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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________________________________________  
FORM 10-Q
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2014
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
000-54991
Commission File Number 
KCG HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction of incorporation or organization)
38-3898306
(I.R.S. Employer Identification Number)
545 Washington Boulevard, Jersey City, NJ 07310
(Address of principal executive offices and zip code)
Registrant’s telephone number, including area code: (201) 222-9400
_______________________________________________ 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each exchange on which registered
Class A Common Stock, $0.01 par value
New York Stock Exchange
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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
ý
Accelerated filer
 
¨
 
 
 
 
 
 
Non-accelerated filer
 
¨
Smaller reporting company
 
¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
At August 7, 2014, the number of shares outstanding of the Registrant’s Class A Common Stock was 118,091,400 (including restricted stock units) and there were no shares outstanding of the Registrant’s Class B Common Stock or Preferred Stock.




EXPLANATORY NOTE
On July 1, 2013, Knight Capital Group, Inc. (“Knight”), through a series of transactions (the "Mergers"), merged with GETCO Holding Company, LLC (“GETCO”) to form KCG Holdings, Inc. ("KCG"). The Mergers were consummated pursuant to the Amended and Restated Agreement and Plan of Merger, dated as of December 19, 2012 and amended and restated as of April 15, 2013 (the "Merger Agreement"). Following the Mergers, each of Knight and GETCO became a wholly-owned subsidiary of KCG.
All references herein to the "Company", "we", "our" or "KCG" relate solely to KCG and not Knight or GETCO. All references to GETCO relate solely to GETCO Holding Company, LLC and not KCG.
The Mergers were treated as a purchase of Knight by GETCO for accounting and financial reporting purposes. As a result, the financial results for the three and six months ended June 30, 2013 comprise the results of GETCO only and the financial results for the three and six months ended June 30, 2014 comprise the results of KCG.
All GETCO earnings per share and unit share outstanding amounts in this Quarterly Report on Form 10-Q have been calculated as if the conversion of GETCO units to KCG Class A Common Stock took place on January 1, 2013, at the exchange ratio, as defined in the Merger Agreement.



2


KCG HOLDINGS, INC.
FORM 10-Q QUARTERLY REPORT
For the Quarter Ended June 30, 2014
TABLE OF CONTENTS
 
 
 
Page
 
 
 
PART I
FINANCIAL INFORMATION:
 
 
 
 
Item 1.
Financial Statements (Unaudited)
 
Consolidated Statements of Operations
 
Consolidated Statements of Comprehensive Income
 
Consolidated Statements of Financial Condition
 
Consolidated Statement of Changes in Equity
 
Consolidated Statements of Cash Flows
 
Notes to Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
 
 
 
PART II
OTHER INFORMATION:
 
 
 
 
Item 1.
Legal Proceedings
Item 1A.
Risk Factors
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.
Defaults Upon Senior Securities
Item 4.
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
Signatures
 



3



PART I.
FINANCIAL INFORMATION
Item 1.
Financial Statements
KCG HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
For the three months ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(In thousands, except per share amounts)
Revenues
 
 
 
 
 
 
 
Trading revenues, net
$
206,780

 
$
98,260

 
$
465,077

 
$
185,025

Commissions and fees
104,776

 
29,813

 
217,033

 
55,312

Interest, net
(289
)
 
(672
)
 
659

 
(793
)
Investment income (loss) and other, net
2,866

 
(7,768
)
 
15,021

 
(4,919
)
Total revenues
314,133

 
119,633

 
697,790

 
234,625

Expenses
 
 
 
 
 
 
 
Employee compensation and benefits
103,430

 
75,143

 
225,749

 
107,352

Execution and clearance fees
73,242

 
45,951

 
148,743

 
86,908

Communications and data processing
38,279

 
21,301

 
75,075

 
41,995

Depreciation and amortization
19,823

 
7,746

 
39,926

 
15,913

Payments for order flow
18,076

 
448

 
40,108

 
1,037

Occupancy and equipment rentals
8,235

 
3,259

 
16,520

 
6,555

Debt interest expense
7,497

 
2,172

 
17,021

 
2,645

Professional fees
7,337

 
23,125

 
12,739

 
29,850

Collateralized financing interest
6,395

 

 
12,557

 

Business development
2,609

 
16

 
4,292

 
41

Writedown of capitalized debt costs
1,995

 

 
9,552

 

Writedown of assets and lease loss accrual, net
1,941

 
1,074

 
2,207

 
3,312

Other
10,767

 
14,234

 
19,410

 
18,711

Total expenses
299,626

 
194,469

 
623,899

 
314,319

Income (loss) from continuing operations before income taxes
14,507

 
(74,836
)
 
73,891

 
(79,694
)
Income tax expense
5,520

 
3,315

 
27,987

 
5,289

Income (loss) from continuing operations, net of tax
8,987

 
(78,151
)
 
45,904

 
(84,983
)
Loss from discontinued operations, net of tax
(67
)
 

 
(1,320
)
 

Net income (loss)
$
8,920

 
$
(78,151
)
 
$
44,584

 
$
(84,983
)
Net loss allocated to preferred and participating units
$

 
$
(21,535
)
 
$

 
$
(21,535
)
Net income (loss) attributable to common shareholders
$
8,920

 
$
(56,616
)
 
$
44,584

 
$
(63,448
)
Basic earnings (loss) per common share from continuing operations
$
0.08

 
$
(1.24
)
 
$
0.40

 
$
(1.39
)
Diluted earnings (loss) per common share from continuing operations
$
0.08

 
$
(1.24
)
 
$
0.39

 
$
(1.39
)
Basic earnings (loss) per common share from discontinued operations
$

 
$

 
$
(0.01
)
 
$

Diluted earnings (loss) per common share from discontinued operations
$

 
$

 
$
(0.01
)
 
$

Basic earnings (loss) per common share
$
0.08

 
$
(1.24
)
 
$
0.39

 
$
(1.39
)
Diluted earnings (loss) per common share
$
0.08

 
$
(1.24
)
 
$
0.38

 
$
(1.39
)
Shares used in computation of basic earnings per common share
114,859

 
45,576

 
115,282

 
45,514

Shares used in computation of diluted earnings per common share
117,601

 
45,576

 
118,170

 
45,514



The accompanying notes are an integral part of these consolidated financial statements.

4


KCG HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)


 
For the three months ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(In thousands)
Net income (loss)
$
8,920

 
$
(78,151
)
 
$
44,584

 
$
(84,983
)
Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized (loss) gain on available for sale securities, net of tax
(96
)
 
(7,394
)
 
(233
)
 
4,550

Cumulative translation adjustment, net of tax
291

 
(487
)
 
492

 
(403
)
Comprehensive income (loss)
$
9,115

 
$
(86,032
)
 
$
44,843

 
$
(80,836
)
 


























The accompanying notes are an integral part of these consolidated financial statements.

5


KCG HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited)

 
June 30,
 
December 31,
 
2014
 
2013
Assets
(In thousands)
Cash and cash equivalents
$
600,865

 
$
674,281

Cash and cash equivalents segregated under federal and other regulations
234,350

 
183,082

Financial instruments owned, at fair value, including securities pledged to counterparties that had the right to deliver or repledge of $514,580 at June 30, 2014 and $552,242 at December 31, 2013:
 
 
 
Equities
2,620,427

 
2,298,785

Listed options
178,598

 
339,798

Debt securities
90,782

 
83,256

Total financial instruments owned, at fair value
2,889,807

 
2,721,839

Collateralized agreements:
 
 
 
     Securities borrowed
1,602,467

 
1,357,387

Receivable from brokers, dealers and clearing organizations
1,588,926

 
1,257,251

Fixed assets and leasehold improvements, less accumulated depreciation and amortization
138,546

 
146,668

Investments
92,143

 
125,413

Goodwill and Intangible assets, less accumulated amortization
196,642

 
208,806

Deferred tax asset, net
175,363

 
175,639

Other assets
143,365

 
146,638

Total assets
$
7,662,474

 
$
6,997,004

Liabilities and equity
 
 
 
Liabilities
 
 
 
Financial instruments sold, not yet purchased, at fair value:
 
 
 
Equities
$
2,011,591

 
$
1,851,006

Listed options
158,942

 
252,282

Debt securities
230,821

 
57,198

Other financial instruments
758

 
5,014

Total financial instruments sold, not yet purchased, at fair value
2,402,112

 
2,165,500

Collateralized financings:
 
 
 
Securities loaned
824,663

 
733,230

Financial instruments sold under agreements to repurchase
950,110

 
640,950

Total collateralized financings
1,774,773

 
1,374,180

Payable to brokers, dealers and clearing organizations
647,120

 
474,108

Payable to customers
622,364

 
481,041

Accrued compensation expense
84,060

 
149,430

Accrued expenses and other liabilities
166,850

 
175,910

Capital lease obligations
9,222

 
10,039

Debt
422,259

 
657,259

Total liabilities
6,128,760

 
5,487,467

Equity
 
 
 
Class A Common Stock
 
 
 
Shares authorized: 1,000,000 at June 30, 2014 and December 31, 2013; Shares issued: 127,162 at June 30, 2014 and 123,317 at December 31, 2013; Shares outstanding: 121,111 at June 30, 2014 and 122,238 at December 31, 2013
1,272

 
1,233

Additional paid-in capital
1,343,963

 
1,306,549

Retained earnings
256,262

 
211,678

Treasury stock, at cost; 6,051 shares at June 30, 2014 and 1,079 shares at December 31, 2013
(69,443
)
 
(11,324
)
Accumulated other comprehensive income
1,660

 
1,401

Total equity
1,533,714

 
1,509,537

Total liabilities and equity
$
7,662,474

 
$
6,997,004





The accompanying notes are an integral part of these consolidated financial statements.

6

KCG HOLDINGS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
For the six months ended June 30, 2014
(Unaudited)




 
(in thousands)
 
 
Class A Common
Stock
 
 
 
 
 
Treasury Stock
 
 
 
 
 
 
Shares
 
Amount
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Shares
 
Amount
 
Accumulated
other
comprehensive
income (loss)
 
Total
Equity
Balance, December 31, 2013 - as reported
 
123,317

 
$
1,233

 
$
1,306,549

 
$
209,393

 
(1,079
)
 
$
(11,324
)
 
$
1,401

 
$
1,507,252

Cumulative effect of change in accounting principle - Footnote 3
 

 

 

 
2,285

 

 

 

 
2,285

Balance, December 31, 2013 - as adjusted
 
123,317

 
1,233

 
1,306,549

 
211,678

 
(1,079
)
 
(11,324
)
 
1,401

 
1,509,537

Class A Common Stock repurchased
 

 

 

 

 
(4,972
)
 
(58,119
)
 

 
(58,119
)
Stock-based compensation
 
3,845

 
39

 
37,414

 

 

 

 

 
37,453

Unrealized loss on available for sale securities, net
 

 

 

 

 

 

 
(233
)
 
(233
)
Cumulative translation adjustment
 

 

 

 

 

 

 
492

 
492

Net income
 

 

 

 
44,584

 

 

 

 
44,584

Balance, June 30, 2014
 
127,162

 
$
1,272

 
$
1,343,963

 
$
256,262

 
(6,051
)
 
$
(69,443
)
 
$
1,660

 
$
1,533,714




























The accompanying notes are an integral part of these consolidated financial statements.

7


KCG HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)




 
For the six months ended June 30,
 
2014
 
2013
Cash flows from operating activities
(In thousands)
Net income (loss)
$
44,584

 
$
(84,983
)
Loss from discontinued operations, net of tax
(1,320
)
 

Income (loss) from continuing operations, net of tax
45,904

 
(84,983
)
Adjustments to reconcile income (loss) from continuing operations, net of tax
to net cash provided by operating activities
 
 
 
Depreciation and amortization
39,926

 
15,913

Stock and unit-based compensation
32,907

 
26,960

Writedown and amortization of debt offering costs
11,557

 
473

Writedown of assets and lease loss accrual, net
2,207

 
3,312

Unrealized (gain) loss on investments
(15,140
)
 
2,978

Deferred rent
(129
)
 

Operating activities from discontinued operations
(1,119
)
 

(Increase) decrease in operating assets
 
 
 
Cash and cash equivalents segregated under federal and other regulations
(51,267
)
 

Financial instruments owned, at fair value
(167,968
)
 
92,101

Securities borrowed
(245,080
)
 
(38,474
)
Receivable from brokers, dealers and clearing organizations
(331,675
)
 
(214,128
)
Other assets
(8,009
)
 
380

(Increase) decrease in operating liabilities
 
 
 
Financial instruments sold, not yet purchased, at fair value
236,612

 
230,108

Securities loaned
91,433

 

Financial instruments sold under agreements to repurchase
309,160

 

Payable to brokers, dealers and clearing organizations
173,012

 
9,916

Payable to customers
141,323

 

Accrued compensation expense
(60,825
)
 
10,069

Accrued expenses and other liabilities
(10,993
)
 
36,658

Net cash provided by operating activities
191,836

 
91,283

Cash flows from investing activities
 
 
 
Proceeds and distributions from investments
48,627

 
1,201

Purchases of fixed assets and leasehold improvements
(14,781
)
 
(12,396
)
Capitalized software development costs
(5,615
)
 

Purchases of investments
(593
)
 

Sale of trading rights
554

 

Net cash provided by (used in) investing activities
28,192

 
(11,195
)
Cash flows from financing activities
 
 
 
Repayment of Credit Agreement
(235,000
)
 

Proceeds from issuance of Senior Secured Notes

 
296,994

Cash held under restrictions

 
(308,081
)
Borrowings under capital lease obligations
4,525

 

Principal payments on capital lease obligations
(5,342
)
 
(8,725
)
Cost of common stock repurchased
(58,119
)
 

Borrowings under secured credit facility

 
25,000

Repayment of secured credit facility

 
(25,000
)
Repurchase of members' interest

 
(21,002
)
Net cash used in financing activities
(293,936
)
 
(40,814
)
Effect of exchange rate changes on cash and cash equivalents
492

 
(403
)
(Decrease) increase in cash and cash equivalents
(73,416
)
 
38,871

Cash and cash equivalents at beginning of period
674,281

 
427,631

Cash and cash equivalents at end of period
$
600,865

 
$
466,502

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
39,129

 
$
3,950

Cash paid for income taxes
$
14,040

 
$
6,197


 


The accompanying notes are an integral part of these consolidated financial statements.

8

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)



1. Organization and Description of the Business
KCG Holdings, Inc. (collectively with its subsidiaries, "KCG" or the "Company") is a leading independent securities firm offering clients a range of services designed to address trading needs across asset classes, product types and time zones. The Company combines advanced technology with specialized client service across market making, agency execution and trading venues and also engages in principal trading via direct-to-client and non-client exchange-based electronic market making. KCG has multiple access points to trade global equities, options, futures, fixed income, currencies and commodities via voice or automated execution.
On December 19, 2012, Knight Capital Group, Inc.(“Knight”) and GETCO Holding Company, LLC (“GETCO”) entered into an agreement and plan of merger (as amended and restated on April 15, 2013 the “Merger Agreement”) for a series of strategic business combinations (the “Mergers”). The Mergers were approved by the respective stockholders and unitholders of both companies at special meetings held on June 25, 2013, and the Mergers were completed on July 1, 2013. As a result of the Mergers, Knight and GETCO each became a wholly-owned subsidiary of KCG.
The Mergers took place in order to combine the businesses, intellectual capital and resources of the two companies to more successfully compete in the highly regulated and technologically advanced marketplace and to allow for further diversification of each company's revenues from principal and agency trading across asset classes and regions. The Mergers were treated as a purchase of Knight by GETCO for accounting and financial reporting purposes. As a result, the financial results for the three and six months ended June 30, 2013 comprise the results of GETCO only and the financial results for the three and six months ended June 30, 2014 comprise the results of KCG.
As of June 30, 2014, the Company's operating segments comprised the following: (i) Market Making; (ii) Global Execution Services; and (iii) Corporate and Other.
Market Making
The Market Making segment principally consists of market making in the cash, futures and options markets across global equities, options, fixed income, foreign currencies and commodities. As a market maker, the Company commits capital on a principal basis by offering to buy securities from, or sell securities to, broker dealers, institutions and banks. Principal trading in the Market Making segment primarily consists of direct-to-client and non-client exchange-based electronic market making, including trade executions conducted as an equities Designated Market Maker (“DMM”) on the New York Stock Exchange ("NYSE") and NYSE Amex Equities ("NYSE Amex"). The Company is an active participant on all major global equity and futures exchanges and also trades on substantially all domestic electronic options exchanges. As a complement to electronic market making, the Company’s cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, marketplaces operated by the OTC Markets Group Inc. and the Alternative Investment Market (“AIM”) of the London Stock Exchange.
Global Execution Services
The Global Execution Services segment comprises agency execution services and trading venues, offering trading in global equities, options, foreign exchange, fixed income and futures to institutions, banks and broker dealers. The Company generally earns commissions as an agent between principals to transactions that are executed within this segment, however, the Company will commit capital on behalf of clients as needed. Agency-based, execution-only trading in the segment is done primarily through a variety of access points including: (i) self-directed trading in global equities through a suite of algorithms or via the Company's execution management system; (ii) institutional high touch sales traders executing program, block and riskless principal trades in global equities and exchange traded funds ("ETFs"); (iii) an institutional spot foreign exchange electronic communication network ("ECN"); (iv) a fixed income ECN that also offers trading applications; (v) an alternative trading system ("ATS") for global equities; and (vi) futures execution and clearing through a futures commission merchant ("FCM").
Corporate and Other
The Corporate and Other segment invests principally in strategic financial services-oriented opportunities; allocates, deploys and monitors all capital; and maintains corporate overhead expenses and all other income and expenses that are not attributable to the other segments. The Corporate and Other segment also contains functions that support the Company’s other segments such as self-clearing services, including stock lending activities.

9

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Discontinued Operations
Management of the Company from time to time conducts a strategic review of its businesses and evaluates their potential value in the marketplace relative to their current and expected returns. To the extent management and the Company's Board of Directors determine a business may return a higher value to stockholders, or is no longer core to the Company's strategy, the Company may divest or exit such business.
In July 2013, KCG entered into an agreement to sell to an investor group Urban Financial of America, LLC, formerly known as Urban Financial Group, Inc. (“Urban”), the reverse mortgage origination and securitization business that was previously owned by Knight. The transaction was completed in the fourth quarter of 2013, and residual expenses of Urban's operations and costs of the related sale have been reported in Loss from discontinued operations, net of tax on the Consolidated Statements of Operations for the three and six months ended June 30, 2014. See Footnote 4 "Discontinued Operations" for further discussion.
2. Merger of GETCO and Knight
Background
Pursuant to the Merger Agreement, each outstanding share of Knight Class A common stock, par value $0.01 per share (“Knight Common Stock”) was converted into the right to elect to receive either $3.75 per share in cash or one third of a share of KCG Class A common stock, par value $0.01 per share (“KCG Class A Common Stock”). As a result of the elections and proration procedures provided in the Merger Agreement, former Knight stockholders received cash payments aggregating $720.0 million and 41.9 million shares of KCG Class A Common Stock.
Upon completion of the Mergers, GETCO unitholders received, in aggregate, 75.9 million shares of KCG Class A Common Stock and 24.3 million warrants to acquire shares of KCG Class A Common Stock. The warrants comprise 8.1 million Class A warrants, having a $12.00 exercise price and exercisable for a four-year term; 8.1 million Class B warrants, having a $13.50 exercise price and exercisable for a five-year term; and 8.1 million Class C warrants, having a $15.00 exercise price and exercisable for a six-year term (collectively the “KCG Warrants”).
Accounting treatment of the Mergers
The Mergers are accounted for as a purchase of Knight by GETCO under accounting principles generally accepted in the United States of America ("GAAP") based on, among other factors, the controlling ownership position of the former GETCO unitholders as of the closing of the Mergers. Under the purchase method of accounting, the assets and liabilities of Knight as of July 1, 2013 were recorded at their respective fair values and added to the carrying value of GETCO's existing assets and liabilities. The reported financial condition and results of operations of KCG for the periods following the Mergers reflect Knight's and GETCO's balances and reflect the impact of purchase accounting adjustments, including revised amortization and depreciation expense for acquired assets. As GETCO is the accounting acquirer, the financial results for KCG for the three and six months ended June 30, 2013 comprise solely the results of GETCO.
Prior to the Mergers, GETCO treated its investment in Knight as an available-for-sale security, which it recorded at fair value, with any gains or losses recorded in other comprehensive income as a component of equity.
All GETCO earnings per share and unit share outstanding amounts in these financial statements have been calculated as if the conversion of GETCO units to KCG Class A Common Stock took place on January 1, 2013, at the exchange ratio as defined in the Merger Agreement. See Footnote 17 "Earnings Per Share" for further discussion.
Purchase price and goodwill
The Knight acquisition was accounted for using the acquisition method of accounting. The aggregate purchase price of $1.37 billion was determined as the sum of the fair value of KCG shares issued to former Knight stockholders at closing; the fair value of Knight employee stock based awards attributable to periods prior to closing; and the fair value of the Knight Common Stock owned by GETCO and its subsidiaries immediately prior to the Mergers (and subsequently canceled in conjunction with the Mergers).
The purchase price has been allocated to the assets acquired and liabilities assumed using their estimated fair values at July 1, 2013, the closing date of the Mergers. For the six months ended June 30, 2014, the Company, based on updated information, recorded purchase accounting adjustments that increased goodwill by $1.1 million, deferred tax assets by $3.1 million, and accrued expenses by $3.5 million, and decreased other assets by $0.7 million on the opening balance sheet at July 1, 2013 as well as the December 31, 2013 Consolidated Statement of Financial Condition.

10

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






As of June 30, 2014, the Company has completed its analysis to finalize the allocation of the purchase price to the Knight acquired assets and liabilities.
Tax treatment of the Mergers
The Company believes that the Mergers will be treated as a transaction described in Section 351 of the Internal Revenue Code, and both Knight and GETCO have received tax opinions from external legal counsel to that effect. Knight’s tax basis in its assets and liabilities therefore generally carries over to the Company following the Mergers. Upon completion of the Mergers, the Company became a corporation subject to U.S. corporate income taxes and, following the Mergers, the Company recorded deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. The Company measures deferred taxes using the enacted tax rates and laws that will be in effect when such temporary differences are expected to reverse.
The Company recorded net deferred tax assets of $65.5 million with respect to recording Knight’s assets and liabilities under the purchase method of accounting as described above as well as recording the value of tax net operating loss ("NOL”) carryforwards and other tax attributes acquired as a result of the Mergers, as described in Footnote 14 “Income Taxes”.
The following table reflects the allocation of the purchase price to the assets acquired and liabilities assumed at the acquisition date (in thousands):
Identifiable Net Assets
 
 
 
 
Cash and cash equivalents
 
 
 
$
509,133

Cash and cash equivalents segregated under federal and other regulations
 
 
 
203,045

Financial instruments owned
 
 
 
1,937,929

Securities borrowed
 
 
 
1,158,981

Receivable from brokers, dealers and clearing organizations
 
 
 
1,369,474

Fixed assets and leasehold improvements
 
 
 
80,280

Investments
 
 
 
106,353

Intangible assets
 
 
 
155,425

Assets within discontinued operations
 
 
 
5,607,063

Deferred tax asset, net
 
 
 
65,465

Other assets
 
 
 
140,933

Total Assets
 
 
 
$
11,334,081

 
 
 
 
 
Financial instruments sold, not yet purchased
 
 
 
$
1,512,983

Collateralized financings
 
 
 
1,166,211

Payable to brokers, dealers and clearing organizations
 
 
 
635,914

Payable to customers
 
 
 
527,918

Accrued compensation expense
 
 
 
107,409

Accrued expenses and other liabilities
 
 
 
130,010

Liabilities within discontinued operations
 
 
 
5,518,168

Debt
 
 
 
375,000

Total Liabilities
 
 
 
$
9,973,613

 
 
 
 
 
Total identified assets acquired, net of assumed liabilities
 
 
 
1,360,468

 
 
 
 
 
Goodwill
 
 
 
12,666

 
 
 
 
 
Total Purchase Price
 
 
 
$
1,373,134

Goodwill has been primarily assigned to the Market Making segment of the Company. None of the goodwill is expected to be deductible for tax purposes; however, as described in Tax treatment of the Mergers above, Knight’s tax basis in its assets, including certain goodwill, has carried over to the Company as a result of the Mergers.

11

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Amounts allocated to intangible assets and goodwill, and the amortization period for intangible assets with finite useful lives, were as follows (dollars in thousands):
 
 
 
 
Amortization
 
 
Amount
 
Years
Technology
 
$
110,504

 
 5 years
Customer relationships
 
35,000

 
 9 - 11 years
Trade names
 
4,000

 
 10 years
Trading rights (1)
 
5,921

 
 7 years
Intangible assets
 
155,425

 
 
Goodwill
 
12,666

 
 
Total
 
$
168,091

 
 
(1)
Trading rights include both assets with a finite useful life and assets with an indefinite useful life. The 7 years amortization period only applies to assets with a finite useful life.
3. Significant Accounting Policies
Basis of consolidation and form of presentation
The Consolidated Financial Statements, prepared in conformity with GAAP, include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated.
Certain reclassifications have been made to the prior periods’ Consolidated Financial Statements in order to conform to the current period presentation. Such reclassifications are immaterial to both current and all previously issued financial statements taken as a whole and have no effect on previously reported Consolidated Net income.
Change in accounting principle
As discussed in Footnote 9 "Investments", during the first quarter of 2014 the Company changed its method of accounting for its investment in BATS Global Markets, Inc. ("BATS") following the merger of BATS and Direct Edge Holdings LLC ("Direct Edge").
As a result of the change in accounting principle, the Consolidated Statement of Financial Condition at December 31, 2013 has been adjusted as follows: Investments increased by approximately $3.4 million, Deferred tax asset, net decreased by $1.1 million and Retained earnings increased by $2.3 million. The Consolidated Statements of Operations for the three and six months ended June 30, 2013 have been adjusted to increase Investment income (loss) and other, net by $1.9 million and $4.3 million, respectively.
During the first quarter of 2014 the Company recognized income of $9.6 million related to the merger of BATS and Direct Edge which is recorded within Investment income (loss) and other, net in the Consolidated Statements of Operations. The $9.6 million comprises a partial realized gain with respect to the Company's investment in Direct Edge of $16.2 million offset, in part, by the Company's share of BATS' and Direct Edge's merger related transaction costs that were charged against their respective earnings of $6.6 million.
Cash and cash equivalents
Cash and cash equivalents include money market accounts, which are payable on demand, and short-term investments with an original maturity of less than 90 days. The carrying amount of such cash equivalents approximates their fair value due to the short-term nature of these instruments.
Cash and cash equivalents segregated under federal and other regulations
The Company maintains custody of customer funds and is obligated by rules and regulations mandated by the U.S. Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) to segregate or set aside cash and/or qualified securities to satisfy these regulations, which have been promulgated to protect customer assets. The amounts recognized as Cash and cash equivalents segregated under federal and other regulations approximate fair value.

12

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Market making, sales, trading and execution activities
Financial instruments owned and Financial instruments sold, not yet purchased, relate to market making and trading activities, include listed and other equity securities, listed equity options and fixed income securities which are recorded on a trade date basis and carried at fair value. Trading revenues, net, which comprises trading gains, net of trading losses, are also recorded on a trade date basis.
Commissions, which includes commission equivalents earned on institutional client orders and commissions on futures transactions, and related expenses are also recorded on a trade date basis. Commissions earned by the Company’s FCM are recorded net of any commissions paid to independent brokers and are recognized on a half-turn basis.
The Company’s third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by such clearing brokers, for facilitating the settlement and financing of securities transactions. Interest income and interest expense which have been netted within Interest, net on the Consolidated Statements of Operations are as follows (in thousands):
 
For the three months ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
Interest Income
$
3,777

 
$
1,043

 
$
7,128

 
$
2,030

Interest Expense
(4,066
)
 
(1,715
)
 
(6,469
)
 
(2,823
)
Interest, net
$
(289
)
 
$
(672
)
 
$
659

 
$
(793
)
Dividend income relating to securities owned and dividend expense relating to securities sold, not yet purchased, derived primarily from the Company’s market making activities are included as a component of Trading revenues, net on the Consolidated Statements of Operations. Trading revenues, net includes dividend income and expense as follows (in thousands): 
 
For the three months ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
Dividend Income
$
9,832

 
$
1,974

 
$
19,615

 
$
2,475

Dividend Expense
$
(8,203
)
 
$
(720
)
 
$
(15,778
)
 
$
(1,136
)
Payments for order flow represent payments to broker dealer clients, in the normal course of business, for directing their order flow in U.S. equities and options to the Company.
 
