Advancing the Evolution of Online Trading
On the surface, Interactive Brokers Group appears to be a run-of-the-mill proprietary trading fund – just another market-maker that seeks profit from buying and selling stock options and futures.
What’s not apparent is that this company is making its breakthrough routing technology available to the public. The secret weapon: a trading platform that will allow retail and institutional investors to conveniently trade futures, options, bonds, and equities on exchanges around the globe.
The key is in the Universal Account feature, which automates most of the currency conversions and back-office functions that normally make trading on multiple exchanges tedious. Through the Universal Account, the trader can seamlessly move cash between a futures trade to a stock trade, and use foreign exchanges such as the Hong Kong Exchange. Never before has trading such a wide variety of securities been so simple.
Interactive Brokers’ automated system allows it to undercut the pricing of many discount brokers such as TD Ameritrade. In 2004, Interactive Brokers created unbundled pricing packages, on which retail investors can make trades for just under a penny per share.
I consider Interactive Brokers to have the next step in the evolution of online trading. They are ahead of the trend, ready to capture a new kind of retail investor - many of whom may be foreigners and cash-flush retired baby boomers seeking to take their stock market endeavors to the next level. At currently 82,000 brokerage accounts, there is plenty of room to!
grow compared to TD Ameritrade’s 2.3 million accounts.
Option Tick Change Beneficial
At its roots, Interactive Brokers is a trading firm. The majority of its revenue comes from market making; a type of trading that involves setting the bid and ask price on a security, hoping to make a profit on the difference.
As the largest stock options market maker with 20% of all options trades in the US, a major concern is an upcoming change in the options market. Recently the SEC has been experimenting with allowing penny ( 0.01) ticks, versus the current 0.05 ticks. The worry is that a smaller tick will lead to smaller spreads and smaller profits for Interactive Brokers’ trading division.
According to data from Sandler O’Neill & Partners, initial results show that the loss caused by the smaller spreads is offset by an increase in trading volume. In fact, I believe that IBKR may stand to benefit from the smaller spreads for the following reasons:
1) Competitors will have lower payment for order flows. PFOFs are discounts, offered by exchanges to give incentive for traders to use their exchange over a competitor. With smaller spreads, PFOFs will also narrow, giving Interactive Brokers a chance to grab more market share of order flow.
2) Institutional Traders will have more difficulty managing. With small ticks and less profitability, automated systems become more prevalent and orders tend to become smaller. Interactive Brokers has the infrastructure to adapt easily.
3) Smaller ticks are friendly for retail investors. Interactive Brokers is well positioned to benefit from a boom in the retail investors’ interest in options.
A Culture of Cutting-Edge Technology
The success of Interactive Brokers is owed to its founder, Thomas Peterffy. A refugee from Communist Hungary, he fled to the United States to become a self-made billionaire. In 1972, he was the first trader to bring his own computer to the floor of the American Stock Exchange. Since then and the inception of his companies, technology has remained a critical element to success.
The adoption of new technology and efficiency has allowed the company to run a low-cost platform. While many other brokerages’ biggest expense is commission, Interactive Brokers’ has kept such costs low through smart order routing systems. Technology such as its API interface has also allowed clients to develop their own software for maximized use of the routing system.
Finally, Interactive Brokers is well positioned to benefit from new trends in the derivatives market. Recently they made a significant investment in OneChicago, an all-electronic exchange for single stock futures. As this new class of derivative grows in popularity, so will Interactive Brokers.
A Word of Caution
Despite the tremendous long term strengths of this company, the first half of 2007 has been rough for Interactive Brokers. Q1 had disappointing market making results, blamed on “certain trading ahead of corporate announcements.” Last week the company announced a $37 million loss from Q2 due to the alleged illegal manipulation of Altanta AG stock.
On the Q1 earnings conference call, Peterffy noted a trend that hedge funds have been competing against market makers. He does not expect this to continue because exchanges do not receive fee revenues from these outside traders, but the short term impacts of this trend are uncertain.
Although these recent issues appear to be short term, investors cannot be certain whether similar problems will occur in the future. Market makers are particularly susceptible to damage from schemes such as Altana AG. A lack of transparency over the company’s trading situation may be masking even more unseen risks.
Currently down 20% from the IPO price, the stock has been hammered over the trading losses in Q1 and Q2. I think the market has overreacted to these short term events and is overlooking the long term possibilities. Now may be the best buying opportunity for this stock.
According to the Sandler O’Neil estimated EPS is $1.32 for 2007 and $1.58 in 2008, IBKR’s current forward PE is below 20. Compared to other growth stocks and exchanges, that’s a steal. Nymex (NMX) currently trades close to a 33 multiple and the Chicago Mercantile Exchange (CME) and IntercontinentalExchange (ICE) just below 30.
Using 2006’s book value of $2.8 billion, IBKR currently trades at a dilutive price/book value just below 3.5. When valued as a bank, it seems expensive compared to other trading firms such as Bear Stearns at about 1.6 and Goldman Sachs at 2.5.
Long Term Risks
The biggest threat Interactive Brokers Group faces is the competitive nature of the derivatives markets. Competitors’ technology can improve and there is always the possibility of new entrants into the market place. With high market share in the US options market, Interactive Brokers has much to lose if other institutional market makers up their game.
Much of my support for this stock is because of the uniqueness of its Universal Account system. If other brokerages begin to replicate it and begin offering access to international exchanges, that could be problem.
Finally, the company’s future success relies on the management of Thomas Peterffy, who holds a 90% controlling stake. This also makes Interactive Brokers an unlikely takeover target, despite its rich level of cash. However, considering that Thomas Peterffy has done so well building this company from scratch and is considered by some traders as one of the smartest in the field, I think the potential upside outweighs any short term risk.
Disclosure: The author has a long position in IBKR.
IBKR 3-mo chart: