Interactive Brokers' CEO Discusses Q2 2012 Results - Earnings Call Transcript

Jul.17.12 | About: Interactive Brokers (IBKR)

Interactive Brokers Group, Inc. (NASDAQ:IBKR)

Q2 2012 Results Earnings Call

July 17, 2012 4:30 PM ET

Executives

Thomas Peterffy – Chairman and CEO

Paul Brody – Group CFO

Deborah Liston – Director, Investor Relations

Analysts

Chris Harris – Wells Fargo

Rich Repetto – Sandler O’Neill

Chris Allen – Evercore Partners

Ed Ditmire – Macquarie

Justin Hughes – Philadelphia Financial

Niamh Alexander – KBW

Matthew Heinz – Stifel Nicolaus

Mac Sykes – Gabelli & Company

Operator

Good day, everyone. And welcome to the Interactive Brokers Second Quarter 2012 Earnings Results Conference Call. This call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call 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 second quarter financial results. We’re going to 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.

I just want to remind everyone that today’s discussion may include forward-looking statements. These statements represent the company’s beliefs regarding future events that by their nature are not certain and outside of 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’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

Thank you for joining us this afternoon. Our performance in the second quarter reflects a combination of positive trends in brokerage growth and slightly better market making conditions that were weighed down by unfavorable currency movements and diminishing investor participation.

In our Brokerage business, we continue to attract accounts and grow customer equity at a faster rate than our peers and our customer trading activity is outperforming the industry. Trading volumes on global exchanges have been sluggish for several quarters now punctuated by some big but unsustainable rebounds. Our customers remain fairly active and their trading volumes are growing.

This quarter total customer DARTs, on Daily Average Revenue Trades grew 5% compared to the year ago quarter, where it is 4% decline in OCC volumes.

Customer equity is up 11% year-over-year exceeding the growth rate of other E-Brokers that we compare ourselves to. And while not a direct proxy, the S&P climbed nearly 6% during the same period.

We must point out though that trading volumes are not growing at as higher rate as number of accounts or customer equity. So that the annualized DARTs per account are now down to 507.

This is largely due to the greater inroads we are making in the registered financial advisors space, where accounts do not change positions as often as rogue traders or hedge funds or even individual investors.

While our Brokerage business is weathering the current environment quite well, we continue to witness events that further erode investors trust in the capital markets and their faith in long-term investing.

This quarter alone has had its share of issues, including high profile overpriced IPO and technical trading which issues at NASDAQ, the massive trading loss at JP Morgan, the LIBOR rate rigging scandal among top banks and the latest futures broker bankruptcy and misappropriation of customer assets. These are just the recent hits the financial sector reputation has taken.

Add to these, the SEC’s recent approval to a allow sub-penny pricing by the exchanges which will further reduce displayed liquidity as well as ever growing conviction by the public that the markets are rigged and unfair to individual investors and you can see the troubles our industry is facing.

However, we do see some clear opportunities ahead. Not more than other investors are looking for a secure place to put their money, even if they are uncertain for the time being where to invest. We see this especially in Europe, where we have started an advertising campaign in certain countries encouraging investors to place their money with Interactive Brokers.

With this recent downgrade of 15 major banks has also helped our case. We continue to emphasize our A minus credit rating from S&P in highlighting our strengths and security relative to other brokers, as well as our strong capital position, conservative balance sheet and aversion to risk.

This latest future broker collapse is unfortunate and yet another reminder of the importance of selecting a well capitalized broker with sound practices for protecting customer assets and automated risk controls. I highly recommend you take a look at our Strength & Security page on our website, which discusses this in further detail.

We are also seeing an increasing awareness by investors over the conflicts of interest that exist between online brokers and their clients with respect to order routing practices. We have always been very outspoken about the importance of understanding where your orders are sent when it comes to choosing the right broker.

We pride ourselves in offering to our customers the best site execution and stand behind the statement with third-party audit results which show that IB consistently exceeds the industry in price improvement.

This is because most orders, like those placed through the large e-Brokers are sold to other firms, who internalize and trade against the orders, or are routed to exchanges are offering rebates, but often at an inferior price. In most cases brokers keep this rebates, however, IB passes rebates along to customers that choose our cost plus pricing structure.

All of these differentiators including the fact that Barron’s has ranked us number one electronic broker for our low cost and state-of-the-art technology by driving out strong account growth.

