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Executives

Thomas Peterffy - Chairman & Chief Executive Officer

Paul Brody - Group Chief Financial Officer

Deborah Liston - Director of Investor Relations

Analysts

Niamh Alexander - KBW

Patrick O’Shaughnessy - Raymond James

Rich Repetto - Sandler O’Neill

Edward Ditmire - Macquarie

Jen Bullard - SIG

Mac Sykes - Gabelli & Co.

Matt Smith - Alpha Portfolio Management

Rob Rutschow - CLSA

Jim Sheridan - Private Investor

Interactive Brokers Group Inc. (IBKR) Q4 2009 Earnings Call January 21, 2010 5:00 PM ET

Operator

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

Deborah Liston

Thank you. Welcome, everyone and thank you for joining us today. Just after the close of regular trading, we released our fourth quarter financial results. We’ll 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-and-A. Our speakers are Thomas Peterffy, our Chairman and CEO; and Paul Brody, Group CFO.

At this time, I’d 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 is 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 Securities and Exchange Commission. I’d also direct 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

Good evening and thank you for joining us. It is a great pleasure that be bid farewell to 2009, which turned out to be a very difficult year for our market making business, especially on the heels of the prior year in which we achieved record gains. Previously, I cautioned that we were unlikely to see an encore of 2008. 2009 turned out to be significantly worse than we expected.

Despite the lackluster trading gains in our market making operations this year, our electronic brokerage business exhibited exceptional growth that continues to outperform our peers. Overall for the entire company, our annual growth in pretax profits for the past five years has averaged 26% and our profit margin was 50% for 2009. Our total equity capital, built solely on retained earnings, has grown at a five year compounded annual growth rate of 22%, reaching a total of $4.9 billion at year end.

I will now focus on our performance in the fourth quarter for each segment. We will start with market making. During the quarter, the most important factors that influenced our market making profitability continued to move against us, reaching extremes just as they moved in our favor and reaching extremes in the opposite direction the year before.

The quarter we just completed was the weakest in a very long time and certainly since we went public. Our expenses slightly exceeded our income for the quarter in market making. The last such period, I remember when this happened to us was 18 years ago, and I do not think that it is any more likely to happen in the future than it was in the past. I expect that, as we move into 2010, we should see ourselves somewhere in the middle in between the results of 2008 and 2009.

From quarter-to-quarter, our market making results will continue to depend on the behavior of bid offer spreads implied and actual volatilities and volume. The lackluster results in market making in this quarter are largely due to the story of volatility. You may remember that we generally carry a long volatility position. This enables us to supply liquidity in both up markets and down markets as we become sellers in up markets and buyers in down markets.

You may also recall that, when implied volatility shot up above 40 and all the way up to 80 in early 2009, we have abandoned this posture as we expected these volumes to come back down and did not want to suffer the loss that driving down volatilities that a long position would generate. As the volatilities came back down below $40, we began accumulating our customary long volatility positions and by the beginning of the fourth quarter, we were at our usual positions.

At this point, implied volatility stood at $26, and as the quarter unfolded, two things happened. Implied volatilities continued to come down from $26 all the way to $20 by the end of the year, and accordingly, our long positions lost value throughout the quarter and the actual volatility, which is a measure of the actual price changes and determines our trading profits, averaged around $16, while the implied averaged $23.

So while we were spending $23 to replenish our gradually expiring long volatility positions, we received only $16 worth of benefits for them. These two developments are largely to blame for our poor performance in market-making during the fourth quarter. The good news is that we are now near the historical bottom with orderly little volatility under $14. So this is very unlikely to happen again at these levels.

Moving onto spreads, according to data published by U.S. Options Exchange bid an offer spreads contracted roughly 6% compared to the third quarter, which was the smallest quarterly decrease for the year. We actually saw spreads expand in September and October before they revert in November and December. Spreads have been tightening throughout 2009, primarily due to contracting volatilities and increased competition from high frequency traders, vector market makers, but utilize their customers’ status to gain advantages over bona fide market makers.

These advantages include priority at the same price and not having to pay exchange fees. We may be seeing an end to this trend due to new rules implemented up to option exchanges that are designed to measure the activity of high frequency traders. As each of these exceed given volume levels, they are assigned professional traders as we mentioned, effectively removing the priority they currently receive.

The IFC rule went into effect in October and the CBOEs went into effect early this month. As of early January, these traders also have to pay exchange fees just as market makers do. We expect the CLECs to follow soon with similar rules. These actions will help to further level the playing field, giving us a better opportunity to recapture our market share.

The fact that exchanges must impose these rules in order to preserve their fee revenues gives us confidence that they will take the enforcement seriously. Another recent development that may result in reducing HFT competition is the SEC’s proposal to ban naked sponsored access, which currently account for a significant portion of market volume.

