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Executives

Deborah Liston - Director of Investor Relations

Thomas Peterffy - Chairman and CEO

Paul Brody - Group CFO

Analysts

Rich Repetto - Sandler O'Neill

Chris Allen – Pali Capital

Edward Ditmire – FPK

Mac Sykes – Gabelli

John Rowan - Sidoti & Company

MZ (initials substituted for full name at participant's request) - Private Investor

Milan Gupta - Southpoint Capital

Rob Rutschow – CLSA

Patrick O'Shaughnessy - Raymond James

Justin Hughes - Philadelphia Financials

Interactive Brokers Group, Inc. (IBKR) Q3 2009 Earnings Call October 22, 2009 5:00 PM ET

Operator

Good day, everyone, and welcome to the Interactive Brokers’ third quarter 2009 earnings results conference call. This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to Ms. Deborah Liston, Director of Investor Relations. Please go ahead.

Deborah Liston

Welcome, everyone, and thanks for joining us today. Just after the close of regular trading, we released our third quarter financial results. We will begin the call today with some prepared remarks on our performance that complements the material included in our press release and allocate the remaining time to Q&A. Our speakers are Thomas Peterffy, our Chairman and CEO, and Paul Brody, Group CFO.

At this time, I would like to remind everyone that today’s discussion may include forward-looking statements. These statements represent the company’s belief regarding future events that by their nature are not certain and outside the company’s control.

The company’s actual results and financial condition may differ, possibly materially, from what’s indicated in these forward-looking statements. For a discussion of some of the risks and factors that could affect the company’s future results, please see the description of risk factors in our filings made with the SEC. I would also direct to you to read the forward-looking disclaimers in our quarterly earnings release.

With that, I’ll turn the call over to Thomas Peterffy.

Thomas Peterffy

As you can see from our results, this was a challenging quarter for our global market making activities with many unhelpful dynamics working in unison. Although I would like to note that due to the vagaries of GAAP accounting concerning foreign subsidiaries, while our GAAP b-tax earnings for the quarter were only $133 million, shareholders equity during the same period increased by $184 million to $4.823 billion or $12 a share, and at the same time the publicly held shares now have a book value of $13.63.

Meanwhile, our brokerage business continues to expand at an accelerating pace with growing profit margins. I will review each segment and then Paul Brody our CFO will discuss the financials in more detail.

Beginning with market making, I will review the various drivers that impact our trading gains and how they behaved this quarter.

First, volatility:

Actual and implied volatility levels continued their retreat. The VIX is now in the very low 20s. As the VIX got below 40, we begun to reestablish our customarily long volatility position and the ratio of actual versus implied volatility has again become an important factor in our trading results.

Just to refresh, the implied volatility derives from the prices of which options trade in the market so that it determines the price we pay for the options we buy in order to be long volatility. The actual volatility is a measure of price movement of the underlying over time and is a determinant of the trading profit that we derive from this long option position. As the ratio of actual to implied volatility decreases, our trading results suffer, as it increases they improve. The ratio during the third quarter decreased to 67% which is an unusually low number, the lowest I can remember.

Volumes; global option volumes are relatively flat compared to the second quarter and fell 6% from the year ago quarter. Our market making options contract volume fell by 27% from the prior year’s quarter, which brought our overall market share to 10.5% globally and 13.4% in the US.

I attribute most of our decreased market share to three factors. First, as I have said before, much of the listed option volume in the past few quarters went to low priced, high volatility financial stock in which our participation was low. As these stocks have most recently stabilized, the trading volume is becoming more evenly distributed.

Second, High Frequency Traders or HFT, as they are often called have been taking an ever larger share of the listed option volume. I will say a lot more about this shortly. Thirdly, so many of the high volume options are now quoted so tight often one penny wide that we are no longer on both sides of every market.

Bid/offer spreads:

Bid and offer spreads on option exchanges are another important driver of profits. As I discussed on the previous quarter’s call, we are still witnessing a contraction of spreads though at a decreasing rate as compared to the first quarter. I also indicated that we expected to see spreads stabilize in the near term and that actually turned out to be the case.

As published data by a US option exchange indicates, spreads contracted further in the third quarter compared to the second quarter by roughly 15%. However, the trend reversed in September when spreads widened slightly by about 5%. I believe that for the time being bid offers spreads have stabilized and they are unlikely to move much further from these levels either way, until the next liquidity event, should there be one.

Competition:

Competition does not only come from traditional market markers, but also high frequency traders who act like market markers but get certain customer preferences at the exchanges which gives them definite advantages. Effective October 9, the ISE has implemented a mandatory professional trader designation rule which identifies and classifies HFT as professional traders depriving them of customer priority which they have enjoyed up to now. Although they still trade for free while market markers pay exchange fees.

I think it is important for you to understand the exchange models in order to form an opinion of how this issue is going to evolve. On all the traditional US option exchanges where more than 90% of listed option trades take place, customers pay no exchange fee and they have priority over market makers at the same price.