Fair value of financial instruments
The Company values its financial instruments using a hierarchy of fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.
The fair value hierarchy can be summarized as follows:
Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
Level 2—Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
Changes in fair value are recognized in earnings each period for financial instruments that are carried at fair value. See Footnote 6 “Fair Value of Financial Instruments” for a description of valuation methodologies applied to the classes of financial instruments at fair value.

13

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Collateralized agreements and financings
Collateralized agreements consist of securities borrowed and collateralized financings include securities loaned and financial instruments sold under agreements to repurchase.
Securities borrowed and securities loaned transactions are recorded at the amount of cash collateral advanced or received. Securities borrowed transactions facilitate the securities settlement process and require the Company to deposit cash or other collateral with the lender. Securities loaned transactions help finance the Company’s securities inventory whereby the Company lends stock to counterparties in exchange for the receipt of cash or other collateral from the borrower. In these transactions, the Company receives or lends cash or other collateral in an amount generally in excess of the market value of the applicable securities borrowed or loaned. The Company monitors the market value of securities borrowed or loaned on a daily basis, and obtains additional collateral or refunds excess collateral as necessary.
Financial instruments sold under agreements to repurchase are used to finance inventories of securities and other financial instruments and are recorded at their contractual amount. The Company has entered into bilateral and tri-party term and overnight repurchase agreements which bear interest at negotiated rates. The Company receives cash and makes delivery of financial instruments to a custodian who monitors the market value of these instruments on a daily basis. The market value of the instruments delivered must be equal to or in excess of the principal amount loaned under the repurchase agreements plus the agreed upon margin requirement. The custodian may request additional collateral, if appropriate.
The Company’s securities borrowed, securities loaned and financial instruments sold under agreements to repurchase are recorded at amounts that approximate fair value. These items are recorded based upon their contractual terms and are not materially sensitive to shifts in interest rates because they are short-term in nature and are fully collateralized. These items would be categorized as Level 2 in the fair value hierarchy if they were required to be recorded at fair value.
Investments
Investments primarily comprise strategic noncontrolling equity ownership interests in financial services-related businesses and are held by the Company's non-broker dealer subsidiaries. These strategic investments are accounted for under either the equity method, at cost or at fair value. The equity method of accounting is used when the Company has significant influence. Strategic investments are held at cost, less impairment if any, when the investment does not have a readily determined fair value, and the Company is not considered to exert significant influence on operating and financial policies of the investee. Strategic investments with a readily determinable fair value are held at fair value.
Prior to the Mergers, GETCO had a strategic investment in Knight which was classified as available for sale and held at fair value with any unrealized gains or losses recorded in Other comprehensive income or loss.
Strategic investments are reviewed on an ongoing basis to ensure that the carrying values of the investments have not been impaired. If the Company determines that an impairment loss on a strategic investment has occurred due to a decline in fair value or other market conditions, the investment is written down to its estimated fair value.
Goodwill and intangible assets
The Company tests goodwill and intangible assets with an indefinite useful life for impairment annually or when an event occurs or circumstances change that signifies the existence of an impairment. The Company capitalizes certain costs associated with the acquisition or development of internal-use software and amortizes the software over its estimated useful life of three years, commencing at the time the software is placed in service. The Company amortizes intangible assets with a finite life on a straight line basis over their estimated useful lives and tests for recoverability whenever events indicate that the carrying amounts may not be recoverable.
Payable to customers
Payable to customers arise primarily from futures transactions and include amounts due on cash and margin transactions. Due to their short-term nature, such amounts approximate fair value.
Treasury stock
The Company records its purchases of treasury stock at cost as a separate component of stockholders’ equity. The Company may obtain treasury stock through purchases in the open market or through privately negotiated transactions. Certain treasury stock repurchases represent shares of KCG Class A Common Stock repurchased in

14

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






satisfaction of tax withholding obligations upon vesting of restricted awards. The Company may re-issue treasury stock, at average cost, for the acquisition of new businesses and in certain other circumstances.
Foreign currency translation and foreign currency forward contracts
The Company's foreign subsidiaries generally use the U.S. dollar as their functional currency. Effective January 1, 2014, one of the Company's U.K. subsidiaries changed its functional currency from British pounds to U.S. dollars. The Company has a subsidiary in India that utilizes the Indian rupee as its functional currency.
Assets and liabilities of this Indian subsidiary are translated at exchange rates at the end of a period. Revenues and expenses are translated at average exchange rates during the period. Gains and losses resulting from translating foreign currency financial statements into U.S. dollars are included in Accumulated other comprehensive income on the Consolidated Statements of Financial Condition and Cumulative translation adjustment, net of tax on the Consolidated Statements of Comprehensive Income.
Gains or losses resulting from foreign currency transactions are included in Investment income (loss) and other, net on the Company’s Consolidated Statements of Operations. For the three months ended June 30, 2014 and 2013, the Company recorded a gain of $34,700 and a loss of $0.6 million, respectively on foreign currency transactions . For the six months ended June 30, 2014 and 2013, the Company recorded losses on foreign currency transactions of $0.7 million and $1.1 million, respectively.
The Company seeks to reduce the impact of fluctuations in foreign exchange rates on its net investment in certain non-U.S. operations through the use of foreign currency forward contracts. For foreign currency forward contracts designated as hedges, the Company assesses its risk management objectives and strategy, including identification of the hedging instrument, the hedged item and the risk exposure and how effectiveness is to be assessed prospectively and retrospectively. The effectiveness of the hedge is assessed based on the overall changes in the fair value of the forward contracts. For qualifying net investment hedges, any gains or losses, to the extent effective, are included in Accumulated other comprehensive income on the Consolidated Statements of Financial Condition. The ineffective portion, if any, is recorded in Investment income (loss) and other, net on the Consolidated Statements of Operations.
Stock and unit based compensation
Stock and unit based compensation is measured based on the grant date fair value of the awards. These costs are amortized over the requisite service period, which is typically the vesting period. Expected forfeitures are considered in determining stock-based employee compensation expense.
The Company applies a non-substantive vesting period approach for stock-based awards related to KCG Class A Common Stock whereby the expense is accelerated for those employees and directors that receive options, stock appreciation rights ("SARs") and restricted stock units ("RSUs") and are eligible to retire prior to the vesting of such awards.
Soft dollar expense
Under a commission management program, the Company allows institutional clients to allocate a portion of their gross commissions to pay for research and other services provided by third parties. As the Company acts as an agent in these transactions, it records such expenses on a net basis within Commissions and fees on the Consolidated Statements of Operations.
Depreciation, amortization and occupancy
Fixed assets are depreciated on a straight-line basis over their estimated useful lives of three to seven years. Leasehold improvements are being amortized on a straight-line basis over the shorter of the term of the related office lease or the expected useful life of the assets. The Company reviews fixed assets and leasehold improvements for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable.
The Company recognizes rent expense under operating leases with fixed rent escalations, lease incentives and free rent periods on a straight-line basis over the lease term beginning on the date the Company takes possession of or controls the use of the space, including during free rent periods.

15

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Lease loss accrual
The Company’s policy is to identify excess real estate capacity and where applicable, accrue for related future costs, net of projected sub-lease income upon the date the Company ceases to use the excess real estate. Such accrual is adjusted to the extent the actual terms of sub-leased property differ from the assumptions used in the calculation of the accrual.
Income taxes
Prior to the Mergers, GETCO and the majority of its subsidiaries were treated as partnerships or disregarded entities for U.S. income tax purposes and, accordingly, were not subject to federal income taxes. Instead, the former GETCO members were liable for federal income taxes on their proportionate share of taxable income. Upon completion of the Mergers, the Company became a corporation subject to U.S. corporate income taxes and, following the Mergers, the Company records deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and measures them using the enacted tax rates and laws that will be in effect when such differences are expected to reverse. The Company evaluates the recoverability of future tax deductions by assessing the adequacy of future expected taxable income from all sources, including reversal of temporary differences and forecasted operating earnings.
Use of estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.
Recently adopted accounting guidance
In March 2013, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standard Update (“ASU”) concerning the parent's accounting for the cumulative translation adjustment upon derecognition of certain subsidiaries or groups of assets within a foreign entity or of an investment in a foreign entity. This ASU provides for the release of the cumulative translation adjustment into net income when a parent sells a part or all of its investment within a foreign entity, no longer holds a controlling interest in an investment in a foreign entity or obtains control of an investment in a foreign entity that was previously recognized as an equity method investment. This ASU was effective for reporting periods beginning after December 15, 2013. The adoption of this ASU did not have an impact on the Company's Consolidated Financial Statements.
In July 2013, the FASB issued an ASU to clarify the financial statement presentation of an unrecognized tax benefit when a NOL carryforward, a similar tax loss, or a tax credit carryforward exists. This ASU requires entities to present an unrecognized tax benefit as a reduction of a deferred tax asset for a NOL carryforward whenever the NOL or tax credit carryforward would be available to reduce the additional taxable income or tax due if the tax position is disallowed. The ASU was effective for reporting periods beginning after December 15, 2013. The adoption of this ASU did not have an impact on the Company's Consolidated Financial Statements.
Recent accounting guidance to be adopted in future periods
In April 2014, the FASB issued an ASU that amends the requirements for reporting discontinued operations. Under the new guidance, discontinued operations reporting will be limited to disposal transactions that represent strategic shifts having a major effect on operations and financial results. The amended guidance also enhances disclosures and requires assets and liabilities of a discontinued operation to be classified as such for all periods presented in the financial statements. The updated guidance is effective prospectively to all disposals occurring for interim and annual reporting periods after December 15, 2014, with early adoption permitted. Due to the change in requirements for reporting discontinued operations described above, presentation and disclosures of future disposal transactions may be different than under current guidance.
In May 2014, the FASB issued an ASU that updates the principles for recognizing revenue. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. The Company is evaluating the impact of this ASU on its Consolidated Financial Statements.

16

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






4. Discontinued Operations
In July 2013, the Company entered into an agreement to sell to an investor group Urban, the reverse mortgage origination and securitization business that was previously owned by Knight. The transaction was completed in the fourth quarter of 2013, and, as a result, the residual expenses of Urban's operations and costs of the related sale have been included in Loss from discontinued operations, net of tax within the Consolidated Statements of Operations for the three and six months ended June 30, 2014.
The revenues and results of operations of discontinued operations are summarized as follows (in thousands):
 
For the three months ended June 30, 2014
 
For the six months ended June 30, 2014
Additional Loss on Sale
$
(1
)
 
$
(1,313
)
 
 
 
 
Expenses:
 
 
 
   Compensation
$
126

 
$
171

   Other expenses
(19
)
 
645

Total Expenses
107

 
816

Pre-tax loss from discontinued operations
(108
)
 
(2,129
)
Income tax benefit
41

 
809

Loss from discontinued operations, net of tax
$
(67
)
 
$
(1,320
)
5. Assets Segregated or Held in Separate Accounts Under Federal or Other Regulations
Cash and securities segregated under U.S. federal and other regulations primarily relate to the Company’s FCM business and consist of the following (in thousands): 
 
June 30,
2014
 
December 31, 2013
   Cash and cash equivalents segregated under federal or other regulations
$
234,350

 
$
183,082

   Receivable from brokers, dealers and clearing organizations (1)
364,955

 
304,294

Total assets segregated or held in separate accounts under federal or other regulations
$
599,305

 
$
487,376

(1) Segregated assets included within Receivable from brokers, dealers and clearing organizations comprise cash and cash equivalents and U.S. government obligations primarily held as deposits with exchange clearing organizations.

17

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






6.    Fair Value of Financial Instruments
The Company’s financial instruments recorded at fair value have been categorized based upon a fair value hierarchy in accordance with accounting guidance, as described in Footnote 3 “Significant Accounting Policies.” The following fair value hierarchy table presents information about the Company’s financial assets and liabilities measured at fair value (in thousands):
 
Assets and Liabilities Measured at
Fair Value on a Recurring Basis
June 30, 2014
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Financial instruments owned, at fair value:
 
 
 
 
 
 
 
Equities (1)
$
2,620,427

 
$

 
$

 
$
2,620,427

Listed options
178,598

 

 

 
178,598

U.S. government and Non-U.S. government obligations (2)
28,317

 

 

 
28,317

Corporate debt (3)
62,465

 

 

 
62,465

Total Financial instruments owned, at fair value
2,889,807

 

 

 
2,889,807

Securities on deposit with clearing organizations (4)
189,045

 

 

 
189,045

Investment in CME Group (5)
3,549

 

 

 
3,549

Deferred compensation investments (5)

 
752

 

 
752

Investment in Deephaven Funds (5)

 
169

 

 
169

Total assets held at fair value
$
3,082,401

 
$
921

 
$

 
$
3,083,322

Liabilities

 

 

 

Financial instruments sold, not yet purchased, at fair value:
 
 
 
 
 
 
 
Equities (1)
$
2,011,591

 
$

 
$

 
$
2,011,591

Listed options
158,942

 

 

 
158,942

U.S. government obligations (2)
160,646

 

 

 
160,646

Corporate debt (3)
70,175

 

 

 
70,175

Foreign currency forward contracts

 
758

 

 
758

Total liabilities held at fair value
$
2,401,354

 
$
758

 
$

 
$
2,402,112

(1) 
Equities of $914.0 million have been netted by their respective long and short positions by CUSIP number.
(2) 
U.S. Government Obligations of $0.6 million have been netted by their respective long and short positions by CUSIP number.
(3) 
Corporate debt of $0.2 million have been netted by their respective long and short positions by CUSIP number.
(4) 
Securities on deposit with clearing organizations consist of U.S. government obligations and are recorded within Receivable from brokers, dealers and clearing organizations on the Consolidated Statements of Financial Condition.
(5) 
Investment in CME Group, Deferred compensation investments and Investment in Deephaven Funds are included within Investments on the Consolidated Statements of Financial Condition.


18

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






 
Assets and Liabilities Measured at
Fair Value on a Recurring Basis
December 31, 2013
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Financial instruments owned, at fair value:
 
 
 
 
 
 
 
Equities (1)
$
2,298,785

 
$

 
$

 
$
2,298,785

Listed options
339,798

 

 

 
339,798

U.S. government and Non-U.S. government obligations
40,053

 

 

 
40,053

Corporate debt
43,203

 

 

 
43,203

Total Financial instruments owned, at fair value
2,721,839

 

 

 
2,721,839

Securities on deposit with clearing organizations (2)
170,235

 

 

 
170,235

Investment in CME Group (3)
3,925

 

 

 
3,925

Deferred compensation investments (3)

 
117

 

 
117

Investment in Deephaven Funds (3)

 
1,958

 

 
1,958

Total assets held at fair value
$
2,895,999

 
$
2,075

 
$

 
$
2,898,074

Liabilities
 
 
 
 
 
 
 
Financial instruments sold, not yet purchased, at fair value:
 
 
 
 
 
 
 
Equities (1)
$
1,851,006

 
$

 
$

 
$
1,851,006

Listed options
252,282

 

 

 
252,282

U.S. government obligations
15,076

 

 

 
15,076

Corporate debt
42,122

 

 

 
42,122

Foreign currency forward contracts

 
5,014

 

 
5,014

Total liabilities held at fair value
$
2,160,486

 
$
5,014

 
$

 
$
2,165,500

(1) Equities of $697.9 million have been netted by their respective long and short positions by CUSIP number.
(2)  
Securities on deposit with clearing organizations consist of U.S. government obligations and are recorded within Receivable from brokers, dealers and clearing organizations on the Consolidated Statements of Financial Condition.
(3) Investment in CME Group, Deferred compensation investments and Investment in Deephaven Funds are included within Investments on the Consolidated Statements of Financial Condition.
The Company’s equities, listed options, U.S. government and non-U.S. government obligations, corporate debt and strategic investments that are actively traded are generally classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices or broker or dealer quotations with reasonable levels of price transparency.
The types of instruments that trade in markets that are not considered to be active, but are valued based on observable inputs such as quoted market prices or alternative pricing sources with reasonable levels of price transparency are generally classified within Level 2 of the fair value hierarchy.
As of June 30, 2014 and December 31, 2013 the Company had no financial instruments classified within Level 3 of the fair value hierarchy.
The Company’s assets measured at fair value on a nonrecurring basis solely relate to goodwill and intangible assets arising from various acquisitions which would be classified as Level 3 within the fair value hierarchy. See Footnote 10 “Goodwill and Intangible Assets” for additional information.
There were no transfers of assets or liabilities held at fair value between levels of the fair value hierarchy for any periods presented.
The Company’s foreign currency forward contracts, deferred compensation investments and remaining investment in the Deephaven Funds are classified within Level 2 of the fair value hierarchy.
The following is a description of the valuation basis, techniques and significant inputs used by the Company in valuing its Level 2 assets and liabilities:
Foreign currency forward contracts
At June 30, 2014, the Company had foreign currency forward contracts with a notional value of 427.2 million Indian Rupees ($6.2 million U.S. dollars). These forward contracts are used to hedge the Company’s investment in its Indian subsidiary.

19

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






At December 31, 2013, the Company also had foreign currency contracts with a notional value of 80.0 million British Pounds. These forward contracts were used to hedge the Company's investment in its European subsidiaries. These forward contracts expired in the first quarter of 2014 and were not renewed.
The fair value of the forward contracts were determined based upon spot foreign exchange rates, LIBOR interest rates and dealer quotations. The Indian Rupee foreign currency forward contracts do not qualify as net investment hedges and any gains and losses are recorded in Investment income (loss) and other, net on the Consolidated Statements of Operations for the three and six months ended June 30, 2014.
Deferred compensation investments
Deferred compensation investments comprise investments in liquid mutual funds that the Company acquires to hedge its obligations to employees and directors under certain non-qualified deferred compensation arrangements. These mutual fund investments can generally be redeemed at any time and are valued based upon quoted market prices.
Investment in Deephaven Funds
Investment in Deephaven Funds represents the Company's residual investment in certain funds that were formerly managed by Deephaven Capital Management, a former Knight subsidiary. These investments are in the process of liquidation and are valued based upon the fair value of the underlying investments within such funds.
Derivative Instruments
Fair value of derivative instruments
The Company enters into derivative transactions, primarily with respect to making markets in listed domestic options. In addition, the Company enters into derivatives to manage foreign currency exposure. Cash flows associated with such derivative activities are included in cash flows from operating activities on the Consolidated Statements of Cash Flows, when applicable.
Futures
During the normal course of business, the Company enters into futures contracts. These financial instruments are subject to varying degrees of risks whereby the fair value of the securities underlying the financial instruments, may be in excess of, or less than, the contract amount. The Company is obligated to post collateral against certain futures contracts.
The amounts and positions included in the tables below for futures contracts are classified as Level 1 and swaps and forward contracts are classified as Level 2 in the fair value hierarchy.


20

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The following tables summarize the fair value of derivative instruments and futures contracts trading activities in the Consolidated Statements of Financial Condition and the gains and losses included in the Consolidated Statements of Operations (fair value and gain (loss) in thousands): 
 
 
 
June 30, 2014
 
Financial Statements
 
Assets
 
Liabilities
 
Location
 
Fair Value
 
Contracts
 
Fair Value
 
Contracts
Foreign currency
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
$
114

 
359

 
$
163

 
1,154

Forward contracts
Financial instruments sold, not yet purchased, at fair value
 
559

 
1

 
1,317

 
1

Equity
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
1,504

 
4,548

 
1,853

 
3,398

Swap contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
9

 
1

 

 

Listed options
Financial instruments owned/sold, not yet purchased, at fair value
 
178,598

 
550,401

 
158,942

 
551,378

Fixed income
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
3,347

 
20,548

 
3,124

 
20,738

Commodity
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
3,189

 
4,181

 
3,516

 
4,351

Total
 
 
$
187,320

 
581,038

 
$
168,915

 
581,020


 
 
 
December 31, 2013
 
Financial Statements
 
Assets
 
Liabilities
 
Location
 
Fair Value
 
Contracts
 
Fair Value
 
Contracts
Foreign currency
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
$
89

 
892

 
$
142

 
533

Forward contracts
Other assets
 
6,913

 
1

 
6,501

 
1

Forward contracts(1)
Financial instruments sold, not yet purchased, at fair value
 

 

 
5,014

 
1

Equity
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
223

 
1,069

 
1,089

 
1,046

Swap contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 

 

 
18

 
1

Listed options
Financial instruments owned/sold, not yet purchased, at fair value
 
339,798

 
730,020

 
252,282

 
755,947

Fixed income
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
4,815

 
18,280

 
2,259

 
15,202

Commodity
 
 
 
 
 
 
 
 
 
Futures contracts
Receivable from/Payable to brokers, dealers and clearing organizations
 
3,392

 
10,629

 
1,773

 
3,806

Total
 
 
$
355,230

 
760,891

 
$
269,078

 
776,537

(1) 
Designated as hedging instrument.

21

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






 
 
 
 
Gain (Loss) Recognized
 
 
Financial Statements
 
For the three months 
 ended June 30,
 
For the six months 
 ended June 30,
 
 
Location
 
2014
 
2013
 
2014
 
2013
Derivative instruments not designated as hedging instruments:
 
 
 
 
 
 
 
 
 
 
Foreign currency
 
 
 
 
 
 
 
 
 
 
Futures contracts
 
Trading revenues, net
 
$
2,952

 
$
2,562

 
$
5,794

 
$
5,132

Forward contracts
 
Investment Income (loss) and other, net
 
(120
)
 
75

 
312

 
584

Equity
 
 
 
 
 
 
 
 
 
 
  Futures contracts
 
Trading revenues, net
 
6,044

 
16,238

 
14,781

 
26,664

  Swap contracts
 
Trading revenues, net
 
1,061

 
5,435

 
2,343

 
8,871

  Listed options (1)
 
Trading revenues, net
 
2,212

 
28,288

 
(71,664
)
 
46,277

Fixed income
 
 
 
 
 
 
 
 
 
 
  Futures contracts
 
Trading revenues, net
 
5,118

 
22,178

 
13,947

 
42,202

Commodity
 
 
 
 
 
 
 
 
 
 
  Futures contracts
 
Trading revenues, net
 
12,435

 
13,975

 
26,005

 
25,279

 
 
 
 
$
29,702

 
$
88,751

 
$
(8,482
)
 
$
155,009

Derivative instruments designated as hedging instruments:
 
 
 
 
 
 
 
 
 
 
   Foreign exchange - forward contract
 
Accumulated other comprehensive income
 
$

 
$

 
$
168

 
$

(1) 
Realized gains and losses on listed equity options relate to the Company’s market making activities in such options. Such market making activities also comprise trading in the underlying equity securities with gains and losses on such securities generally offsetting the gains and losses reported in this table. Gains and losses on such equity securities are also included in Trading revenues, net on the Company’s Consolidated Statements of Operations.
Assets and Liabilities Subject to Netting
The gross amounts of assets and liabilities subject to netting and gross amounts offset in the Consolidated Statements of Financial Condition were as follows (in thousands):
 
June 30, 2014
Gross Amounts Recognized
 
Gross Amounts Offset in the Statements of Financial Condition
 
Net Amounts of Assets Presented in the Statements of Financial Condition
 
Gross Amounts Not Offset in the Statement of Financial Condition
 
Net Amount
 
Financial Instruments
 
Cash Collateral
 
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
Listed options
$
178,598

 
$

 
$
178,598

 
$

 
$

 
$
178,598

 
Securities borrowed
1,602,467

 

 
1,602,467

 
1,562,911

 

 
39,556

 
Receivable from brokers, dealers and clearing organizations (1)
13,206

 

 
13,206

 
12,991

 

 
215

 
Foreign currency forward contracts
559

 
559

 

 

 

 

 
Futures
8,154

 
7,589

 
565

 

 

 
565

 
Total Assets
$
1,802,984

 
$
8,148

 
$
1,794,836

 
$
1,575,902

 
$

 
$
218,934

 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
Listed options
$
158,942

 
$

 
$
158,942

 
$

 
$
15,113

 
$
143,829

 
Securities loaned
824,663

 

 
824,663

 
812,001

 

 
12,662

 
Financial instruments sold under agreements to repurchase
950,110

 

 
950,110

 
950,110

 

 

 
Foreign currency forward contracts
1,317

 
559

 
758

 

 

 
758

 
Futures
8,656

 
8,656

 

 

 

 

 
Total Liabilities
$
1,943,688

 
$
9,215

 
$
1,934,473

 
$
1,762,111

 
$
15,113

 
$
157,249

(1) Represents reverse repurchase agreements at broker dealer.

22

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






 
December 31, 2013
Gross Amounts Recognized
 
Gross Amounts Offset in the Statements of Financial Condition
 
Net Amounts of Assets Presented in the Statements of Financial Condition
 
Gross Amounts Not Offset in the Statement of Financial Condition
 
Net Amount
 
Financial Instruments
 
Cash Collateral
 
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
Listed options
$
339,798

 
$

 
$
339,798

 
$

 
$

 
$
339,798

 
Securities borrowed
1,357,387

 

 
1,357,387

 
1,326,220

 

 
31,167

 
Receivable from brokers, dealers and clearing organizations (1)
24,366

 

 
24,366

 
24,249

 

 
117

 
Foreign currency forward contracts
6,913

 
6,501

 
412

 

 

 
412

 
Futures
8,519

 
4,369

 
4,150

 

 

 
4,150

 
Total Assets
$
1,736,983

 
$
10,870

 
$
1,726,113

 
$
1,350,469

 
$

 
$
375,644

 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
Listed options
$
252,282

 
$

 
$
252,282

 
$

 
$
10,924

 
$
241,358

 
Securities loaned
733,230

 

 
733,230

 
726,948

 

 
6,282

 
Financial instruments sold under agreements to repurchase
640,950

 

 
640,950

 
640,948

 

 
2

 
Foreign currency forward contracts
11,515

 
6,501

 
5,014

 

 

 
5,014

 
Futures
5,263

 
5,263

 

 

 

 

 
Swaps
18

 

 
18

 

 

 
18

 
Total Liabilities
$
1,643,258

 
$
11,764

 
$
1,631,494

 
$
1,367,896

 
$
10,924

 
$
252,674

(1) Represents reverse repurchase agreements at broker dealer.
7.    Collateralized Transactions
The Company receives financial instruments as collateral in connection with securities borrowed and financial instruments purchased under agreements to resell. Such financial instruments generally consist of equities, convertible securities and obligations of the U.S. Government, but may also include obligations of federal agencies, foreign governments and corporations. In most cases the Company is permitted to deliver or repledge these financial instruments in connection with securities lending, other secured financings or for meeting settlement obligations.
The table below presents financial instruments at fair value received as collateral and included within Securities borrowed or Receivable from brokers, dealers and clearing organizations on the Consolidated Statements of Financial Condition that were permitted to be delivered or repledged and that were delivered or repledged by the Company as well as the fair value of financial instruments which could be further repledged by the receiving party (in thousands):
 
June 30,
2014
 
December 31,
2013
Collateral permitted to be delivered or repledged
$
1,562,642

 
$
1,315,803

Collateral that was delivered or repledged
1,472,862

 
1,231,468

Collateral permitted to be further repledged by the receiving counterparty
266,603

 
142,938

In order to finance securities positions, the Company also pledges financial instruments that it owns to counterparties who, in turn, are permitted to deliver or repledge them. Under these transactions, the Company pledges certain financial instruments owned to collateralize repurchase agreements and other secured financings. Repurchase agreements and other secured financings are short-term and mature within one year. Financial instruments owned and pledged to counterparties that do not have the right to sell or repledge such financial instruments consist of equity securities.