Our total customer accounts have reached 200,000, a 14% growth rate year-over-year. While this annual growth rate has fallen into the teens since the start of this year versus the consistent 20% growth rate we have experienced last year, I will mention that it significantly outpaces the growth rate of the large e-Brokers which fall into the single digits.

We generally find that monthly account adds are correlated with trading volumes. Of our 200 -- of our 200,000 customers, 20% are financial advisors, one of our fastest growing segments. Registered Investment Advisors or RIAs are drawn to our low cost platform and advisor specific trading tools like our trade allocation software. We are diligently working to improve existing technology and develop new useful tools for RIAs.

Our model portfolio tool is our latest innovation for financial advisors, which we have just launched this year and it incorporates valuable feedback from our most active advisor clients in its development.

This technology allows advisors to create virtual in-house mutual funds by grouping instruments into models, based on specific investment strategic criteria and to invest client funds into these advisor-constructed models. By simply trading the assets in the model, the advisor avoids having to trade for multiple client accounts separately.

We also believe a unique feature of our model portfolio technology is that our models can have dynamic or static target percentage allocations. Satisfied IB customers serve as our most successful marketing too even more so than our print and media efforts.

Growth of marked referrals by satisfied customers continues to be our strongest driver of new account growth, so we recently introduced a referral program to reward our customers for attracting new accounts to IB which has seen a positive early response.

Key strategy in growing our Brokerage business has always been to offer our customers the best technology with sophisticated trading tools at the absolute lowest cost. This was the driving theme behind our introduction of IBIS, the IB Information System which provides a comprehensive set of research and analytical data similar to that provided by Bloomberg or FactSet.

We initially offered this platform to both customers and non-customers at the fraction of the cost of similar research terminals. The response to-date has been very positive. In fact, we believe that this will be a major driver of new account growth and so we decided to unlock the true value of IBIS and to make this platform free to all customers.

By having instant access to IBIS as a component of our trading platform, we believe that this will not only attract more customers to IB but also drive existing customer to subscribe to premium research data that IBIS offers like Reuters, Dow Jones, Morningstar, Fly on the Wall to name just a few, to take advantage of more trading opportunities and to ultimately be more successful traders.

We believe ours to be the most comprehensive robust trading platform available to active traders for the best value out there and this will continue to help us take market share from our competitors and fuel account growth.

The platform is now automatically available free of charge to all new customers and we will be pushing it up to existing customers in the near future. We continue to be the largest broker by number of trades and this development will ensure our leading position.

Now, I’ll discuss the performance of our Marketing Making segment. While we saw an improvement this quarter in the U.S. market making conditions that drive our domestic trading gains, these benefits were more than offset by significant headwinds due to foreign currency movement, as well as weaker trading gains in Europe.

We do not have clear picture of all the things that can happen in Europe and do not want to be exposed to the region any more than we have to. Accordingly, we decided to scale back on our positions and to reduce the size of the position we are willing to carry in the future.

As you are well aware by now, we are a globally diversified business that trades products in multiple countries and currencies, and report its financial results in U.S. dollar. In order to minimize our exposure to currency risk, we have implemented a conservative strategy of basing our total equity in GLOBALs, a self-defined basket of 16 currencies.

This strategy has served us well over time. While it can produce significant fluctuations the U.S. dollar impact from quarter-to-quarter this generally nets out over time. This quarter the GLOBALs as expect the U.S. dollars declined by 1.9%, resulting in a negative impact to our comprehensive earnings of about $90 million. However, the net impact to our comprehensive earnings since the beginning of 2009 as a result of this hedging strategy net to nearly zero.

Aside from currency movements the environment generally improved for Market Making. With the exception of market trading volumes most other factors would appear to have moved in our favor.

Volatility levels climbed back into the 20s in the last two months of the quarter as investors grew more agitated over concerns in Greece and Spain. The average volatility as measured by VIX was 20 for the second quarter versus 17 the year ago quarter and 18 in the previous quarter.

The ratio of actual to implied volatility also rose from its multi-year low of 51% that we saw in the first quarter to 72% in the year ago quarter and 81% this quarter.

Bid-offer spreads on U.S. exchanges -- the U.S. exchange-traded options also continued the positive widening trend that begun since reaching historic lows in the third quarter of 2010. These spreads are influenced by volatility levels and greatly driven by the level of competition amongst Market Making firms and others who mimic Market Making strategies.