So the exchanges generate zero revenues when a customer trades with another customer including an HFT. As more and more HFTs came into the market and got priority over market markers, customers to market marker interaction diminished and customer to customer increased. Thus the exchange is collecting revenues in a smaller portion of the trade.

This is the reason the ISE came with the rule to reclassify HFTs as professionals. Although they will still not pay exchange fees, by being on parity with market markers instead of having priority over them, the market marker trading volume should increase and with that exchange revenues will last.

The next question is why not have them pay exchange fees just like market markers do? If you charge them exchange fees, exchange revenues will increase by those fees collected but some HFTs may trade less or stop trading entirely. To the extent that lost volume was trades with customers who will now trade with market makers, the exchange is ahead by charging fees to HFTs. To the extent that volume was with HFTs trading with market makers the exchange would lose revenues.

It seems clear to me and I’m fairly certain that the balance is well in favor of charging the fees and that in order to maximize revenues the ISE will end up charging exchange fees to HFTs for their trades, possibly at some lower level.

This brings us to the question: will the other exchanges, the CBOE and the PHLX follow the ISE with this new rule? As you know, the CBOE is preparing for an IPO and they appear to be unsure if they are better off maximizing revenues or maximizing volumes in the near-term. We think that as HFTs are being pushed from the ISE to the CBOE and the PHLX, their customer to market makers trade will diminish further, along with their revenues. That indicates to me, that you have a little choice, but to follow the ISE.

Penny Pricing:

As you know in September, the SEC approved the expansion of the NYSEs proposed pending pilot which already covers 63 US option clauses and accounts for roughly 50% of industry volume. Expansion will extend to 300 additional issues, phased in over four quarterly increments and ultimately encompass 85% of market volume.

Options quoted in pennies typically have tighter spreads, with greater volume and participation from HFTs. It is too early to predict how this expansion will affect our business, since it will depend on how much trading volume will increase due to tighter spreads and how much of our market maker share will expand as a result of the new ISE ruling to classify HFTs as professional customers.

As spreads and dealer profits are shrinking in the exchange listed space, OTC dealers are riding higher than ever before. I'm referring to large bank trading profits. This is prompting us to evaluate the pros and cons of expanding our market making activities to include OTC products. Regulators are inching closer to requiring central clearing and higher reporting of this and tighter reporting of these products to promote greater transparency.

The proposal to bring OTC derivatives onto exchanges seems to have taken a backseat for the time being, but may gain momentum further down the road. However, we believe that introducing a central clearing mechanism is a major first step in gaining transparency. We have come to the point where the playing field is too small on the exchanges and the opportunity is on the OTC market is too big to pass up given our sizeable capital position. With net capital of about, with shareholders equity of nearly $5 billion, we are the largest non-bank broker/dealer and well positioned to enter this market. The opportunity and the need are presented by our expanding brokerage business.

First, as you know, we are already active in the OTC foreign exchange market, where we conduct hedging transactions for our proprietary brokerage customers. We are now going to expand this to OTC forex options.

Second, we have brought in a small team of corporate bond traders. Up until now corporate bond markets on the IB brokerage platform weren't as liquid as our customers would have liked. With the addition of this team, we are planning to become a more significant presence in this market.

Thirdly, our prime brokerage customers tell us that they need to be able to trade equity-based individual index and basket swaps in order to prime with us. Given the high barriers to entry due to credit and capital considerations and the lessened competition in the wake of the credit crisis, this is a very lucrative market, compared to the exchange related products.

Brokerage:

This brings us to recent development in our brokerage business, which continues to post impressive growth rates that far outpace the industry. Year-over-year, total accounts have grown 20% and customer equity has grown by an unparallel 43%. This exemplifies the fact that the growing number of sophisticated traders seek to achieve the best execution using our superior trading technology at a lowest possible trading costs.

Although as a whole, our customers are only about 50% invested, year-to-date through September 30, while the S&P had gained 17%, the average equity per customer account grew by 37%. Savvy investors who have continued to seek out the best priced broker that can make a meaningful impact on their performance, and with our expanding global presence, this effect will multiply exponentially as we enter new countries and activate our brokerage engines.

While our brokerage operating metrics continue to shine, financial results are still off slightly from the year ago quarter, when we saw record customer trading volume. People are much more cautious about trading than they were a year ago. DARTs fell 10% year-over-year. Pre-tax income is off 11% year-over-year, but it is flat with the prior quarter. Brokerage pre-tax margin has climbed to 51% from 48% in the year ago quarter.

We are extremely excited by the accelerating growth of our brokerage business as measured by customer equity. Customer equity is at 43% year-over-year and 17% over the prior quarter. Our target customer base of financial professionals understands the impact of low financing rates and lower transaction costs on their returns.

Finally, after all these years there is a buzz about IB among professional traders and investors. Finally they are beginning to believe that what we say about our brokerage platform is not just buzz words, but the advantages we give them in cost, execution quality and market access are true and very significant. Looking at the day-to-day increase in our customer’s equity is the highlight of my morning routine.