Under naked access, high speed traders can buy and sell stocks and options directly on an exchange using a Brokers access code with limited oversight. Often, these brokers are purposefully thinly capitalized, and due to the technological hiccup for just a misconceived strategy, a large loss to occur, they maybe unable to pay the loss. This makes all of us with substantial deposits at the trading houses nervous, and we are glad that the regulators are looking up measures to reduce the likelihood of such happening.

The broker would require an arrangement called sponsor of access, whereby these traders would have to route their orders through the systems over a distant broker and subject them to prepaid checks before routing onto an exchange. This is exactly what we have been interactive brokers do and have always done with all of our customer orders.

The concern among HFTs is that these prepaid checks would increase latency and affect the competitive edge that they previously enjoyed with unfettered access. Smaller firms may agree to the sponsored arrangement while the larger ones may apply to become regulated brokers themselves.

Some will ultimately drop out of the game altogether. All these developments taken together, the loss of priority, having to pay exchange fees, and sponsored access will put our HFT competitors on an even footing with us, which is a significant positive development for us going forward.

As far as global option volumes are concerned, they were relatively flat compared to the third quarter, but rose 8% year-over-year. This of course ignores the ever increasing volume associated with dividend captured trades that would note that by the IFC in a recent statement.

From the published reports of broker dealers, we can surmise that customer trading volumes and options in fact decreased, so that the apparent increase must be due to HFTs. This 8% increase compares with our market making option volume, which declined 3% sequentially and 23% year-on-year.

Our total market share including market making and brokerage, came in at 10.4% globally and 13.3% in the U.S. Another variable that impacts our trading gains is the level of M&A activity, which has been relatively low around the globe in the past year. However, in Q4, this activity jumped to over $500 billion, roughly flat with the year ago quarter, but nearly 50% higher sequentially.

As this activity grows, there’s an increased likelihood that we may trade with others that have more information than we do. We did have some losses associated with corporate announcements during the quarter, but they were not significant. We are encouraged by the SEC’s renewed efforts to curb insider trading.

Now, I will turn to discussing our brokerage segment. Year-over-year, customer accounts increased by 21% to 134,000 at year end, our customers equity grew at a fantastic 71% rate year-over-year and 13% sequentially to a total of $15.2 billion. This is far ahead of the growth rate of our competitors. I attribute this huge surge in customer equity to the reputation we have built as being the best broker for sophisticated, high volume traders that need to attain the best execution price and pay the lowest possible costs.

I’m pleased to say that we have carefully built a steady customer base that takes advantage of our sophisticated trading software and analytics and understands that our extremely low financing rates and trading commissions have a very meaningful impact on their bottom line. This is evidenced by the fact that year-over-year equity per client account grew over 40% to an average of $113,000 per account, even though nearly 60% of our customer accounts are still small, having less than $25,000.

Our customer DARTs have weathered the past year fairly well. Our DARTs decreased only about 3% from last year, but increased 2% sequentially. Our typical, more sophisticated clients are quicker to recover from last year’s shock, and our metrics reflect it. Our brokerage profit margins came in at 48% for the year, compared to 44% in 2008.

Growing our brokerage business is becoming an ever stronger focus for us. We have a huge opportunity here, because we are more automated, we have a better understanding of trading, and we are more globally diversified than any of our competitors. Relying on our superior strength in programming, we were able to position ourselves along a price and automated service continuum where we have no credible competitors.

We want to be the broker of choice for financial professionals all around the globe. Financial professionals need a platform that is connected to all the exchanges and can handle all the tradable products and currencies, one that is inexpensive enough and smart enough to enable them to go after even smaller opportunities and leave them with a profit. We are very far along with having built such a platform, and we are determined to continue building it.

I will now turn it over to our CFO, Paul Brody, who will discuss the financials.

Paul Brody

Thank you, Thomas, and welcome, everyone. As usual, I will start by reviewing the summary results, and then we’ll get into the segments before we take questions. While 2009 was a challenging year to say the least, the numbers show some bright spots along with the dim spots. The comparisons to the prior year make it especially clear that this past year’s sub-par performance followed the most profitable year in our history.

Our net pre-tax profits of $545 million represent a return on equity of 12.4% as compared to 35% in 2008. Nevertheless, our continuing efforts to build the Brokerage business are meeting with success and this diversification has allowed us to weather the downturn in market-making profitability.

Overall operating metrics were again, mixed for the latest quarter, but quite solid in Brokerage. Average overall daily trade volume was 888,000 trades per day, down 2% from the prior quarter and down 1% for the full year versus ‘08. Market-making trade volume was down 34% from the prior year quarter across options, futures and stock trading.

