public display and execution access. Regulation ATS, discussed
below, requires display of institutional orders that represent the best price on
the Nasdaq quote montage.

When the order handling rules were introduced, we were the first and only
existing ECN, and the best bids and offers from our trading system were directly
displayed for the first time in the Nasdaq quote montage. The order handling
rules, however, facilitated the proliferation of ECNs by providing a role for
ECNs in the display and execution of orders. As additional ECNs came into
existence, their quotes were also displayed in the Nasdaq quote montage, which
has produced greater price transparency for investors in the market for
Nasdaq-quoted stocks and resulted in greater competition for us.

Since the introduction of the order handling rules, the SEC's Division of
Market Regulation has issued a series of "no-action" letters to us over a number
of years verifying and extending our status as an ECN in compliance with these
rules. The most recent "no-action" letter is valid until March 31, 2002. The
Division continues to condition its "no-action" position upon, among other
things, our representation that we have sufficient capacity to handle reasonably
anticipated peak volumes of trading. The Division also conditions its position
upon specified limitations on the fees we charge brokers for access to our
trading system. We expect that the Division will continue to extend its
"no-action" position, but we cannot assure you that it will do so or that its
applicable rules or the enforcement of those rules will not change. In
connection with its annual examination of the capacity of market participants,
the Division has from time to time raised issues regarding

23

the adequacy of our capacity, our testing of capacity limits and our plans for
increasing capacity, which we believe we have addressed.

Regulation ATS

In December 1998, following the issuance of the order handling rules, the
SEC promulgated new rules relating to the regulation of certain ATSs. The SEC
expanded its interpretation of the definition of "exchange" under the U.S.
securities laws to encompass a range of electronic brokerage activities,
including those conducted by us. At the same time, Regulation ATS permits
systems to register as broker-dealers, rather than as national securities
exchanges with the SEC, if they comply with the regulation.

The requirements of Regulation ATS applicable to us include:

- mandatory public display of, and public access to, best-priced orders
displayed within the system;

- the establishment and application of fair access and capacity, integrity
and security standards; and

- additional notice, recordkeeping, reporting, confidential treatment and
other requirements.

We have modified and enhanced our trading systems to comply with Regulation ATS
and continue to review and monitor our systems and procedures for compliance.

SuperSoes

In part as a reaction to the growing competitive pressures from ECNs, in
July 2001, the NASD implemented SuperSoes as its new platform for the trading of
the most widely held Nasdaq-quoted stocks (Nasdaq National Market stocks).
SuperSoes substantially expanded the functionality of SOES -- Nasdaq's existing
automatic execution system available only for small orders from public
customers -- by incorporating many trading features common among ECNs. (SOES
remains the trading system for Nasdaq SmallCap stocks, which are not eligible to
be traded on SuperSoes.) Unlike SOES, SuperSoes may be used by market makers
when trading for their own accounts. SuperSoes also improves the speed of
executions and provides the ability to enter large orders, obtain automatic
executions of orders, and interact with both publicly displayed orders and
non-publicly displayed (reserve) orders. Full participation in SuperSoes is
mandatory for all market makers in any SuperSoes-eligible securities in which
they make markets. Although ECNs may elect to participate in SuperSoes either
only for order-entry or also for display of its best priced orders in the Nasdaq
market ("full" participation), only one ECN to date has chosen full
participation. There are a number of disadvantages to full participation for
ECNs, particularly those with significant internal liquidity pools, one of the
most significant of which is the manner in which the automatic execution
functionality of SuperSoes is designed, generally exposing ECNs -- but not
market makers -- to the risk of multiple executions against the same order.
Without full participation in SuperSoes, ECNs must rely on SelectNet to display
and provide access to their customers' orders in the Nasdaq market. (SelectNet
is an older order delivery and negotiation system that electronically
facilitates, but does not automatically provide, order executions.) In addition,
SuperSoes' pricing structure is disadvantageous to order-entry only
participants. SuperSoes, in light of its features and functionality, may have
shifted, and may continue to shift, some order flow away from ECNs.