To increase our penetration among financial professionals, we developed our Employee Track Program. Financial institutions must monitor their employee’s personal trading activities. Working with the compliance staff of several institutions, we have developed online monitoring and periodic customized reporting capabilities. We are now in the great position where compliance personnel are helping us market our brokerage platform to our target audience, the financial professionals.

With a similar purpose in mind we developed the Interactive Brokers Order Management System, for broker/dealer trading desks. This system is now installed on five sites: Bernstein, FBR Capital Markets, GFI, Canter and a large hedge fund, and we are in conversations with other potential users.

In addition to numerous additions and upgrades to our global brokerage platform, I would like to point out two significant steps that we have taken in the past quarter.

As I am sure you have heard there has been a great deal of retention by securities regulators focused on the securities lending market with a demand for greater transparency and centralized clearing model. Quadriserv AQS platform addresses these concerns and we believe it will be a critical component of our total offering that will help fuel our prime Brokerage business. We are just in the process of completing full integration of this electronic securities lending platform into our trading and brokerage system.

Our trader workstation now displays the best borrowing and lending rates that are available in the market for each stock and our customers can now borrow or indicate their own rate at which they would borrow stock. If you want to look at this please remember that the stock loan market closes before 11:00 am. The lending side we are still working on and I expect to bring it online soon.

Transactions are cleared by OCC so that they become the counterparty to each trade the same way as in listed options or in listed single stock futures. Several other large member firms have also joined which will add liquidity to the platform which is key to its success.

Also pending acceptance by Apple we are introducing our complementary free market data service for non-customers on the iPhone. Our customers can already access more store services on the iPhone and now non-customers may also receive market data from over 80 global exchanges, charts, screening and price alert services for free.

The non-customer data is delayed from those exchanges that charge for real time market data, but it is up to the moment for other things like spot foreign exchange quotes and all price alerts. We are currently working on offering the same service for BlackBerry users.

Finally, I’d like to provide an update on our international activities. I’ll reiterate that Asia presents our biggest opportunity for growth in brokerage, where we face little to no competition in terms of servicing in professional traders that seek a global platform and can benefit from best trade execution.

In Japan, although our acquisition of Moriai Securities gave us a jump start in securing exchange membership and licenses and we have just received our membership in the Osaka Exchange. We are still facing some hurdles to becoming a direct member of the Tokyo Stock Exchange.

We opened a representative office in Shanghai last month, although we are not allowed to solicit from here, but it may talk to potential customers who come there and ask the various questions.

In India, we are still working on our membership in the Bombay Stock Exchange and our licenses to provide brokerage services to non-resident Indians and foreign institutions.

We are active on the National Stock Exchange and we are servicing Indian citizens residing in India. I will now turn it over to our CFO, Paul Brody to discuss the financials.

Paul Brody

As usual I'm going to review our summary results and then we'll discuss the segments before we take questions.

Our overall operating results for the quarter as you can see were down from the third quarter of 2008. As a comparison period, the year ago quarter was a time of great market turmoil that drove record trading volumes in all product categories. In addition interest rates were nearly 2% higher than in the current quarter, which produced higher net interest income in that quarter.

Electronic brokerage remains a bright spot as we repeated the strong results of the second quarter. Market Making revenues were down sharply, but were partially offset by a decline in non-interest expense.

The variable costs of execution and clearing were lower than in the year ago quarter, reflecting both the drop in derivatives volumes and a shift in trade volume to products with lower costs or liquidity rebates. Overall operating metrics were mixed this quarter, but were solid in brokerage.

Average overall daily trade volume was 909,000 trades per day, down 7% from the year ago quarter. Market Making trade volume was down 9% in the prior year quarter, reflecting primarily a decrease in listed options volumes for reasons that Thomas discussed earlier.

Electronic brokerage metrics were strong this quarter. The customer base continues to grow as total customer equity increased 43% to $13.4 billion. While volume was off from the near all time high of the year ago quarter total customer DARTs were down 10% and clear customer DARTs were down 9%. Volume from cleared customers who clear and carry their positions and cash with us and contribute more revenue continues to account for about 90% of total DARTs.

Net revenues were $272 million, down 45% on the year ago quarter. Trading gains were $155 million, down 57% from the same period in '08. Commissions and execution fees were $89 million, down 9%. Net interest income was $15 million, down 51% from the third quarter of '08. And other income was $13 million, up 83%, and that’s primarily on a non-recurrence of the write-down in our Hambrecht investment that we took in '08.

Non-interest expenses were $138 million, a decrease of 8% on the year ago quarter driven by lower variable cost. Our aggressive expense management has kept our fixed cost fairly stable. Within the non-interest expense category, execution and clearing expenses were 70 million, a decrease of 16% from the year ago quarter. This reduction in variable cost came from both Market Making and brokerage, as volume shifted towards SOX, where exchange and clearing fees are generally lower and liquidity rebates can be higher.