However, electronic brokerage metrics continued at a strong pace with healthy increases in the number of customer accounts and especially in customer equity. Total customer DARTs were down 7% and cleared customer DARTs were down 9% from the year ago quarter, when those measures were at or near their all time highs. Volume from cleared customers, who clear and carry their positions and cash with us, continued to account for about 90% of total DARTs.

Net revenues were $200 million for the fourth quarter, down 53% from the year ago quarter and $1.1 billion for the full year, down 41% from the prior year. Within that trading gains were $75 million, down 75% from the same period in ‘08. Commissions and execution fees were $90 million, up 2%. Net interest income was $17 million, down 8% from the fourth quarter of ‘08, and other income was $19 million, down 25%.

Non-interest expenses were $148 million, down 8% on the year ago quarter and 7% for the full year, driven by lower variable costs and the non-recurrence of bad debt expense associated with customers, who suffered trading losses in 2008. These declines were partly offset by increases in employee compensation and in communication costs.

Our other fixed operating costs have remained fairly stable. Within the non-interest expense category, execution and clearing expenses were $72 million, a decrease of 9% from the year ago quarter. This reduction in variable costs came from the market making segment, where the noticeable drop in volume occurred.

Compensation expenses were $48 million, a 28% increase from the year ago quarter, reflecting our growth in staff count and in part the continued phase in of expenses related to our employee stock incentives plan. For the year, compensation expenses were up 11%. At December 31, out total headcount was 801 and increased at 7% from the prior year end count.

We continue to expand staff at a measured pace, though somewhat slower in the past year than in recent years. We continue to focus on the areas of software development, trading, and risk management and customer service. As a percentage of net revenues, total non-interest expenses were 74%. Out of this number, execution and clearing expense accounted for 36%, and compensation expense accounted for 24%.

Our fixed expenses were 38% of net revenues, well above our target range and the direct result of lower revenues in the quarter. Pretax income was $52 million, down 81% from the same quarter last year. For the year, pretax income was down 56% from 2008. For 2009, market making represented 59% of pretax income and brokerage represented 41%. These proportions shifted markedly from the 82% for market making and 18% for brokerage in the prior year.

For the fourth quarter, our overall pretax profit margin was 26%, as compared to 63% in the fourth quarter of ‘08. While market making showed a small pretax loss for the quarter, brokerage pretax profit margin was 49%, up from 36% a year ago. For the full year of 2009, pretax profit margins were 53% market making and 49% brokerage.

As I mentioned earlier, for the full year, we earned pretax income of $545 million on net revenues of $1.1 billion, as compared to 2008 when pretax income was $1.25 billion on net revenues of $1.85 billion. 2009 full year overall pretax profit margin was 50%, down from 68% in ‘08. Diluted earnings per share were $0.06 for the quarter as compared to $0.49 for the fourth quarter of ‘08. For the full year ‘09, diluted earnings per share were $0.87 as compared to $2.24 for ‘08.

Looking at the balance sheet, it remains highly liquid with relatively low leverage. We actively manage 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 the balance sheet. This provides us with a buffer should we need immediately available funds for any reason.

We also continue to maintain over $1 billion in excess regulatory capital in our broker dealer companies around the world. Long term debt to capitalization at December 31 was 4%, which was down from 9.1% at year-end 2008.Our consolidated equity capital at December 31, ‘09 was $4.88 billion.

Turning to the segments, we will start with market-making. Trading gains for market making for the fourth quarter of ‘09 were $74 million, down 74% on the year ago quarter and down 51% for the full year. Net interest from market-making was an expense of $400,000, a decrease of $11 million from the year ago quarter. Net revenues from market-making were $75 million, down 76% from the fourth quarter of ‘08 and down 53% for the full year.

Lower trading volumes led to a 21% decrease in the variable costs of execution and clearing, our largest expense category, accounting for 55% of non-interest expenses in market-making from the fourth quarter of ‘08 to $43 million. Market-making suffered a marginal pre-tax loss of $3.5 million, versus a gain of $222 million in the year ago quarter. For the full year 2009, pre-tax income from market making was $331 million, down 68% from the prior year.

Turning to Electronic Brokerage, despite the usual fourth quarter holiday period, customer trade volumes were fairly brisk, up in options and prominently in stocks, and down in futures as compared to the year ago quarter. Customer accounts grew by 21% over the total at year end 2008, and by about 5% in the latest quarter. Total customer DARTs were 346,000, down 7% under the hyperactive fourth quarter of 2008, though up 2% from the third quarter of ‘09.

Our cleared customer DARTs, which generates direct revenues for the Brokerage business, was $309,000, down 9% on the year ago quarter, but up 1% sequentially. The average number of DARTs per account on an annualized basis was 597, down 24% from the 2008 period and down 4% sequentially. However, as we attract larger customers, we are observing increases in the average trade sizes across stocks, options and futures. This has resulted in 13% increase in the average commission per DART to $4.36.