23

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The table below presents information about assets pledged by the Company (in thousands):
 
June 30,
2014
 
December 31,
2013
Financial instruments owned, at fair value, pledged to counterparties that had the right to deliver or repledge
$
514,580

 
$
552,242

Financial instruments owned, at fair value, pledged to counterparties that do not have the right to deliver or repledge
913,040

 
676,956


8.    Receivable from and Payable to Brokers, Dealers and Clearing Organizations
Amounts receivable from and payable to brokers, dealers and clearing organizations consist of the following (in thousands):
 
June 30,
2014
 
December 31, 2013
Receivable:
 
 
 
Clearing organizations and other
$
883,047

 
$
750,440

Assets segregated or held in separate accounts under federal or other regulations
364,955

 
304,294

Securities failed to deliver
340,924

 
202,517

Total Receivable
$
1,588,926

 
$
1,257,251

Payable:
 
 
 
Clearing organizations and other
$
462,875

 
$
425,196

Securities failed to receive
184,245

 
48,912

Total Payable
$
647,120

 
$
474,108

Management believes that the carrying value of amounts receivable from and payable to brokers, dealers and clearing organizations approximates fair value since they are short term in nature.
9.    Investments
Investments comprise strategic investments, deferred compensation investments, and investment in the Deephaven Funds. Investments consist of the following (in thousands): 
 
June 30,
2014
 
December 31,
2013
Strategic investments:
 
 
 
Investments accounted for under the equity method
$
78,719

 
$
110,460

Investments held at fair value
3,549

 
3,925

Common stock or equivalent of companies representing less than 20% equity ownership held at adjusted cost
8,954

 
8,953

Total Strategic investments
91,222

 
123,338

Deferred compensation investments
752

 
117

Investment in Deephaven Funds
169

 
1,958

Total Investments
$
92,143

 
$
125,413

Investments held at fair value are accounted for as available for sale securities and any unrealized gains or losses are recorded in Other comprehensive income.

24

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Merger of BATS and Direct Edge
In January 2014, BATS and Direct Edge, each of whose equity the Company held as an investment, completed their previously announced merger into BATS. Prior to the merger, the Company accounted for its investment in BATS under the cost method and accounted for its investment in Direct Edge under the equity method. Following the merger, the Company owns 16.7% of the overall equity of BATS and holds 19.9% of the voting equity and a board seat. Based on these facts, the Company will account for its interest in BATS under the equity method. This change in accounting principle is applied retrospectively and, as such, the Company will present its financial results for all prior periods with BATS accounted for under the equity method. See Footnote 3 "Significant Accounting Policies" for a discussion of the effect of this retrospective adjustment.
The Company received approximately $42.2 million from the aggregate distributions paid by BATS and Direct Edge at or around the close of the merger, which the Company recorded as a return of capital under the equity method of accounting.
During the first quarter of 2014 the Company recognized income of $9.6 million related to the merger of BATS and Direct Edge which is recorded within Investment income (loss) and other, net in the Consolidated Statements of Operations. The $9.6 million comprises a partial realized gain with respect to the Company's investment in Direct Edge of $16.2 million offset, in part, by the Company's share of BATS' and Direct Edge's merger related transaction costs that were charged against their respective earnings of $6.6 million.
10.    Goodwill and Intangible Assets
Goodwill and intangible assets with indefinite lives are assessed for impairment annually or when events indicate that the amounts may be impaired. The Company assesses goodwill for impairment at the reporting unit level. The Company’s reporting units are the components of its business segments for which discrete financial information is available and is regularly reviewed by the Company’s management. As part of the assessment for impairment, the Company considers the cash flows of the respective reporting unit and assesses the fair value of the respective reporting unit as well as the overall market value of the Company compared to its net book value. The assessment of fair value of the reporting units is principally performed using a discounted cash flow methodology with a risk-adjusted weighted average cost of capital which the Company believes to be the most reliable indicator of the fair values of its respective reporting units. The Company also assesses the fair value of each reporting unit based upon its estimated market value and assesses the Company’s overall market value based upon the market price of KCG Class A Common Stock.
Intangible assets are assessed for recoverability when events or changes in circumstances indicate that the carrying amount of the asset or asset group may not be recoverable. The Company assesses intangible assets for impairment at the “asset group” level which is the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. As part of the assessment for impairment, the Company considers the cash flows of the respective asset group and assesses the fair value of the respective asset group. Step 1 of the impairment assessment for intangibles is performed using undiscounted cash flow models, which indicates whether the future cash flows of the asset group are sufficient to recover the book value of such asset group. When an asset is not considered to be recoverable, step 2 of the impairment assessment is performed using a discounted cash flow methodology with a risk-adjusted weighted average cost of capital to determine the fair value of the intangible asset group. In cases where amortizable intangible assets and goodwill are assessed for impairment at the same time, the amortizable intangibles are assessed for impairment prior to goodwill being assessed.
As discussed in Footnote 2 "Merger of GETCO and Knight", as a result of the Mergers, $155.4 million and $12.7 million in identifiable intangible assets and goodwill, respectively, were recorded by the Company as of the date of the Mergers.
No events occurred in the three and six months ended June 30, 2014 or 2013 that would indicate that the carrying amounts of the Company’s goodwill or intangible assets may not be recoverable. In December 2013, the Company assessed the impairment of goodwill and intangible assets as part of its annual assessment and concluded that there was no impairment.

25

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The following table summarizes the Company’s goodwill by segment (in thousands):
 
June 30,
2014
 
December 31, 2013
Market Making
$
16,404

 
$
16,404

Global Execution Services
907

 
907

Total
$
17,311

 
$
17,311

Intangible assets with definite useful lives are amortized over their estimated remaining useful lives, the majority of which have been determined to range from one to 10 years. The weighted average remaining life of the Company’s intangible assets with definite useful lives at both June 30, 2014 and December 31, 2013 was approximately six years.
The following tables summarize the Company’s Intangible assets, net of accumulated amortization by segment and type (in thousands):
 
June 30,
2014
 
December 31, 2013
Market Making
 
 
 
Technology
$
50,917

 
$
53,315

Trading rights
46,092

 
48,920

Total
97,009

 
102,235

Global Execution Services
 
 
 
Technology
35,166

 
38,682

Customer relationships
31,556

 
33,278

Trade names
3,600

 
3,800

Total
70,322

 
75,760

Corporate and Other
 
 
 
   Technology
12,000

 
13,500

Consolidated Total
$
179,331

 
$
191,495


 
 
June 30,
2014
 
December 31, 2013
Technology (1)
Gross carrying amount
$
125,961

 
$
120,346

 
Accumulated amortization
(27,878
)
 
(14,849
)
 
Net carrying amount
98,083

 
105,497

Trading rights (2)
Gross carrying amount
61,897

 
62,450

 
Accumulated amortization
(15,805
)
 
(13,530
)
 
Net carrying amount
46,092

 
48,920

Customer relationships (3)
Gross carrying amount
35,000

 
35,000

 
Accumulated amortization
(3,444
)
 
(1,722
)
 
Net carrying amount
31,556

 
33,278

Trade names (4)
Gross carrying amount
4,000

 
4,000

 
Accumulated amortization
(400
)
 
(200
)
 
Net carrying amount
3,600

 
3,800

Total
Gross carrying amount
226,858

 
221,796

 
Accumulated amortization
(47,527
)
 
(30,301
)
 
Net carrying amount
$
179,331

 
$
191,495

(1) 
The weighted average remaining life for technology, including capitalized software, was approximately 4 years as of both June 30, 2014 and December 31, 2013.

26

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






(2) 
Trading rights provide the Company with the rights to trade on certain exchanges. The weighted average remaining life of trading rights with definite useful lives was approximately 7 and 8 years as of June 30, 2014 and December 31, 2013, respectively. As of June 30, 2014 and December 31, 2013, $7.1 million and $7.6 million, respectively, of trading rights had indefinite useful lives.
(3) 
Customer relationships relate to KCG Hotspot and KCG BondPoint. The weighted average remaining life was approximately 9 and 10 years as of June 30, 2014 and December 31, 2013, respectively. Lives may be reduced depending upon actual retention rates.
(4) 
Trade names relate to KCG Hotspot and KCG BondPoint. The weighted average remaining life was approximately 9 and 10 years as of June 30, 2014 and December 31, 2013, respectively.
The following table summarizes the Company’s amortization expense from continuing operations relating to Intangible assets (in thousands):
 
For the three months ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
Amortization expense
$
8,732

 
$
1,380

 
$
17,226

 
$
2,759

As of June 30, 2014, the following table summarizes the Company’s estimated amortization expense for future periods (in thousands):
 
    Amortization    
expense
For the six months ended December 31, 2014
$
17,646

For the year ended December 31, 2015
34,476

For the year ended December 31, 2016
33,398

For the year ended December 31, 2017
30,950

For the year ended December 31, 2018
19,396

11.    Debt
The carrying value and fair value of the Company's debt is as follows (in thousands):
 
June 30, 2014
 
December 31, 2013
 
Carrying Amount  
 
Fair Value
 
Carrying Amount  
 
Fair Value
Cash Convertible Senior Subordinated Notes
$
117,259

 
$
116,086

 
$
117,259

 
$
118,432

Senior Secured Notes
305,000

 
325,588

 
305,000

 
320,823

First Lien Credit Facility

 

 
235,000

 
235,000

Total Debt
$
422,259

 
$
441,674

 
$
657,259

 
$
674,255

The fair value of the Cash Convertible Senior Subordinated Notes and Senior Secured Notes is based upon the value of such debt in the secondary market. The carrying value of the First Lien Credit facility approximated fair value as it was not materially sensitive to shifts in interest rates due to its floating interest rate, which also considers changes in the Company's credit quality and financial condition. These liabilities would all be categorized as Level 2 in the fair value hierarchy if they were required to be recorded at fair value.
Cash Convertible Senior Subordinated Notes
In March 2010, Knight issued $375.0 million aggregate principal amount of Cash Convertible Senior Subordinated Notes (the “Convertible Notes”) due on March 15, 2015 in a private offering exempt from registration under the Securities Act of 1933, as amended.
The Convertible Notes bear interest at a rate of 3.50% per year, payable semi-annually in arrears, on March 15 and September 15 of each year, commencing on September 15, 2010 and will mature on March 15, 2015, subject to earlier repurchase or conversion. The Convertible Notes are reported as Debt in the Company’s Consolidated Statements of Financial Condition.

27

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






As a result of the Mergers, on July 1, 2013, KCG became a party to Knight's $375.0 million Convertible Notes. On July 1, 2013, the Company delivered a notice (the “Convertible Notes Notice”) to the holders of the Notes. The Convertible Notes Notice advised holders of the Convertible Notes of the following (among others):     
The completion of the Mergers on July 1, 2013 and the results of the election of the holders of KCG Class A Common Stock to receive cash consideration for such KCG Class A Common Stock constitutes a “Fundamental Change";     
Each holder of the Convertible Notes had the right to deliver a “Fundamental Change Repurchase Notice” requiring the Company to repurchase all or any portion of the principal amount of the Convertible Notes at a Fundamental Change Repurchase Price of 100% of the principal amount plus accrued and unpaid interest on August 5, 2013, the Fundamental Change Repurchase Date; and
The Company deposited with the paying agent an amount of money sufficient to repurchase all of the Convertible Notes to be repurchased; and upon payment by the paying agent such Convertible Notes will cease to be outstanding.
On July 1, 2013, $375.0 million, which was the amount needed to repurchase the aggregate amount of Convertible Notes in full at maturity, was deposited in a cash collateral account under the sole dominion and control of the collateral agent under the First Lien Credit Facility (the "Collateral Account").
After the Mergers, a total of $257.7 million in principal amount of the Convertible Notes were repurchased using funds deposited in the Collateral Account. The repurchase included accrued and unpaid interest of $3.6 million. In October 2013, after receiving consent from the Holders of the Senior Secured Notes (as defined below), the funds remaining in the Collateral Account were used to repay a portion of the First Lien Credit Facility. As of June 30, 2014 and December 31, 2013 there were no funds in the Collateral Account. As of June 30, 2014 and December 31, 2013, $117.3 million of the Convertible Notes were outstanding.
Debt incurred in connection with Mergers
In connection with the Mergers, KCG entered into a series of debt financing transactions. Described below are the details of these transactions.
Senior Secured Notes
On June 5, 2013 GETCO Financing Escrow LLC (“Finance LLC”), a wholly-owned subsidiary of GETCO, issued 8.250% senior secured notes due 2018 in the aggregate principal amount of $305.0 million (the “Senior Secured Notes”) pursuant to an indenture, dated June 5, 2013 (as amended and supplemented, the "Senior Secured Notes Indenture"). On July 1, 2013, KCG entered into a first supplemental indenture (the “First Supplemental Indenture”) pursuant to which KCG assumed all of the obligations of Finance LLC which comprised the Senior Secured Notes plus certain escrow agent fees and expenses of $3.0 million.
On July 1, 2013, KCG and certain subsidiary guarantors (the "Guarantors") under the First Lien Credit Facility, as defined below, entered into a Second Supplemental Indenture, whereby the Senior Secured Notes and the obligations under the Senior Secured Notes Indenture will be fully and unconditionally guaranteed on a joint and several basis by the Guarantors and are secured by second-priority pledges and second-priority security interests in, and mortgages on, the collateral securing the First Lien Credit Facility, subject to certain exceptions.
The Senior Secured Notes mature on June 15, 2018 and bear interest at a rate of 8.250% per year, payable on June 15 and December 15 of each year, beginning on December 15, 2013.
The Senior Secured Notes Indenture contains customary affirmative and negative covenants, including limitations on indebtedness, liens, hedging agreements, investments, loans and advances, asset sales, mergers and acquisitions, dividends, transactions with affiliates, prepayments of other indebtedness, restrictions on subsidiaries and issuance of capital stock. As of June 30, 2014, the Company was in compliance with the covenants.
On July 1, 2013, KCG and the Guarantors entered into a joinder to the registration rights agreement dated June 5, 2013, (the "Senior Secured Notes Registration Rights Agreement") between Finance LLC and Jefferies LLC as representative of the initial purchasers of the Senior Secured Notes. Pursuant to the registration rights agreement, KCG shall use commercially reasonable efforts to (i) file an exchange offer registration statement with the SEC with respect to a registered offer to exchange the Senior Secured Notes (the "Exchange Offer"), (ii) issue in exchange for the Senior Secured Notes a new series of exchange notes within 365 days after June 5, 2013, and, (iii) in certain

28

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






circumstances, file a shelf registration statement with respect to resales of the Senior Secured Notes. If KCG and the Guarantors fail to comply with certain obligations under the Senior Secured Notes Registration Rights Agreement, additional interest of up to 1.00% per annum will begin to accrue and be payable on the Senior Secured Notes.
In October 2013, the Company received consents from holders ("Holders") of 99.7% of the aggregate principal amount of the Senior Secured Notes outstanding to amend, among other things, the terms of the Senior Secured Notes among the Company, The Bank of New York Mellon, as trustee and collateral agent (the “Trustee”), and the Guarantors. As a result, the Company entered into the Third Supplemental Indenture with the Trustee to amend the Senior Secured Notes Indenture to permit the purchase, redemption or repayment of the Convertible Notes at any price, including at a premium or at a discount from the face value thereof, with any available cash.
In May 2014, the Company received consents from Holders of 98.5% of the aggregate principal amount of the Senior Secured Notes outstanding to amend the terms of the Senior Secured Notes Registration Rights Agreement. As a result, the Company entered into the First Amendment (the “Amendment”) to the Senior Secured Notes Registration Rights Agreement. The Amendment (i) postponed the deadline by which the Company must use commercially reasonable efforts to prepare and file the Exchange Offer with the SEC, from June 5, 2014 to June 30, 2015, and (ii) postponed the deadline by which the Company must use commercially reasonable efforts to file with and have declared effective by the SEC a shelf registration statement to cover certain resales of the Senior Secured Notes from June 5, 2014 to June 30, 2015. The Amendment also had the effect of postponing the date on which an additional interest, which constitutes liquidated damages and is the exclusive remedy available to Holders for failing to register the Senior Secured Notes, begins to accrue as a result of failing to consummate the Exchange Offer or have a shelf registration statement declared effective. Accordingly, the Company and the Guarantors no longer have any obligation to pay Holders additional interest as of June 5, 2014, even though the Company and the Guarantors did not prepare, file or have declared effective a registration statement or a shelf registration statement or consummate the Exchange Offer by such date.
First Lien Credit Facility
On July 1, 2013, KCG, as borrower, entered into a first lien senior secured credit agreement (the “Credit Agreement”) with Jefferies Finance LLC and Goldman Sachs Bank USA. The Credit Agreement was in the amount of $535.0 million (the “First Lien Credit Facility”), all of which was drawn on July 1, 2013. The First Lien Credit Facility also provided for a future uncommitted incremental first lien senior secured revolving credit facility of up to $50.0 million, including letter of credit and swingline sub-facilities, on certain terms and conditions contained in the Credit Agreement.
In 2013, the Company repaid $300.0 million of principal of the First Lien Credit Facility. A portion of the $300.0 million totaling $117.3 million was drawn from cash held in the Collateral Account and the remainder of the $300.0 million was paid out of available cash including proceeds from the sale of Urban. In conjunction with these payments, the Company wrote down $13.2 million of its capitalized debt costs associated with the Credit Agreement.
During the six months ended June 30, 2014, the Company repaid the remaining $235.0 million of principal of the First Lien Credit Facility out of available cash and the Credit Agreement was terminated. In conjunction with these payments, the Company wrote down the remaining $9.6 million, of its capitalized debt costs associated with the Credit Agreement.
The First Lien Credit Facility bears interest, at KCG's option, at a rate based on the prime rate (“First Lien Prime Rate Loans”) or based on LIBOR (“First Lien Eurodollar Loans”). First Lien Prime Rate Loans bear interest at a rate per annum equal to the greatest of prime rate, 2.25%, the federal funds rate plus 0.50%, and an adjusted one-month LIBOR rate plus 1.00%, in each case plus an applicable margin of 3.50%. First Lien Eurodollar Loans bear interest at a rate per annum equal to the adjusted LIBOR rate (subject to a 1.25% LIBOR floor) corresponding to the interest period plus an applicable margin of 4.50% per annum.
The Company incurred issuance costs of $38.5 million in connection with the issuance of Senior Secured Notes, Credit Agreement and consent solicitations. The remaining issuance costs are recorded within Other assets on the Consolidated Statements of Financial Condition and are amortized over the term of the Senior Secured Notes. Including issuance costs, the Senior Secured Notes had an effective yield of 9.1%.

29

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Revolving Credit Agreement
On July 1, 2013, OCTEG, LLC (“OCTEG”) and Knight Capital Americas LLC ("KCA"), wholly-owned broker dealer subsidiaries of KCG, as borrowers, and KCG, as guarantor, entered into a credit agreement (the "KCGA Facility Agreement”) with a consortium of banks and financial institutions. The KCGA Facility Agreement replaces an existing credit agreement, dated as of June 6, 2012, among OCTEG and three banks.
The KCGA Facility Agreement comprises two classes of revolving loans in a total committed amount of $450.0 million, together with a swingline facility with a $50.0 million sub-limit, subject to two borrowing bases (collectively, the “KCGA Revolving Facility”): Borrowing Base A and Borrowing Base B. The KCGA Revolving Facility also provides for a future increase of the revolving credit facility of up to $300.0 million to a total of $750.0 million on certain terms and conditions.
The KCGA Revolving Facility was amended on October 24, 2013 to permit OCTEG to be removed as a borrower under the KCGA Revolving Facility. As of January 1, 2014, OCTEG was merged with and into KCA and KCA was renamed KCG Americas LLC ("KCGA").
Borrowings under the KCGA Revolving Facility shall bear interest, at the applicable borrower's option, at a rate based on the federal funds rate (“Base Rate Loans”) or based on LIBOR (“Eurodollar Loans”), in each case plus an applicable margin. For each Base Rate Loan, the interest rate per annum is equal to the greater of the federal funds rate or an adjusted one-month LIBOR rate plus (a) for each Borrowing Base A loan, a margin of 1.75% per annum and (b) for each Borrowing Base B loan, a margin of 2.25% per annum. For each Eurodollar Loan, the interest rate per annum is equal to an adjusted LIBOR rate corresponding to the interest period plus (a) for each Borrowing Base A loan, a margin of 1.75% per annum and (b) for each Borrowing Base B loan, a margin of 2.25% per annum. As of June 30, 2014, there were no outstanding borrowings under the KCGA Facility Agreement.
The proceeds of the Borrowing Base A loans may be used solely to finance the purchase and settlement of securities. The proceeds of Borrowing Base B loans may be used solely to fund clearing deposits with the National Securities Clearing Corporation.
The borrower is being charged a commitment fee at a rate of 0.35% per annum on the average daily amount of the unused portion of the KCGA Facility Agreement.
The loans under the KCGA Facility Agreement will mature on June 6, 2015. The KCGA Revolving Facility is fully and unconditionally guaranteed on an unsecured basis by KCG and, to the extent elected by KCGA, any of their respective subsidiaries. It is secured by first-priority pledges of and liens on certain eligible securities, subject to applicable concentration limits, in the case of Borrowing Base A loans, and by first-priority pledges of and liens on the right to the return of certain eligible NSCC margin deposits, in the case of Borrowing Base B loans.
The KCGA Facility Agreement includes customary affirmative and negative covenants, including limitations on indebtedness, liens, hedging agreements, investments, loans and advances, asset sales, mergers and acquisitions, dividends, transactions with affiliates, restrictions on subsidiaries, issuance of capital stock, negative pledges and business activities. It contains financial maintenance covenants establishing a minimum total regulatory capital for KCGA, a maximum total asset to total regulatory capital ratio for KCGA, a minimum excess net capital limit for KCGA, a minimum liquidity ratio for KCGA, and a minimum tangible net worth threshold for KCGA. As of June 30, 2014, the Company was in compliance with the covenants.
In connection with the KCGA Revolving Facility, the Company incurred issuance costs of $1.2 million which is recorded within Other assets on the Consolidated Statements of Financial Condition and it is being amortized over the term of the facility.

30

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The Company recorded expenses with respect to the Debt as follows (in thousands):
 
For the three months 
 ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
Interest expense
$
7,349

 
$
1,970

 
$
16,765

 
$
2,193

Amortization of debt issuance cost (1)
2,791

 
359

 
11,557

 
472

Commitment fee
394

 
8,937

 
788

 
8,937

Total
$
10,534

 
$
11,266

 
$
29,110

 
$
11,602

(1) 
Of the $2.8 million of amortization of debt issuance cost incurred during the three months ended June 30, 2014, $2.0 million is included in Writedown of debt issuance costs and $0.8 million is in Other expenses. Of the $11.6 million of amortization of debt issuance cost incurred during the six months ended June 30, 2014, $9.6 million is included in Writedown of debt issuance costs and $2.0 million is in Other expenses. The writedown amounts were incurred as a result of the $50.0 million and $235.0 million repayment of the First Lien Credit Facility made during the three and six months ended June 30, 2014, respectively.
12.    Related Parties
In the normal course of business the Company interacts with Jefferies LLC (together with certain of its affiliates, “Jefferies”), BATS and, prior to its merger with BATS, Direct Edge, each of which is considered to be a related party as of June 30, 2014, and in the case of BATS only, as of June 30, 2013.  As of June 30, 2014, Jefferies was the beneficial owner of more than 10 percent of KCG’s Class A Common Stock and KCG owned more than 10 percent of the equity of BATS.  Following the Mergers and prior to Direct Edge's merger with BATS in January 2014, KCG owned more than 10 percent of the equity of Direct Edge. Neither Jefferies nor Direct Edge was a related party as of June 30, 2013.
The Company earns revenues, incurs expenses and maintains balances with these related parties or their affiliates. As of the date and period indicated below, the Company had the following balances and transactions with the related parties or their affiliates (in thousands):
 
For the three months ended June 30,
 
For the six months ended June 30,
Statement of Operations
2014
 
2013
 
2014
 
2013
Revenues
 
 
 
 
 
 
 
Commissions and fees
$
2,740

 
$

 
$
7,886

 
$

Trading revenues, net
541

 

 
1,355

 

Interest, net
130

 

 
318

 

Total revenues from related parties
$
3,411

 
$

 
$
9,559

 
$

Expenses
 
 
 
 
 
 
 
Execution and clearance fees(1)
$
(2,798
)
 
$
(3,732
)
 
$
(7,090
)
 
$
(8,626
)
Interest expense
120

 

 
279

 

Other expense
434

 

 
834

 

Total expenses incurred with respect to related parties
$
(2,244
)
 
$
(3,732
)
 
$
(5,977
)
 
$
(8,626
)
(1)    Represents net volume based fees received from providing liquidity to related trading venues.

31

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Statements of Financial Condition
June 30,
2014
 
December 31,
2013
Assets
 
 
 
Securities borrowed
$
47,667

 
$
57,732

Receivable from brokers, dealers and clearing organizations
98,680

 
20,826

Other assets

 
277

Liabilities
 
 
 
Securities loaned
$
10,992

 
$
116,062

Payable to brokers, dealers and clearing organizations
114,343

 
17,820

Accrued expenses and other liabilities
4,334

 
179

13.    Stock-Based Compensation
KCG Equity Incentive Plan
The Knight Capital Group, Inc. Amended and Restated 2010 Equity Incentive Plan was established to provide long-term incentive compensation to employees and directors of the Company. As a result of the Mergers, on July 1, 2013, this plan was assumed by KCG and was renamed the KCG Holdings, Inc. Amended and Restated Equity Incentive Plan ("the KCG Plan"). As of June 30, 2014, there were approximately 33.0 million shares authorized for issuance under the KCG Plan, of which approximately 15.5 million shares are available for grant (subject to adjustment as provided under the KCG Plan).
The KCG Plan is administered by the Compensation Committee of the Company’s Board of Directors, and allows for the grant of options, SARs, restricted stock and RSUs (collectively, the “awards”), as defined by the KCG Plan. In addition to overall limitations on the aggregate number of awards that may be granted, the KCG Plan also limits the number of awards that may be granted to a single individual. The KCG Plan replaced prior Knight stockholder-approved equity plans for future equity grants and no additional grants will be made under those historical Knight stock plans. However, the terms and conditions of any outstanding equity grants under the historical Knight stock plans are not affected.
As a result of the Mergers on July 1, 2013, each outstanding Knight stock option, whether vested or unvested, was automatically replaced with an option to purchase KCG Class A Common Stock equal to one third of the number of shares of Knight Common Stock subject to such original stock option immediately prior to the completion of the Mergers (rounded down to the nearest whole share of KCG Class A Common Stock). The exercise price per share of KCG Class A Common Stock is equal to the exercise price per share of Knight Common Stock subject to such Company stock option multiplied by three (rounded up to the nearest whole cent). Pursuant to the terms of the applicable Knight stock plans and award agreements, each option granted on or prior to December 19, 2012 immediately vested. There were no Knight stock options granted subsequent to December 19, 2012 through June 30, 2013.
As a result of the Mergers, each Knight restricted share granted after December 19, 2012 and each outstanding Knight RSU was replaced with a KCG restricted share or RSU, as applicable, in respect of one third of a share of common stock of KCG (rounded to the nearest whole share). Knight restricted share and RSU awards granted on or prior to December 19, 2012 (except for RSUs subject to performance-based vesting conditions) automatically vested upon the completion of the Mergers. Knight awards granted after December 19, 2012 (and RSUs granted on or prior to December 19, 2012 that were subject to performance-based vesting conditions) continue to vest in accordance with their existing vesting schedule, subject to acceleration under certain circumstances.
Restricted Shares and Restricted Stock Units
Eligible employees and directors may receive restricted shares and/or RSUs (collectively “restricted awards”) as a portion of their total compensation. The majority of restricted awards vest ratably over three years and are subject to accelerated vesting, or continued vesting, following certain termination circumstances, in accordance with the applicable award documents and employment agreements between the Company and the participant. For certain restricted awards, the Company has the right to fully vest employees and directors upon retirement and in certain other circumstances.