Compensation expenses were 43 million, a 9% increase from the year ago quarter, reflecting growth in staff count. At September 30, our total headcount was 794, an increase of 9% from September 30 of '08 and 6% from the year end 2008 count. We continue to expand staff at a measured pace, looking to hire talented people, especially in the areas of software development, trading and risk management, and customer service.

As a percentage of net revenues, total non-interest expenses were 51% and out of this number, execution and clearing expense accounted for 26% and compensation expense accounted for 16%. Our fixed expenses were 25% of net revenues which is above our target range and obviously a direct result of lower revenues in the quarter.

Pre-tax income was $133 million, down 62% from the same quarter last year. For the quarter, Market Making represented 55% of pre-tax income and brokerage represented 45%.

This proportion shifted from 82% from Market Making and 18% from brokerage in the year ago quarter, and while this is the reflection of the poor results in Market Making, it also reveals a robust quarter in the brokerage business.

For the third quarter, our overall pre-tax profit margin was 49% as compared to 70% in the third quarter of 2008 and 58% in the trailing quarter.

Market Making pre-tax profit margin was 50%, down from 79% in the year ago quarter. Brokerage pre-tax profit margin was 51%, up from 48% a year ago and we are even with this historical high of the second quarter of ’09. We continue to view this diversification of the revenue streams as a positive development in the long term growth of our business.

Diluted earnings per share were $0.20 per quarter, as compared to $0.65 for the third quarter of ’08 and $0.31 for the trailing quarter.

Turning to balance sheet, the balance sheet remains highly liquid with relatively low leverage. We actively managed our excess liquidity and we maintain significant borrowing facilities through the securities lending markets and with banks.

In response to the credit market environment, we continue to hold a higher level of cash on hand which can be seen on our balance sheet. This provides us with a buffer should we need immediately available funds for any reason. We also continue to maintain well over $1 billion excess regulatory capital in our broker dealer companies around the world.

Long-term debt to capitalization at September 30 was 3.7% which was down substantially from 9.1% at year end '08 and up slightly from the prior quarter. Our consolidated equity capital at September 30th '09 was $4.82 billion.

Now I will turn to the segments, beginning with Market Making. Trading gains for Market Making for the third quarter of '09 were 148 million, down 58% on the year ago quarter. Net interest income from Market Making was 1 million, a decrease of 86% on the year ago quarter, but an improvement from the 5 million net interest expense of the trailing quarter. Net revenues from Market Making were $150 million, down 58% from the third quarter of '08.

Mixed trading volumes, down in options and futures, but up in stock, led to a 10% decrease in the variable cost of execution and clearing, our largest expense category, which amounts to 57% of non-interest expenses in Market Making from the third quarter of '08 to $43 million. Pre-tax income from Market Making was $75 million, down 74% on the year ago quarter.

Turning to Electronic Brokerage, customer trade volumes were healthy, though down 5% from the outstanding level of the year ago quarter. Customer accounts grew by 20% over the total at September 30th '08 and by about 5% in the latest quarter. Total customer DARTs was 340,000 down 10% from the third quarter of '08 and 1% sequentially.

Our cleared customer DARTs which generate direct revenues for the brokerage business was 307,000, down 9% on the year ago quarter and 3% sequentially. Customer equity grew to $13.4 billion up 43% from the year ago quarter and 17% sequentially. The source of this growth continues to be a steady inflow of new accounts and customer deposits and so far in 2009, profit for customers as well.

We believe this reflects the continuing trend of customers transferring their accounts to Interactive Brokers for safety and security, as well as for our advanced execution services. In order to foster this growth, we have developed new software and staff who specialize in the customer on-boarding process and we are achieving higher new customer funding rates as a result.

Trade volumes resulted in revenue from commissions and execution fees of 89 million, a decrease of 9% from the year ago quarter and 1% sequentially. Net interest income fell to 15 million down 27% from the third quarter of ’08. Lower benchmark interest rates have continued to compress this spreads earned by our brokerage unit on customer credit balances.

Average US interest rates, measured by the overnight Federal Funds rate, were about 0.2% during the third quarter of 2009, as compared to about 2% during the third quarter of ‘08. Our net interest income, which historically we have relied upon less than other brokers do, fell to 12% of net revenues from 15% in the year ago quarter. However, this represents a slight improvement on the trailing quarter and our growing customer cash balances positioned us well for any increase in interest rates.

Net revenues from brokerage were $122 million for the quarter, down 10% from the third quarter of ‘08, but up 1% sequentially.

As with our Market Making segment, execution and clearing fees account for a large part 45% in the case of brokerage of our non-interest expenses in brokerage. Based on the mix of trade volumes across product and customer types, these variable costs decreased to 27 million for the quarter, down 27% on the year ago quarter and 1% sequentially.

Total cost of execution and clearing arises from several factors, including declining options volume from non-cleared customers, which is a lower profit margin business. The proportion of customer orders that provide liquidity which results in fee rebates on the exchanges and ECNs, and the mix of options futures and stock. In particular, we saw a sharp 86% increase over the year ago quarter in shares of stock traded by our cleared customers.

Our real time risk management systems operated well during the quarter and there were no unusual errors or reserves for bad debts.