Customer equity grew to $15.2 billion, up a striking 71% from the fourth quarter of ‘08 and up 13% sequentially. The source of this growth continues to be a steady inflow of new accounts and customer deposits and to some extent customer profit. We believe this reflects the continuing trend of customers transferring their accounts to interactive brokers for safety and security, as well as our advanced execution services.

In order to foster this growth, we have developed new software and staff to specialize in the customer onboarding process, and we continue to achieve higher new customer funding rates as a result. Trade volumes drove revenue from commissions and execution fees to $90 million, an increase of 2% from the year ago quarter and about 1% sequentially. For the full year, this top line revenue was down 2% from 2008.

Net interest income increased to $17 million, up 29% from the fourth quarter of ‘08. Lower benchmark interest rates have continued to compress the spreads earned by our Brokerage unit on customer credit balances. Average U.S. interest rates, measured by the overnight fed funds rate, were approximately 12 basis points, that’s 0.12% during the fourth quarter of ‘09, as compared to 51 basis points during the fourth quarter of ‘08.

Our net interest income, which historically we have relied on less than other brokers do, rose to 14% of net revenues from 11% in the year ago quarter. Strong growth in customer cash balances has more than offset the compression in spreads, and of course positions us well for any increase in interest rates in the future.

Net revenues from brokerage were $125 million for the quarter, up 5% from the fourth quarter of 2008, and up 3% sequentially. For the full year, net revenues from brokerage were down 6% from the prior year. As with our market making segment, execution and clearing fees account for a large part, now at 44% of our non-interest expenses in Brokerage.

Driven in part by increases in stocks and options trade volume, these variable costs increased to $28 million for the quarter, up 14% on the year ago quarter and 5% sequentially. This increase was also due to higher regulatory fees, and in particular the SEC increased its transaction fee rate fivefold in April of 2009. The rate has been reduced by about half starting this month.

Once again, our real time risk management systems operated well during the quarter, and there were no unusual errors or reserves for bad debt. Pretax income from electronic brokerage was $62 million for the fourth quarter, up 43% on the year ago quarter though down about 1% sequentially. For the full year 2009, pretax income from brokerage was $231 million, up 3% over the prior year.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Niamh Alexander - KBW.

Niamh Alexander - KBW

Thomas, you sound like the quarter kind of almost beat you up there. It was very challenging. Certainly, we weren’t expecting the market making gains to turn out and I appreciate the color, but something you said about as you know, we have to kind of drive our models forward. So anything you can give us helps.

You said you think you’ve kind of bottomed out in terms of the volatility and the spreads coming down, but when we look at the VIX, back in 2006, your trading gains were much higher per contract traded and the VIX was still lower than it is today. So help me kind of triangulate back to why maybe you think things might have bottomed out and could improve from here?

Thomas Peterffy

So I would like to tell you the story again. One, we are long volatility and the volatility has come down. Two, we are long volatility at a high price, and we realize a small reward for the position because we have to pay the implied volatility, when we buy options and we realize the actual volatility, when we trade against it. So as far as 2006, I do not remember what the net movement in volatility was at that time for the actual volatility related to the implied volatility.

Niamh Alexander - KBW

So for example, if volatility continues to fall and you would still be applying the same strategy in the quarters ahead?

Thomas Peterffy

Anytime volatility falls, we will take a loss on our long volatility position. When it rises, we take a gain on our volatility position. When the actual volatility exceeds the implied volatility, we generate a trading gain in excess of what we pay for the volatility. When it’s the other way around, when actual volatility is lower than the implied volatility, our trading gains will not measure up to the amount of money we spent on acquiring the long volatility position.

Niamh Alexander - KBW

So we should not expect any change in how that works, even if volatility continues to decline. How do you feel about the competitive situation? You’ve explained competitive situation, but I just wanted to understand. Do you feel that the new rules because IFC put them in place already in October and they’ve been in place for a few months now, but you think that could help maybe expand the spreads a little bit as more of the exchanges put that into effect?

Thomas Peterffy

I’m pretty sure that they are doing away with the priority for non-market makers and doing away with the priority for professional traders and charging them exchange fees is going to force them to quote a little wider, and as a result quote in the market will become wider and they have become wider.

Niamh Alexander - KBW

Then you talked about the M&A environment, and we’re kind of seeing a lot more even so far into this year. That’s typically not as favorable for your business. Could that be enough to offset the spread maybe coming back from the leveling of the playing field, do you think? Is it still relatively small in comparison to kind of heat it is three years ago?

Thomas Peterffy

That would be tough for me to speculate in big merger announcements that are being front run by insider traders we have of times looked as much as $5 million a pop. So if you have some of those happening, then that could be all money.

Niamh Alexander - KBW

You didn’t think there was any unusual amount of that even in the last quarter as activity picked up a little bit?