32

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The Company measures compensation cost related to restricted awards based on the fair value of KCG Class A Common Stock at the date of grant. Compensation expense from continuing operations relating to restricted awards, which is primarily recorded in Employee compensation and benefits, and the corresponding income tax benefit, which is recorded in Income tax expense on the Consolidated Statements of Operations are presented in the following table (in thousands):
 
For the three months 
 ended June 30,
 
For the six months
 ended June 30,
 
2014
 
2014
Stock award compensation expense
$
14,937

 
$
31,175

Income tax benefit
5,676

 
11,846

The following table summarizes restricted awards activity for the six months ended June 30, 2014 (awards in thousands):
 
 
Restricted Stock Units
 
 
Number of
Units
 
Weighted-
Average
Grant date
Fair Value
Outstanding at December 31, 2013
 
8,420

 
$
10.71

Granted
 
4,157

 
11.09

Vested
 
(1,119
)
 
11.11

Forfeited
 
(313
)
 
12.13

Outstanding at June 30, 2014
 
11,145

 
$
10.77

There is $74.1 million of unamortized compensation related to unvested RSUs outstanding at June 30, 2014. The cost of these unvested RSUs is expected to be recognized over a weighted average life of 2.0 years.
Stock Options and Stock Appreciation Rights
The Company’s policy is to grant options for the purchase of shares of KCG Class A Common Stock and SARs to purchase or receive the cash value of shares of KCG Class A Common Stock, in each case with an exercise price not less than the market value of KCG Class A Common Stock on the grant date. Options and SARs generally vest ratably over a three year period and expire on the fifth or tenth anniversary of the grant date, pursuant to the terms of the applicable award agreement. Options and SARs are subject to accelerated vesting, or continued vesting following certain termination circumstances, in accordance with the applicable award agreements and employment agreements between the Company and the participant. Options and SARs are otherwise canceled if employment is terminated before the end of the relevant vesting period. The Company’s policy is to issue new shares upon option exercises by its employees and directors. The Company may issue new shares or provide a cash payment upon SARs exercises by its employees.
The fair value of each option and SAR granted is estimated as of its respective grant date using the Black-Scholes option-pricing model. Stock options and SARs are granted with exercise prices equal to or greater than the market value of the Company’s common stock at the date of grant as defined by the stock plans. The principal assumptions utilized in valuing options and SARs and the methodology for estimating such model inputs include: 1) risk-free interest rate—estimate is based on the yield of U.S. zero coupon securities with a maturity equal to the expected life of the option or SAR; 2) expected volatility—estimate is based on several factors including implied volatility of market-traded options on the Company’s common stock on the grant date and the volatility of the Company’s common stock; and 3) expected option or SAR life—estimate is based on internal studies of historical experience and projected exercise behavior based on different employee groups and specific option and SAR characteristics, including the effect of employee terminations. There were no stock options or SARs granted during the three and six month ended June 30, 2014 and 2013.

33

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






Compensation expense from continuing operations relating to stock options and SARs, all of which was recorded in Employee compensation and benefits, as well as the corresponding income tax benefit, which is recorded in Income tax expense on the Consolidated Statements of Operations are as follows (in thousands):
 
For the three months  ended June 30, 2014
 
For the six months
 ended June 30, 2014
Stock option and SAR compensation expense
$
958

 
$
1,920

Income tax benefit
364

 
730

 
The following table summarizes stock option and SAR activity and stock options exercisable for the six months ended June 30, 2014 (awards in thousands):
 
 
Number of Stock Awards
 
Weighted-
Average
Exercise
Price
 
Aggregate
Intrinsic
Value
 
Weighted-
Average
Remaining
Life (years)
Outstanding at December 31, 2013 (1)
 
4,967

 
$
18.45

 
 
 
 
Granted at market value
 

 

 
 
 
 
Exercised
 

 

 
 
 
 
Forfeited or expired
 
(123
)
 
38.77

 
 
 
 
Outstanding at June 30, 2014 (1)
 
4,844

 
$
17.93

 
$
3,752

 
3.83
Exercisable at June 30, 2014
 
521

 
$
40.75

 
$

 
2.12
Available for future grants at June 30, 2014 (2)
 
15,509

 
 
 
 
 
 
(1) Includes 1.7 million of SARs.
(2) Represents options, SARs and awards available for grant.
The aggregate intrinsic value is the amount by which the closing price of the Company’s common stock exceeds the exercise price of the stock options multiplied by the number of shares. There were no stock options exercised during the three and six months ended June 30, 2014.
There is $5.2 million of unamortized compensation related to unvested stock options and SARs outstanding at June 30, 2014. The cost of these unvested awards is expected to be recognized over a weighted average life of 1.4 years.
Incentive units
Prior to the Mergers, GETCO awarded deferred compensation to its employees in the form of incentive units that generally vested over time. The value of these incentive units was determined at the date of grant based on the estimated enterprise value of GETCO and the amount expensed was determined based on this valuation multiplied by the percent vested. In connection with the Mergers, all outstanding unvested incentive units vested and were converted into units based on the applicable exchange ratio of GETCO units to KCG Class A Common Stock. The units are marked to the current stock price of KCG Class A Common Stock at the end of each period with the resulting change in the liability reflected as either an expense or gain included in Employee compensation and benefits. Given that the units vested in connection with the Mergers, the Company fully amortized the units as of June 30, 2013. Deferred compensation payable at June 30, 2014 and December 31, 2013 related to incentive units was $3.4 million and $3.8 million, respectively, and is included in Accrued compensation expense on the Consolidated Statements of Financial Condition.

34

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The following is a summary of the changes in the incentive units for the six months ended June 30, 2014 (units in thousands):
 
Vested
Incentive units at December 31, 2013
49

Issued

Vested

Exercised
(6
)
Canceled

Incentive units at June 30, 2014
43

Class B units
Prior to the Mergers, GETCO granted membership unit awards to employees in the form of Class B units. The Class B units were valued based on the same methodology used to value the GETCO incentive units. Prior to 2012, these non-voting units vested in full three years from the grant date, provided certain conditions of employment and performance were met by the employee. In 2012, GETCO changed the vesting of units granted in 2012 to annual vesting of one-third of the units over a three year period. Upon termination of employment, GETCO had the option to repurchase all or a portion of the units granted within six months. The purchase price for the unvested units was determined as a percentage of grant date fair value. GETCO classified these unit awards as equity as the employees received full membership rights with respect to allocation of income and participation in member distributions. In connection with the Mergers, all outstanding unvested Class B units vested on June 25, 2013.
Class E units
In 2012, GETCO also granted employees profit interests in the form of Class E units. Prior to 2012, Class E units primarily vested in full three years from the grant date. For units granted in 2012, GETCO changed the vesting of Class E units to an annual vesting of one-third of the units over the three year period and provided GETCO an option to repurchase the units at the end of 5 years. Class E units allowed for future appreciation in excess of the GETCO's value over a certain strike price per unit and allocation of income once the units are vested. Upon the departure of an employee, the Class E units were forfeited whether vested or not, and if vested, the cash value of the Class E units above their strike price was paid to the employee. GETCO classified these unit awards as equity. In connection with the Mergers all outstanding unvested Class E units vested on June 25, 2013 and were canceled for no consideration.
As noted, in connection with the Mergers, all outstanding incentive units, Class B units and Class E units vested, and as a result the remaining unamortized expense was accelerated. The accelerated amortization expense recorded during the three and six months ended June 30, 2013 for incentive units, Class B units and Class E units was $1.3 million, $9.4 million and $3.5 million, respectively.
Compensation expense (benefit) related to the Class B, Class E and Incentive units, all of which are recorded within Employee compensation and benefits on the Consolidated Statements of Operations are as follows (in thousands):
 
For the three months 
 ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
Class B and E units
$

 
$
16,942

 
$

 
$
19,860

Incentive units
(14
)

1,884

 
(188
)

2,293

Total
$
(14
)
 
$
18,826

 
$
(188
)
 
$
22,153


35

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






14.   Income Taxes
Following the Mergers, the Company and its subsidiaries will file a consolidated federal income tax return as well as combined state income tax returns in certain jurisdictions. In other jurisdictions, the Company and its subsidiaries will file separate company state and local income tax returns. Prior to the Mergers, GETCO and the majority of its subsidiaries were treated as partnerships or disregarded entities for U.S. income tax purposes and, accordingly, were not subject to federal income taxes. Instead, former GETCO members were liable for federal income taxes on their proportionate share of taxable income; however, certain subsidiaries were subject to corporate income taxes related to the taxable income generated by their operations.
Upon completion of the Mergers, the Company became subject to U.S. corporate income taxes. As described in Footnote 2 “Merger of GETCO and Knight”, following the Mergers the Company recorded $65.5 million of deferred tax assets as a result of recording Knight’s assets and liabilities under the purchase method of accounting as well as recording the value of Knight’s NOLs and tax credit carryforwards as described below.
As a result of the Company becoming subject to U.S. corporate income taxes, the Company also recorded, upon the closing of the Mergers on July 1, 2013, a nonrecurring $103.5 million deferred tax benefit and corresponding deferred tax asset relating to GETCO's existing tax attributes. This deferred tax asset primarily relates to differences between GETCO’s book and tax bases in its intangible assets and its strategic investments.
The following table reconciles the U.S. federal statutory income tax to the Company's actual income tax from continuing operations (in thousands):
 
For the three months ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
U.S. federal statutory income tax expense (benefit)
$
5,077

 
$
(26,193
)
 
$
25,862

 
$
(27,893
)
Income not subject to U.S. corporate income tax

 
27,461

 

 
29,206

U.S. state and local income taxes, net of U.S. federal income tax effect
676

 
247

 
1,956

 
473

Nondeductible expenses (1)
211

 
132

 
414

 
170

Foreign taxes
(165
)
 
1,761

 
(102
)
 
3,559

Other, net
(279
)
 
(93
)
 
(143
)
 
(226
)
Income tax expense
$
5,520

 
$
3,315

 
$
27,987

 
$
5,289

(1) Nondeductible expenses include nondeductible compensation and meals and entertainment.
Deferred income taxes reflect the net tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when such differences are expected to reverse. Valuation allowances recorded on the balance sheet dates are necessary in cases where management believes that it is more likely than not that some portion or all of the deferred tax assets will not be realized.
Based on the weight of the positive and negative evidence considered, management believes that it is more likely than not that the Company will be able to realize its federal deferred tax assets in the future, and therefore no valuation allowance has been recorded at June 30, 2014. Management believes that positive evidence including the Company's history of sustainable profitability, actual profitability for the first half of 2014, and its forecasts of future profitability outweighs the negative evidence. The Company has recorded a full valuation allowance against state and local deferred tax assets as it is more likely than not that the benefit of such items will not be realized due to limitations on utilization in the particular jurisdictions in which the Company operates.
Included in the Company’s deferred tax assets are benefits associated with NOL carryforwards generated by Knight in periods prior to the Mergers. At June 30, 2014, the Company had projected overall U.S. federal NOL carryforwards of $194.7 million of which $89.2 million resulted from the acquisition of Knight. The Company recorded a related deferred income tax asset for $68.1 million and an offsetting valuation allowance of $6.8 million at June 30, 2014, which represents the portion of these net operating loss carryforwards that are considered more likely than not to expire unutilized. The Company did not have any NOLs or related deferred tax assets at June 30, 2013.

36

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






In accordance with Section 382 of the Internal Revenue Code, a change in equity ownership of greater than 50% of a corporation within a three-year period results in an annual limitation on the corporation’s ability to utilize its NOL carryforwards that were created during tax periods prior to the change in ownership. As a result of the Mergers as well as prior ownership changes, Knight experienced ownership changes under Section 382 and as a result, the rate of utilization of NOL carryforwards generated by Knight may be limited. The Company does not believe these limitations will have a significant effect on the Company's ability to utilize its anticipated federal NOL carryforward. The Company's U.S. federal NOL carryforwards will begin to expire in 2019.
At June 30, 2014 the Company recorded a valuation allowance for substantially all of its state and local NOL carryforwards as it is more likely than not that the benefit of such items will not be realized due to limitations on utilization in the particular jurisdictions in which the Company operates. Certain of these carryforwards are subject to annual limitations on utilization and they will begin to expire in 2019.
At June 30, 2014, the Company had non-U.S. NOL carryforwards of $86.4 million of which $65.7 million were generated by Knight in periods prior to the Mergers. The Company recorded a foreign deferred income tax asset of $19.1 million for these NOL carryforwards as of June 30, 2014, along with an offsetting U.S. federal deferred tax liability of $18.9 million for the expected future reduction in U.S. foreign tax credits associated with the use of the non-U.S. loss carryforwards. These non-U.S. net operating losses may be carried forward indefinitely. At June 30, 2014, the Company had tax credit carryforwards which were generated by Knight in periods prior to the Mergers, general business credit carryforwards of $4.4 million and alternative minimum tax credit carryforwards $6.8 million.
At June 30, 2014, the Company had $2.2 million of unrecognized tax benefits, all of which would affect the Company's effective tax rate if recognized. The Company had no such unrecognized tax benefits at June 30, 2013.
As of June 30, 2014, the Company is subject to U.S. Federal income tax examinations for the tax years 2009 through July 1, 2013, and to non-U.S. income tax examinations for the tax years 2007 through 2012. In addition, the Company is subject to state and local income tax examinations in various jurisdictions for the tax years 2007 through July 1, 2013. The final outcome of these examinations is not yet determinable. However, the Company anticipates that adjustments to the unrecognized tax benefits, if any, will not result in a material change to the results of operations or financial condition.
The Company's policy for recording interest and penalties associated with audits is to record such items as a component of income or loss from continuing operations before income taxes. Penalties, if any, are recorded in Other expenses and interest paid or received is recorded in Debt interest expense and Interest, net, on the Consolidated Statements of Operations.
15. Accumulated Other Comprehensive Income
The following table presents changes in Accumulated other comprehensive income, net of tax by component for the three and six months ended June 30, 2014 and 2013 (in thousands):
 
 
Unrealized Gains (Losses) on Available-for-Sale Securities
 
Foreign Currency Translation Adjustments
 
Total
Balance March 31, 2014
 
$
(101
)
 
$
1,566

 
$
1,465

Other comprehensive income (loss)
 
(96
)
 
291

 
195

Balance June 30, 2014
 
$
(197
)
 
$
1,857

 
$
1,660


37

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






 
 
Unrealized Gains (Losses) on Available-for-Sale Securities
 
Foreign Currency Translation Adjustments
 
Total
Balance December 31, 2013
 
$
36

 
$
1,365

 
$
1,401

Other comprehensive income (loss)
 
(233
)
 
492

 
259

Balance June 30, 2014
 
$
(197
)
 
$
1,857

 
$
1,660

 
 
Unrealized Gains on Available-for-Sale Securities
 
Foreign Currency Translation Adjustments
 
Total
Balance March 31, 2013
 
$
126,263

 
$
84

 
$
126,347

Other comprehensive loss
 
(7,394
)
 
(487
)
 
(7,881
)
Balance June 30, 2013
 
$
118,869

 
$
(403
)
 
$
118,466

 
 
Unrealized Gains on Available-for-Sale Securities
 
Foreign Currency Translation Adjustments
 
Total
Balance December 31, 2012
 
$
114,319

 
$

 
$
114,319

Other comprehensive income (loss)
 
4,550

 
(403
)
 
4,147

Balance June 30, 2013
 
$
118,869

 
$
(403
)
 
$
118,466

For the three and six months ended June 30, 2013, the Company recorded ($7.4 million) and $4.6 million, respectively, in unrealized (losses) gains related to GETCO's investment in Knight prior to the Mergers.
16. Writedowns and Other Charges
Writedown of capitalized debt costs
During the three and six months ended June 30, 2014, the Company made $50.0 million and $235.0 million, respectively, in principal repayments under the Credit Agreement. As a result, $2.0 million and $9.6 million, respectively, in capitalized debt costs were written down.
Lease loss accrual
For the three and six months ended June 30, 2014, the Company recorded $1.9 million and $2.2 million, respectively, of net lease loss accruals related to excess real estate capacity. For the three and six months ended June 30, 2013, the Company recorded $0.9 million of net lease loss accrual related to excess real estate capacity.
Writedown of assets
For the three and six months ended June 30, 2013, the Company recorded $0.2 million and $2.4 million, respectively, in writedown of assets primarily related to leasehold improvements and fixed assets in connection with the shut down of the Company's Hong Kong office.
17. Earnings Per Share
Basic earnings or loss per common share (“EPS”) has been calculated by dividing net income (loss) from continuing operations by the weighted average shares of KCG Class A Common Stock outstanding during each respective period. Diluted EPS reflects the potential reduction in EPS using the treasury stock method to reflect the impact of common stock equivalents if stock options, SARs and warrants were exercised and restricted awards were to vest.

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KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The number of such options, warrants and SARs excluded from the EPS calculation was approximately 28.3 million for both the three and six months ended June 30, 2014. Such options, warrants and SARS were excluded from the EPS calculation as their inclusion would have an anti-dilutive impact on the EPS calculation. The computation of diluted shares can vary among periods due in part to the change in the average price of KCG Class A Common Stock.
The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations from continuing operations for the three and six months ended June 30, 2014 and 2013 (in thousands):
 
For the three months ended June 30,
 
2014
 
2013
 
Numerator /
net income
 
Denominator /    
shares
 
Numerator /
net (loss)
 
Denominator / 
shares
Income (loss) from continuing operations and shares used in basic calculations
$
8,987

 
114,859

 
$
(78,151
)
 
45,576

Effect of dilutive stock based awards
 
 
2,742

 
 
 

Income (loss) from continuing operations and shares used in diluted calculations
$
8,987

 
117,601

 
$
(78,151
)
 
45,576

Loss from continuing operations allocated to preferred and participating units
$

 
 
 
$
(21,535
)
 
 
Income (loss) from continuing operations attributable to common shareholders
$
8,987

 
 
 
$
(56,616
)
 
 
Basic earnings (loss) per common share from continuing operations
 
 
$
0.08

 
 
 
$
(1.24
)
Diluted earnings (loss) per common share from continuing operations
 
 
$
0.08

 
 
 
$
(1.24
)
 
For the six months ended June 30,
 
2014
 
2013
 
Numerator /
net income
 
Denominator /    
shares
 
Numerator /
net (loss)
 
Denominator / 
shares
Income (loss) from continuing operations and shares used in basic calculations
$
45,904

 
115,282

 
$
(84,983
)
 
45,514

Effect of dilutive stock based awards
 
 
2,888

 
 
 

Income (loss) from continuing operations and shares used in diluted calculations
$
45,904

 
118,170

 
$
(84,983
)
 
45,514

Loss from continuing operations allocated to preferred and participating units
$

 
 
 
$
(21,535
)
 
 
Income (loss) from continuing operations attributable to common shareholders
$
45,904

 
 
 
$
(63,448
)
 
 
Basic earnings (loss) per common share from continuing operations
 
 
$
0.40

 
 
 
$
(1.39
)
Diluted earnings (loss) per common share from continuing operations
 
 
$
0.39

 
 
 
$
(1.39
)
Prior to the Mergers, GETCO units comprised preferred and common units, and net income was allocated among the various classes of units based upon participation rights in undistributed earnings. The number of shares used to calculate EPS for 2013 are GETCO units converted into KCG shares using an exchange ratio as detailed in the Merger Agreement.
18. Significant Clients
The Company considers significant clients to be those clients who account for 10% or more of the total U.S. equity dollar value traded by the Company. No clients accounted for more than 10% of the Company’s U.S. equity dollar value traded during the three and six months ended June 30, 2014 or 2013.
19. Commitments and Contingent Liabilities
Legal Proceedings
In the ordinary course of business, the nature of the Company’s business subjects it to claims, lawsuits, regulatory examinations and other proceedings. The Company and its subsidiaries are subject to several of these matters at the present time. Given the inherent difficulty of predicting the outcome of the litigation and regulatory matters, particularly

39

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






in cases or proceedings in which substantial or indeterminate damages or fines are sought, or where cases or proceedings are in the early stages, the Company cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. In addition, there are numerous factors that result in a greater degree of complexity in class-action lawsuits as compared to other types of litigation. Due to the many intricacies involved in class-action lawsuits particularly in the early stages of such matters, obtaining clarity on a reasonable estimate is difficult which may call into question its reliability. There can be no assurance that these matters will not have a material adverse effect on the Company’s results of operations in any future period, and a material judgment could have a material adverse impact on the Company’s financial condition and results of operations. However, it is the opinion of management, after consultation with legal counsel that, based on information currently available, the ultimate outcome of these ordinary matters will not have a material adverse impact on the business, financial condition or operating results of the Company although they might be material to the operating results for any particular reporting period, depending, in part, upon operating results for that period. The Company carries directors and officers liability insurance coverage for potential claims, including securities actions, against the Company, Knight and GETCO and their respective directors and officers.
As previously disclosed in Knight's public filings, Knight experienced a technology issue at the open of trading at the NYSE on August 1, 2012. This issue was related to the installation of trading software and resulted in KCA sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market. Knight has since been named as a defendant in two putative class action complaints (one of which was voluntarily dismissed) and one derivative lawsuit, all of which relate to the technology issue. Knight has also received several derivative demand letters and/or requests for the inspection or production of certain books and records pursuant to Delaware law related to the technology issue and the raising of $400.0 million in equity financing through a convertible preferred stock offering to certain investors (the "August 6, 2012 recapitalization").
After the announcement on December 19, 2012 of the signing of the Merger Agreement, Knight, GETCO, GA-GTCO, as well as the individual members of the Knight's Board of Directors prior to the Mergers (the “Individual Defendants”), were named as defendants in several lawsuits brought by certain purported Knight stockholders challenging the proposed Mergers. The lawsuits generally allege, among other things, that the Mergers failed to properly value Knight, that the Individual Defendants breached their fiduciary duties in approving the Merger Agreement and that those breaches were aided and abetted by GETCO and GA-GTCO. The lawsuits, among other things, seek to enjoin the defendants from completing the Mergers on the agreed-upon terms, rescission of the Mergers (to the extent the Mergers have already been consummated), monetary relief and attorneys' fees and costs.
While the Company is currently unable to predict the outcome of any existing or future litigation related to the August 1, 2012 technology issue, the August 6, 2012 recapitalization, or the Mergers, an unfavorable outcome in one or more of these matters could have a material adverse effect on its financial condition or ongoing results of operations. In addition, the Company expects to incur additional expenses in defending against such litigation.
Legal
Litigation Related to the August 1, 2012 Technology Issue
On October 26, 2012, Knight, its Chairman and Chief Executive Officer, Thomas M. Joyce, and its Executive Vice President, Chief Operating Officer and Chief Financial Officer, Steven Bisgay, were named as defendants in an action entitled Fernandez v. Knight Capital Group, Inc. in the U.S. District Court for the District of New Jersey, Case No. 2:12-cv-06760. Generally, this putative class action complaint alleged that the defendants made material misstatements and/or failed to disclose matters related to the events of August 1, 2012. The plaintiff asserted claims under Sections 10(b) and 20 and Rule 10b-5 of the federal securities laws, claiming that he and a purported class of Knight's stockholders who purchased Knight's Class A Common Stock between January 19, 2012 and August 1, 2012 paid an inflated price. Following the appointment of a lead plaintiff and counsel, the plaintiff filed an amended complaint on March 14, 2013, alleging generally that the defendants made material misstatements and/or failed to disclose matters related to the events of August 1, 2012. The plaintiff asserted claims under Sections 10(b) and 20 and Rule 10b-5 of the federal securities laws, claiming that it and a purported class of Knight's stockholders who purchased Knight's securities between November 30, 2011 and August 1, 2012 paid an inflated price. On May 13, 2013, Knight filed a motion to dismiss the amended complaint, which was fully briefed as of August 2013. Before the court rendered a decision on the motion to dismiss, the plaintiff filed a second amended complaint on December 20, 2013, alleging generally that the defendants made material misstatements and/or failed to disclose matters related to the events of August 1, 2012. More specifically, the plaintiff referred to KCA's October 2013 settlement with the SEC and alleged that the defendants made false and misleading statements concerning Knight's risk management procedures and protocols, available cash

40

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






and liquidity, Value at Risk and internal controls over financial reporting. The plaintiff asserted claims under Sections 10(b) and 20 and Rule 10b-5 of the federal securities laws, claiming that it and a purported class of Knight's stockholders who purchased Knight's securities between May 10, 2011 and August 1, 2012 paid an inflated price. The defendants filed a motion to dismiss the second amended complaint on February 18, 2014. The motion was fully briefed as of June 5, 2014, and is before the court for decision.
As noted above, Knight received several demand letters requesting that it commence a lawsuit against certain directors and officers for alleged breaches of fiduciary duties, waste, wrongdoing, mismanagement and/or demanding that it produce certain books and records pursuant to Delaware law concerning the technology issue and the August 6, 2012 recapitalization. The Company responded to each of these demand letters and, except as noted below in the New York litigation, none of these letters has resulted in litigation.
Mergers Litigation
Delaware Litigation. On December 28, 2012, a purported stockholder class action complaint was filed in the Court of Chancery of the State of Delaware, captioned Ann Jimenez McMillan v. Thomas M. Joyce, et al., Case No. 8163-VCP. The complaint names as defendants Knight, the Individual Defendants, GETCO, and GA-GTCO, LLC. The complaint generally alleges, among other things, that the Individual Defendants violated their fiduciary duties by accepting an inadequate merger price, approving the transaction despite material conflicts of interest, and agreeing to a number of improper deal protection devices and voting agreements, which allegedly make it less likely that other bidders would make successful competing offers for Knight. The complaint also alleges that Knight, GETCO, and GA-GTCO, LLC aided and abetted these purported breaches of fiduciary duties. The relief sought includes, among other things, an injunction prohibiting consummation of the Mergers, rescission of the Mergers (to the extent the Mergers have already been consummated), and attorneys' fees and costs. On December 28, 2012, a purported stockholder class action complaint was filed in the Court of Chancery of the State of Delaware, captioned Chrislaine Dominique v. Thomas M. Joyce, et al., Case No. 8159-VCP. The complaint names as defendants Knight, the Individual Defendants, GETCO, and GA-GTCO, LLC. The complaint generally alleges, among other things, that the Individual Defendants violated their fiduciary duties by accepting an inadequate merger price, approving the transaction despite material conflicts of interest, including that they were appointed by an investor group that included GETCO, and agreeing to a number of improper deal protection devices, which allegedly make it less likely that other bidders would make successful competing offers for Knight. The complaint also alleges that Knight and GETCO aided and abetted these purported breaches of fiduciary duties. The relief sought includes, among other things, an injunction prohibiting consummation of the Mergers, rescission of the Mergers (to the extent the Mergers have already been consummated), and attorneys' fees and costs. On January 31, 2013, the Court of Chancery consolidated for all purposes the McMillan and Dominique actions into a single action captioned In re Knight Capital Group, Inc. Shareholder Litigation, C.A. No. 8159-VCP. On March 5, 2013, the co-lead plaintiffs in the Delaware Consolidated Action filed an amended complaint and motions for expedited discovery and a preliminary injunction. In addition to the allegations in the initial complaints, the Delaware amended complaint contains allegations that the Knight Board of Directors breached its fiduciary duties by providing stockholders with allegedly deficient disclosures about the proposed transaction in the Company's Preliminary Form S-4, filed with the SEC on February 13, 2013 (the “Preliminary Proxy”).
New Jersey Litigation. On December 31, 2012, a purported stockholder class action complaint was filed in the Superior Court of New Jersey, Chancery Division of Hudson County, NJ, captioned Charles Bryan v. Knight Capital, et al., Case No. HUD-C-001-13. The complaint names as defendants Knight, the Individual Defendants, Jefferies & Company, Inc., Jefferies High Yield Trading, LLC, TD Ameritrade Holding Corp., Blackstone Capital Partners VI L.P., Blackstone Family Investment Partnership VI-ESC L.P., Blackstone Family Investment Partnership VI L.P., Stephens Investments Holdings LLC, Stifel Financial Corp., GETCO Strategic Investments, LLC, GETCO Holding Company LLC, and GA-GTCO, LLC. The complaint generally alleges that the Individual Defendants breached their fiduciary duties by accepting an inadequate merger price, agreeing to a number of improper deal protection devices and voting agreements, which allegedly make it less likely that other bidders would make successful competing offers for Knight and approving the transaction despite material conflicts of interest, including that they were appointed by an investor group that included GETCO. The complaint further alleges that the entity defendants (except for Knight and GA-GTCO, LLC) breached alleged fiduciary duties in connection with the Individual Defendants' approval of the Mergers. The complaint also alleges that GETCO and GA-GTCO, LLC aided and abetted the Individual Defendants' purported breaches of fiduciary duty. The relief sought includes, among other things, an injunction prohibiting the consummation of the Mergers, rescission of the Mergers (to the extent the Mergers have already been consummated), and attorneys' fees and costs.

41

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






On December 31, 2012, a purported stockholder class action complaint was filed in the Superior Court of New Jersey, Chancery Division of Hudson County, NJ, captioned James Ward v. Knight Capital, et al., Case No. HUD-C-0003-13. The complaint names as defendants Knight, the Individual Defendants, Jefferies & Company, Inc., Jefferies High Yield Trading, LLC, TD Ameritrade Holding Corp., Blackstone Capital Partners VI L.P., Blackstone Family Investment Partnership VI-ESC L.P., Blackstone Family Investment Partnership VI L.P., Stephens Investments Holdings LLC, Stifel Financial Corp., GETCO Strategic Investments, LLC, GETCO Holding Company LLC, and GA-GTCO, LLC. The complaint generally alleges that the Individual Defendants breached their fiduciary duties by accepting an inadequate merger price, agreeing to a number of improper deal protection devices and voting agreements, which allegedly make it less likely that other bidders would make successful competing offers for Knight and approving the transaction despite material conflicts of interest, including that they were appointed by an investor group that included GETCO. The complaint further alleges that the entity defendants (except for Knight and GA-GTCO, LLC) breached alleged fiduciary duties in connection with the Individual Defendants' approval of the Mergers. The complaint also alleges that GETCO and GA-GTCO, LLC aided and abetted the Individual Defendants' purported breaches of fiduciary duty. The relief sought includes, among other things, an injunction prohibiting the consummation of the Mergers, rescission of the Mergers (to the extent the Mergers have already been consummated), and attorneys' fees and costs. On February 20, 2013, Knight moved to dismiss or, in the alternative, stay the New Jersey actions in deference to the first-filed Delaware actions. The New Jersey court granted the motion on March 28, 2013, and ordered that the New Jersey actions be stayed for all purposes in deference to the first-filed Delaware actions.
New York Litigation. On January 15, 2013, Knight, the Individual Defendants, GETCO, GA-GTCO, LLC and General Atlantic were named as defendants in an action entitled Joel Rosenfeld v. Thomas M. Joyce, et al., Case No. 6540147/2013, in the Supreme Court of the State of New York (New York County). The plaintiff, Joel Rosenfeld, is one of the stockholders mentioned above who previously sent Knight a derivative demand letter. Generally, this complaint asserts both derivative and class action claims. First, it purports to assert derivative claims, which allege, among other things, that the seven Knight directors who were serving as of August 1, 2012 breached their fiduciary duties and wasted corporate assets by failing to erect and oversee effective safeguards to prevent against technology issues, such as the one that occurred on August 1, 2012, for which Knight incurred a realized pre-tax loss of approximately $457.6 million. Second, it asserts putative class action claims resulting from the proposed Mergers for (1) breach of fiduciary duty against the Individual Defendants; and (2) aiding and abetting the purported breach of fiduciary duty against GETCO, GA-GTCO, LLC, and General Atlantic. The complaint generally alleges that the Individual Defendants breached their fiduciary duties by approving the Mergers at an inadequate price, agreeing to a number of improper deal protection devices and voting agreements, which allegedly make it less likely that other bidders would make successful competing offers for Knight, and that certain of Knight's directors have conflicts of interest in connection with the transaction, including that certain directors sought to enter into the transaction to avoid potential liability relating to the derivative claims asserted in the complaint. With respect to the merger claims, the plaintiff seeks, among other things, to enjoin the proposed Mergers, rescission of the proposed Mergers (to the extent they have already been consummated) and attorneys' fees. With respect to the derivative claims, the plaintiff seeks, among other things, an order requiring the Knight directors who were serving as of August 1, 2012 to pay restitution and/or compensatory damages in favor of Knight and/or the proposed class of Knight stockholders. On March 14, 2013, the plaintiff filed an amended complaint, which, in addition to the allegations in the initial complaint, contains allegations that the Knight Board of Directors breached its fiduciary duties by providing stockholders with allegedly deficient disclosures about the proposed transaction in the Preliminary Proxy. On March 21, 2013, the plaintiff moved by order to show cause for expedited discovery in support of his claims. The New York court issued an order on March 25, 2013, setting a hearing on the plaintiff's motion for April 4, 2013. On March 28, 2013, the parties in the New York action reached an agreement with respect to the matters raised in the plaintiff's motion and other aspects of the action, and as a result, on March 29, 2013, the plaintiff withdrew his motion for expedited discovery. On April 9, 2013, the New York court granted permission for the plaintiff to withdraw his motion.
On June 10, 2013, the defendants entered into a memorandum of understanding with the plaintiffs in the Delaware shareholder actions and New York shareholder action regarding the settlement of those actions. In connection with the settlement, Knight and GETCO agreed to make supplemental disclosures to the joint proxy statement/prospectus filed with the SEC on May 28, 2013 (the “Proxy Statement”). In addition, Knight and GETCO agreed to make certain revisions to Knight's risk committee charter, as well as to KCG's risk committee charter.
The memorandum of understanding contemplated that the parties would enter into a stipulation of settlement, which would be subject to customary conditions, including court approval following notice to Knight's former stockholders. It also contemplated that in the event that the parties enter into a stipulation of settlement, a hearing

42

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






would be scheduled at which the Delaware Court of Chancery would consider the fairness, reasonableness and adequacy of the settlement. If the settlement is finally approved by the court, it would resolve and release all claims that were brought or could have been brought in the Delaware, New York, and New Jersey shareholder actions, including claims challenging any aspect of the Mergers, the Merger Agreement, or any disclosure made in connection therewith, pursuant to terms that will be disclosed to Knight's former stockholders prior to final approval of the settlement. In addition, in connection with the settlement, the parties contemplated that plaintiffs' counsel will file a petition in the Delaware Court of Chancery for an award of attorneys' fees and expenses to be paid by KCG.
On June 5, 2014, the parties entered into a Stipulation and Agreement of Compromise, Settlement and Release (the “Stipulation”). As contemplated in the memorandum of understanding, the Stipulation provides, among other things, that in exchange for the supplemental disclosures and changes to Knight’s and KCG’s risk committee charters discussed above, and upon final approval by the Delaware Court of Chancery, the Delaware and New York stockholder plaintiffs, and a class of former Knight stockholders that includes such plaintiffs, will finally and fully resolve and release all claims that were brought or could have been brought in the Delaware, New York, and New Jersey shareholder actions, including claims challenging any aspect of the Mergers, the Merger Agreement, or any disclosure made in connection therewith. The Stipulation further provides that counsel for the Delaware and New York shareholder plaintiffs will seek, and the defendants will not oppose, court approval of an award of attorneys’ fees and costs in an amount not to exceed $490,000. The Stipulation and the settlement it contemplates, is not, and should not be construed as, an admission of wrongdoing or liability by any of the defendants. Nonetheless, the defendants entered into the settlement to avoid the risk of the stockholder actions delaying or adversely affecting the Mergers, to minimize the substantial expense, burden, distraction and inconvenience of continued litigation, and to fully and finally resolve the claims in the stockholder actions.
On June 9, 2014, the parties to the Stipulation filed the Stipulation and associated exhibits with the Delaware Court of Chancery, seeking among other things, preliminary approval of the settlement, conditional certification of a non-opt-out class of former Knight stockholders for settlement purposes only, and the scheduling of a final settlement hearing.
On June 17, 2014, the Delaware Court of Chancery entered an order preliminarily approving the settlement as set forth in the Stipulation, conditionally certifying a non-opt-out class of former Knight stockholders for settlement purposes only pursuant to Court of Chancery Rules 23(a), 23(b)(1), and 23(b)(2), and scheduling a final settlement hearing to be held on September 26, 2014. The Court’s preliminary order provides that at the final settlement hearing, the Court will, among other things, determine whether to finally certify the non-opt-out class of former Knight stockholders, determine whether the settlement is fair, reasonable, and adequate to the class and should be approved by the Court, determine whether to enter a final order and judgment dismissing the action with prejudice, consider the application for attorneys’ fees and costs by counsel for the Delaware and New York shareholder plaintiffs, and rule on such other matters as the Court may deem appropriate. The Court’s preliminary order further provides that members of the conditionally-certified class shall receive notice of the settlement hearing at least 45 days prior to the hearing, which notice shall describe, among other things, the material terms of the settlement and the procedures for class members to follow if they wish to object to the settlement and/or be heard at the final hearing. If the Court finally approves the settlement, it will dismiss the Delaware shareholder action with prejudice. Within ten days of such an order, the New York shareholder plaintiff is required by the Stipulation to seek dismissal with prejudice of the New York shareholder action.
Trading Litigation
On April 18, 2014, KCG and 40 other market participants were named as defendants in a purported class action complaint entitled City of Providence v. BATS Global Markets, Inc. et al., 14-cv-2811, in the U.S. District Court for the Southern District of New York on behalf of public stockholders who purchased and/or sold stock in the United States during the period from on and after April 18, 2009 on a U.S.-based public stock exchange or alternative trading venue. Generally, the complaint alleges that defendants engaged in manipulative, self-dealing and deceptive conduct in connection with the trading of securities. The claims against KCG are made pursuant to Sections 10b and 20A and Rule 10b-5 of the Securities Exchange Act of 1934. The complaint seeks, among other things, equitable and injunctive relief, as well as unspecified compensatory damages, restitution and disgorgement.  Between May 2, 2014 and June 13, 2014, three other groups of plaintiffs filed similar complaints in the same court under the following captions:  American European Insurance Co. v. BATS Global Markets, Inc. et al., 14-cv-3133; Harel Insurance Co., Ltd. v. BATS Global Markets, Inc. et al., 14-cv-3608; and Flynn et al. v. Bank of America Corp. et al., 14-cv-4321.  On July 2, 2014, the

43

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






court consolidated the four actions and appointed the original plaintiffs - primarily institutional investors - lead plaintiffs and their chosen counsel as lead counsel.
Other Legal and Regulatory Matters
The Company owns subsidiaries including regulated entities that are subject to extensive oversight under federal, state and applicable international laws as well as SRO rules. Changes in market structure and the need to remain competitive require constant changes to the Company's systems and order handling procedures. The Company makes these changes while continuously endeavoring to comply with many complex laws and rules. Compliance, surveillance and trading issues common in the securities industry are monitored by, reported to, and/or reviewed in the ordinary course of business by the Company's regulators in the U.S. and abroad. As a major order flow execution destination, the Company is named from time to time in, or is asked to respond to a number of regulatory matters brought by U.S. regulators, foreign regulators and SROs that arise from its business activities. The Company is currently the subject of various regulatory reviews and investigations. In some instances, these matters may rise to a disciplinary action and/or civil or administrative action.
In addition, there has been an increased focus by regulators, the New York Attorney General, Congress and the media on market structure issues, and in particular, high frequency trading, ATS manner of operations, market fragmentation and complexity, colocation, access to market data feeds and remuneration arrangements, such as payment for order flow and exchange fee structures. The Company has received information requests from the SEC requesting, among other items, information regarding these market structure matters, which the Company is in the process of responding.
Lease and Contract Obligations
Capital Leases
The Company enters into capitalized lease obligations related to certain computer equipment. These obligations represent drawdowns under a revolving secured lending facility with a single lender. At June 30, 2014, the obligations have a weighted-average interest rate of 4.19% per annum and are on varying 3-year terms. The carrying amounts of the capital leases approximate fair value. The future minimum payments including interest under the capitalized leases at June 30, 2014 consist of (in thousands):
 
Minimum Payments
Six months ending December 31, 2014
$
4,226

2015
3,686

2016
1,614

2017
322

Total
$
9,848

The total interest expense related to capital leases for the three and six months ended June 30, 2014, and 2013 included in the Consolidated Statements Operations is as follows (in thousands):
 
For the three months ended June 30,
 
For the six months ended June 30,
 
2014
 
2013
 
2014
 
2013
Interest expense - Capital leases
$
102

 
$
201

 
$
190

 
$
451

Operating Leases
The Company leases office space under noncancelable operating leases. Certain office leases contain fixed dollar-based escalation clauses. Rental expense from continuing operations under the office leases was $5.0 million and $2.3 million for the three months ended June 30, 2014 and 2013, respectively, and $10.1 million and $4.8 million for the six months ended June 30, 2014 and 2013, respectively, and is included in Occupancy and equipment rentals on the Consolidated Statements of Operations.

44

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






The Company leases certain computer and other equipment under noncancelable operating leases. As of June 30, 2014, future minimum rental commitments under all noncancelable office, computer and equipment leases (“Gross Lease Obligations”), and Sublease Income were as follows (in thousands):
 
Gross Lease
Obligations
 
Sublease
Income
 
Net Lease
Obligations
Six months ending December 31, 2014
$
15,407

 
$
2,042

 
$
13,365

Year ending December 31, 2015
29,530

 
4,914

 
24,616

Year ending December 31, 2016
29,183

 
4,850

 
24,333

Year ending December 31, 2017
27,640

 
4,426

 
23,214

Year ending December 31, 2018
26,796

 
2,720

 
24,076

Thereafter through December 31, 2027
82,676

 
12,521

 
70,155

Total
$
211,232

 
$
31,473

 
$
179,759

Contract Obligations
During the normal course of business, the Company collateralizes certain leases or other contractual obligations through letters of credit or segregated funds held in escrow accounts. At June 30, 2014, the Company had provided letters of credit for $2.5 million, collateralized by U.S. Treasury Bills, as a guarantee for two of its lease obligations. In the ordinary course of business, KCG also has provided, and may provide in the future, unsecured guarantees with respect to the payment obligations of certain of its subsidiaries under trading, repurchase, financing and stock loan arrangements, as well as under certain leases.
20.    Financial instruments with Off-Balance Sheet Risk and Concentrations of Credit Risk
As a market maker in global equities, fixed income, futures, options, commodities and foreign currencies, the majority of the Company’s securities transactions are conducted as principal or riskless principal with broker dealers and institutional counterparties primarily located in the United States. The Company self-clears substantially all of its U.S. equity and option securities transactions. The Company clears a portion of its securities transactions through third party clearing brokers. Foreign transactions are settled pursuant to global custody and clearing agreements with major U.S. banks. Substantially all of the Company’s credit exposures are concentrated with its clearing brokers, broker dealer and institutional counterparties. The Company’s policy is to monitor the credit standing of counterparties with which it conducts business.
The Company, through its FCM, also provides execution and clearing services in futures and options on futures contracts to facilitate customer transactions on major U.S. and European futures and options exchanges. Customer activities may expose the Company to off-balance sheet risk in the event the FCM customer is unable to fulfill its contracted obligation as the Company guarantees the performance of its clients to the respective clearing houses or other brokers. In accordance with regulatory requirements and market practice, the Company requires its customers to meet, at a minimum, the margin requirements established by each of the exchanges at which contracts are traded. Margin is a good faith deposit from the customer that reduces risk to the Company of failure by the customer to fulfill obligations under these contracts. The Company establishes customer credit limits and monitors required margin levels on a daily basis and, pursuant to such guidelines, require customers to deposit additional collateral, or to reduce positions, when necessary. Further, the Company seeks to reduce credit risk by entering into netting agreements with customers, which permit receivables and payables with such customers to be offset in the event of a customer default. Management believes that the margin deposits and collateral held at June 30, 2014 were adequate to minimize the risk of material loss that could be created by positions held at that time.
In the normal course of its operations, the Company enters into contracts that contain a variety of representations and warranties which provide general indemnifications. The Company’s maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Company that have not yet occurred. However, based on experience, the Company believes the risk of significant loss is minimal.
Financial instruments sold, not yet purchased, at fair value represent obligations to purchase such securities (or underlying securities) at a future date. The Company may incur a loss if the market value of the securities subsequently increases.
The Company currently has no loans outstanding to any former or current executive officer or director.

45

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






21.    Business Segments
As of June 30, 2014, the Company's operating segments comprised the following: (i) Market Making; (ii) Global Execution Services; and (iii) Corporate and Other.
The Market Making segment principally consists of market making in the cash, futures and options markets across global equities, options, fixed income, foreign currencies and commodities. As a market maker, the Company commits capital on a principal basis by offering to buy securities from, or sell securities to, broker dealers, institutions and banks. Principal trading in the Market Making segment primarily consists of direct-to-client and non-client exchange-based electronic market making, including trade executions conducted as an equities DMM on the NYSE and NYSE Amex. The Company is an active participant on all major global equity and futures exchanges and also trades on substantially all domestic electronic options exchanges. As a complement to electronic market making, the Company’s cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, marketplaces operated by the OTC Markets Group Inc. and AIM of the London Stock Exchange.
The Global Execution Services segment comprises agency execution services and trading venues, offering trading in global equities, options, foreign exchange, fixed income and futures to institutions, banks and broker dealers. The Company generally earns commissions as an agent between principals to transactions that are executed within this segment, however, the Company will commit capital on behalf of clients as needed. Agency-based, execution-only trading in the segment is done primarily through a variety of access points: (i) self-directed trading in global equities through a suite of algorithms or via an execution management system; (ii) institutional high touch sales traders executing program, block and riskless principal trades in global equities and ETFs; (iii) an institutional spot foreign exchange ECN; (iv) a fixed income ECN that also offers trading applications; (v) an ATS for global equities; and (vi) futures execution and clearing through a FCM.
The Corporate and Other segment principally invests in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains corporate overhead expenses and all other income and expenses that are not attributable to the other segments. The Corporate and Other segment also contains functions that support the Company’s other segments such as self-clearing services, including stock lending activities.
The Company’s revenues, income (loss) from continuing operations before income taxes (“Pre-tax earnings”) and total assets by segment are summarized in the following table (in thousands): 
 
Market
Making
 
Global Execution Services
 
Corporate
and Other
 
Consolidated
Total
For the three months ended June 30, 2014:
 
 
 
 
 
 
 
Revenues
$
218,446

 
$
85,903

 
$
9,784

 
$
314,133

Pre-tax earnings
36,004

 
736

 
(22,233
)
 
14,507

Total assets
4,303,928

 
1,560,919

 
1,797,627

 
7,662,474

For the three months ended June 30, 2013:
 
 
 
 
 
 
 
Revenues
$
113,501

 
$
13,060

 
$
(6,928
)
 
$
119,633

Pre-tax earnings
1,922

 
(3,121
)
 
(73,637
)
 
(74,836
)
Total assets
1,924,622

 
20,666

 
245,413

 
2,190,701

For the six months ended June 30, 2014:
 
 
 
 
 
 
 
Revenues
$
495,792

 
$
173,123

 
$
28,875

 
$
697,790

Pre-tax earnings
112,036

 
2,752

 
(40,897
)
 
73,891

Total assets
4,303,928

 
1,560,919

 
1,797,627

 
7,662,474

For the six months ended June 30, 2013:
 
 
 
 
 
 
 
Revenues
$
215,568

 
$
22,334

 
$
(3,277
)
 
$
234,625

Pre-tax earnings
7,809

 
(4,948
)
 
(82,555
)
 
(79,694
)
Total assets
1,924,622

 
20,666

 
245,413

 
2,190,701

In the first quarter of 2014, the Company began to charge the Market Making and Global Execution Services segments for the cost of aggregate debt interest. The interest amount charged to each of the segments is determined

46

KCG HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)






based on capital limits and requirements. Historically, debt interest was included within the Corporate and Other segment. This change in the measurement of segment profitability has no impact on the consolidated results and will only be reported prospectively, and will not be reflected in financial results prior to January 1, 2014. For the three months ended June 30, 2014 debt interest expense included in the results of the Market Making and Global Execution Services segments was $5.9 million and $1.8 million, respectively. For the six months ended June 30, 2014 debt interest expense included in the results of the Market Making and Global Execution Services segments was $13.0 million and $4.2 million, respectively.

47


Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Explanatory Note
On July 1, 2013, Knight Capital Group, Inc. (“Knight”), through a series of transactions (the "Mergers"), merged with GETCO Holding Company, LLC (“GETCO”) to form KCG Holdings, Inc. ("KCG" or the "Company"). The Mergers were consummated pursuant to the Amended and Restated Agreement and Plan of Merger, dated as of December 19, 2012 and amended and restated as of April 15, 2013 (the "Merger Agreement"). Following the Mergers, each of Knight and GETCO became a wholly-owned subsidiary of KCG.
All references herein to the "Company", "we", "our" or "KCG" relate solely to KCG and not Knight. All references to "GETCO" relate solely to GETCO and not KCG.
The Mergers were treated as a purchase of Knight by GETCO for accounting and financial reporting purposes. As a result, the financial results for the three and six months ended June 30, 2013 comprise the results of GETCO only and the financial results for the three and six months ended June 30, 2014, comprise the results of KCG.
All GETCO earnings per share and unit share outstanding amounts in this Quarterly Report on Form 10-Q have been calculated as if the conversion of GETCO units to KCG Class A Common Stock took place on January 1, 2013, at the exchange ratio, as defined in the Merger Agreement.
Cautionary Statement Regarding Forward-Looking Information
Certain statements contained in this Quarterly Report on Form 10-Q, including without limitation, those under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” herein (“MD&A”), “Quantitative and Qualitative Disclosures About Market Risk” in Part I, Item 3, “Legal Proceedings” and "Risk Factors" in Part II and the documents incorporated by reference herein may constitute "forward-looking statements" within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are typically identified by words such as “believe,” “expect,” “anticipate,” “intend,” “target,” “estimate,” “continue,” “positions,” “prospects” or “potential,” by future conditional verbs such as “will,” “would,” “should,” “could” or “may,” or by variations of such words or by similar expressions. These forward-looking statements are not historical facts and are based on current expectations, estimates and projections about the Company's industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond the Company's control. Any forward-looking statement contained herein speaks only as of the date on which it is made. Accordingly, readers are cautioned that any such forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict including, without limitation, risks associated with: (i) the Mergers including, among other things, (a) difficulties and delays in integrating the Knight and GETCO businesses or fully realizing cost savings and other benefits, (b) the inability to sustain revenue and earnings growth, and (c) customer and client reactions to the Mergers; (ii) the August 1, 2012 technology issue that resulted in Knight’s broker dealer subsidiary sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market and the impact to Knight’s capital structure and business as well as actions taken in response thereto and consequences thereof; (iii) the sale of KCG's reverse mortgage origination and securitization business and the departure of the managers of KCG's listed derivatives group; (iv) changes in market structure, legislative, regulatory or financial reporting rules, including the increased focus by regulators, the New York Attorney General, Congress and the media on market structure issues, and in particular, the scrutiny of high frequency trading, alternative trading systems ("ATS") manner of operations, market fragmentation, colocation, access to market data feeds, and remuneration arrangements such as payment for order flow and exchange fee structures; (v) past or future changes to KCG's organizational structure and management; (vi) KCG's ability to develop competitive new products and services in a timely manner and the acceptance of such products and services by KCG's customers and potential customers; (vii) KCG's ability to keep up with technological changes; (viii) KCG's ability to effectively identify and manage market risk, operational and technology risk, legal risk, liquidity risk, reputational risk, counterparty and credit risk, international risk, regulatory risk, and compliance risk; (ix) the cost and other effects of material contingencies, including litigation contingencies, and any adverse judicial, administrative or arbitral rulings or proceedings; and (x) the effects of increased competition and KCG's ability to maintain and expand market share. The above list is not exhaustive. Because forward-looking statements involve risks and uncertainties, the actual results and performance of the Company may materially differ from the results expressed or implied by such statements. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Unless otherwise required by law, the Company also disclaims any obligation to update its view of any such risks or uncertainties or to announce publicly the result of any revisions to the forward-looking statements made herein. Readers should carefully review the risks and uncertainties

48


disclosed in the Company’s reports with the SEC, including, without limitation, those detailed under “Certain Factors Affecting Results of Operations” in MD&A herein and under “Risk Factors” in Part II, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2013, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. This information should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes thereto contained in this Quarterly Report on Form 10-Q, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time.
Executive Overview
We are a leading independent securities firm offering clients a range of services designed to address trading needs across asset classes, product types and time zones. The Company combines advanced technology with specialized client service across market making, agency execution and trading venues and also engages in principal trading via exchange-based market making. KCG has multiple access points to trade global equities, options, futures, fixed income, foreign currencies and commodities via voice or automated execution.
On December 19, 2012, Knight, and GETCO entered into the Merger Agreement. The Mergers were approved by the respective stockholders and unitholders of both companies at special meetings held on June 25, 2013, and the Mergers were completed on July 1, 2013. As a result of the Mergers, Knight and GETCO became wholly-owned subsidiaries of KCG.
Pursuant to the Merger Agreement, each outstanding share of Knight Class A common stock, par value $0.01 per share ("Knight Common Stock") was converted into the right to elect to receive either $3.75 per share in cash or one third of a share of KCG Class A Common Stock. As a result of the elections and proration procedures provided in the Merger Agreement, former Knight stockholders received a cash payment, in aggregate, of $720.0 million and 41.9 million shares of KCG Class A Common Stock.
Upon completion of the Mergers, GETCO unitholders received, in aggregate, 75.9 million shares of KCG Class A Common Stock and 24.3 million warrants to acquire shares of KCG Class A Common Stock. The warrants comprise 8.1 million Class A warrants, having a $12.00 exercise price and exercisable for a four-year term; 8.1 million Class B warrants, having a $13.50 exercise price and exercisable for a five-year term; and 8.1 million Class C warrants, having a $15.00 exercise price and exercisable for a six-year term (collectively the “KCG Warrants”).
The Mergers are accounted for as a purchase of Knight by GETCO under accounting principles generally accepted in the United States of America ("GAAP"). Under the purchase method of accounting, the assets and liabilities of Knight were recorded, as of completion of the Mergers, at their respective fair values and added to the carrying value of GETCO's existing assets and liabilities. The reported financial condition and results of operations of KCG following completion of the Mergers reflect Knight's and GETCO's balances and reflect the impact of purchase accounting adjustments, including revised amortization and depreciation expense for acquired assets. As GETCO is the accounting acquirer under GAAP, all financial information prior to the Mergers is that of GETCO.
Results of Operations
As of June 30, 2014, our operating segments comprised the following:
Market Making— Our Market Making segment principally consists of market making in the cash, futures and options markets across global equities, options, fixed income, foreign currencies and commodities. As a market maker, we commit capital on a principal basis by offering to buy securities from, or sell securities to, broker dealers, institutions and banks. Principal trading in the Market Making segment primarily consists of direct-to-client and non-client exchange-based electronic market making, including trade executions conducted as an equities Designated Market Maker (“DMM”) on the New York Stock Exchange ("NYSE") and NYSE Amex Equities ("NYSE Amex"). We are an active participant on all major global equity and futures exchanges and also trade on substantially all domestic electronic options exchanges. As a complement to electronic market making, our cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, marketplaces operated by the OTC Markets Group Inc. and the Alternative Investment Market (“AIM”) of the London Stock Exchange.
Global Execution Services— Our Global Execution Services segment comprises agency execution services and trading venues, offering trading in global equities, options, foreign exchange, fixed income and futures to institutions, banks and broker dealers. We generally earn commissions as an agent between principals to transactions that are executed within this segment, however, we will commit capital on behalf of clients as needed. Agency-based, execution-only trading in the segment is done primarily through a variation of

49


access points: (i) self-directed trading in global equities through a suite of algorithms or via our execution management system; (ii) institutional high touch sales traders executing program, block and riskless principal trades in global equities and exchange traded funds ("ETFs"); (iii) an institutional spot foreign exchange electronic communication network ("ECN"); (iv) a fixed income ECN that also offers trading applications; (v) an ATS for global equities; and (vi) futures execution and clearing through a futures commission merchant ("FCM").
Corporate and Other— Our Corporate and Other segment invests principally in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains corporate overhead expenses and all other income and expenses that are not attributable to the other segments. Our Corporate and Other segment also contains functions that support our other segments such as self-clearing services, including stock lending activities.
Management from time to time conducts a strategic review of our businesses and evaluates their potential value in the marketplace relative to their current and expected returns. To the extent management and our Board of Directors determine a business may return a higher value to stockholders, or is no longer core to our strategy, the Company may divest or exit such business.
The following table sets forth: (i) Revenues, (ii) Expenses and (iii) Pre-tax earnings (loss) from continuing operations of our segments and on a consolidated basis (in thousands): 
 
 
For the three months ended June 30,
 
For the six months ended June 30,
 
 
2014
 
2013
 
2014
 
2013
Market Making
 
 
 
 
 
 
 
 
Revenues
 
$
218,446

 
$
113,501

 
$
495,792

 
$
215,568

Expenses
 
182,442

 
111,579

 
383,756

 
207,759

Pre-tax earnings
 
36,004

 
1,922

 
112,036

 
7,809

Global Execution Services
 
 
 
 
 
 
 
 
Revenues
 
85,903

 
13,060

 
173,123

 
22,334

Expenses
 
85,167

 
16,181

 
170,371

 
27,282

Pre-tax earnings (loss)
 
736

 
(3,121
)
 
2,752

 
(4,948
)
Corporate and Other
 
 
 
 
 
 
 
 
Revenues
 
9,784

 
(6,928
)
 
28,875

 
(3,277
)
Expenses
 
32,017

 
66,709

 
69,772

 
79,278

Pre-tax loss
 
(22,233
)
 
(73,637
)
 
(40,897
)
 
(82,555
)
Consolidated
 
 
 
 
 
 
 
 
Revenues
 
314,133

 
119,633

 
697,790

 
234,625

Expenses
 
299,626

 
194,469

 
623,899

 
314,319

Pre-tax earnings (loss)
 
$
14,507

 
$
(74,836
)
 
$
73,891

 
$
(79,694
)
Totals may not add due to rounding.
In the first quarter of 2014, the Company began to charge the Market Making and Global Execution Services segments for the cost of aggregate debt interest. The interest amount charged to each of the segments is determined based on capital limits and requirements. Historically, debt interest was included within the Corporate and Other segment. This change in the measurement of segment profitability has no impact on the consolidated results and will only be reported prospectively, and will not be reflected in any financial results prior to January 1, 2014. For the three months ended June 30, 2014 debt interest expense included in the results of the Market Making and Global Execution Services segments was $5.9 million and $1.8 million, respectively. For the six months ended June 30, 2014 debt interest expense included in the results of the Market Making and Global Execution Services segments was $13.1 million and $4.2 million, respectively.