Spreads increased 10% compared to the first quarter and 24% since the year ago quarter. Wider spreads generally benefit our Market Making profits. Since the flash crash of 2010, regulators have continued to tighten scrutiny placed on the high frequency and algorithmic traders.

The latest efforts includes the SEC soon to be approved audit trail proposal which is aimed to increase transparency of hedge funds by tracking their trading behaviors to monitor for activities that may undermine the integrity of financial market.

Exchange trade option volumes decreased 4% in the U.S. and decreased 3% globally from the first quarter. By comparison, our firm’s total option volume increased 4%. As a result, our firm’s market share increased from 13.3% to 14.2% in the U.S. and from 9.5% to 10.2% globally.

In the Market Making segment alone our option volume increased by 6% during the second quarter, which drove our market share in that segment from 7.7% to 8.4% in the U.S. and from 6.2% to 6.8% globally.

All this should be good news, but the fact is that after we correct for all the currency effects, our Market Making performance in this quarter was roughly the same as last quarter.

A pre-tax gain after all expenses of around $60 million per quarter or about an 8% annualized return on the capital we devote to this business, well under our expectation of minimum 10%.

Why is that? The sad fact is that Market Making business is in trouble. It is being squeezed among four unfavorable trends that are not likely to reverse in the near future. Diminishing market participation by the public customer appears to be the number one culprit. Since the May 2010 flash crash, the scandals I mentioned earlier are not helpful either in trying to bring the public back to the market.

You cannot quite see this just by looking at the volume figures as the public customer volume is being replaced by more and more professional orders engaging in a zero sum gain.

So, we may be trading more volumes, but we make smaller profits because we are wrong more often. All of the people we trade with have better information than we do and the slightly wider bid-offer spreads do not entirely make up for the disadvantage.

Second, the space is becoming more over crowded. As the public customer is leaving, more and more market makers and high frequency traders are crowding into. As Wall Street continues to shrink, new expiring participants are entering the auction market, coming from even less lucrative segments of the industry. This is happening by substandard profitability. The publication of our good returns last year was not helpful in dissuading newcomers.

Thirdly, regulatory expenses are increasing at a very fast clip. We are seeing more news rules and greater effort and expense needed to comply with them, more examinations, more administrative proceedings and more and heavier fines. The increasing regulatory burden is relevant not only to Market Making but also to brokerage business.

Finally, exchanges keep increasing various fees and charges, and try to attract participants with new venues, new rules and promises of ever faster trading opportunities. But as the first mover gains everybody follows and the gains soon evaporate and only the additional expenses remain. This will not go on indefinitely, if market makers and brokers make less money the exchangers will not be far behind.

I’m sorry that I cannot paint a rosier picture of the business environment for you. The good thing that I can say that due to our decades of investing in technology and our expertise in Market Making, we are at the forefront of electronic brokerage. We are committed to continue with this investment and you can be assured that our brokerage business is going to continue to grow even if in a shrinking industry. Thank you. Paul?

Paul Brody

Thank you, Thomas, and thanks everyone for joining the call. As usual, I will first review the summary results and then give segment highlights before we take questions. Inside the overall lower results this quarter as compared to a year ago, brokerage performance was marginally better and Market Making was about even with the year ago quarter after adjusting for currency translation effects.

Net revenues were driven by a small increase in brokerage commissions and trading gains were dragged down by the strength of the U.S. dollar relevant to nearly all other currencies. Net interest income declined slightly on lower customer margin borrowing.

As a reminder, our financial statements include the GAAP accounting presentation known as comprehensive income which we adopted early in mid 2011 and became mandatory in the first quarter of this year.

Comprehensive income reports all currency translation gains and losses, including those that reflect that changes in the U.S. dollar value of the company’s non-U.S. subsidiaries, that’s know as other comprehensive income or OCI.

These are reported in the statement of comprehensive income, which replace the traditional income statement. Previously OCI was reported only in the balance sheet. We present compressive income first in our earnings release which we feel is appropriate as it represents the full measure of the change in our capital.

In light of the strengthening of the U.S. dollar against the number of other currencies, adding OCI to net income decreased our reported earnings per share by $0.08 for this quarter.

