Business Breakdowns
· Jacopo Di Nardo
[00:00:00] S2: When you look at Interactive, it was born out of a person who is first and foremost an engineer and a technologist. And that type of culture has reverberated throughout the firm. Day one. So when you look at Interactive, it's by far the most automated of all brokers. So when you go onto the app, most of the functions you'll hit on it, including actually eliminating accounts because they exceeded the margin loan, is done automatically by a bot. This doesn't tend to be the case for the competitors. And this has also morphed the broker into being really one that is liked and used first and foremost by experienced traders. In the first days, the business was really only used by individuals and what today we call prop traders. These are individuals with account balances that tend to vary between, let's say, 200,000 up to a couple million dollars per account of client equity. And this compares, broadly speaking, quite favorably versus other online brokerages. So you'd think someone like Robinhood or Etoro would have account balances averaging maybe 5 to 10,000. So it would be the first brokerage you go to when you learn about trading. And places like Schwab would have higher account balances, but they would be used in a much less frenetic way. As Freddie mentioned, you make about 200 trades a year per account on an Interactive, and that number might be tens of times even lower if you're using your Fidelity or Schwab account, which tend to be used for slightly different purposes. So obviously 401(k)s being one of those in the US.
· Zack Fuss
[00:00:00] S0: So I think it's impossible to really appreciate how differentiated IBKR Interactive Brokers is without spending some time discussing its founder, Thomas Peterffy came here with effectively nothing, I believe, in the 1960s and is now one of the wealthiest and relatively unknown Americans. Can you just tell a little bit about his story, how this business came to be, how it's evolved over time, and then how much of the business and how involved Thomas is today?
· Jacopo Di Nardo
[00:00:00] S2: As you said, he was born in Hungary during basically the period of war in Europe. And he migrated with nothing to the US pursuing the classic American dream. And the business started out actually as a market-making business for options. When Thomas bought a seat on the Chicago Mercantile or Boston Options Exchange, and initially his broad idea was that of pioneering a way of pricing options. It was at the time when the formulas were coming out from Black and Scholes and when option trading was nothing compared to today. And the company was called Timber Hill and it was really an option market maker. That if you think about that, the way Thomas approached the business was completely different in the sense that he wanted to automate everything that could be automated. And this still permeates the culture of a business today. Interactive doesn't want to be in businesses that eventually cannot be automated in the future. On top of it, if you think about the role of the option maker, risk management is at the center of everything you have to do. So you're taking obviously both sides of a trade most of the times and you're just creating a market for participants. So up to these days, obviously risk management is one of the most important points that differentiates Interactive compared to other brokerages. There's a couple of examples, but the only time they really actually lost some money in a significant way, which is not significant compared to the total amount of equity they have, was when the Swiss central bank let the Swiss franc appreciate freely and the company lost about 1% of their capital at the time. And recent examples include when interest rates were zero in 2021. And a lot of other online brokers decided that it was the time to take some duration risk to make some more money on net interest income. The company refrained from doing that. So I think when one thinks about the two vectors on why this business is so well managed and managed to succeed, that I think his starts as someone who is fundamentally an engineer and focused on risk management are two very important aspects of the business. And it's worth saying that he's also a very hard-nosed and smart businessman.
· Jacopo Di Nardo, Zack Fuss
So whenever he saw that the option market-making business due to changes in regulation and the market environment after the great financial crisis was not a business but would earn excess ROEs anymore, he decided actually to close that down to focus entirely on the online brokerage. [00:00:00] S0: And so when you consider the business of online brokerage, there was a pretty big evolution, I'd say, over the course of the last decade, primarily focused on payment for order flow or PFOF. And so what you went from is a world where commissions were 5, 10, $25 per trade to a competitive landscape where many of their peers offered zero commissions. And so I'm curious, despite that, IBKR, while still being a business that charges commissions, has seen its growth explode. What is going on? What is the debate around PFOF, which I believe is actually not even a legal business proposition outside of the U.S.? How do you think about that backdrop as it relates to Interactive Brokers' ability to continue to take share?
· Freddie Lait
[00:00:00] S1: We think this is one of their key competitive advantages, that since day one they've always chosen to have direct market access. So imagine like a kind of Costco model, they're cutting out the wholesaler, they don't have someone else, they don't have to go to a broker. And so they have linked their system up to every exchange in the world, give or take directly, and so they execute directly at the best price on your behalf. Whereas payment for order flow, which is pretty much just a US phenomenon, these businesses who buy that order flow clearly make a large amount of profit. And so that has to come out of someone's wallet and implicitly that has to come out of the customer's execution price. And so you can listen to the CEO Thomas Peterffy, talking quite vociferously about this practice and other banking practices that have yet to be regulated. But it's something that they've always avoided and it does save them a huge amount and allow them to move much faster than a lot of competitors as well. So it's no higher cost. They don't get the payment for order flow into their revenues like some other businesses do. But they don't need it because they can prove best execution. They still have lower commissions across the marketplace. They charge far less than others in most cases. And their other draws are their much cheaper margin loans and their much more generous payment for cash on deposit. They basically pay 50 basis points less the local base rate on any cash deposits over a certain threshold. So they're seen correctly as giving back everything they can to customers with a small margin. And then it's just that's their principal competitive advantage. The second, as Jacopo has already touched on, is the automation of the trading itself, of the risk management and of the management of the business and all the opex, which means that their cost base is just so much thinner than the others. So they're able to continuously reinvest in price.
· Zack Fuss
[00:00:00] S0: I think one of the things that's interesting is if you look at the headcount of IBKR relative its peers, it obviously speaks to their interest in making sure that everything is tech-enabled. I will say amongst some investors who use the platform, they do complain about the lack of customer service at times, but it's what allows them to offer such incredible low-cost execution. And then the other aspects of it being really your ability to use leverage at a very low cost of capital. Can we just talk about how they use their balance sheet in a way that provides such a structural cost advantage relative to their peer set?