50


Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax Earnings
We believe that certain non-GAAP financial presentations, when taken into consideration with the corresponding GAAP financial presentations, are important in understanding our operating results. The non-GAAP adjustments incorporate the effects of the writedown of capitalized debt costs related to early repayment of debt; gains and losses from strategic assets; professional and other fees related to the Mergers; compensation expense related to a reduction in workforce; writedowns of assets and lease loss accruals primarily related to office consolidations.
We believe the presentation of results excluding these adjustments provides meaningful information to stockholders and investors as they provide a useful summary of our results of operations for the three and six months ended June 30, 2014 and 2013.
The following tables provide a full reconciliation of GAAP to non-GAAP pre- tax results ("adjusted pre-tax earnings") for the three and six months ended June 30, 2014 and 2013 (in thousands): 
Three months ended June 30, 2014
 
Market Making
 
Global
Execution
Services
 
Corporate and
Other
 
Consolidated
Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax:
 
 
 
 
 
 
 
 
GAAP Income (loss) from continuing operations before income taxes
 
$
36,004

 
$
736

 
$
(22,233
)
 
$
14,507

Writedown of capitalized debt costs
 

 

 
1,995

 
1,995

Compensation related to reduction in workforce
 
383

 
1,886

 
800

 
3,069

Writedown of assets and lease loss accrual
 
452

 

 
1,489

 
1,941

Adjusted pre-tax earnings
 
$
36,839

 
$
2,622

 
$
(17,949
)
 
$
21,512

Totals may not add due to rounding
Three months ended June 30, 2013
 
Market Making
 
Global
Execution
Services
 
Corporate and
Other
 
Consolidated
Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax:
 
 
 
 
 
 
 
 
GAAP Income (loss) from continuing operations before income taxes
 
$
1,922

 
$
(3,121
)
 
$
(73,637
)
 
$
(74,836
)
Professional and other fees related to Mergers
 

 

 
33,299

 
33,299

Compensation and other expenses related to Mergers
 

 

 
22,031

 
22,031

Compensation and other expenses related to reduction in workforce
 
1,852

 
335

 

 
2,187

Impairment of strategic asset
 

 

 
9,184

 
9,184

Writedown of assets and lease loss accrual
 

 

 
1,074

 
1,074

Adjusted pre-tax earnings
 
$
3,774

 
$
(2,786
)
 
$
(8,049
)
 
$
(7,061
)
Totals may not add due to rounding
Six months ended June 30, 2014
 
Market Making
 
Global
Execution
Services
 
Corporate and
Other
 
Consolidated
Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax:
 
 
 
 
 
 
 
 
GAAP Income (loss) from continuing operations before income taxes
 
$
112,036

 
$
2,752

 
$
(40,897
)
 
$
73,891

Writedown of capitalized debt costs
 

 

 
9,552

 
9,552

Income resulting from merger of BATS and Direct Edge, net
 

 

 
(9,644
)
 
(9,644
)
Compensation related to reduction in workforce
 
383

 
1,886

 
800

 
3,069

Writedown of assets and lease loss accrual, net
 
811

 

 
1,396

 
2,207

Adjusted pre-tax earnings
 
$
113,230

 
$
4,638

 
$
(38,793
)
 
$
79,075

Totals may not add due to rounding

51


Six months ended June 30, 2013
 
Market Making
 
Global
Execution
Services
 
Corporate and
Other
 
Consolidated
Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax:
 
 
 
 
 
 
 
 
GAAP Income (loss) from continuing operations before income taxes
 
$
7,809

 
$
(4,948
)
 
$
(82,555
)
 
$
(79,694
)
Professional and other fees related to Mergers
 

 

 
38,875

 
38,875

Compensation and other expenses related to Mergers
 

 

 
22,031

 
22,031

Compensation and other expenses related to reduction in workforce
 
3,963

 
865

 
378

 
5,206

Impairment of strategic asset
 

 

 
9,184

 
9,184

Writedown of assets and lease loss accrual
 

 

 
3,312

 
3,312

Adjusted pre-tax earnings
 
$
11,772

 
$
(4,083
)
 
$
(8,775
)
 
$
(1,086
)
Totals may not add due to rounding
A summary of the changes in our financial results and balances follows. The primary reason for the variance between the three and six months ended June 30, 2014 and 2013 results is the Mergers which occurred on July 1, 2013. Financial results for periods prior to the Mergers reflect solely the results of GETCO while periods following the Mergers reflect the results of KCG which includes both GETCO and Knight.
Consolidated revenues for the three months ended June 30, 2014 increased $194.5 million from the same period a year ago, while consolidated expenses increased $105.2 million. Consolidated pre-tax earnings from continuing operations for the three months ended June 30, 2014 was $14.5 million as compared to a consolidated pre-tax loss of $74.8 million for the same period a year ago.
The Company’s net revenues, which it defines as total revenues, less execution and clearance fees, payments for order flow, collateralized financing interest and non-recurring gains (losses) on investments (“adjusted net revenues”) were $216.4 million for the three months ended June 30, 2014, compared to $82.4 million for the comparable period in 2013.
Adjusted pre-tax earnings increased from a loss of $7.1 million in the second quarter of 2013 to earnings of $21.5 million in the second quarter of 2014.
Consolidated revenues for the six months ended June 30, 2014 increased $463.2 million from the same period a year ago, while consolidated expenses increased $309.6 million. Consolidated pre-tax earnings from continuing operations for the six months ended June 30, 2014 was $73.9 million as compared to a consolidated pre-tax loss of $79.7 million for the same period a year ago.
The Company’s adjusted net revenues were $486.7 million for the six months ended June 30, 2014, compared to $155.9 million for the comparable period in 2013.
Adjusted pre-tax earnings increased from a loss of $1.1 million in the first half of 2013 to earnings of $79.1 million in the first half of 2014.
Adjusted pre-tax earnings for the three and six months ended June 30, 2014 exclude net non-GAAP adjustments totaling $7.0 million and $5.2 million, respectively. These items primarily comprise the writedown of capitalized debt costs, writedown of assets and lease loss accruals and compensation related to a reduction in workforce offset, in part, by a gain on the BATS Global Markets Inc. ("BATS") and Direct Edge Holdings LLC ("Direct Edge") merger. Adjusted pre-tax earnings for the three and six months ended June 30, 2013 exclude net non-GAAP adjustments totaling $67.8 million and $78.6 million, respectively. These items primarily comprise professional and other fees related to the Mergers, compensation expense related to the Mergers and reduction in workforce, impairment of a strategic asset and writedown of assets and lease loss accruals. A detailed breakdown of these items can be found in the Reconciliation of GAAP pre-tax to Non-GAAP pre-tax earnings tables above.
The changes in our adjusted pre-tax earnings by segment from the three and six months ended June 30, 2013 are summarized as follows:
Market Making— Our adjusted pre-tax earnings from Market Making for the three months ended June 30, 2014 was $36.8 million, compared to adjusted pre-tax earnings of $3.8 million for the comparable period in 2013. Our adjusted pre-tax earnings from Market Making for the six months ended June 30, 2014 was $113.2 million, compared to adjusted pre-tax earnings of $11.8 million for the comparable period in 2013. Results

52


for the current periods were driven by the acquisition of Knight and its direct-to-client market making strategies. This segment's strong revenue capture, improvements in trading strategies and order routing efficiencies, particularly in direct-to-client equity trading activity, aided the results and were able to offset the low market volumes and volatility in the current quarter which, also particularly impacted the performance of our non-client trading strategies.
Global Execution Services— Our adjusted pre-tax earnings from Global Execution Services for the three months ended June 30, 2014 was $2.6 million, compared to an adjusted pre-tax loss of $2.8 million for the comparable period in 2013. Our adjusted pre-tax earnings from Global Execution Services for the six months ended June 30, 2014 was $4.6 million, compared to an adjusted pre-tax loss of $4.1 million for the comparable period in 2013. Despite a quarter in which market volumes across many products declined, results for the current quarter and first six months of 2014 were aided by the acquisition of Knight. In the first half of 2014, the Global Execution Services segment included solid results from businesses included in the Knight acquisition such as KCG Hotspot, KCG Bondpoint as well as KCG EMS, which includes Knight Direct and GETAlpha.
Corporate and Other—Our adjusted pre-tax earnings from our Corporate and Other segment was a loss of $17.9 million for the three months ended June 30, 2014 compared to a loss of $8.0 million for the comparable period in 2013. Our adjusted pre-tax earnings from our Corporate and Other segment was a loss of $38.8 million for the six months ended June 30, 2014 compared to a loss of $8.8 million for the comparable period in 2013. A larger infrastructure, including additional corporate employees, a stock lending business and other required costs associated with being a public company all contributed to the additional expense within this segment.
Certain Factors Affecting Results of Operations
We may experience significant variation in our future results of operations. Fluctuations in our future performance may result from numerous factors, including, among other things, global financial market conditions and the resulting competitive, credit and counterparty risks; cyclicality, seasonality and other economic conditions; the value of our securities positions and other financial instruments and our ability to manage the risks attendant thereto; the volume, notional dollar value traded and volatility levels within the core markets where our market making and trade execution businesses operate; the composition, profile and scope of our relationships with institutional and broker dealer clients; the performance, size and volatility of our direct-to-client market making portfolios; the performance, size and volatility of our exchange-based trading activities; the overall size of our balance sheet and capital usage; impairment of goodwill and/or intangible assets; the performance of our global operations, trading technology and technology infrastructure; the effectiveness of our self-clearing and futures platforms and our ability to manage risks related thereto; the availability of credit and liquidity in the marketplace; our ability to prevent erroneous trade orders from being submitted due to technology or other issues (such as the events that affected Knight on August 1, 2012) and avoiding the consequences thereof; the performance, operation and connectivity to various market centers; our ability to manage personnel, compensation, overhead and other expenses, including our occupancy expenses under our office leases and expenses and charges relating to legal and regulatory proceedings; the strength of our client relationships; changes in payments for order flow; changes to execution quality and changes in clearing, execution and regulatory transaction costs; interest rate movements; the addition or loss of executive management, sales, trading and technology professionals; geopolitical, legislative, legal, regulatory and financial reporting changes specific to financial services and global trading; legal or regulatory matters and proceedings; the Mergers and the costs and integration associated therewith; the amount, timing and cost of business divestitures/acquisitions or capital expenditures; the integration, performance and operation of acquired businesses; the incurrence of costs associated with acquisitions and dispositions; investor sentiment; and technological changes and events.
Such factors may also have an impact on our ability to achieve our strategic objectives, including, without limitation, increases in market share, growth and profitability in the businesses in which we operate. If demand for our services declines or our performance deteriorates significantly due to any of the above factors, and we are unable to adjust our cost structure on a timely basis, our operating results could be materially and adversely affected. As a result of the foregoing factors, period-to-period comparisons of our revenues and operating results are not necessarily meaningful and such comparisons cannot be relied upon as indicators of future performance. There also can be no assurance that we will be able to continue to achieve the level of revenues that we have experienced in the past or that we will be able to improve our operating results.

53


Trends
Global Economic Trends
Our businesses are affected by many factors in the global financial markets and worldwide economic conditions. These factors include the growth level of gross domestic product in the U.S., Europe and Asia, and the existence of transparent, efficient and liquid equity and debt markets and the level of trading volumes and volatility in such markets.
During the quarter ended June 30, 2014, trade volume and volatility levels across equity markets decreased as compared to the previous quarter as did similar trading metrics generally across all products we execute. Overall, there are still concerns about global stability and growth, inflation and declining asset values.
Trends Affecting Our Company
We believe that our businesses are affected by the aforementioned global economic trends as well as more specific trends. Some of the specific trends that impact our operations, financial condition and results of operations are:
Clients continue to focus on statistics measuring the quality of equity executions (including speed of execution and price improvement). In an effort to improve the quality of their executions as well as increase efficiencies, market makers continue to increase the level of sophistication and automation within their operations and the extent of price improvement. The continued focus on execution quality has resulted in greater competition in the marketplace, which, along with market structure changes and market conditions, has negatively impacted the revenue capture and margin metrics of the Company and other market making firms.
Market Making and Global Execution Services transaction volumes executed by clients have fluctuated over the past few years due to retail and institutional investor sentiment, market conditions and a variety of other factors. Market Making and Global Execution Services transaction volumes may not be sustainable and are not predictable.
Over the past several years exchanges have become far more competitive, and market participants have created ATS, ECNs and other execution venues which compete with the OTC and listed trading venues. Initiatives by these and other market participants could draw market share away from the Company, and thus negatively impact our business. In addition, there are many new entrants into the market, including ATS, Multilateral Trading Facilities, systematic internalizers, dark liquidity pools, high frequency trading firms, and market making firms competing for retail and institutional order flow. Further, many broker dealers offer their own internal crossing networks. These factors continue to create further fragmentation and competition in the marketplace.
Market structure changes, competition, market conditions and a steady increase in electronic trading have resulted in a reduction in institutional commission rates and volumes which may continue in the future. Additionally, many institutional clients allocate commissions to broker dealers based not only on the quality of executions, but also in exchange for research, or participation in soft dollar and commission recapture programs.
There continues to be growth in electronic trading, including direct market access platforms, algorithmic and program trading, high frequency trading ECNs, ATS and dark liquidity pools. In addition, electronic trading continues to expand to other asset classes, including options, currencies and fixed income. The expansion of electronic trading may result in the growth of innovative electronic products and competition for order flow and may further reduce demand for traditional institutional voice services.
Market structure changes, competition and technology advancements have led to an industry focus on increasing execution speeds and a dramatic increase in electronic message traffic. Increases in execution speeds and message traffic require additional expenditures for technology infrastructure and place heavy strains on the technology resources, bandwidth and capacities of market participants. Additionally, the expansion by market participants into trading of non-equities products offers similar challenges.
There has been increased scrutiny of the capital markets industry by the regulatory and legislative authorities, both in the U.S. and abroad, which could result in increased regulatory costs in the future. As has been widely reported, there has been an increased focus by regulators, the New York Attorney General, Congress and the media on market structure issues, and in particular, high frequency trading, ATS manner of operations, market fragmentation and complexity, colocation, access to market data feeds and remuneration

54


arrangements such as payment for order flow and exchange fee structures. New legislation or new or modified regulations and rules could occur in the future. Members of the U.S. Congress continue to ask the SEC and other regulators to closely review the financial markets regulatory structure and make the changes necessary to insure the rule framework governing the U.S. financial markets is comprehensive and complete. The SEC and other regulators, both in the U.S. and abroad, have adopted and will continue to propose and adopt rules and take other policy actions where necessary, on a variety of marketplace issues – including, but not limited to: high frequency trading, market fragmentation and complexity, transaction taxes, off-exchange trading, dark liquidity pools, internalization, post-trade attribution, colocation, market access, short sales, consolidated audit trails, policies and procedures relating to technology controls and systems, and market volatility rules (including, Regulation Systems Compliance and Integrity commonly referred to as, Regulation SCI).
We expect increases, possibly substantial, in Section 31 fees and fees imposed by other regulators. In addition, the Depository Trust & Clearing Corporation ("DTCC") and National Securities Clearing Corporation ("NSCC") are considering proposals which could require substantial increases in clearing margin, liquidity and collateral requirements.
The Dodd-Frank Act affects nearly all financial institutions that operate in the U.S. While the weight of the Dodd-Frank Act falls more heavily on large, complex financial institutions, smaller institutions will continue to face a more complicated and expensive regulatory framework.
Income Statement Items
The following section briefly describes the key components of, and drivers to, our significant revenues and expenses.
Revenues
Our revenues consist principally of Trading revenues, net and Commissions and fees from all of our business segments.
Trading profits and losses on principal transactions primarily relate to our global market making activities and are included within Trading revenues, net. These revenues are primarily affected by changes in the amount and mix of equity trade and share volumes; our revenue capture, dollar value of equities traded, fixed income, options, futures and FX trading volume and strategies; our ability to derive trading gains by taking proprietary positions; changes in our execution standards; development of, and enhancement to, our market making models; performance of our direct-to-client and non-client trading models; volatility in the marketplace; our mix of broker dealer and institutional clients; client service and relationships and regulatory changes and evolving industry customs and practices.
Revenues on transactions for which we charge explicit commissions or commission equivalents, which include the majority of our institutional client orders and commissions on futures transactions are included within Commissions and fees. Also included in Commissions and fees are volume based fees earned from providing liquidity to other trading venues. Commissions and fees are primarily affected by changes in our equity, fixed income, futures and foreign exchange transaction volumes with institutional clients; client relationships; changes in commission rates; client experience on the various platforms; level of volume based fees from providing liquidity to other trading venues; and the level of our soft dollar and commission recapture activity.
Interest, net is earned from our cash held at banks, cash held in trading accounts at third party clearing brokers and from collateralized financing arrangements, such as securities borrowing. The Company’s third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the settlement and financing of securities transactions. Net interest is primarily affected by interest rates; the level of cash balances held at banks and third party clearing brokers including those held for customers; the level of our securities borrowing activity; our level of securities positions in which we are long compared to our securities positions in which we are short; and the extent of our collateralized financing arrangements.
Investment income (loss) and other, net primarily represents returns on our strategic and deferred compensation investments. Such income or loss is primarily affected by the performance and activity of our strategic investments.
Expenses
Employee compensation and benefits expense primarily consists of salaries and wages paid to all employees; performance-based compensation, which includes compensation paid to sales personnel and incentive compensation

55


paid to other employees based on our performance; employee benefits; and stock and unit-based compensation. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our revenues and business mix, profitability and the number of employees. Compensation for certain employees engaged in sales activities is determined primarily based on a percentage of their gross revenues net of certain transaction-based expenses.
Execution and clearance fees primarily represent fees paid to third party clearing brokers for clearing equities, options and fixed income transactions; transaction fees paid to Nasdaq and other exchanges, clearing organizations and regulatory bodies; and execution fees paid to third parties, primarily for executing trades on the NYSE, other exchanges and ECNs. Execution and clearance fees primarily fluctuate based on changes in trade and share volume, execution strategies, rate of clearance fees charged by clearing brokers and rate of fees paid to ECNs, exchanges and certain regulatory bodies.
Communications and data processing expense primarily consists of costs for obtaining market data, connectivity, telecommunications services, co-location and systems maintenance.
Payments for order flow primarily represent payments to broker dealer clients, in the normal course of business, for directing to us their order flow in U.S. equities and options. Payments for order flow will fluctuate as we modify our rates and as our percentage of clients whose policy is not to accept payments for order flow varies. Payments for order flow also fluctuate based on U.S. equity share and option volumes, our profitability and the mix of market orders, limit orders, and customer mix.
Depreciation and amortization expense results from the depreciation of fixed assets, which consist of computer hardware, furniture and fixtures, and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. We depreciate our fixed assets and amortize our intangible assets on a straight-line basis over their expected useful lives. We amortize leasehold improvements on a straight-line basis over the lesser of the life of the improvement or the remaining term of the lease.
Debt interest expense consists primarily of costs associated with our debt.
Collateralized financing interest consists primarily of costs associated with financing arrangements such as securities lending and sale of financial instruments under our agreements to repurchase.
Occupancy and equipment rentals consist primarily of rent and utilities related to leased premises and office equipment.
Professional fees consist primarily of legal, accounting, consulting, and other professional fees.
Business development consists primarily of costs related to sales and marketing, advertising, conferences and relationship management.
Writedown of capitalized debt costs represents charges recorded as the result of the repayment of our debt.
Writedown of assets and lease loss accrual consist primarily of costs associated with the writedown of assets which management has determined to be impaired and adjustments to lease loss accruals related to excess office space.
Other expenses include regulatory fees, corporate insurance, employment fees, amortization of capitalized debt costs and general office expense.

56


Three Months Ended June 30, 2014 and 2013
Revenues
Market Making
 
For the three months
 ended June 30,
 
 
 
 
 
2014
 
2013
 
Change
 
% of Change
Trading revenues, net (thousands)
$
199,053

 
$
98,241

 
$
100,813

 
102.6
%
Commissions and fees (thousands)
25,829

 
16,753

 
9,075

 
54.2
%
Interest, net and other (thousands)
(6,436
)
 
(1,493
)
 
(4,943
)
 
N/M

Total Revenues from Market Making (thousands)
$
218,446

 
$
113,501

 
104,945

 
92.5
%
Totals may not add due to rounding.
N/M - Not meaningful
Total revenues from the Market Making segment, which primarily comprises Trading revenues, net and Commissions and fees from our domestic businesses, were $218.4 million for the three months ended June 30, 2014 and $113.5 million for the comparable period in 2013. Revenues for the three months ended June 30, 2014 were driven by our direct-to-client trading strategies and strong U.S. equity revenue capture offset, in part, by lower market volumes and volatility which, also particularly impacted the performance of our non-client trading strategies.
Global Execution Services 
 
For the three months
 ended June 30,
 
 
 
 
 
2014
 
2013
 
Change
 
% of Change
Commissions and fees (thousands)
$
78,947

 
$
13,060

 
$
65,887

 
504.5
%
Trading revenues, net (thousands)
7,836

 
19

 
7,817

 
N/M

Interest, net and other (thousands)
(881
)
 
(19
)
 
(862
)
 
N/M

Total Revenues from Global Execution Services (thousands)
$
85,903

 
$
13,060

 
72,843

 
557.8
%
Totals may not add due to rounding.
N/M - Not meaningful
Total revenues from the Global Execution Services segment, which primarily comprises Commissions and fees and, to a lesser extent, Trading revenues, net from agency execution activity and activity on our venues were $85.9 million for the three months ended June 30, 2014. Revenues principally reflect the performance of our high and low touch equity businesses, including KCG EMS, which includes Knight Direct and GETAlpha, as well as trading venues such as KCG Hotspot and KCG Bondpoint.
Corporate and Other 
 
For the three months
 ended June 30,
 
 
 
 
 
2014
 
2013
 
Change
 
% of Change
Total Revenues from Corporate and Other (thousands)
$
9,784

 
$
(6,928
)
 
$
16,712

 
N/M
N/M - Not meaningful
Total revenues from the Corporate and Other segment, which represent interest income from our stock borrow activity and gains or losses on strategic investments were $9.8 million for the three months ended June 30, 2014 and negative revenues of $6.9 million for the comparable period in 2013. Revenues for the three months ended June 30, 2013 includes a $9.2 million charge for impairment of a strategic asset.
Expenses
Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability and the number of employees. Employee compensation and benefits expense was $103.4 million for the three months ended June 30, 2014 and $75.1 million for the comparable period in 2013. The increase on a dollar basis was primarily due to an increase in the number of employees following the Mergers. Excluding the compensation expense related to a reduction in workforce of $3.1 million, employee compensation and benefits was $100.4 million or 46.4% of adjusted net revenues for the three months ended June 30, 2014. Excluding the compensation

57


expense related to a reduction in workforce as well as compensation expense related to the Mergers totaling $24.2 million, employee compensation was $50.9 million or 61.8% of adjusted net revenues for the comparable period in 2013. The decrease in compensation as a percentage of adjusted net revenues related to the improved performance of the Company as well as a decrease in discretionary bonuses.
The number of full time employees increased to 1,207 at June 30, 2014 as compared to 394 at June 30, 2013. As of the Merger date of July 1, 2013, the number of full time employees was 1,397 (excluding employees of Urban).
Execution and clearance fees were $73.2 million for the three months ended June 30, 2014 and $46.0 million for the comparable period in 2013. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Execution and clearance fees were 23.3% of revenues excluding non-recurring gains and losses on investments ("adjusted revenues") for the three months ended June 30, 2014 and 35.7% for the comparable period in 2013. The variance on a percentage of revenues basis primarily relates to a larger revenue base as well as improved trading performance.
Payments for order flow fluctuate as a percentage of revenue due to changes in volume, client and product mix, profitability, and competition. Payments for order flow were $18.1 million for the three months ended June 30, 2014 and $0.4 million for the comparable period in 2013. The variance is due to the addition of the direct-to-client market making business that was added as part of the Mergers. As a percentage of adjusted revenues, Payments for order flow were 5.8% in the three months ended June 30, 2014 and 0.3% for the comparable period in 2013.
Depreciation and amortization expense results from the depreciation of fixed assets and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. Depreciation and amortization expense was $19.8 million for the three months ended June 30, 2014 and $7.7 million for the comparable period in 2013. The increase was primarily due to the amortization of fixed assets, leasehold improvements and intangible assets acquired during the Mergers.
Debt interest expense was $7.5 million for the three months ended June 30, 2014 and $2.2 million for the comparable period in 2013. Interest expense increased primarily due to interest on the debt financing for the Mergers.
Professional fees were $7.3 million for the three months ended June 30, 2014 and $23.1 million for the comparable period in 2013. Excluding the $22.1 million in legal, consulting and investment banking fees related to the Mergers, Professional fees were $1.1 million for the three months ended June 30, 2013. Professional fees related to being a larger publicly traded firm as well as integrating the two firms led to an increase in legal, consulting and auditing fees compared to the second quarter of 2013.
Collateralized financing interest expense was $6.4 million for the three months ended June 30, 2014. Collateralized financing interest expense relates to the funding of our securities positions through stock loan and repurchase agreements. There were no such agreements in place in the second quarter of 2013 and therefore, there was no such interest expense for that period.
Writedown of capitalized debt costs of $2.0 million for the three months ended June 30, 2014 relates to the writedown of debt issuance costs as a result of the repayment of the remaining $50.0 million principal of the First Lien Credit Facility.
Writedown of assets and lease loss accrual of $1.9 million for the three months ended June 30, 2014 primarily relates to a writedown of excess real estate as we consolidated offices located in Chicago and New York during the quarter. Writedown of assets of $1.1 million for the three months ended June 30, 2013 comprised the writedown of leasehold improvements and fixed assets in connection with excess real estate capacity.
All other expenses were $59.9 million for the three months ended June 30, 2014 and $38.8 million for the comparable period in 2013. These cost increases primarily relate to the addition of the Knight businesses as a result of the Mergers. Communications and data processing expense primarily relates to market data, co-location and connectivity expenses. The increase in Occupancy and equipment rentals expense is due to additional real estate related costs following the Mergers. Business development expense primarily includes client-related events. Other expense includes higher employment fees and insurance costs. In the second quarter of 2013, Other expense also included $9.5 million in costs related to the Mergers.
Our effective tax rate for the three months ended June 30, 2014 from continuing operations of 38.0% differed from the federal statutory rate of 35% primarily due to state and local taxes offset, in part by the effect of nondeductible charges. Our effective tax rate for the three months ended June 30, 2013 from continuing operations of (4.4)% differed