Before turning to our operating results, I’d like to provide an update on the accounting issue that came up recently. In May we filed disclosures with the SEC and issued a press release that our first quarter 10-Q filing was deficient. In that our independent registered public accounting firm have been unable to complete its review of this filing due to an unresolved accounting issue.

This deficiency also resulted in noncompliance with NASDAQ listing rules. The end result issue is whether non-controlling interest, which represents the ownership of IBG Holdings LLC in the company should be classified as permanent or temporary equity on our balance sheet.

The accounting treatment being examined has no effect on reported results of operations or earnings per share, or on the valuation or classification of assets or liability for the current period or any previously reported period, nor does it impact total equity when including non-controlling interest.

In light of the question raised by our independent account, we concluded that it would best serve the investing public and the company to request an interpretation from the SEC on this issue.

So, in early June, we submitted such a request to the SEC’s office of the Chief Accountant. We expect to have this matter resolved in the near future, which will allow us to file final Form 10-Q for March 31st and to regain compliance with NASDAQ listing rules

Our expectation is that our accounting treatment will remain unchanged in future financial statement reports. This is because on June 6, 2012 as previously reported, we amended our exchange agreement with affiliated parties to eliminate the provision that gave rise to the accounting issue. We are awaiting guidance from the SEC regarding appropriate reporting of our ownership in IBG Holdings LLC for prior periods.

Overall, operating metrics for the latest quarter were mixed, average overall daily trade volume was 948,000 trades per day, up 7% from the second quarter of 2011. Electronic Brokerage metrics showed healthy increases in the number of customer accounts and customer equity.

Total and cleared customer DARTs were both up from the year ago quarter and about unchanged sequentially. Orders from cleared customers who clear and carry their positions in cash with us and contribute more revenue continues to account for over 90% of total DARTs.

Market Making trade volume was up 14% from the prior year quarter though mixed across the product types, options and futures contract volumes were up 28% and 1%, respectively, while stock share volume was down 2%. The higher options volume was driven largely by our decision to tighten our bid offer spread which may have increased volume while reducing per contract gain.

Net revenues were $261 million for the second quarter down 12% from the year ago quarter.

Trading gains were $85 million for the quarter, largely impacted by negative currency translation effect. While trading gains compared to the year ago quarter decreased 30% excluding this currency translation losses, trading gains would have been just 1% shy of the year ago result.

Commissions and execution fees were $108 million up 2%. Net interest income was $53 million down 4% from the second quarter of 2011, and brokerage produced $46 million and Market Making $7 million. Other income was $15 million up 2%.

Non-interest expenses were $152 million up 3% from the year ago quarter. Within the non-interest expense category, execution and clearing expenses totaled $66 million about unchanged from the year ago quarter.

Compensation expenses were $60 million, a 14% increase from the year ago quarter. This increase reflects the revised method for recognizing expenses related to our employee stock incentive plan, which was disclosed beginning of the fourth quarter of 2011.

While total expense over the life cycle of the grant is unchanged, this treatment accelerates the recognition of the related compensation expense to earlier years and decreases expense recognition in subsequent years. A special one-time grant to employees made in January also contributed to the increase.

At June 30th, our total headcount was 893, an increase of 4% over the year ago quarter and 2% over the prior year headcount.

As a percentage of net revenues, total non-interest expenses were 58% and out of this number execution and clearing expense accounted for 25%, and compensation expense accounted for 23%. Our fixed expenses were 33% of net revenues.

Pre-tax income was $109 million down 27% from the same quarter last year. For the quarter brokerage represented 79% and Market Making represented 21% of pre-tax income from the two segments.

These proportions shifted largely based on the impact of the currency translation reflected in the Market Making segment. For the year ago quarter, the break down on 60% of brokerage and 40% for Market Making. We estimate that without the currency translation effect, the Market Making segment would have accounted for approximately 42% of pre-tax income in the current quarter.

For the second quarter our overall pre-tax profit margin was 42% as compared to 50% in the second quarter of 2011. Brokerage pre-tax profit was 53%, level with the year ago quarter, Marketing Making pre-tax profit margin was 26% down from 27% in the year ago quarter.

Comprehensive diluted earnings per share were $0.09 for the quarter as compared to $0.31 for the second quarter of 2011, and on a non-comprehensive basis which excludes OCI diluted earnings per share on net income were $0.17 for the quarter as compared to $0.22 for the same period in 2011.

