Business Breakdowns
· Zack Fuss
[00:00:00] S0: And so I think it would be helpful to illustrate how this manifests by demonstrating what an account looks like and how a customer uses the business. For example, let's say you have someone that's a professional trader that has a million dollar account and maybe is running at 2 or 3 million dollars of gross long and short. They're obviously borrowing and lending securities. What does it look like? And then how does that translate into the different revenue line items? So the commission revenue, the net interest income, the fees and services that they provide, just to really drive home how people interact with this business and its ability to be differentiated on every service that it provides to its key customers.
· Freddie Lait
[00:00:00] S1: The difficulty here is that one does need to disaggregate a little bit. We've been discussing this as an online broker, which makes it feel very much like it's aimed entirely at individuals logging onto a website or an app. The truth is more than 50% of the business and a large portion of the growth in the business, although individuals are still growing very nicely, is the other three main cohorts which are white labeling the platform and service for RIAs advisors around the world, prop traders and hedge funds. They're now the fifth largest prime broker in the world. So they're larger than many of the big banks you could name from a standing start about 10 years ago. They're growing far faster than the market for prime because they are seen as more attractive to the hedge fund groups in general. And then the final one which is just worth touching on is what they call introducing brokers. And you can think about this as another bank or another brokerage business who is outsourcing and canceling their own internal technology investments. As an example, they just brought on HSBC globally and then they're going to plug in the underlying trading capability of Interactives. And I would think about this in the same way that a lot of people have become comfortable with outsourcing admin or custody to JP Morgan or these large custody banks like Northern Trust. A large number of these huge global institutions, as opposed to investing in the technology, are renting it implicitly from Interactive. And that is where a lot of the growth's coming from. So what we see at an account level is slightly averages of those things. We can make some assumptions about where the margin skews towards the hedge funds and the prop traders and obviously away from a lot of the RIA business. But what you see is an average account balance that even when it was individual-led was much higher than most other firms and very normal, typical to have 100, 150, $200,000 as the average account balance. Against that there are two other interesting assets which are the margin loans which we've discussed, which used to be far higher actually and have come down as a percentage of equity over the last 10 years, but are ticking up again at the moment in the short term at about 10 to 12% of assets.
· Freddie Lait
So if you've got a $200,000 account, you might have $20,000 of margin loans against some securities in there on leverage. What's also been very popular with all of the brokerage platforms, including Interactive, has been securities lending. And again, as we've probably become boring saying this is fully automated so you can sign in if you want to. Your securities, your stocks can be lent out to people who wish to borrow them and to short them. They're still fully tradable, they're fully collateralized from our perspective as shareholders, by cash. And the client earns most of that lending fee. And again there's a small but very honest spread which is all transparent. So they have a similar amount of securities lending about that sort of, for a $200,000 account, about $20,000 of lending. So 10% of the base. So that's the kind of average. But we do believe it skews a lot. A lot of the introducing business and a lot of the RIAs we think are probably using less, probably trading less as well under that sort of 200 trades per year. And then really the majority of this stock lending margin loan, and even the turnover, the number of trades or darts as they call them, daily average revenue trades. If anyone's reading the annual report after this, that skews towards the hedge fund business. So it's a variety of different clients, all benefiting from the same low-cost platform, but they're using it in different ways.
· Zack Fuss
[00:00:00] S0: When you look at this business's P&L and I'm looking at 2024 as a reference, you have about $1.7 billion in commissions which results in around $2 billion of non-interest related income. And then the rest $3 billion. Is that net interest income that NIM resulting in about $5 billion of revenue? How do you think about how that should evolve over time? The mix in quality as it relates to the evolution of their customer base, which you just mentioned? And then a second question related to that: When you see a business that's as significant an earner on net interest margin, you beg the question as it relates to interest rates and how they impact the business and what would happen in an environment where rates were going down versus going up. Just curious on those two items, really. Revenue mix and NIM. As the business evolves over time.
· Freddie Lait
[00:00:00] S1: There’s quite a few ways to cut it. This is clearly a cyclical business. It grows very rapidly, and account growth that had been around 25% per year is inflecting up towards 30 and 35% per year at the moment. As the flywheel gathers ahead of steam, the most important thing that I want to compel you to understand from our perspective is that it's account growths that matter. And if you need to believe account growths are what matter, then one needs to believe there's sort of stability in the other things like the amount of trading and the revenue per account. And so when we've interrogated the sort of the number of trades that's been going on as the mix has changed and the accounts have been growing, the trades per year have been falling. And again, one would expect hedge funds are trading many times a day, but RIAs and introducing brokers in particular are probably trading less than the 200 average trades per year. So we expect, and we've observed over the last five or ten years a kind of 5 to 10% decline in trades per year. So if the growth is similarly skewed between the different cohorts over the next few years, obviously in periods of volatility, one trades more, in periods of low volatility, one trades less. But as a trend, we put a deflation, if you like, in the number of trades per year. And I think there's probably small amount of potential deflation to come through from commissions. But the management team have talked about flat average commission levels from here, and it really does depend on mix. Again, a crypto trade is a very different commission level or an option compared to trading Google shares. The way it's worked is you have that kind of average 5, $600 per account of commission, it'll probably trade a little bit lower, maybe 5% down per year on an average basis, and then be cyclical with client equity. But if account growth is 35% or anything along those lines, that will dwarf any reinvestment backing price. That's the easier one, is the commissions. And obviously you can take your own view on average client equity and average equity market performance over the long term. When you factor those things in too, they offset that reduction normally on the nim.
· Freddie Lait
And I think this is probably one of the greatest misunderstandings in the business and it was certainly what gave us the opportunity to invest in it 18 months ago is the actual sensitivity. If you think about the alternative, if you think about a business like Schwab, which only a couple of years ago almost needed effectively a wholesale rights issue because it had what was effectively a run on its funding source because they weren't paying anything on their customers cash. And customers, when interest rates went up, started saying we'd better go to a bank or we better go to a money market fund. And they robbed Schwab of that source of cash and funding. The arrangement between interactive brokers and their customers is just far more honest and it's very transparent. And it's, as I said, on any large balance, more than $10,000, which is about two thirds of their entire customer cash, they just pay the local market base rate less 50 basis points. That results in a far lower risk. Firstly, to the point about Thomas Peterffy's risk conservation, clients are probably not going to leave because they get 50bps more elsewhere, even if they could. But secondarily, it's actually less interest rate sensitive than you think because if rates go down by 50 basis points, they still just take 50 basis points on a spread. And so they do disclose that overall interest rate sensitivity and for 100 basis point move down in interest rates around the globe. And again, this is a global business, probably 40% US. Jacopo's nodding at me, but it's global in nature. But if global interest rates fell 100 basis points, NIM would fall by 10%. And again, that's NIM per account. So if you're growing your accounts at 30, 35%, it will more than offset a multiple of times that net interest sensitivity. So that's why we focus so obsessively on the business model and the potential for account growth.