Thomas Peterffy

As I said, there was some, but it was not significant, and as I also said, I think that people will now think twice about front running insider news, given what’s happening with the SEC going after these people in a much stronger manner than they used to.

Niamh Alexander - KBW

If I could just ask real quickly on the brokerage before and jumping back in the line, how about acquiring growth in the brokerage space? Because, you’ve got this great platform and very suited to the active traders, and is that something that maybe we might see a little bit more of in the years ahead?

Thomas Peterffy

No, I don’t think that there are too many folks out there. Ameritrade usually buys them anyway. We would never pay as much as what they are willing to pay. We would rather invest in our own technology and grow the business internally, because we think that’s a better deal.

Operator

Your next question comes from Patrick O’Shaughnessy - Raymond James.

Patrick O’Shaughnessy - Raymond James

So my first question, can you help me understand the difference between your market making profitability in the third quarter and the fourth quarter? I know you’ve kind of gone through the key drivers, but as I’m thinking through the third quarter, we had falling volatility, we had actual volatility being less than implied volatility and we had tight spreads.

Those are the same exact three things that we saw in the fourth quarter and yet your market making gains were a lot lower than they were in the third quarter. So if you can kind of help me understand the difference, I think that would be appreciated.

Thomas Peterffy

Yes. As I said, going into the third quarter, we were close to being flat volatility, because the volatility was coming down from 80 to at that time around 40 or so, right? So when it got below 40, we started gradually acquiring volatility throughout the third quarter. So, we weren’t as long volatility as we usually are. Therefore, we didn’t lose that much money on the volatility coming in further, and we didn’t lose that much money on having paid for the implied rate and realizing the actual rate.

Patrick O’Shaughnessy - Raymond James

My next question was I’ve heard different quotes for the equities markets that naked sponsored access might be 20%, might be 30% of order flow. I haven’t seen any numbers out there for options. My sense would be that it would be a lot smaller percentage than an equities space, but I was curious if you had any insights as to how substantial naked sponsored access is in the options marketplace right now?

Thomas Peterffy

I’m sorry to confess to you that I don’t know.

Patrick O’Shaughnessy - Raymond James

My third question and then I’ll jump back in the queue is, it looks like you guys continue to hire, you continue to invest in the business. At what point would you start to look at cutting costs? Would it take for you to say, we think the market making business is permanently impaired, to start looking at some cost reductions?

I guess the follow up to that would be, at what point do you say the market making business is permanently impaired, versus we’re just going through some tough times, it’s cyclical and it’s going to bounce back?

Thomas Peterffy

I do not think that the market making business could ever be permanently impaired for us because of the technology that we have in place and others do not. So at times and we do not do well for an extended period of time, others must be doing even worse. As a result, they are more likely to leave the business before we would and when they do so then the business becomes more interesting again.

Secondly, we are committed to hiring people and building our brokerage business, and that seems to be working extremely well. I can’t see any reason, why we would ever think that business is something that we do not want to drive as hard and invest in as much as we do.

Operator

Your next question comes from Rich Repetto - Sandler O’Neill.

Rich Repetto - Sandler O’Neill

Paul mentioned this for heat the broker, when rates comedown, the results are sort of asymmetric. You make less net interest income because the spreads get narrower. I guess when we look at your market making business, the question I have, is it that simple that it is asymmetric when you have volatility declining?

There isn’t a way for you not to be long volatility? Like if we actually looked back at your volatility and your pretax income all the way back to ‘02, and it does look, when volatility is falling, your results aren’t as well. Is there no way to improve on that asymmetry?

Thomas Peterffy

I don’t think we want to because you see as volatility goes down, as I said before, it very rarely ever goes below 14. We never want to be in a situation when the market acts up and we are short volatility. We will never stand there and lose billions of dollars like some of these big trading outfits have because they’re just funds. They’re sometimes long, sometimes short, again that most of the time they make money because they trade against customers, but we just simply don’t want to do that. We will always be long volatility, when volatility is at a reasonable level.

Rich Repetto - Sandler O’Neill

I guess, but you’re saying you don’t want to be shorted, either. Like when it was at 40, you wouldn’t be shorted; you just wouldn’t take as much risk. Is that…?

Thomas Peterffy

That’s correct. You see, ultimately it is our money and we are not about to lose it.

Rich Repetto - Sandler O’Neill

Moving on then, the next question is the volatility thing that hopefully is a cyclical thing, but we haven’t mentioned the Penny Pilot on the call. I’m just trying to see. Is there anything secular at least on the spread side of this because of the latest phase of the Penny Pilot? Is it secular drive or are going to keep spreads down longer or historically lower than before?

Thomas Peterffy

I would be surprised if spreads would go any lower than where they were in the fourth quarter.