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

As a general practice we held an amount of cash on hand that provides us with a buffer should we need immediately available funds for any reason. We also continue to maintain over $2 billion in excess regulatory capital in our broker dealer companies around the world.

Long-term debt-to-capitalization at June 30th was at zero down from 2.1% at year end 2011, as we completed the gradual winding down of our senior notes program. Our consolidated equity capital at June 30, 2012 was $5 billion.

The recent bankruptcy of another futures broker and the likely misappropriation of that brokerage customers funds, once again puts the projection of customer funds in the spot light. As we did after the collapse of MF Global, we would like to highlight a few important facts that may not be apparent from a customary review of our balance sheet.

We believe it is essential that customers and investors understand how brokers are permitted to operate and in particular how Interactive Brokers protect its customers assets while servicing their needs to trade on margins.

We have posted an informative statement on this topic, on our website, but the important points are the following. IB segregate customer assets within SEC and CFTC regulations and where appropriate local regulations outside the U.S.

Current SEC regulations require broker dealers to perform a detailed reconciliation of customer money and securities known as the reserve computation, at least weekly, to ensure that customer moneys are properly segregated from the broker dealers own funds.

In order to further enhance our protection of our customer assets, Interactive Brokers sought and received approval from FINRA, the Financial Industry Regulatory Authority, to perform and report the reserve computation on a daily basis, instead of once per week. IB initiated daily computations in December 2011, along with daily adjustments of the money set aside in safekeeping for our customers.

Reconciling our accounts and customer reserves daily instead of weekly is just another way that Interactive Brokers seeks to provide state-of-the-art protection for our customers. We have brought any efforts by the regulators to automate the process of confirming cash and asset balances reported by brokers directly with banks and consortiums.

In response to some of the specific concerns of a broker dealer operations across the industry, we like to again make it clear that IB does not circumvent U.S. Securities and Commodities rule with the expense of our customers. IB does not invest customer segregated funds in bonds, sovereign debt or utilized in-house repurchase agreement.

IB does not mingle or utilize client’s segregated assets for proprietary operation. IB does not enter into agreements which are designed to take advantage of supposedly unrestricted U.K. rehypothecation rules and IB does not engage in transactions deemed with hyper-hypothecation.

Now, I will turn to the segment operating result. Beginning with Electronic Brokerage, customer trade volumes were mixed. Credit customer options and futures contracts volumes were up 6% and 17% respectively and stock share volume was down 23% from the year ago quarter. Stock volume dropped in part to the low priced stocks after we raised margin rates last year to better protect against certain price moves on low cap companies.

Customer accounts grew by 14% over the total at June 30, 2011 and by 3% in the latest quarter. Total customer DARTs were 427,000, up 5% from the year ago quarter and even with the third quarter of 2012.

Our cleared customer DARTs, which generate direct revenues to the Brokerage business were 399,000, up 6% on the year ago quarter and up 2% sequentially. The average number of DARTs per account on an annualized basis was 507, down 8% from the 2011 period and 1% sequentially.

Commission revenue rose on a product mix and featured average trade sizes that decreased for options and stocks and increased for futures, which resulted in a 6% lower overall average commission for DART at $4.10 for the quarter.

Customer equity grew to $28.6 billion, up 11% from June 30, 2011 but down 1% sequentially. These changes took place during periods in which the S&P 500 Index rose 3% over the year and fell 3% over the last quarter. The source of this growth continues to be a steady inflow of new accounts and customer deposits.

In addition, our favorable financing rates have allowed us to attract customer margin borrowings. Although margin debit are up 17% from their year ago peak. They have been building steadily since customers paired back positions during the market turmoil of 2011 third quarter.

Customer credit balances, which increased 3% over the year ago quarter also continue to grow progressively. Spread compression, especially in certain foreign currencies persists in reducing interest income.

Higher options and futures trade volumes resulted in top line revenue from commissions and execution fees of $108 million, an increase of 2% from the year ago quarter and 7% sequentially. These revenues are spread mainly across options, futures and stock but revenue from FX brokerage continues to grow.

Execution and clearing fees expenses decreased to $36 million for the quarter, down 3% from the year ago quarter, but up 17% sequentially. The sequential increase was driven by higher futures trading volume where exchange fees which are passed on to customers are higher than another product.