Pre-tax income from electronic brokerage was $62 million for the third quarter, down 3% on the year ago quarter and level with the second quarter of ‘09. We believe the fundamental factors that are continuing to grow our low cost automated brand of brokerage -- and we’re encouraged by the steady expansion of the customer base.

Now, I’d like to turn the call back over to the moderator and we will take questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we’ll go first to Rich Repetto with Sandler O'Neill.

Rich Repetto - Sandler O'Neill

I guess the first question is, it seems from on the market marker there was a couple of things, that if you put it in broad terms, the competition and now spreads being one and then the other thing being -- something that’s in the market -- the actual being much, much lower as a ratio than the implied volatility. And I was just trying to get -- I know you can’t break this out Thomas. But if you had to attribute the lower trading gains to one or the other, which do you think played a bigger factor, just the competition spreads or this?

Thomas Peterffy

If you want to look at the deterioration from quarter-to-quarter, then it’s the volatility ratio was a greater of it. If you want to look at the deterioration from the year ago quarter then it’s the smaller spreads.

Rich Repetto - Sandler O'Neill

Okay. So all in all, if that ratio would have been better you would have seen results probably as good as last quarter there on a very -- the sequential to prior quarter comparison?

Thomas Peterffy

Well, probably close to it. Yeah.

Rich Repetto - Sandler O'Neill

Okay. Okay. And then I'm just trying to see, like you pointed out, spreads did in September start to expand slightly like you predicted. And I was just wondering any big variation in the inter -- the monthly results as far as the Market Making profitability?

Thomas Peterffy

Well as you know, we publish quarterly results and we don’t narrow them down.

Rich Repetto - Sandler O'Neill

Okay, fair enough. I guess my last question is you mentioned this, I know it’s a complex subject but the impact, you said equity went up by 184 million even though the pre-tax was 133 and I know Paul this is not easy to review on, but could you just go through, I'm assuming it was foreign currency translation being the issue and the difference?

Paul Brody

That's right, Rich. We're essentially saying that we hold -- as you know, we target to hold our equity in a basket of currencies, and when those currencies appreciate against the dollar, then our equity goes up. And to the extent that it is our -- the equity of our funds subsidiaries is growing in value then it shows up in the balance sheet according to GAAP, not in the income statement.

Rich Repetto - Sandler O'Neill

So in this particular quarter, it's obviously hurt you in the reported -- on your reported income and pre-tax income and net income. Is that -- if we went back prior quarter, I know we can just look and find the translation, but if we looked at the change in equity and the change in your pre-tax income, I got a feeling it's going to -- they move in different directions, and I’m just trying to see whether this is a bigger differential than usual?

Paul Brody

It did not have a large impact on the income in this quarter.

Rich Repetto - Sandler O'Neill

Okay.

Paul Brody

And we'll as usual report that in the 10-Q.

Rich Repetto - Sandler O'Neill

Understood.

Paul Brody

We wanted to give you a little bit more color in advance.

Operator

Thank you. We'll go next to Chris Allen with Pali Capital.

Chris Allen – Pali Capital

Thomas, you talked about the new rule being put in place by the ISE, but in the last conference call, you mentioned that there was going to be problems in terms of measuring the brokerage measuring high frequency trading customer’s activity. Can you just expand -- you are just thinking change around the ability to measure their activity levels?

Thomas Peterffy

I actually do not know what procedure the ISE is using to identify which trades belong to HFTs. We understand that there is some cheating that goes on, but we also hear that people turn on each others. I don’t have any hard data for you.

Chris Allen – Pali Capital

Putting in another way, it sounds that you have increased confidence so that they will be able to enforce the rule. Is that a fair statement?

Thomas Peterffy

I think that they eventually we will enforce the rule because it goes to their bottom line. So, they will have to. The exchanges compete with each other on share of the US option volume. So it’s very hard for an exchange to swallow the idea that they will go from second place to third place or whatever because those are bragging rights.

On the other hand, the net income, nobody knows, nobody ever hears about because these exchanges are subsidiaries of larger companies and up until the CBOE, if it goes public without becoming subsidiary of the Merc then we’ll hear about it but if the Merc idea goes through, we will never know.

Chris Allen – Pali Capital

Got it. Just one other question, just on the expansion into the corporate bond team and to FX options. I would imagine that these expansions are not very material right now. Is that a fair statement?

Thomas Peterffy

They are not very material right now, but if we carry through with going into the OTC swap dealing, then we expect that to be a substantial business.

Operator

We'll go next to Edward Ditmire with FPK.

Edward Ditmire - FPK

Is the spread dynamics in the Market Making business relatively uniform globally, and can you detail the performance of the US Market Making business versus the international business?

Thomas Peterffy

It is fairly uniform, and I would prefer not to get into breaking out the different geographies because we are already an open book to our competitors.

Edward Ditmire - FPK

I'm sorry if I missed this year. Did you discuss the tax rate? It seemed like an unusually high tax rate this quarter?

