Disclosure: both a happy investor and client of Interactive Brokers.

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It is a well-known human bias to neglect large absolute trading commissions because we look at them relatively to the even bigger amount of money we invest. I am a big believer in minimizing any friction in the investment process (trading less which lessens commissions and frees up time to think long term; paying less for trades by being an IBKR client, although the cheapness creates a “casino effect” of wanting to trade more frequently).

Intro

We will cover IBKR’s November month results that were released this week. Founder Mr. Peterffy had interesting comments about them on the Goldman Sachs 2018 conference that took place yesterday.

First I’ll explain how I go about thinking about the IBKR’s monthly metrics in general.

Executive summary

  • most important monthly KPI to track: user account growth (it drives LT equity growth which is IBKR’s most important value driver)
  • November user account growth was “disappointing”, yet still in line with the last 10 year historical pace of 18% CAGR. The disappointment was driven by China curbing remittances to stellar grower – and intro broker to IBKR – Tiger Brokers
  • IBKR will start paying interest on smaller accounts
  • Israel markets will be added to IBKR
  • important question for the thesis: will exchange volumes keep on losing share to internalizers?

Let’s get started…

IBKR’s monthly metrics mental model*

*Hate using this snobby term but it made for the shortest title.

Although equity growth is the value driver for IB going forward (driving interest income) , account growth is the most useful reported number to gauge future LT equity growth, as

  • monthly equity growth numbers are affected by short term stock market movements
  • equity growth lags account growth because people only start depositing large chunks of money into their account once they are familiar with the platform (i.e. half of end-of-first-12-months money only arrives after >6 months)

Commission growth is also very noisy ( ~f(volatility)) and only 1/3rd of earnings.

In short, closely track MoM account growth to know if IB is on pace for LT equity growth.

Account growth + (ST NOISY= Clients adding deposits + asset inflation) = LT Equity growth

So I observe account growth and know that (ST NOISY) was historically 10% and should be at least 4% on avg. going forward, i.e. observed account growth + 4% =  conservative LT equity growth.

Let’s discuss the latest results and the interesting conference.

November numbers & Peterffy on the GS Conference

  • On the November numbers, IB swung up 8% intraday & ended slightly down on the day
  • I agree with the directional close-to-closing price given the numbers
    • Short-term value driver commissions were great (market volatility) while
    • accounts growth disappointed at +1.3% MoM (vs huge growth last months of course, even the annualized disappointing MoM pace is still 17%, +- on par with the 10-year CAGR of 18%)
      • Peterffy revealed on the GS conference that MoM account growth was affected by special measures by Chinese govt that constrained mainland Chinese customers to deposit money into their Beijing-based intro-broker Tiger Broker app accounts (i.e. IB bank accounts in Hong Kong). Probable reason: Yuan is under pressure and growing money outflows put further pressure on Yuan
        • Tiger Brokers grew at a stellar rate last years (now processing >200BUSD in trading volume p.a.) & has a great app with local support, advertising and investors in the mainland (the Robinhood of China but with a smarter client base as unsophisticated Chinese retail investors are not interested in global investing) but back-end of the app is 100% IBKR and the bank account is with IBKR HK
        • My take: a yuan devaluation event should be positive as the restraint can be more easily lifted afterwards & as more Chinese would consider investing outside China after a deval

Notwithstanding current market correction, IB’s LT equity growth (main value driver) should be at least 4% p.a. above account growth as clients deposit more money into their existing accounts and asset prices rise in long haul. In fact, historically the equity CAGR was 10 %-points above account CAGR. As interest rates rise and IB pays even more interest on client cash than competition, there is no reason the pace of client deposits should slow so 4% seems very conservative.

Even annualizing these disappointing MoM numbers gives us 17% account growth or in my view 21% conservative LT client equity growth, which is still 2 pp above my model of LT equity growth at 19%.

Recent additions to the platform Peterffy discussed:

  • Israel markets (next week)
  • New screening functions for IB’s bond platform (direct electronic access)
  • IB features in recent past makes them more & more of a bank:  IB is now considering getting banking license abroad & US. In US, broker-dealers can do almost anything but  limitations abroad are generally more extensive
  • Effective 1st of Jan IB will start paying interest for small clients with total equity lower than 100k (previously 0%). The rate these clients will get will be linearly ramping from 0% to benchmark minus 0.5% with account size from 0 to 100k, e.g. 60k client would get 60%*(bench-0.5%) on his cash

Recent SEC action on the payment for order flow “PFOF” competitor broker’s practice

  • Competitors burdened with more disclosure requirements to clients

Peterffy voiced his concern that brokers who’re accepting PFOF (the vast majority) are routing their orders increasingly to “internalizers” that execute customer orders against their private “parallel” market (e.g.  HFT arm of Citadel, public firm Virtu Financial):

  • This means less and less retail orders are going to the exchanges
    • Because retail orders are the lifeblood of market makers as they are viewed as profitable “noise”, there’s less incentive for market makers to provide liquidity-adding orders limit orders to the exchanges
  • thinks the decreasing real liquidity on exchanges is a “disaster waiting to happen”

I read the Virtu Financial prospectus, and the story is not that simple it seems: exchanges are monopolies and they have been inflating their commissions and data fees over the last years at higher than inflation. IBKR IR themselves complained about that to me when I asked about that cost item. Customers using internalizers save exchange fees that could theoretically be shared amongst client, broker and internalizer. In practice however, this windfall (and slightly worse execution when using an internalizer) goes to internalizer and broker. I still think the internalizer model is a threat to IB’s 100% direct-exchange model as this ongoing exchange trading substitution may continue. This is mitigated by IB’s tiny market share that can grow much bigger in 3 or 4 out of 5 client types (prop shops is saturated &  sophisticated individuals is saturated but only in the US).

Somewhat distressing is Peterffy exaggerating JPMorgan’s new “free trading app” clients being patsies:

Well, obviously, businesses have to make a profit or at least break even. So one day advertise no commissions. They may have to make it up somehow, and so that is partly in selling the orders, partly not paying interest on the deposits, partly charging higher margin rates. I understand that Robinhood does this, and that’s okay. But to the extent JPMorgan is doing this, I think it’s a big mistake. People don’t like to be taken for a patsy, and it’s going to be — they will regret this, I think.

There are huge differences among brokers how much they take as PFOF as they negotiate how good the client execution should be. Fidelity and Schwab have ~10x better price execution than RobinHood and earn less from PFOF. As stated above, theoretically PFOF could be compatible with great execution as exchange fees are saved.  The difference between IB’s price execution and the more established brokers is really a few basis points (insignificant for individuals), while for Robinhood it’s >20bp.

Growth

Interesting point was that not only Asian intro broker clients are growing fast. A lot of European private banks are becoming intro brokers too as they can’t keep up technologically.

TC