Fixed expenses increased to $45 million, up 3% on the year-ago quarter primarily due to higher employee compensation expenses related to the stock incentive plan, as I mentioned earlier. Pre-tax income from electronics brokerage was $90 million for the second quarter, up 1% on the year-ago quarter and up 8% sequentially.

Now, I’ll turn to Market Making. Trading gains for Market Making for the second quarter of this year were $85 million, down 30% on the year ago quarter. This resulted in pre-tax income from Market Making of $24 million, down 60% from the year ago quarter.

Currency translation effect negatively impacted the second quarter’s reported earnings by about $41 million as compared to about $7 million in the year ago quarter. In other words, currency translation accounted for 98% of the drop in pre-tax income from Market Making. Our overall equity as measured in U.S. dollars was decreased by the general strengthening of the U.S. dollar.

More specifically, to measure the overall loss from our strategy is carrying our equity in proportion to the basket of currencies, we call it GLOBAL to be about $91 million for the quarter. Because of that $49 million of loss is reported pursuant to GAAP as other comprehensive income. Typically it’s a loss of $41 million to be included in reported non-comprehensive earnings.

Note that even under the new guidance, OCI is only reflected in earnings per share on comprehensive income and not in pre-tax income itself. To summarize this, if we eliminated all currency effects, pre-tax income from Market Making would be about $65 million.

Execution and clearing fees expenses increased to $31 million for the quarter, up 5% on the year ago quarter driven by higher options trading volume and fixed expenses decreased to $36 million, down 2% from the year ago quarter. Reflecting our aggressive expense management, the decrease was spread across multiple expense categories, which offset higher employee compensation expenses related to the stock incentive plan.

Thank you. And now, I’ll turn the call back over to the moderator, and we’ll take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Chris Harris from Wells Fargo.

Chris Harris – Wells Fargo

Thanks. Good evening. Question on the FX impact in the Market Making segment. Is all of that loss related to GLOBAL?

Paul Brody

The loss you’re referring to comes from the fact that we chose to carry our equity in proportion to the basket of currencies we call the GLOBAL. So that had a total of $91 million negative impact this quarter. As Thomas mentioned it can vary a lot from quarter-to-quarter and over the long period of time, it seems to prove itself to be fairly flat to the dollar.

Chris Harris – Wells Fargo

Okay. And a lot of what’s driving that clearly is declining in the euro?

Paul Brody

The euro is the major component of it.

Chris Harris – Wells Fargo

Okay. Sorry, then Thomas want to follow-up on some of the comments you made. It sounds like you have a pretty cautious outlook for the Market Making segment, and just curious whether you guys are doing anything that kind of offset that negative outlook whether there is any flexibility on the expense side that you could take to maybe kind of offset those headwinds. Any additional color you have there would be great?

Thomas Peterffy

Well, no, we’re not trying to cut back on our efforts as we are just going to keep on trucking here and see if things get better in the coming quarter. And secondarily, we are waiting to see whether there will be any fallout from this Dodd-Frank regulation that we could have carved out a niche for ourselves, given that we have a very high amount of capital relative to the other brokers that are not banks. So there may be a special situation for us, we’re not sure yet.

Chris Harris – Wells Fargo

Just trying to balance your comments with some of the deteriorating fundamentals, but then if you take a look at kind of your compensation costs they have just been basically rising every single year, which is kind of flies in the face of some of the deteriorating performance, particularly in the Market Making business but maybe that higher compensation is being used to support your brokerage business, I presume?

Thomas Peterffy

Of course, to a large extent it is. And as you look around, you will see other firms cutting compensation. We don’t intend to do that. We like everybody that works here and we want to reward them for their good work.

Paul Brody

I may just add. Part of the increase we see in compensation with what I refer to which was a changed in the recognition of our stock incentive plan expenses which is the shift towards the front and away from the back end of the grant cycle. So, the overall expense taken by the company over time will be the same, but some of the expense recognition was shifted forward.

Chris Harris – Wells Fargo

Last one from me and then I will hop back in the queue. Appreciate the comments of Paul on the SEC review. Just wondering if there is a plan B in case you don’t hear back from the SEC in a timely manner, my understanding is that NASDAQ is giving you until November to have this issue resolved. And I’m just wondering if the issue isn’t resolved by then the regulators kind of drag your feet, what are you prepared to do to keep your listing active?