58


from the federal statutory rate of 35% primarily due to losses not subject to U.S. corporate income taxes offset by the effect of state, local and non-U.S. income taxes on profitable subsidiaries.
Six Months Ended June 30, 2014 and 2013
Revenues
Market Making
 
For the six months
 ended June 30,
 
 
 
 
 
2014
 
2013
 
Change
 
% of Change
Trading revenues, net (thousands)
$
53,997

 
$
32,978

 
$
21,019

 
63.7
%
Commissions and fees (thousands)
453,685

 
184,996

 
268,689

 
145.2
%
Interest, net and other (thousands)
(11,890
)
 
(2,405
)
 
(9,485
)
 
N/M

Total Revenues from Market Making (thousands)
$
495,792

 
$
215,568

 
280,224

 
130.0
%
Totals may not add due to rounding.
N/M - Not meaningful
Total revenues from the Market Making segment, which primarily comprises Trading revenues, net and Commissions and fees from our domestic businesses, were $495.8 million for the six months ended June 30, 2014 and $215.6 million for the comparable period in 2013. Revenues for the six months ended June 30, 2014 were driven by strong U.S. equity revenue capture. Specifically, direct-to-client trading strategies performed extremely well in the first half of 2014, but was offset, in part, by lower market volume and volatility which also particularly impacted our non-client trading strategies.
Global Execution Services 
 
For the six months
 ended June 30,
 
 
 
 
 
2014
 
2013
 
Change
 
% of Change
Commissions and fees (thousands)
$
163,036

 
$
22,334

 
$
140,701

 
630.0
%
Trading revenues, net (thousands)
11,585

 
28

 
11,557

 
N/M

Interest, net and other (thousands)
(1,498
)
 
(28
)
 
(1,470
)
 
N/M

Total Revenues from Global Execution Services (thousands)
$
173,123

 
$
22,334

 
150,789

 
675.2
%
Totals may not add due to rounding.
N/M - Not meaningful
Total revenues from the Global Execution Services segment, which primarily comprises Commissions and fees and, to a lesser extent, Trading revenues, net from agency execution activity and activity on our venues were $173.1 million for the six months ended June 30, 2014. Revenues principally reflect the performance of our high and low touch equity businesses, including KCG EMS, which includes Knight Direct and GETAlpha, as well as trading venues such as KCG Hotspot and KCG Bondpoint.
Corporate and Other 
 
For the six months
 ended June 30,
 
 
 
 
 
2014
 
2013
 
Change
 
% of Change
Total Revenues from Corporate and Other (thousands)
$
28,875

 
$
(3,277
)
 
$
32,152

 
N/M
N/M - Not meaningful
Total revenues from the Corporate and Other segment, which represent interest income from our stock borrow activity and gains or losses on strategic investments were $28.9 million for the six months ended June 30, 2014 and negative revenues of $3.3 million for the comparable period in 2013. Revenues for the six months ended June 30, 2014 includes a $9.6 million gain which comprises a partial realized gain with respect to the Company’s investment in Direct Edge of $16.2 million offset, in part, by the Company’s share of BATS' and Direct Edge's merger related transaction costs that were charged against their respective earnings of $6.6 million. Revenues for the six months ended June 30, 2013 includes a $9.2 million charge for impairment of a strategic asset.

59


Expenses
Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability and the number of employees. Employee compensation and benefits expense was $225.7 million for the six months ended June 30, 2014 and $107.4 million for the comparable period in 2013. The increase on a dollar basis was primarily due to an increase in the number of employees following the Mergers. Excluding the compensation expense related to a reduction in workforce of $3.1 million, employee compensation and benefits was$222.7 million or 45.7% of adjusted net revenues for the six months ended June 30, 2014. Excluding the compensation expense related to a reduction in workforce as well as compensation expense related to the Mergers, employee compensation was $80.1 million or 51.4% of adjusted net revenues for the comparable period in 2013. The decrease in compensation as a percentage of adjusted net revenues related to the improved performance of the Company as well as a decrease in discretionary bonuses.
Execution and clearance fees were $148.7 million for the six months ended June 30, 2014 and $86.9 million for the comparable period in 2013. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Execution and clearance fees were 21.6% of adjusted revenues for the six months ended June 30, 2014 and 35.6% for the comparable period in 2013. The variance on a percentage of revenues basis primarily relates to a larger revenue base as well as improved trading performance.
Payments for order flow fluctuate as a percentage of revenue due to changes in volume, client and product mix, profitability, and competition. Payments for order flow were $40.1 million for the six months ended June 30, 2014 and $1.0 million for the comparable period in 2013. The variance is due to the addition of the direct-to-client market making business that was added as part of the Mergers. As a percentage of adjusted revenues, Payments for order flow were 5.8% in the six months ended June 30, 2014 and 0.4% for the comparable period in 2013.
Depreciation and amortization expense results from the depreciation of fixed assets and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. Depreciation and amortization expense was $39.9 million for the six months ended June 30, 2014 and $15.9 million for the comparable period in 2013. The increase was primarily due to the amortization of fixed assets, leasehold improvements and intangible assets acquired during the Mergers.
Debt interest expense was $17.0 million for the six months ended June 30, 2014 and $2.6 million for the comparable period in 2013. Interest expense increased primarily due to interest on the debt financing for the Mergers.
Professional fees were $12.7 million for the six months ended June 30, 2014 and $29.9 million for the comparable period in 2013. Excluding the $27.6 million in legal, consulting and investment banking fees related to the Mergers, Professional fees were $2.2 million for the six months ended June 30, 2013. Professional fees related to being a larger, publicly traded firm as well as integrating the two firms led to an increase in legal, consulting and auditing fees compared to the six months ended June 30, 2013.
Collateralized financing interest expense was $12.6 million for the six months ended June 30, 2014. Collateralized financing interest expense relates to the funding of our securities positions through stock loan and repurchase agreements. There were no such agreements in place in the first half of 2013 and therefore, there was no such interest expense for that period.
Writedown of capitalized debt costs of $9.6 million for the six months ended June 30, 2014 relates to the writedown of debt issuance costs as a result of the repayment of the remaining $235.0 million principal of the First Lien Credit Facility.
Writedown of assets and lease loss accrual of $2.2 million for the six months ended June 30, 2014 primarily relates to a writedown of excess real estate as we consolidated offices located in Chicago and New York during the year. Writedown of assets of $3.3 million for the six months ended June 30, 2013 comprised the writedown of leasehold improvements and fixed assets in connection with the shutdown of the Company's Palo Alto and Hong Kong office.
All other expenses were $115.3 million for the six months ended June 30, 2014 and $67.3 million for the comparable period in 2013. These cost increases primarily relate to the addition of the Knight businesses as a result of the Mergers. Communications and data processing expense primarily relates to market data, co-location and connectivity expenses. The increase in Occupancy and equipment rentals expense is due to additional real estate related costs following the Mergers. Business development expense primarily includes client-related events. Other expense includes higher employment fees and insurance costs. In the first half of 2013, Other expense also included $9.5 million in costs related to the Mergers.

60


Our effective tax rate for the six months ended June 30, 2014 from continuing operations of 37.9% differed from the federal statutory rate of 35% primarily due to state and local taxes offset, in part by the effect of nondeductible charges. Our effective tax rate for the six months ended June 30, 2013 from continuing operations of (6.6)% differed from the federal statutory rate of 35% primarily due to losses not subject to U.S. corporate income taxes offset by the effect of state, local and non-U.S. income taxes on profitable subsidiaries.
Financial Condition, Liquidity and Capital Resources
Financial Condition
We have historically maintained a highly liquid balance sheet, with a substantial portion of our total assets consisting of cash, highly liquid marketable securities and short term receivables. As of June 30, 2014 and December 31, 2013, we had total assets of $7.66 billion and $7.00 billion, respectively, a significant portion of which consisted of cash or assets readily convertible into cash as follows (in thousands): 
 
June 30,
2014
 
December 31, 2013
Cash and cash equivalents
$
600,865

 
$
674,281

Financial instruments owned, at fair value:
 
 
 
Equities
2,620,427

 
2,298,785

Listed options
178,598

 
339,798

Debt securities
90,782

 
83,256

Collateralized agreements:
 
 
 
Securities borrowed
1,602,467

 
1,357,387

Receivable from brokers, dealers and clearing organizations (1)
883,047

 
750,440

Total cash and assets readily convertible to cash
$
5,976,186

 
$
5,503,947

* Totals may not add due to rounding.
(1) Excludes $365.0 million and $304.3 million of assets segregated or held in separate accounts under federal or other regulations and $340.9 million and $202.5 million of securities failed to deliver as of June 30, 2014 and December 31, 2013, respectively.
Substantially all of the non-cash amounts disclosed in the table above can be liquidated into cash within five business days under normal market conditions, however, the liquidated values may be subjected to haircuts during distressed market conditions as Knight saw following its August 1, 2012 trading loss.
Financial instruments owned principally consist of equities and listed options that trade on the NYSE, NYSE Amex and NYSE Arca markets, Nasdaq and on the OTC Bulletin Board as well as U.S. government and non-U.S. government obligations and corporate debt securities, which include short-term bond funds. These financial instruments are used to generate revenues in our Market Making and Global Execution Services segments.
Securities borrowed represent the value of cash or other collateral deposited with securities lenders to facilitate our trade settlement process.
Receivable from brokers, dealers and clearing organizations include interest bearing cash balances held with third party clearing brokers, including, or net of, amounts related to securities transactions that have not yet reached their contracted settlement date, which is generally within three business days of the trade date.
As of June 30, 2014, $1.43 billion of equities have been pledged as collateral to third-parties under financing arrangements. As of December 31, 2013, $1.23 billion of equities were pledged as collateral to third-parties under financing arrangements.
Other assets primarily comprises deposits, prepaids and other miscellaneous receivables.
The change in the balances of financial instruments owned, receivable from brokers, dealers and clearing organizations and securities borrowed are all consistent with activity of our trading strategies. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits.
Total liabilities were $6.13 billion at June 30, 2014 and $5.49 billion at December 31, 2013. Similar to the asset side, the growth in Financial instruments sold, not yet purchased, Collateralized financings and Payable to brokers, dealers and clearing organizations is related to activity of our trading strategies. As noted throughout the document,

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substantially all of our debt was issued in order to complete the Mergers, while the decrease in the balance since December 31, 2013 is due to repayments of our debt. The “Liquidity and Capital Resources” section below includes a detailed description of the debt.
Equity increased by $24.2 million, from $1.51 billion at December 31, 2013 to $1.53 billion at June 30, 2014. The increase in equity from December 31, 2013 was primarily a result of earnings and stock-based compensation activity during the six months ended June 30, 2014, offset by our stock repurchase activity.  
Liquidity and Capital Resources
We have financed our business primarily through cash generated by operations, a series of debt transactions and the issuance of equity.
At June 30, 2014, we had net current assets, which consist of net assets readily convertible into cash including assets segregated or held in separate accounts under federal and other regulations, less current liabilities, of approximately $1.21 billion.
Net income from continuing operations was $9.0 million during the three months ended June 30, 2014 compared to a net loss from continuing operations of $78.2 million for the three months ended June 30, 2013. Included in these amounts were certain non-cash income and expenses such as loss on investment, stock and unit-based compensation, depreciation, amortization and certain non-cash writedowns. Stock and unit-based compensation was $15.9 million and $24.0 million for the three months ended June 30, 2014 and 2013, respectively. Depreciation and amortization expense was $19.8 million and $7.7 million for the three months ended June 30, 2014 and 2013, respectively. We had non-cash charges of $1.9 million and $1.1 million for the writedown of excess real estate and fixed assets at certain locations for the three months ended June 30, 2014 and 2013, respectively, and $2.0 million for the writedown of capitalized debt costs in conjunction with our remaining $50.0 million in principal repayment of debt for the three months ended June 30, 2014. We also had a non-cash loss of $9.2 million from an impairment of a strategic asset for the three months ended June 30, 2013. There were no non-cash writedowns for the three months ended June 30, 2014.
Capital expenditures related to our continuing operations were $12.3 million and $6.2 million during the three months ended June 30, 2014 and 2013, respectively. Purchases of investments were $11,000 during the three months ended June 30, 2014 and none for the three months ended June 30, 2013. Proceeds and distributions received from investments were $6.3 million for the three months ended June 30, 2014 and none during the three months ended June 30, 2013.
Cash Convertible Senior Subordinated Notes
In March 2010, Knight issued $375.0 million aggregate principal amount of Cash Convertible Senior Subordinated Notes (the “Convertible Notes”) due on March 15, 2015 in a private offering exempt from registration under the Securities Act of 1933, as amended.
The Convertible Notes bear interest at a rate of 3.50% per year, payable semi-annually in arrears, on March 15 and September 15 of each year, commencing on September 15, 2010 and will mature on March 15, 2015, subject to earlier repurchase or conversion. The Convertible Notes are reported as Debt in our Consolidated Statements of Financial Condition.
As a result of the Mergers, on July 1, 2013, KCG became a party to Knight's $375.0 million Convertible Notes. On July 1, 2013, we delivered a notice (the “Convertible Notes Notice”) to the holders of the Notes. The Convertible Notes Notice advised holders of the Convertible Notes of the following (among others):     
The completion of the Mergers on July 1, 2013 and the results of the election of the holders of KCG Class A Common Stock to receive cash consideration for such KCG Class A Common Stock constitutes a “Fundamental Change";     
Each holder of the Convertible Notes had the right to deliver a “Fundamental Change Repurchase Notice” requiring the Company to repurchase all or any portion of the principal amount of the Convertible Notes at a Fundamental Change Repurchase Price of 100% of the principal amount plus accrued and unpaid interest on August 5, 2013, the Fundamental Change Repurchase Date; and
The Company deposited with the paying agent an amount of money sufficient to repurchase all of the Convertible Notes to be repurchased; and upon payment by the paying agent such Convertible Notes will cease to be outstanding.

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On July 1, 2013, $375.0 million, which was the amount needed to repurchase the aggregate amount of Convertible Notes in full at maturity, was deposited in a cash collateral account under the sole dominion and control of the collateral agent under the First Lien Credit Facility (the "Collateral Account").
After the Mergers, a total of $257.7 million in principal amount of the Convertible Notes were repurchased using funds deposited in the Collateral Account. The repurchase included accrued and unpaid interest of $3.6 million. In October 2013, after receiving consent from the Holders of the Senior Secured Notes (as defined below), the funds remaining in the Collateral Account were used to repay a portion of the First Lien Credit Facility. As of June 30, 2014 and December 31, 2013 there were no funds in the Collateral Account. As of June 30, 2014 and December 31, 2013, $117.3 million of the Convertible Notes were outstanding.
Debt incurred in connection with Mergers
In connection with the Mergers, we entered into a series of debt financing transactions. Described below are the details of these transactions.
Senior Secured Notes
On June 5, 2013 GETCO Financing Escrow LLC (“Finance LLC”), a wholly-owned subsidiary of GETCO, issued 8.250% senior secured notes due 2018 in the aggregate principal amount of $305.0 million (the “Senior Secured Notes”) pursuant to an indenture, dated June 5, 2013 (as amended and supplemented, the "Senior Secured Notes Indenture"). On July 1, 2013, KCG entered into a first supplemental indenture (the “First Supplemental Indenture”) pursuant to which KCG assumed all of the obligations of Finance LLC which comprised the Senior Secured Notes plus certain escrow agent fees and expenses of $3.0 million.
On July 1, 2013, KCG and certain subsidiary guarantors (the "Guarantors") under the First Lien Credit Facility, as defined below, entered into a Second Supplemental Indenture, whereby the Senior Secured Notes and the obligations under the Senior Secured Notes Indenture will be fully and unconditionally guaranteed on a joint and several basis by the Guarantors and are secured by second-priority pledges and second-priority security interests in, and mortgages on, the collateral securing the First Lien Credit Facility, subject to certain exceptions.
The Senior Secured Notes mature on June 15, 2018 and bear interest at a rate of 8.250% per year, payable on June 15 and December 15 of each year, beginning on December 15, 2013.
The Senior Secured Notes Indenture contains customary affirmative and negative covenants, including limitations on indebtedness, liens, hedging agreements, investments, loans and advances, asset sales, mergers and acquisitions, dividends, transactions with affiliates, prepayments of other indebtedness, restrictions on subsidiaries and issuance of capital stock. As of June 30, 2014, the Company was in compliance with the covenants.
On July 1, 2013, KCG and the Guarantors entered into a joinder to the registration rights agreement dated June 5, 2013, (the "Senior Secured Notes Registration Rights Agreement") between Finance LLC and Jefferies LLC as representative of the initial purchasers of the Senior Secured Notes. Pursuant to the registration rights agreement, KCG shall use commercially reasonable efforts to (i) file an exchange offer registration statement with the SEC with respect to a registered offer to exchange the Senior Secured Notes (the "Exchange Offer"), (ii) issue in exchange for the Senior Secured Notes a new series of exchange notes within 365 days after June 5, 2013, and, (iii) in certain circumstances, file a shelf registration statement with respect to resales of the Senior Secured Notes. If KCG and the Guarantors fail to comply with certain obligations under the Senior Secured Notes Registration Rights Agreement, additional interest of up to 1.00% per annum will begin to accrue and be payable on the Senior Secured Notes.
In October 2013, we received consents from holders ("Holders") of 99.7% of the aggregate principal amount of the Senior Secured Notes outstanding to amend, among other things, the terms of the Senior Secured Notes among the Company, The Bank of New York Mellon, as trustee and collateral agent (the “Trustee”), and the Guarantors. As a result, we entered into the Third Supplemental Indenture with the Trustee to amend the Senior Secured Notes Indenture to permit the purchase, redemption or repayment of the Convertible Notes at any price, including at a premium or at a discount from the face value thereof, with any available cash.
In May 2014, we received consents from Holders of 98.5% of the aggregate principal amount of the Senior Secured Notes outstanding to amend the terms of the Senior Secured Notes Registration Rights Agreement. As a result, we entered into the First Amendment (the “Amendment”) to the Senior Secured Notes Registration Rights Agreement. The Amendment (i) postponed the deadline by which the Company must use commercially reasonable efforts to prepare and file the Exchange Offer with the SEC, from June 5, 2014 to June 30, 2015, and (ii) postponed the deadline by

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which the Company must use commercially reasonable efforts to file with and have declared effective by the SEC a shelf registration statement to cover certain resales of the Senior Secured Notes from June 5, 2014 to June 30, 2015. The Amendment also had the effect of postponing the date on which an additional interest, which constitutes liquidated damages and is the exclusive remedy available to Holders for failing to register the Senior Secured Notes, begins to accrue as a result of failing to consummate the Exchange Offer or have a shelf registration statement declared effective. Accordingly, the Company and the Guarantors no longer have any obligation to pay Holders additional interest as of June 5, 2014, even though the Company and the Guarantors did not prepare, file or have declared effective a registration statement or a shelf registration statement or consummate the Exchange Offer by such date.
First Lien Credit Facility
On July 1, 2013, KCG, as borrower, entered into a first lien senior secured credit agreement (the “Credit Agreement”) with Jefferies Finance LLC and Goldman Sachs Bank USA. The Credit Agreement was in the amount of $535.0 million (the “First Lien Credit Facility”), all of which was drawn on July 1, 2013. The First Lien Credit Facility also provided for a future uncommitted incremental first lien senior secured revolving credit facility of up to $50.0 million, including letter of credit and swingline sub-facilities, on certain terms and conditions contained in the Credit Agreement.
In 2013, we repaid $300.0 million of principal of the First Lien Credit Facility. A portion of the $300.0 million totaling $117.3 million was drawn from cash held in the Collateral Account and the remainder of the $300.0 million was paid out of available cash including proceeds from the sale of Urban. In conjunction with these payments, we wrote down $13.2 million of our capitalized debt costs associated with the Credit Agreement.
During the six months ended June 30, 2014, we repaid the remaining $235.0 million of principal of the First Lien Credit Facility out of available cash and the Credit Agreement was terminated. In conjunction with these payments, we wrote down the remaining $9.6 million, of our capitalized debt costs associated with the Credit Agreement.
The First Lien Credit Facility bears interest, at KCG's option, at a rate based on the prime rate (“First Lien Prime Rate Loans”) or based on LIBOR (“First Lien Eurodollar Loans”). First Lien Prime Rate Loans bear interest at a rate per annum equal to the greatest of prime rate, 2.25%, the federal funds rate plus 0.50%, and an adjusted one-month LIBOR rate plus 1.00%, in each case plus an applicable margin of 3.50%. First Lien Eurodollar Loans bear interest at a rate per annum equal to the adjusted LIBOR rate (subject to a 1.25% LIBOR floor) corresponding to the interest period plus an applicable margin of 4.50% per annum.
We incurred issuance costs of $38.5 million in connection with the issuance of Senior Secured Notes, Credit Agreement and consent solicitations. The remaining issuance costs are recorded within Other assets on the Consolidated Statements of Financial Condition and are amortized over the respective term of the Senior Secured Notes. Including issuance costs, the Senior Secured Notes had an effective yields of 9.1%.
Revolving Credit Agreement
On July 1, 2013, OCTEG, LLC (“OCTEG”) and Knight Capital Americas LLC ("KCA"), wholly-owned broker dealer subsidiaries of KCG, as borrowers, and KCG, as guarantor, entered into a credit agreement (the "KCGA Facility Agreement”) with a consortium of banks and financial institutions. The KCGA Facility Agreement replaces an existing credit agreement, dated as of June 6, 2012, among OCTEG and three banks.
The KCGA Facility Agreement comprises two classes of revolving loans in a total committed amount of $450.0 million, together with a swingline facility with a $50.0 million sub-limit, subject to two borrowing bases (collectively, the “KCGA Revolving Facility”): Borrowing Base A and Borrowing Base B. The KCGA Revolving Facility also provides for a future increase of the revolving credit facility of up to $300.0 million to a total of $750.0 million on certain terms and conditions.
The KCGA Revolving Facility was amended on October 24, 2013 to permit OCTEG to be removed as a borrower under the KCGA Revolving Facility. As of January 1, 2014, OCTEG was merged with and into KCA and KCA was renamed KCG Americas LLC ("KCGA").
Borrowings under the KCGA Revolving Facility shall bear interest, at the applicable borrower's option, at a rate based on the federal funds rate (“Base Rate Loans”) or based on LIBOR (“Eurodollar Loans”), in each case plus an applicable margin. For each Base Rate Loan, the interest rate per annum is equal to the greater of the federal funds rate or an adjusted one-month LIBOR rate plus (a) for each Borrowing Base A loan, a margin of 1.75% per annum and (b) for each Borrowing Base B loan, a margin of 2.25% per annum. For each Eurodollar Loan, the interest rate per annum is equal to an adjusted LIBOR rate corresponding to the interest period plus (a) for each Borrowing Base A

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loan, a margin of 1.75% per annum and (b) for each Borrowing Base B loan, a margin of 2.25% per annum. As of June 30, 2014, there were no outstanding borrowings under the KCGA Facility Agreement.
The proceeds of the Borrowing Base A loans may be used solely to finance the purchase and settlement of securities. The proceeds of Borrowing Base B loans may be used solely to fund clearing deposits with the NSCC.
The borrower is being charged a commitment fee at a rate of 0.35% per annum on the average daily amount of the unused portion of the KCGA Facility Agreement.
The loans under the KCGA Facility Agreement will mature on June 6, 2015. The KCGA Revolving Facility is fully and unconditionally guaranteed on an unsecured basis by KCG and, to the extent elected by KCGA, any of their respective subsidiaries. It is secured by first-priority pledges of and liens on certain eligible securities, subject to applicable concentration limits, in the case of Borrowing Base A loans, and by first-priority pledges of and liens on the right to the return of certain eligible NSCC margin deposits, in the case of Borrowing Base B loans.
The KCGA Facility Agreement includes customary affirmative and negative covenants, including limitations on indebtedness, liens, hedging agreements, investments, loans and advances, asset sales, mergers and acquisitions, dividends, transactions with affiliates, restrictions on subsidiaries, issuance of capital stock, negative pledges and business activities. It contains financial maintenance covenants establishing a minimum total regulatory capital for KCGA, a maximum total asset to total regulatory capital ratio for KCGA, a minimum excess net capital limit for KCGA, a minimum liquidity ratio for KCGA, and a minimum tangible net worth threshold for KCGA. As of June 30, 2014, the Company was in compliance with the covenants.
In connection with the KCGA Revolving Facility, we incurred issuance costs of $1.2 million which is recorded within Other assets on the Consolidated Statements of Financial Condition and it is being amortized over the term of the facility.
See Footnote 11 “Debt” included in Part I, Item 1 “Financial Statements (Unaudited)” of this Form 10-Q.
Stock repurchase
During the second quarter of 2014, the Company approved an initial program to repurchase up to a total of $150.0 million in shares of the Company's outstanding KCG Class A Common Stock and KCG Warrants. Through June 30, 2014, we had repurchased 4.5 million shares for $52.9 million under this program. As of June 30, 2014, we had $97.1 million available to repurchase additional shares under the program. We may repurchase shares from time to time in open market transactions, accelerated stock buyback programs, tender offers, privately negotiated transactions or by other means. Repurchases may also be made under Rule 10b5-1 plans. The timing and amount of repurchase transactions will be determined by our management based on its evaluation of market conditions, share price, legal requirements and other factors. The program may be suspended, modified or discontinued at any time without prior notice. We caution that there are no assurances that any further repurchases will actually occur. As of June 30, 2014 we had 121.1 million shares of KCG Class A Common Stock outstanding.
Regulatory requirements
Our U.S. registered broker dealer is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker dealers and FCMs and require the maintenance of minimum levels of net capital, as defined in SEC Rule 15c3-1 as well as other capital requirements from several commodity organizations including the Commodity Futures Trading Commission (“CFTC”) and the National Futures Association. These regulations also prohibit a broker dealer from repaying subordinated borrowings, paying cash dividends, making loans to its parent, affiliates or employees, or otherwise entering into transactions which would result in a reduction of its total net capital to less than 120% of its required minimum capital. Moreover, broker dealers are required to notify the SEC, CFTC and other regulators prior to repaying subordinated borrowings, paying dividends and making loans to its parent, affiliates or employees, or otherwise entering into transactions, which, if executed, would result in a reduction of 30% or more of its excess net capital (net capital less minimum requirement). The SEC and the CFTC have the ability to prohibit or restrict such transactions if the result is detrimental to the financial integrity of the broker dealer. As of June 30, 2014, our broker dealer was in compliance with the applicable regulatory net capital rules.