Rich Repetto - Sandler O’Neill

Last question, so you talked about the professional trader and the ISE and the CBOE spots. You talked about some pretty good regulatory things that could help you out, regulatory tailwinds, let’s say. Are there any regulatory headwinds? Like for example, is there anything that, regulation looks like it could help you, but I’m just trying to make sure we’re covering all like short sale rule or Flash or anything like that. Is there anything in the works that could possibly be a headwind?

Thomas Peterffy

No, the Flash or the short tail wouldn’t impact us in anyway. What would kill our business would be the transaction tax.

Operator

Your next question comes from Edward Ditmire - Macquarie.

Edward Ditmire - Macquarie

You had said earlier in the call that you believe in 2010, you can get to a level of income from the market maker somewhere in between the levels of ‘08 and ‘09. Do you believe you can hit that with spreads where they are today, absent any more headwinds in terms of implied actual volatility or falls in volatility? Meaning can we get to those numbers with spreads where they are today?

Thomas Peterffy

Yes.

Edward Ditmire - Macquarie

Then question on the brokerage if I could, are the new account that you rated in 2009 of a similar type of trades per account potential of your legacy accounts? When I look at the trades per account falling in 2009, do you believe that that’s simply a function of a less volatile market, or else you add accounts? Are you adding different kinds of customers that might just trade less?

Thomas Peterffy

Well, that’s both. On the one hand, we had a much more quiet market, so people did trade less, but we also have started to market our platform to registered financial advisors, and we have had some success in that area. Those customers are they are not professional traders even though they are advisors in fact is a perfect financial professional, so they do not do as much trading as our regular customers do. So, that is part of the reason why you see a drop in trading volume per account.

Edward Ditmire - Macquarie

Then one last question, could you answer the question? Just someone was trying to do some of the parts valuation. How much liquid financial capital, meaning how much cash does the Brokerage segment need to operate? I know you’ve disclosed the regulatory requirements, but also most brokers have a certain level of cash in excess of that they wouldn’t feel comfortable breaching.

Thomas Peterffy

I don’t think it’s an issue of comfort. We would like our customers to feel comfortable, so we currently have $1 billion of equity in the brokerage company itself. I think that is about right.

Operator

Your next question comes from Jen Bullard - SIG.

Jen Bullard - SIG

I just had a question regarding the topic of spreads. I was hoping maybe to get your thoughts on penny quoting, maybe a little bit more color on that, just given that the next wave is coming over the next month or so on several stocks. Do you have any outlook on that and how that might impact you?

Thomas Peterffy

The clauses that we’re going to pennies will certainly be somewhat tighter than they were before, but I do not expect the options going to pennies from here on to have a substantial impact on the overall business.

Jen Bullard - SIG

Then I just had a follow up question related to your comment on hiring in the Brokerage area. Is that expansion more targeted to institutional accounts or retail type accounts?

Thomas Peterffy

You mean is the hiring targeted to institutional accounts?

Jen Bullard - SIG

Right or more towards retail? I guess where is sort of your target area for growth there?

Thomas Peterffy

So you’re talking about customer service people?

Jen Bullard - SIG

Yes.

Thomas Peterffy

You see, the way we’re building this business is that we’re bringing young people into customer service and we have them start at the retail level. As they learn more and more about our platform, we move them up into the higher and higher level of customers. After they have gone through that, they can go into sales or technology or whatever they are good at.

Operator

Your next question comes from Mac Sykes - Gabelli & Co.

Mac Sykes - Gabelli & Co.

Can you just go over some of the factors that drive the ratio of implied VaR to actual VaR? Are some of those factors, have they changed in secular fashion in last year or so? Then just to follow up on that, can you quantify how much risk is involved in market making?

I guess something more on the order of, is there an average daily VaR that we can think about? Then just one more derivative to that is there a point where you can just eliminate all your positions if you decide that VaRs going not your way, or does it really take a couple of days to undo that?

Thomas Peterffy

To answer the VaR question, our VaR is slightly under $30 million. Whether we could eliminate all of our positions if the world didn’t go in our favor, I can’t conceive of having to do that. We run a much hashed position as far as at least delta and gamma is concerned, other than our volatility exposure. If the volatility doesn’t go in our favor, if we wanted to change our position, we could change it, rather than eliminating it. So I don’t quite know how to take that question. Your first question was…?

Mac Sykes - Gabelli & Co.

Sort of the factors that drive…?

Thomas Peterffy

The implied volatility, I assume is driven by fees. It’s driven by expectation of people. On the first hand, it is the people’s expectation of how the market will move, because the actual volatility actually is a reflection of how much the market moves minute-to-minute or hour-to-hour or day-to-day or week-to-week.

The implied volatility is people’s expectation of the actual volatility, plus either fear or greed factor. The fear factor makes it when everybody wants the insurance, then they buy it up, and when people feel good about nothing much can happen, then they just sell volatility sell options into the market.