SuperMontage

On January 10, 2001, the SEC approved the NASD's rule changes creating a
new trading platform for the Nasdaq market, generally known as SuperMontage.
These new rules will significantly change the nature of trading in Nasdaq-quoted
stocks, including changing the information required to be displayed on, and the
method of operation of, the Nasdaq quote montage. When implemented, SuperMontage
will combine a computer display containing more bid and offer information about
trading interest in individual Nasdaq-quoted stocks than is currently displayed,
together with new rules establishing the execution priority of quotes and orders
submitted to Nasdaq. The execution priority rules also contain provisions that
could disadvantage us by comparison to market makers and any ECN that does not
charge broker fees for accessing orders in its trading system through Nasdaq. We
are unable to predict the impact that the implementation of

24

SuperMontage will have on our business, but it could cause us to receive fewer
orders and execute fewer orders in our liquidity pool for Nasdaq-quoted stocks,
leading to a reduction in our liquidity pool.

Nasdaq Exchange Application

Nasdaq is in the process of becoming a for-profit exchange, independent
from the NASD. On March 15, 2001, Nasdaq submitted its application for
registration as a national securities exchange to the SEC. By operating as an
exchange with SuperMontage as its trading platform, Nasdaq continues to move
from a quote-driven display system to an order-driven execution system that will
directly compete with us and other ATSs. Nasdaq is currently considering the fee
structure it would introduce as an independent, for-profit exchange. We are
unable to predict what fee changes Nasdaq might propose or eventually implement,
but Nasdaq's fee structure may have a significant impact on our equity
securities business.

Alternative Display Facility, NASD Fees and Securities Information Processor

The SEC conditioned its approval of SuperMontage on the NASD establishing
an alternative facility that market makers and ECNs can use to meet their order
display obligations. The SEC has also noted that even if Nasdaq gains status as
an exchange, the NASD will continue to be required to collect bids, offers and
quotation sizes for parties seeking to trade U.S. exchange-listed
stocks -- which would then include Nasdaq stocks -- other than on an exchange.
As a result, the SEC has indicated that the NASD must have an alternative
display facility (ADF) operational by the time Nasdaq is granted exchange
status. Accordingly, on December 7, 2001, the NASD submitted to the SEC proposed
changes to the NASD's rules to reflect Nasdaq's anticipated approval as an
exchange, its resultant separation from the NASD and the creation of an ADF. The
NASD has indicated that in creating the ADF, it intends to provide a facility
that will display quotes and collect trade data, while keeping its obligations
to operate a market to a minimum. Other than providing access to the Intermarket
Trading System, the NASD's proposed ADF would not provide for order execution or
routing services, so that ADF market participants themselves would be required
to provide NASD member broker-dealers with electronic access to their
quotations. It is unclear when and in what form the ADF might be implemented and
whether the ADF, as currently contemplated, would prove to be a viable
marketplace. We continue to review the NASD's ADF proposal and consider its
possible implications for our business and our potential participation in the
ADF.

The SEC is also considering the establishment of a securities information
processor for data regarding quotations in Nasdaq-quoted stocks independent from
Nasdaq. Nasdaq's current role as the exclusive information processor gives it
financial and other competitive advantages. It is uncertain what form this new
securities information processor might take and what effect it might have on our
business.

The NASD has also proposed changes in its fee structure that would impose a
fee on all transactions in Nasdaq-quoted stocks regardless of where those
transactions occur. In addition, in order to assess this fee, the NASD would
require NASD members not using Nasdaq's Automated Confirmation Transaction (ACT)
service to otherwise report all of their transactions in Nasdaq-quoted stocks.
We are unable to predict what impact these fee changes and required reporting
would have on our business.