Paul Brody

We didn’t it, sorry. As we've discussed in the past, there is an element of the tax expense that comes from the benefit, the tax benefit that is built into our structure that we created at the time of our IPO. The result of that, and I'll try to explain this without being too long winded, the result of that is that a fixed tax expense is recorded in the income tax expense line every quarter. It actually represents a befit that’s being taken in real terms. When the income is lower, as it is this quarter, that fixed number appears to be disproportionately high and that’s what you see in a quarter like this.

Edward Ditmire - FPK

Is there any real reason you think that in the coming quarters, that you're tax experience will be any different than say it was up until this quarter over the last couple of years.

Paul Brody

We have no reason to foresee it changing much. As we’ve explained also in the past that it’s somewhat depended on where our earnings are realized, in what tax jurisdictions as, how they are taxed in the United States, and that does effects what shows up on our income statement.

We have no way to predict that because the way the marketing making operations run on a integrated Market Making around the world, there is somewhat random element as to whether profits are earned here or there.

Edward Ditmire - FPK

I have one question for Mr. Peterffy, it seems like where in the past you’ve talked about the dynamics and spreads as being highly cyclical and due to the nature of that low returns, you know within the competitive landscape and high returns attracted. It sounds like what you are saying right now is that perhaps there is a bigger structure all met to the low returns and that’s why you are prioritizing new markets and new products most of them in the past.

Thomas Peterffy

Well, that is partly, only partly the reason. We are more attracted by the huge profits we see, the big brokers harvesting here, and don’t forget that as our capital approaches $5 billion we have to look at other opportunities. As I have said before there are a number of structural changes that have taken place in these distant market such as the penny quoting and the competition by the HFTs. I can’t forsee how that HFT or professional trader designation will play out but even though I believe that the advantage will be diminished, it will not completely disappear.

Edward Ditmire - FPK

So it sounds like, what you are saying is that there is probably a good deal of upside in the legacy business from where the reversion of some of the cyclical elements that are currently working against you, but perhaps the spread doesn’t get as wide as they have in other points of the cycle in the past?

Thomas Peterffy

We will not see years as good as ‘08.

Operator

We’ll go next to Mac Sykes of Gabelli.

Mac Sykes - Gabelli

If you are going to circle back to the over the counter opportunity, can you just describe as a timing of that, in terms of revenue, is that you think about for latter part of next year, and then what would be some of the requirements, would it be additional personnel, knowledge or technology that you would need to sort of facilitate that what’s the sort of the catalyst for that business?

Thomas Peterffy

Well, if you look at this stock market, basically not a lot we would have to do to our trading system in order to be able to quote them and keep track of positions. What is more unpredictable is where these rules will actually end up.

Now our early information is that the legislation sometime by very early next year based on which stock dealers will have to register and they that they will have to register with the SEC if they are dealing in stocks that are securities based with the CFTC dealing in stocks that are commodities based.

There will also be legislation that will require the SEC and the CFTC to promulgate capital requirement and haircut rules for stock positions on the books of swap dealers within 180 days after the enactment of the legislation. So there also more swaps will be required to be cleared by clearing houses.

So all this adds to a point where what we see is that there has been more transparency in the market that is dealing with stocks and baskets and indexes which we are very, very good at and we're currently dealing with. On the other hand there are also the important capital requirements which very few dealers next to the current swap dealers will be able to meet other than ourselves. So that’s why we feel that this is a logical expansion of our business at this time.

Operator

And we'll go next to John Rowan with Sidoti & Company.

John Rowan - Sidoti & Company

Paul I know you talked about how the variable costs shifted on a quarter or year over year basis, but can you explain why there really wasn't a decline in operating costs on a sequential basis when the revenues were down 20%?

Paul Brody

Well, the primary factor in the decrease is from the variable cost of execution and clearing; so that's exchange fees and clearing fees primarily, little bit things like SEC transaction fees. But it's highly dependent on the actual mix of products because as we described in the past, for example, executing a futures contract has an entirely different expense associated with it, a higher expense than executing 100 shares of stock. In fact executing 100 shares of stock may even generate a rebate rather than a fee.

So there are a number of moving parts in the product sets between options, futures and stocks that have to come together to determine what that blended expense is, and so it was fairly stable, down a little bit sequentially but down more significantly year-over-year, because as you can see one of the reason is a lot of the volume was pushed into stocks.

John Rowan - Sidoti & Company

So the volume switching to stocks, so that's year-over-year. Looking at the quarter-over-quarter, your brokerage clearing expense fees aren't down that much, when obviously your trading volume and your trades were down quite a bit. Was there a shift into a more expensive products versus the June quarter?

Thomas Peterffy

I don't believe our trading volume was down quite a bit from the previous quarter.

John Rowan - Sidoti & Company

Or Market Making trades were down.

Paul Brody

Yes, but remember, the trades are one measure of the volume that is contracts in terms of options, futures and shares in terms of stock; it's a fair measure because that’s where the fees are based on.

John Rowan - Sidoti & Company

Just two housekeeping questions, can you give me the full average diluted share count and also make sure that the ownership is still 10.4%?