So for example, I now recall the correct answer to Niamh’s question that in the 2006 and 2007 right into 2008, a lot of people showed their option sellers because there were a lot of funds that did buy rights and individual investors used to do buy rights. So there was an oversupply of options. As a result, we were able to run a long option position of implied volatilities that were a little bit lower than actual volatilities. So that’s basically the answer to your question.

Mac Sykes - Gabelli & Co.

Just customer account growth, can you provide some color on where you’re gathering the most customers, I think more on a global basis? Are you seeing the most pickup in Asia, Europe, Japan, I guess more color ex-U.S.? Then my last question was just could you provide an update on Quadriserv? What’s your opinion of customer adoption and are you seeing any material revenue there?

Thomas Peterffy

As far as new customers, new customer inflow has been from outside the United States more than 50% of new customers come from outside and that evolved to an extent where today, as of the end of the year, very, very slightly more than 50% of our existing customers today are non-U.S.

The large were non-U.S. customers come from are Hong Kong and China combined, Canada, Germany, and then the other European countries. As far as Quadriserv is concerned, Paul is on the Board of Quadriserv, so he knows a lot more about this than I do, so I’ll ask him to respond to your question.

Paul Brody

Of course, I won’t be disclosing anything that a Board member knows anybody else does, but Quadriserv, as you know, has a securities lending platform called AQS. It clears through the Options Clearing Corporation, so it operates as a centralized marketplace. It went online in last May of ‘09. It is gathering participation amongst broker dealers, agent lenders.

Agent lenders are primarily large banks providing trust services to institutional clients and other participants such as hedge funds who want to reduce the fees they currently pay to their prime brokers. The regulatory environment is quite ripe for an exchange in the central clearing model for securities lending.

We think there are a number of reasons it should succeed, including it will reduce the credit exposure and systemic risks. It should reduce the costs with a transparent price discovery mechanism. There’s regulatory pressure to move away from the OTC market, so we’re solidly behind it.

Operator

Your next question comes from Matt Smith - Alpha Portfolio Management.

Matt Smith - Alpha Portfolio Management

I also would like to understand a little bit about what type of customer gets attracted to interactive brokers. Can you give some metrics, like a percentage of accounts that is under portfolio margin, a percentage and how many choose unbundled commission, and particularly how many accounts use IBR goods?

Thomas Peterffy

How many accounts use IBR goods? I don’t know the answer. I know the answer to the scale creator and the accumulate distributor because those are my babies and I watch that very closely and somewhat over 200 customers use those two outgoings. As far as portfolio margin is concerned, approximately a third of our customer money is in portfolio margin accounts. I do not know how many customers that belong to. I would expect, do you know, Paul?

Paul Brody

5,600.

Thomas Peterffy

How many?

Paul Brody

5,600.

Thomas Peterffy

5,600 customers; unbundled commissions, I don’t know. You see, all of our option customers are none of our foreign customers were unbundled, which is 50%, up until just two weeks ago when we introduced unbundled commissions in Europe and Asia, but they were able to avail themselves of unbundled commissions in the United States. I’m sorry I can’t give you a clear number.

Matt Smith - Alpha Portfolio Management

There’s one thing you like to attract short sellers, yes. They are basically good for IB business. What I would like to have an understanding, it seems as if, in December, there was a slight policy shift in the way the borrow fee gets calculated. Sometimes it was taken the stock price and quantity and fee and that’s it, yes.

It changed to the industry norm of rounding up to the next integer, which is nothing one shorts goggle into these things, but especially with stocks well below $1, this is like a fee increase. Yes?

Thomas Peterffy

I think we know the answer to your question. Paul.

Paul Brody

It’s a very simple answer, which is with more and more stocks trading at lower and lower prices and those being the stocks that tend to attract the short sellers. This industry convention put us in an awkward situation, which is we would have to put up more collateral effectively than our customer was. To the extent that you pay a fee to borrow those hard to borrow stocks, we ended up may pay more fees than our customer paid. So we simply lined up the customer with the industry convention and everything is in line now.

Matt Smith - Alpha Portfolio Management

One last question, once you said the growth rate for the brokerage business you would put at 50% and for market making 15%. Given 2008, 2009 would you pick different numbers today? I think this question goes to Thomas Peterffy.

Thomas Peterffy

My numbers are the same.

Matt Smith - Alpha Portfolio Management

You stick with these numbers long term?

Thomas Peterffy

Yes.

Operator

Your next question comes from Rob Rutschow - CLSA.

Rob Rutschow - CLSA

My first question relates to the long volatility position. In terms of the way this works on the income statement, is it sort of amortized or is it more of accounted for like a trade? So in other words, if implied volatility is it remains below actual volatility, would that generate additional losses in future quarters…?

Thomas Peterffy

It’s part of trading gains.