Decimalization

The introduction of decimalization in April 2001 has also had an impact on
the U.S. securities markets and increased competition for ATSs. Decimalization
may assist investors in obtaining price improvement because improvement in
smaller increments is possible. Because decimalization narrows the average
trading spreads, it has also had a significant negative impact on the
profitability of traditional broker-dealers. As a result, we have received, and
may continue to receive, fewer orders from our broker-dealer customers.
Decimalization has also caused, and may continue to cause, traditional
broker-dealers to execute their customers' orders internally rather than route
them to external market centers, other than our own, for execution, because the
additional price risk they incur to fill orders internally has decreased to as
little as a penny a share. Increased internal trading by traditional
broker-dealers has also reduced, and could continue to reduce, our order flow.

25

In addition, the decline in broker-dealer profitability has resulted in
some market makers moving from a business model in which they trade as principal
for their own account to an agency business model. The SEC's recently expanded
interpretation of Section 28(e) of the Exchange Act, discussed below, may
further encourage this trend, which may increase our competition.

Section 28(e)

Section 28(e) of the Exchange Act creates a limited safe harbor that allows
investment advisers to cause their client accounts to pay more than the lowest
available commission rate, as long as the adviser determines in good faith that
the commission is reasonable in relation to the value of the research and
brokerage services the broker provides to the adviser. In December, 2001, the
SEC issued an expanded interpretation of Section 28(e) allowing institutional
investors to obtain soft dollar credits from certain transactions executed
through broker-dealers on a "riskless" principal basis, rather than only on an
agency basis (which is how Instinet executes transactions). Coupled with the
move of some market makers from a business model in which they trade as
principal for their own account to an agency business model as a result of
decimalization, this new SEC interpretation may create greater competition for
our soft dollar business.

Abolition of Rule 390

In addition to our activity in Nasdaq-quoted stocks, we provide our
customers with access to U.S. exchange-listed stocks, including connectivity to
the NYSE and its exchange specialists. NYSE Rule 390 was abolished, in May 2000.
This rule had required that all NYSE members and member firms execute
transactions in stocks listed or traded on or before April 26, 1979, during
market hours only on the floor of the NYSE, subject to exceptions. Rule 390 had
prevented NYSE members from executing some transactions with their customers
completely in-house, but it also prevented them from exposing orders in other
market centers such as ours. As a result, we are able to execute trades
involving all NYSE-listed stocks on behalf of all of our customers. Because
these stocks accounted for approximately 50% of average daily trading volume in
2001, abolition of Rule 390 may eventually lead to increased competition in
trading NYSE-listed stocks that were previously subject to the rule.

Order Routing and Execution Disclosure Rules

On January 30, 2001, SEC rules became effective (and were fully implemented
by the end of November 2001) that require many market participants, including
us, to make detailed public disclosure in electronic form of certain statistical
measures of execution quality for orders in equity securities. Market centers
must disclose information, categorized by security, size and type of order about
the time frames in which orders are executed and on the prices offered by
participants relative to each other and the marketplace. The rules also require
securities brokers, including us, to provide detailed disclosure in electronic
form regarding their order routing practices. In September 2001, the SEC issued
an interpretation that provides an exemption from this order routing disclosure
as long as the average number of customer non-directed orders routed by the
security broker during the calendar quarter is 500 or less. To date, Instinet
Clearing Services, Inc. has satisfied the requirements of the exemption.

We cannot predict what impact these rules and the consequent disclosures
will have on the number and size of orders we receive from customers.

Regulation of Clearing Activities

We are a self-clearing broker in the United States through our subsidiary
Instinet Clearing Services, Inc. We also have a correspondent clearing business
in which we provide clearing services in the United States for broker-dealers
that are not affiliated with us. Brokers that clear their own trades are subject
to substantially more regulatory requirements than brokers that rely on others
to perform those functions. Errors in performing clearing functions, including
clerical, technological and other errors related to the handling of funds and
securities held by us on behalf of customers and broker-dealers, could lead to
civil penalties imposed by applicable regulatory authorities as well as losses
and liability in related lawsuits and proceedings brought by

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our customers, the customers of our wholesale customers and others. Any
liability that arises as a result of our clearing operations could have a
material adverse effect on our business, financial condition and operating
results.

In addition, securities industry regulators in the United States are
currently reviewing the extent to which clearing firms should be held
accountable for the improper activities of the broker-dealers for which they
provide cleari