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The following table sets forth the net capital level and requirements for our regulated U.S. broker dealer subsidiary at June 30, 2014, as reported in its respective regulatory filing (in thousands):
Entity
 
Net Capital
 
Net Capital
Requirement
 
Excess Net
Capital
KCG Americas LLC
 
$
326,935

 
$
31,208

 
$
295,727

As of January 1, 2014, OCTEG was merged into KCA as a result of consolidating our domestic broker dealers and KCA was subsequently renamed KCG Americas LLC.
Our U.K. registered broker dealers are subject to certain financial resource requirements of Financial Conduct Authority ("FCA") while our Singapore and Australian broker dealers are subject to certain financial resource requirements of the Securities and Futures Commission and the Australian Securities and Investment Commission, respectively. The following table sets forth the financial resource requirement for the following significant foreign regulated broker dealers at June 30, 2014 (in thousands):
Entity
 
Financial
Resources
 
Resource
Requirement
 
Excess
Financial
Resources
KCG Europe Limited
 
$
222,416

 
$
177,749

 
$
44,667

GETCO Europe Limited
 
11,480

 
4,688

 
6,792

The businesses of GETCO Europe Limited were combined into KCG Europe Limited in the second quarter of 2014 but the legal entity itself has not officially dissolved. We are in the process of withdrawing GETCO Europe Limited's membership with the FCA.
Off-Balance Sheet Arrangements
As of June 30, 2014, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Effects of Inflation
The majority of our assets are liquid in nature and therefore are not significantly affected by inflation. However, the rate of inflation may affect our expenses, such as employee compensation, office leasing costs and communications expenses, which may not be readily recoverable in the prices of the services offered by us. To the extent inflation results in rising interest rates and has other adverse effects on the securities markets, it may adversely affect our financial position and results of operations.
Discontinued Operations
In July 2013, we entered into an agreement to sell to an investor group our reverse mortgage origination securitization business, Urban, that was previously owned by Knight. The transaction completed in the fourth quarter of 2013 and residual expenses of Urban's operations and costs of the related sale have been reported in Loss from discontinued operations, net of tax on the Consolidated Statements of Operations for the three and six months ended June 30, 2014.
Critical Accounting Policies
Our Consolidated Financial Statements are based on the application of GAAP which requires us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates and any such differences may be material to our Consolidated Financial Statements. We believe that the estimates set forth below may involve a higher degree of judgment and complexity in their application than our other accounting estimates and represent the critical accounting estimates used in the preparation of our consolidated financial statements. We believe our judgments related to these accounting estimates are appropriate. However, if different assumptions or conditions were to prevail, the results could be materially different from the amounts recorded.
Financial Instruments and Fair Value—We value our financial instruments using a hierarchy of fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.

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The fair value hierarchy can be summarized as follows:
 
Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
Level 2—Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
Changes in fair value are recognized in earnings each period for financial instruments that are carried at fair value.
Our financial instruments owned and financial instruments sold, not yet purchased will generally be classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices or broker or dealer quotations with reasonable levels of price transparency.
The types of instruments that trade in markets that are not considered to be active, but are valued based on observable inputs such as quoted market prices or alternative pricing sources with reasonable levels of price transparency are generally classified within Level 2 of the fair value hierarchy.
Our foreign currency forward contracts, investment in the Deephaven Funds and deferred compensation investments are also classified within Level 2 of the fair value hierarchy.
We have no financial instruments classified within Level 3 of the fair value hierarchy.
There were no transfers of financial instruments between levels of the fair value hierarchy for any periods presented.
Goodwill and Intangible Assets—As a result of our various acquisitions, we have acquired goodwill and identifiable intangible assets. We determine the values and useful lives of intangible assets upon acquisition. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date. We test goodwill and intangible assets with an indefinite useful life for impairment at least annually or when an event occurs or circumstances change that signifies the existence of impairment.
Goodwill
Goodwill of $17.3 million at June 30, 2014 is primarily a result of the Mergers and primarily relates to our Market Making segment. We test the goodwill in each of our reporting units for impairment at least annually by comparing the estimated fair value of each reporting unit with its estimated net book value. We will derive the fair value of each of our reporting units based on valuation techniques we believe market participants would use for each segment (observable market multiples and discounted cash flow analyses) and we will derive the net book value of our reporting units by estimating the amount of stockholders’ equity required to support the activities of each reporting unit. As part of our test for impairment, we will also consider the profitability of the applicable reporting unit as well as our overall market value, compared to our book value. No events occurred during the quarter ended June 30, 2014 that would indicate that our goodwill may not be recoverable.
Intangible Assets
Intangible assets, less accumulated amortization, of $179.3 million at June 30, 2014 are primarily a result of the Mergers and are primarily attributable to our Market Making and Global Execution Services segments. We amortize intangible assets with definite lives on a straight-line basis over their useful lives, the majority of which have been determined to range from one to 10 years. We will test amortizable intangibles for recoverability whenever events indicate that the carrying amounts may not be recoverable. No events occurred during the quarter ended June 30, 2014 that would indicate that the carrying amounts of our intangible assets may not be recoverable.
Investments—Investments primarily comprise strategic investments and deferred compensation investments. Strategic investments include noncontrolling equity ownership interests in financial services-related businesses held by us within our non-broker dealer subsidiaries. Strategic investments are accounted for under the equity method, at cost or at fair value. We use the equity method of accounting when we have significant influence, generally considered to be between 20% and 50% equity ownership or greater than 3% to 5% of a partnership interest. We hold strategic

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investments at cost, less impairment if any, when we are not considered to exert significant influence on operating and financial policies of the investee. Strategic investments with a readily determinable fair value are held at fair value.
We review investments on an ongoing basis to ensure that the carrying values of the investments have not been impaired. If we assess that an impairment loss on a strategic investment has occurred due to a decline in fair value or other market conditions, we write the investment down to its estimated impaired value.
We maintain a deferred compensation plan related to certain employees and directors. This plan provides a return to the participants based upon the performance of various investments. In order to hedge our liability under this plan, we generally acquire the underlying investments and hold such investments until the deferred compensation liabilities are satisfied. We record changes in value of such investments in Investment income (loss) and other, net, with a corresponding charge or credit to Employee compensation and benefits on the Consolidated Statements of Operations.
Market Making, Sales, Trading and Execution Activities—Financial instruments owned and Financial instruments sold, not yet purchased, which relate to market making and trading activities, include listed and other equity securities, listed equity options and fixed income securities which are recorded on a trade date basis and carried at fair value. Trading revenues, net (trading gains, net of trading losses) and commissions (which includes commission equivalents earned on institutional client orders and futures transactions) and related expenses are also recorded on a trade date basis. Our third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the settlement and financing of securities transactions.
Dividend income relating to securities owned and dividend expense relating to securities sold, not yet purchased, derived from our market making activities are included as a component of Trading revenues, net on our Consolidated Statements of Operations.
Lease Loss Accrual—It is our policy to identify excess real estate capacity and where applicable, accrue for related future costs, net of estimated sublease income. In the event we are able to sublease the excess real estate after recording a lease loss, such accrual is adjusted to the extent the actual terms of sub-leased property differ from the assumptions used in the calculation of the accrual. In the event that we conclude that previously determined excess real estate is needed for our use, such lease loss accrual is adjusted accordingly. Any such adjustments to previous lease loss accruals are recorded in Writedown of assets and lease loss accrual, net on the Consolidated Statements of Operations
Income taxes—Prior to the Mergers, GETCO and the majority of its subsidiaries were treated as partnerships or disregarded entities for U.S. income tax purposes and, accordingly, were not subject to federal income taxes. Instead, the former GETCO members were liable for federal income taxes on their proportionate share of taxable income. Upon completion of the Mergers, the Company became a corporation subject to U.S. corporate income taxes and, following the Mergers, the Company records deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and measures them using the enacted tax rates and laws that will be in effect when such differences are expected to reverse. The Company evaluates the recoverability of future tax deductions by assessing the adequacy of future expected taxable income from all sources, including reversal of temporary differences and forecasted operating earnings.
Other Estimates—The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. In addition to the estimates that we make in connection with accounting for the items noted above, the use of estimates is also important in determining provisions for potential losses that may arise from discontinued operations, litigation, regulatory proceedings and tax audits.
When determining stock-based employee compensation expense, we make certain estimates and assumptions relating to volatility and forfeiture rates. We estimate volatility based on several factors including implied volatility of market-traded options on our common stock on the grant date and the historical volatility of our common stock. We estimate forfeiture rates based on historical rates of forfeiture of employee stock awards.
We accrue for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be estimated. Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability accrued with respect to litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses based on, among other factors, the progress of each case, our experience and industry experience with similar cases and the opinions and views of internal and external legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines

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are sought, or where cases or proceedings are in the early stages, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. For more information on our legal and regulatory matters, see Footnote 19 "Commitments and Contingent Liabilities" included in Part I, Item 1 "Financial Statements (Unaudited)" of this Form 10-Q and other reports or documents the Company files with, or furnishes, to the SEC from time to time.
Change in accounting principle
During the first quarter of 2014 the Company changed its method of accounting for its investment in BATS following the merger of BATS and Direct Edge.
As a result of the change in accounting principle, the Consolidated Statement of Financial Condition at December 31, 2013 has been adjusted as follows: Investments increased by approximately $3.4 million, Deferred tax asset, net decreased by $1.1 million and Retained earnings increased by $2.3 million. The Consolidated Statements of Operations for the three and six months ended June 30, 2013 have been adjusted by an increase in Investment income (loss) and other, net by $1.9 million and $4.3 million, respectively.
During the first quarter of 2014 the Company recognized income of $9.6 million related to the merger of BATS and Direct Edge which is recorded within Investment income (loss) and other, net in the Consolidated Statements of Operations. The $9.6 million comprises a partial realized gain with respect to the Company's investment in Direct Edge of $16.2 million offset, in part, by the Company's share of BATS' and Direct Edge's merger related transaction costs that were charged against their respective earnings of $6.6 million.
See Footnote 9 “Investments” included in Part I, Item 1 "Financial Statements (Unaudited)" of this Form 10-Q.
Accounting Standards Updates
Recently adopted accounting guidance
In March 2013, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standard Update (“ASU”) concerning the parent's accounting for the cumulative translation adjustment upon derecognition of certain subsidiaries or groups of assets within a foreign entity or of an investment in a foreign entity. This ASU provides for the release of the cumulative translation adjustment into net income when a parent sells a part or all of its investment within a foreign entity, no longer holds a controlling interest in an investment in a foreign entity or obtains control of an investment in a foreign entity that was previously recognized as an equity method investment. This ASU was effective for reporting periods beginning after December 15, 2013. The adoption of this ASU did not have an impact on our Consolidated Financial Statements.
In July 2013, the FASB issued an ASU to clarify the financial statement presentation of an unrecognized tax benefit when a net operating loss (“NOL”) carryforward, a similar tax loss, or a tax credit carryforward exists. This ASU requires entities to present an unrecognized tax benefit as a reduction of a deferred tax asset for a NOL carryforward whenever the NOL or tax credit carryforward would be available to reduce the additional taxable income or tax due if the tax position is disallowed. The ASU is required for reporting periods beginning after December 15, 2013. The adoption of this ASU did not have an impact on our Consolidated Financial Statements.
Recent accounting guidance to be adopted in future periods
In April 2014, the FASB issued an ASU that amends the requirements for reporting discontinued operations. Under the new guidance, discontinued operations reporting will be limited to disposal transactions that represent strategic shifts having a major effect on operations and financial results. The amended guidance also enhances disclosures and requires assets and liabilities of a discontinued operation to be classified as such for all periods presented in the financial statements. The updated guidance is effective prospectively to all disposals occurring for interim and annual reporting periods after December 15, 2014, with early adoption permitted. Due to the change in requirements for reporting discontinued operations described above, presentation and disclosures of future disposal transactions may be different than under current guidance.
In May 2014, the FASB issued an ASU that updates the principles for recognizing revenue. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. We are evaluating the impact of this ASU on our Consolidated Financial Statements.

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Item 3.
Quantitative and Qualitative Disclosures About Market Risk
We are exposed to numerous risks in the ordinary course of our business and activities; therefore, effective risk management is critical to our financial soundness and profitability. We have a comprehensive risk management structure and processes to monitor and evaluate the principal risks we assume in conducting our business. Our risk management policies, procedures and methodologies are subject to ongoing review and modification. The principal risks we face are as follows:
Market Risk
Our market making and trading activities expose our capital to significant risks. These risks include, but are not limited to, absolute and relative price movements, price volatility, interest rates, credit spreads and changes in liquidity. Price risks result from exposure to changes in prices of individual financial instruments, baskets and indices. Further risks may result from changes in the factors determining options prices. Interest rate risks result primarily from exposure and changes in the yield curve, the volatility of interest rates and credit spreads. As market makers we are also exposed to “open order” risk where during unusual market conditions we could have an abnormally high percentage of our open orders filled simultaneously and therefore acquire a larger than average position in securities or derivative instruments.
For working capital purposes, we invest in money market funds and government securities or maintain interest bearing balances at banks and in our trading accounts with clearing brokers, which are classified as Cash and cash equivalents and Receivable from brokers, dealers and clearing organizations, respectively, on the Consolidated Statements of Financial Condition. These financial instruments do not have maturity dates; the balances are short term, which helps to mitigate our market risks. Our cash and cash equivalents held in foreign currencies are subject to the exposure of foreign currency fluctuations. These balances are monitored daily and are hedged or reduced when appropriate and therefore not material to our overall cash position.
We employ proprietary position management and trading systems that provide real-time, on-line position management and inventory control. We monitor our risks by reviewing trading positions and their appropriate risk measures. We have established a system whereby transactions are monitored by senior management and an independent risk control function on a real-time basis as are individual and aggregate dollar and inventory position totals, capital allocations, and real-time profits and losses. Our management of trading positions is enhanced by our review of mark-to-market valuations and position summaries on a daily basis.
In the normal course of business, we maintain inventories of exchange-listed and other equity securities, and to a lesser extent, listed equity options and fixed income securities. The fair value of these financial instruments at June 30, 2014 and 2013 was $2.89 billion and $562.8 million, respectively, in long positions and $2.40 billion and $742.7 million, respectively, in short positions. We also enter into futures contracts, which are recorded on our Consolidated Statements of Financial Condition within Receivable from brokers, dealers and clearing organizations or Payable to brokers, dealers and clearing organizations as applicable.
We calculate daily the potential losses that might arise from a series of different stress events. These include both single factor and multi factor shocks to asset prices based off both historical events and hypothetical scenarios. The stress calculations include a full recalculation of any option positions, non-linear positions and leverage. Senior management and the independent risk function carefully monitor the highest stress scenarios to ensure that the Company is not unduly exposed to any extreme events.
The potential change in fair value is estimated to be a gain of $8.0 million using a hypothetical 10% increase in equity prices as of June 30, 2014, and an estimated loss of $7.3 million using a hypothetical 10% decrease in equity prices at June 30, 2014. These estimates take into account the offsetting effect of such hypothetical price movements on the fair value of short positions against long positions, and the effect on the fair value of options, futures, nonlinear positions and leverage. The Company has employed a third party tool to assist in the calculation of the Company’s stress risk under the various scenarios that we model.
Operational Risk
Operational risk can arise from many factors ranging from routine processing errors to potentially costly incidents arising, for example, from major systems failures or human errors. For example, on August 1, 2012, at the open of trading at the NYSE, Knight experienced a technology issue related to the installation of trading software which resulted in its broker dealer subsidiary, KCA, sending numerous erroneous orders in NYSE-listed and NYSE Arca securities

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into the market. As a result of this technology issue, Knight incurred a pre-tax loss of $461.1 million which principally relates to trading losses.
Following the events of August 1, 2012, Knight carefully reviewed the matter internally and subsequently took numerous remedial measures designed to enhance its processes and controls. Subsequent to the Mergers, KCG has continued to refine and enhance its risk governance and control infrastructure. The changes that have been implemented since August 1, 2012 include: appointing a Chief Risk Officer; establishing a formal Risk Committee of the Board; adopting a Risk Committee Charter; establishing a formal Operational Risk Management function and hiring a Global Head of Operational Risk Management; implementing change management controls which require at different stages an additional layer of review and supervisory approval for significant software installations; adding market access controls designed to more closely monitor outbound routers and enable the rapid automatic shut-down of the routers; deploying various kill switches for specific applications and market access; establishing an Emergency Response Center ("ERC") that provides 24-hour coverage during global trading days, creates transparency and awareness around operational risks and changes, and is organized and tasked with responding to operational incidents or natural disasters in real-time; and establishing an Emergency Management Plan that sets forth procedures to be followed when responding to an emergency event that goes beyond individual emergency solving capabilities and has become significant enough to warrant involvement beyond individual groups or the ERC to ensure sound decision making and to minimize impact to the Company. We will continue to carefully monitor, enhance and strengthen our controls as needed.
Our businesses are highly dependent on our ability and our market centers' ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in several currencies and products. We incur operational risk across all of our business activities, including revenue generating activities as well as support functions. Legal and compliance risk is included in the scope of operational risk and is discussed below under “Legal Risk.”
Primary responsibility for the management of operational risk lies with our operating segments and supporting functions, and secondary responsibility lies with the Operational Risk Management function. Our operating segments maintain controls designed to manage and mitigate operational risk for existing activities. As new products and business activities are developed, we endeavor to identify operational risks and design controls to seek to mitigate the identified risks.
Disaster recovery plans are in place for critical facilities related to our primary operations and resources, and redundancies are built into the systems as deemed reasonably appropriate. We have also established policies, procedures and technologies designed to seek to protect our systems and other assets from unauthorized access. There is no assurance that such plans, policies, procedures and technologies will prevent a significant disruption to our business.
Liquidity Risk
Liquidity risk is the risk that we would be unable to meet our financial obligations as they arise in both normal and strained funding environments. To that end, we have established a comprehensive and conservative set of policies and procedures that govern the management of liquidity risk for the Company at the corporate level and at the subsidiary entity level.
We maintain a liquidity pool consisting of primarily cash and other highly liquid instruments at the holding company level to satisfy intraday and day-to-day funding needs, as well as potential cash needs in a strained funding environment.
Secured funding for the majority of the firm’s inventory is done through the firm’s regulated U.S. broker dealer subsidiary, KCGA. As such, a significant portion of the firm’s liquidity risk lies within KCGA. We consider cash and other highly liquid instruments held within KCGA, up to $150.0 million, a part of the firm’s liquidity pool to support financial obligations in normal and strained funding environments. Together with the cash and highly liquid instruments held at the holding company level and KCGA, we target having $350.0 million in the firm’s liquidity pool.
Cash and other highly liquid investments held by all other subsidiary entities are available to support financial obligations within those entities.

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Our liquidity pool comprises the following (in thousands):
 
June 30,
2014
 
December 31, 2013
Liquidity Pool Composition
 
 
 
  Holding companies
 
 
 
Cash held at banks
$
210,689

 
$
225,597

Money market and other highly liquid investments
97,967

 
27,420

  KCGA
 
 
 
Cash held at banks
106,303

 
19,605

Money market and other highly liquid investments
22,597

 
130,395

Total Liquidity Pool
$
437,556

 
$
403,017

Cash and other highly liquid investments held by other subsidiary entities
$
163,309

 
$
271,264

In addition, we maintain committed and uncommitted credit facilities with a number of unaffiliated financial institutions. In connection with the uncommitted credit facilities, the lenders are at no time under any obligation to make any advances under the credit facilities, and any outstanding loans must be repaid on demand.
We regularly perform liquidity risk stress testing based on a scenario that considers both market-wide stresses and a company-specific stress over a one-month period. Given the nature of the Company’s business activity and balance sheet composition, survival over the first one to three days of a severe stress environment is most critical, after which management actions could be effectively implemented to navigate through prolonged periods of financial stress. The modeled cash inflows and outflows from the stress test serve as a quantitative input to assist us in establishing the Company’s liquidity risk appetite and amount of liquid assets to be held at the corporate level. The liquidity stress test considers cash flow risks arising from, but not limited to, a dislocation of the secured funding market, additional unexpected margin requirements, and operational events.
We maintain a contingency funding plan (“CFP”) which clearly delineates the roles, responsibilities and actions that will be utilized as the Company encounters various levels of liquidity stress with the goal of fulfilling all financial obligations as they arise while maintaining business activity. We periodically update and test the operational functionality of various aspects of the CFP to ensure it remains current with changing business activity.
Capital Risk
Government regulators, both in the U.S. and globally, as well as self-regulated organizations, have supervisory responsibility over our regulated activities and require us to maintain specified minimum levels of regulatory capital in our broker dealer subsidiaries. If not properly monitored, our regulatory capital levels could fall below the required minimum amounts set by our regulators, which could expose us to various sanctions ranging from fines and censure to imposing partial or complete restrictions on our ability to conduct business.
To mitigate this risk, we continuously evaluate the levels of regulatory capital at each of our regulated subsidiaries and adjust the amounts of regulatory capital as necessary to ensure compliance with regulatory capital requirements. We also maintain excess regulatory capital to accommodate periods of unusual or unforeseen market volatility. In addition, we monitor regulatory developments regarding capital requirements and prepare for changes in the required minimum levels of regulatory capital that may occur in the future.
Legal Risk
Legal risk includes the risk of non-compliance with applicable legal and regulatory requirements and standards. Legal risk also includes contractual and commercial risk such as the risk that counterparty’s performance obligations will be unenforceable. We are generally subject to extensive regulation in the different jurisdictions in which we conduct our business. We have established procedures based on legal and regulatory requirements that are designed to foster compliance with applicable statutory and regulatory requirements. We have also established procedures that are designed to require that our policies relating to conduct, ethics and business practices are followed.


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Credit Risk
Credit risk represents the loss that we would incur if a counterparty fails to perform its contractual obligations in a timely manner. We manage credit risk with a global, independent credit risk management function that is responsible for measuring, monitoring and controlling the counterparty credit risks inherent in our business activities. 
Our credit risk function’s process for managing credit risk includes a qualitative and quantitative risk assessment of significant counterparties prior to engaging in business activity, as well as, on an ongoing basis. The review includes formal financial analysis and due diligence when appropriate.
Our credit risk function is responsible for approving counterparties and establishing credit limits to manage credit risk exposure by counterparty and business line. The assigned limits reflect the various elements of assessed credit risk and are subsequently revised to correspond with changes in the counterparties’ credit profiles. Our credit risk function communicates counterparty limits to the business areas as well as senior management, and monitors compliance with the established limits.
Where appropriate, counterparty exposure is monitored on a daily basis and the collateral, if required, is marked to market daily to accurately reflect the current exposure.
Foreign Currency Risk
Our international businesses include transactions in currencies other than the U.S. dollar. As such, changes in foreign exchange rates relative to the U.S. dollar can affect the value of our non-U.S. dollar assets, revenues and expenses. Additionally, our foreign subsidiary in India has a functional currency other than the U.S. dollar which exposes us to foreign currency transaction gains and losses. A portion of these risks are hedged, but fluctuations in currency exchange rates could impact our results of operations, financial position and cash flows.
Item 4.
Controls and Procedures
(a) Disclosure Controls and Procedures. KCG's management, with the participation of KCG's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. This evaluation does not include an assessment of internal controls over financial reporting related to GETCO Holding Company, LLC and GA-GTCO, LLC, (collectively "GETCO") each of which were party to a business combination with Knight Capital Group, Inc. that was completed on July 1, 2013, resulting in the formation of KCG Holdings, Inc.
Based on such evaluation, KCG's Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2014, KCG's disclosure controls and procedures are effective.
(b) Changes in Internal Control Over Financial Reporting. There have not been any changes in KCG's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, KCG's internal control over financial reporting. 


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PART II
OTHER INFORMATION
Item 1.
Legal Proceedings
The information required by this Item is set forth in the “Legal Proceedings” section in Footnote 19 "Commitments and Contingent Liabilities" to the Company's Consolidated Financial Statements included in Part I, Item 1 "Financial Statements (Unaudited)" herein.
Item 1A.
Risk Factors
In addition to the other information set forth below and in this report, you should carefully consider the factors discussed in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
The following table contains information about our purchases of KCG Class A Common Stock during the second quarter of 2014 (in thousands, except average price paid per share):
Period
 
Total Number of
Shares Purchased
 
Average
Price Paid
per Share
 
Total Number of
Shares Purchased as
Part of Publicly
Announced Plans
or Programs(1)
 
Approximate Dollar
Value of Shares That
May Yet Be Purchased
Under  the Plans or
Programs
April 1, 2014 - April 30, 2014
 
 
 
 
 
 
 
 
Common stock repurchases
 

 
 
 

 

Employee transactions (2)
 
2

 
 
 

 
 
Total
 
2

 
$
9.96

 

 
 
May 1, 2014 - May 31, 2014
 
 
 
 
 
 
 
 
Common stock repurchases
 
2,381

 
 
 
2,381

 
$
122,332

Employee transactions (2)
 
3

 
 
 

 
 
Total
 
2,384

 
$
11.62

 
2,381

 
 
June 1, 2014 - June 30, 2014
 
 
 
 
 
 
 
 
Common stock repurchases
 
2,114

 
 
 
2,114

 
$
97,123

Employee transactions (2)
 
52

 
 
 

 
 
Total
 
2,166

 
$
11.92

 
2,114

 
 
Total
 
 
 
 
 
 
 
 
Common stock repurchases
 
4,495

 
 
 
4,495

 
 
Employee transactions (2)
 
58

 
 
 

 
 
Total
 
4,553

 
$
11.76

 
4,495

 
 
________________________________________
Totals may not add due to rounding.
(1) During the second quarter of 2014, the Company’s Board of Directors approved an initial program to repurchase up to a total of $150.0 million in shares of the Company’s outstanding KCG Class A Common Stock and KCG Warrants. Under the program, the Company may repurchase shares from time to time in open market transactions, accelerated stock buyback programs, tender offers, privately negotiated transactions or by other means. Repurchases may also be made under Rule 10b5-1 plans. The timing and amount of repurchase transactions will be determined by the Company’s management based on its evaluation of market conditions, share price, legal requirements and other factors. The program may be suspended, modified or discontinued at any time without prior notice. The Company cautions that there are no assurances that any further repurchases will actually occur. Through June 30, 2014, we had repurchased 4.5 million shares for $52.9 million under this program.
(2) Represents shares of KCG Class A Common Stock withheld in satisfaction of tax withholding obligations upon vesting of employee restricted equity awards.
Item 3.
Defaults Upon Senior Securities
None

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Item 4.
Mine Safety Disclosures
Not applicable.
Item 5.
Other Information

75


Item 6.
Exhibits
NUMBER ASSIGNED
TO EXHIBIT (I.E. 601
OF REGULATION S-K)
 
DESCRIPTION OF EXHIBITS
 
 
 
31.1*
 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
31.2*
 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
32.1*
 
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
32.2*
 
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
101**
 
The following financial statements from KCG Holdings, Inc's Quarterly Report on Form 10-Q for the three months ended June 30, 2014, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Statements of Operations for the three and six months ended June 30, 2014 and 2013 (ii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2014 and 2013, (iii) Consolidated Statements of Financial Condition at June 30, 2014 and December 31, 2013, (iv) Consolidated Statement of Changes in Equity for the six months ended June 30, 2014, (v) Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and 2013 and (vi) the Notes to Consolidated Financial Statements.
 
 
 
________________________________________ 
*
Filed herewith.
**
Pursuant to rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 11th day of August 2014.
 
KCG HOLDINGS, INC.
 
 
By:
/s/ DANIEL COLEMAN
 
Daniel Coleman
 
Chief Executive Officer


 
 
By:
/s/ STEVEN BISGAY
 
Steven Bisgay
 
Chief Financial Officer




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