Rob Rutschow - CLSA

All else being equal though going forward, if we had the exact same level of actual and implied volatility in the first quarter, that wouldn’t have any impact, negative impact, on trading gains?

Thomas Peterffy

It would have a negative impact on trading gains always; it is part of trading gains. Trading gains are still positive because of course we make money by buying from sellers and selling to buyers, the differential which is the spread. Obviously, when the market is running up, there are more buyers.

So we are a net seller, and when it’s falling, there are more sellers, so we are a net buyer. That is the reason why we have to be long the volatility. So it is part of whatever the debt differential between actual and implied volatility, whether that makes us money or loses us money to the part of our trading gain.

Rob Rutschow - CLSA

Then historically, have there been periods where implied volatility has remained well below actual volatility?

Thomas Peterffy

As I recall in 2006 and 2007, they were slightly below.

Rob Rutschow - CLSA

The last question is just related to the ownership of the company. Are there any thoughts to taking the company private at this point? I mean, with stock close to book value?

Thomas Peterffy

No.

Operator

Your next question comes from Jim Sheridan - Private Investor.

Jim Sheridan - Private Investor

I wondered if I could get an update on your efforts to develop the OTC markets. You talked a little bit about the Quadriserv model for securities lending, but it would appear that President Obama has shifted his focus back to financial reform. What is the chance that we move towards bringing some of these OTC markets into a central clearing and onto centralized exchanges? What is your progress to be prepared for that if and when it happens?

Thomas Peterffy

We have been busily investigating this area and coming up with various ways of establishing ourselves in the business, mostly spending some legal fees, but lately we have been bombarded by news every day about this change or that change or the third change by the regulators. I think that the situation is much too fluid to do anything in this area unless we know the landscape we are going to have to operate in.

Jim Sheridan - Private Investor

Could I also just go back to understand, how the ISE and CBOE characterize a high frequency trader as a professional trader, you mentioned a trigger and I didn’t hear what you said.

Thomas Peterffy

If a trader in any months makes more than 390 orders on the average day. It’s going to be characterized as a professional trader in the sub segment quarter.

Jim Sheridan - Private Investor

In the third-quarter results, Thomas, you had said that the ISE’s change was going to affect the priority of the professional trader but he would not have to pay exchange fees. I think you said today that both the CBOE and the ISE have moved to not only eliminating the priority status, but also charging exchange fees. A, is that correct? B, why have they changed their attitude here on liquidity and volume?

Thomas Peterffy

Number one, it is correct. Number two, they have changed this because as customers do not pay exchange fees and then HFTs are creating with customers, the exchange doesn’t generate any revenues. So to the extent the HFT has a higher priority, it comes ahead of the market maker.

The more of them there are, the less the market maker stays and the market makers are the only ones or were the only ones before this rule changes that pay the exchange fees. So the exchanger revenues were going down and they sooner or later had to do something. So that’s what they did.

Jim Sheridan - Private Investor

Are you seeing evidence of enforcement of these new rules?

Thomas Peterffy

They will enforce these rules because, if they don’t, they will not have revenues and they will lose money.

Jim Sheridan - Private Investor

The last question, just to go back to Ed’s earlier comment and your start off by saying that the three big drivers for the company are volumes, volatilities both absolute and relative, and bid offer spreads. It sounds like of the three, volatility is by far and away the most important driver.

Thomas Peterffy

I wouldn’t say that. I think that if there’s zero volume, there’s no profit. If there’s zero spread, there’s zero profit. So no, in this quarter, volatility had a larger impact than the other two, but I generally wouldn’t say that.

Jim Sheridan - Private Investor

As a result of the weaker bid offer spreads in November and December, and these very low levels, which you I think said earlier mark the low in your view, for the spreads, are you seeing evidence that some of your competitors are exiting the business?

Thomas Peterffy

Only hearsay.

Operator

Your next question comes from Edward Ditmire - Macquarie.

Edward Ditmire - Macquarie

Just one follow-up question, would you be able to estimate what the cost was of the long volatility position during 4Q ‘09?

Thomas Peterffy

I would think it was $70 million to $80 million.

Operator

Your final question comes from Rob Rutschow - CLSA.

Rob Rutschow - CLSA

One more follow-up on the volatility as well, is it possible to estimate the duration of the long volatility position?

Thomas Peterffy

You could say that our volatility position is generally about 2.5 months forward, but it can move around that.

Operator

At this time, we have no further questions. I’ll now turn the call back over to management for any additional or closing remarks.

Deborah Liston

Thank you. We would like to thank everyone for participating today. This call will be available for replay on our website. Thanks again for everyone’s time.

Operator

This does conclude today’s conference. Thank you for your participation.

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Source: Interactive Brokers Group Inc Q4 2009 Earnings Call Transcript
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