Paul Brody

That’s approximately 10.5 and share count is -- if you look in the release, you will see it on the…

Thomas Peterffy

41.9 million to something I remember. I think 41.9...

Paul Brody

518 is the diluted share count, but its….

John Rowan - Sidoti & Company

Yes, but what about the full share account. I mean before that the fully diluted share count was closer to 400 million.

Paul Brody

It still is.

Operator

We’ll take our next question from Milan Gupta with Southpoint Capital.

Milan Gupta - Southpoint Capital

I just want to follow up on the previous question on you guys’ entry into the OTC market. It sounds like a big chunk of that is contingent on some of these rules and legislation coming through. In other words, if they don’t come through that you guys are anticipating, you might not enter those markets.

Thomas Peterffy

I wouldn’t say that. I think that we considering entering these markets and whether the legislation comes about or not, that is not going to be one of the considerations. In other words, if there is no new legislation whatsoever, we will enter into these markets. If this legislation is favorable we will enter. If there is some legislation that makes it prohibitive then we won’t.

Milan Gupta - Southpoint Capital

I guess in the past you’ve been reluctant to enter the OTC market and I understand the legislation would help you get comfortable with the risk parameters around some of these markets. But I guess if the legislation doesn't happen you’re still considering entering. How do you get comfortable, given your previous hesitation to enter some of these markets?

Thomas Peterffy

Well given that everybody is more under the magnifying glass now at least as far as the larger brokers are concerned. I don’t think that the counter party credit risk is as bad as it used to be. Secondly any deal we would enter, it would be the kind where there is an agreement to pay and receive variation margin and marking to market every day. And also even if there is no legislative change on the swap deals right now that occur between US counter parties, there is an initial margin of roughly 10% posted by both sides. So, the counter party credit risk is greatly diminished as things stand today, provided that you are dealing with US entities only.

Milan Gupta - Southpoint Capital

Got it, that’s very helpful. And then secondly, other question I had was just sequentially the cleared DARTs are down, your accounts are up nicely. What do you attribute the sequential fall to?

Paul Brody

The sequential drop in the volumes?

Milan Gupta - Southpoint Capital

In DART's yeah, and on the brokerage side.

Thomas Peterffy

People were very active a year ago and the market was extremely volatile at this time last year and there was a lot of trading. So people roughly were trading twice as much as they do today.

Milan Gupta - Southpoint Capital

No I know, but sequentially I guess?

Thomas Peterffy

Sequentially it’s …what is that?

Milan Gupta - Southpoint Capital

From the last quarter.

Thomas Peterffy

I tell you we have many of our new accounts are financial advisors and they trade substantially less than other accounts, than individual traders or money managers, I mean, like proprietary traders and…

Operator

Thank you. We will go next to MZ, Private Investor.

MZ - Private Investor

Good evening. I would like to ask you to expand a little bit on the issue of share outstanding basic diluted and the number of shares owned by what is called in the balance sheet as non-controlling interest in subsidiaries? And I would also like to understand why the public shares have different value of equity per share than the others?

Paul Brody

Yes. So, the first question on the non-controlling interest, I would point you back to our original SEC filings where there is a diagram on our corporate structure. But I can tell you that our operating company has two owners, one is the public company which owns about 10.5% and then other is called IBG Holdings, which is owned by the private former owners of the whole operating company that is what is represented by what is called the non-controlling interest. GAAP rules actually changed a little bit, it used to be call minority interest is now known as non-controlling interest. But it is the same there.

With regards to your question on the book value, the answer is that the public company’s -- the book value per share is somewhat is higher because again, as I mentioned before, there is a tax benefit that was built into the IPO structure, the tax benefit that accrues to the public company. It is essentially similar to goodwill. It captured overtime and lower taxes paid by the public company.

There is an agreement between the public company and IBG Holding the 90% on it to pay 85% of any tax benefit realized in cash over to the private company as its received, which means that the public company retains 15% of the tax benefits overtime that it otherwise would not have an opportunity to keep. That is the primary reason. That will benefit which will accrue overtime is a primary reason why the public book value per share is higher than what you would compute as the total.

Thomas Peterffy

And there is also in addition, there is, we pay dividends quarterly to the owners of the private company, so that they can pay their taxes and the public company receives dividends too and the dividend exceeds -- so far, have exceeded the public companies tax obligation. So as a result, the public company is sitting on some chunk of cash.

MZ - Private Investor

I see. The second question is whether you intend to release information on the Market Making but of the business monthly, as you have started to release on the brokerage part?

Thomas Peterffy

We will never do that.

Operator

Thank you. We'll go next to Rob Rutschow with CLSA.

Rob Rutschow - CLSA

Hi, good evening. I just wanted to ask another question on the spread information that you gave. It looks like your market share in the US was pretty flat from second quarter to third quarter and I’m sorry?

Thomas Peterffy

It went down a little bit, yeah.

Rob Rutschow - CLSA

Right. So, I guess, I'm wondering if -- historically you've kind of shied away from the activity in the very low price stocks which I feel like made up a bigger percentage of third quarter volume than they did in the second, and you correct me if I'm wrong there. But I guess I'm wondering if that was the dynamic, that was the increase in spreads we saw a result, the increase in spreads that we saw in September, was that a result of less activity in those lower price stocks?

Thomas Peterffy

Yes, that’s partly the result. I mentioned three reasons and that was one of them. You have to understand that a very low price stocks the options are very inexpensive so the spreads are very tight and the tighter the spread, the easier it is for HFT to compete, because as a volume of the contract itself, the spread by itself is a larger amount and then on a very low contract we have to pay something like a $0.20 exchange fee where the penny the spread, bid/offer spread is only a penny wide. So it would be if we had the full size of the market or the time, it's half of the profit of the profit that we paid out to the exchanges. So, it's not a good deal for us to compete in those.

Rob Rutschow - CLSA

Okay. Well, I guess the reason I asked is that I was kind of surprised that your market share was as high as it was given that dynamic?

Thomas Peterffy

Right.

Rob Rutschow - CLSA

Okay. I guess most of the other questions have been asked. It seems like the pace of hiring has slowed a little bit. Is that something we should look for going forward?

Thomas Peterffy

It's not intentional. We are anxious to hire qualified people.

Rob Rutschow - CLSA

Okay. And last question, do you guys generates a significant amount of your Market Making options volume from other online brokers?

Thomas Peterffy

No. We only -- so far we only market make and exchange.

Rob Rutschow - CLSA

Okay, but they don't route and of their volumes to you as far as?

Thomas Peterffy

I can't hear you?

Rob Rutschow - CLSA

They don't use you to access the options markets?

Thomas Peterffy

Well they do execute for certain of their brokers, yes, but that's -- we are not more likely to trade with them than people who execute through other I mean.

Operator

We'll go next to Patrick O'Shaughnessy with Raymond James.

Patrick O'Shaughnessy - Raymond James

I don't think you mentioned this. Have you got an early read -- and I think that 10 or 11 trading days since the ISE mandatory professional designation went into place, has your market share in ISE increased since that's gone into place or is it just too early to tell?

Thomas Peterffy

It's too early to tell.

Patrick O'Shaughnessy - Raymond James

I was worrying that you would answer that with that response, perhaps something that you can address?

Thomas Peterffy

Because I also don’t know to what extent the rules are being followed, and how they are enforced. I know that nobody has been penalized up till now for not following the rules. And I understand from the ISE that they will not levy any penalties in the first quarter of this experiment.

Patrick O'Shaughnessy - Raymond James

And presumably, you haven't seen a very substantial jump in your market share at this early point?

Thomas Peterffy

Not that really jumps out at me, right.

Patrick O'Shaughnessy - Raymond James

Fair enough. And then the second last question I had was, with the SEC talking about banning flash trades, it’s not just in equity markets but also in options markets. Potentially that could impact the traditional pro rata exchanges like CBOE and ISE, where if I recall correctly, you tend to do a little bit better. So is that a market structure issue that also concerns you looking forward?

Thomas Peterffy

We do very little, our participation in the receiving flashes, is very small and we do not -- it wouldn’t impact us if they banned it because you see the idea about flash trading is that some people see the flashes and then they front run it in other markets, which we believes to be illegal and so we’ve never done it. And So I don’t expect that to have any impact on us.

Operator

Thank you, we go next to Justin Hughes with the Philadelphia Financials.

Justin Hughes - Philadelphia Financials

Good afternoon and thank you for taking my question. It’s been a long call, so I’ll try to make it quick. On the OTC clearing, I was just wondering where you are going to source business from because in your Market Making business now you get business when you have the best bid and the best offer on in exchange, but OTC business is usually more of a direct customer facing relationship so?

Thomas Peterffy

The direct customer facing relationship we have, some existing relationships with larger hedge funds that would like to see some competition into marketplace. And so that is where we would be starting.

Justin Hughes - Philadelphia Financials

Okay. I mean is that the handful of accounts at this point, so you don’t…

Thomas Peterffy

Yeah but they aren’t large.

Justin Hughes - Philadelphia Financials

Okay. And then the second question on the OTC trading, the investor-wise, is that kind of peace of mind that all your trading was done on exchange and centrally cleared. And if we look at companies that are kind of similar, that have done OTC trading, whether it be MF or FC Stone and I love the way these products are less liquid and blow ups happen. How can you avoid that where others have fallen into pitfalls?

Thomas Peterffy

Well FC Stone got into the trouble they got into because there were clearing for an option market maker and they didn’t understand options.

Justin Hughes - Philadelphia Financials

Okay, thank you.

Thomas Peterffy

We're talking about swap markets here that are very simple. They are just plain delta trade. Okay, we're done. One more?

Deborah Liston

Thanks. I would like to thank you for participating today. This call will be available for replay on our website and thanks again for your time.

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Source: Interactive Brokers Group, Inc. Q3 2009 Earnings Call Transcript
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