Paul Brody

Right. We certainly expect to have it resolved fairly shortly. And in fact we’ve had helpful and ongoing discussion with SEC staff and they have not drag their feet at all on this issue. And I wouldn’t expect them to start dragging their feet now. So, it is our expectation that we will be able to get back on track in a short period of time.

Chris Harris – Wells Fargo

Okay. Thank you.

Operator

Our next question comes from Rich Repetto from Sandler O’Neill.

Rich Repetto – Sandler O’Neill

Good evening, Thomas. Good evening, Paul. My first question is just when you mentioned Dodd Frank and capital, Thomas, are you talking about the excess capital at the market maker and then I’m just trying to understand the opportunity even in just vague terms that you are thinking about that could be potentially there?

Thomas Peterffy

Well, the large brokers that are all banks have to take more and more, greater and greater reserve, it appears. And so we’ll see what happens here with non-exchange OTC product. So we don’t know -- I really don’t want to put too much work into this up until the rules become really clear. But we suspect that there may be opportunities for us there, I don’t want to actually point out any one specific thing at this moment.

Rich Repetto – Sandler O’Neill

Okay. And then, you may have mentioned Thomas of NYSE’s RLP program and the sort of the sub penny pricing. I guess I was just trying to understand your views on it, it might give as a broker, it might give you another venue to execute your retail equity trades, but that again, the market structure issues are the sub penny pricing, I think that’s what’s bothering you I guess. But just trying to…

Thomas Peterffy

It’s bothering me because if I were trying to make bids on the NYSE, knowing fully there that somebody can outbid me with very small amount and I can see that I will be less willing to make those bids.

Rich Repetto – Sandler O’Neill

So from a market making standpoint people can step…

Thomas Peterffy

It’s not only from a market markers standpoint, I think that the visible market will widen out.

Rich Repetto – Sandler O’Neill

And then the last, if I understand this right. There is a large amount of excess capital at the market maker and I know your strategy to -- sort of and you just explained it to the previous question of watching the quarters and see how the market maker does. But is there even possible, you said that you outlined the four sort of headwinds that weren’t going to correct themselves any time soon.

So is there any other remedies where you could pull capital away more quickly than the dividend policy that you have or even in the -- in an extreme case, splitting the e-broker off?

Thomas Peterffy

We will never say never but there is nothing that will imminently happen along those lines.

Rich Repetto – Sandler O’Neill

Understood. Okay. Thank you.

Operator

Thank you. Our next question comes from Chris Allen from Evercore.

Chris Allen – Evercore Partners

I just wanted to touch on the account growth. Thomas, you mentioned before that in terms of like some of the slower account growth is just due to a slower overall environment. I wonder if there is some specifics in terms of where we are seeing the account growth slow in terms of customer buckets and if there is anything more to it than just kind of the environmental slow down.

Thomas Peterffy

Our account growth is shifting more and more away from the United States and more and more towards -- in the United States, more and more towards financial advisors. So that’s basically what I can say about that.

Chris Allen – Evercore Partners

Okay. And then some of the headwinds you talked about in the Market Making business, I mean were you seeing them over the course of the quarter or are they just want to manifest themselves right now and looking back to the last period, we saw, this probably back in 2010 and lasted basically for about four quarters. Is that like the timeframe we should be thinking about here?

Thomas Peterffy

Well, when the market becomes extremely active, spreads widen out and the market maker usually does very well and that money is in fact lost by participants who then curtail their activity subsequently. So last -- in the third quarter last year was a period that although was not as pronounced than 2008 and ‘09, a lot of the people have quite a bit of money and therefore have cut down on the activities. So I would think that this is probably going to last there couple of quarters or so, if nothing else happens.

Chris Allen – Evercore Partners

Okay. Thanks guys.

Operator

Our next question comes from Ed Ditmire from Macquarie.

Ed Ditmire – Macquarie

Good afternoon. My question was about the market maker, especially in light of your latest commentary about the difficult pressures on the business. Do you think that the 10% capital return policy is aggressive enough as a self regulating force to help guide the unit towards acceptable returns.

It seems like if a market maker produces below your target of say, 10% returns, it could take quite a while for this policy to right size the market markers capital base towards better returns. So that’s my first question.

Thomas Peterffy

I think it’s a very appropriate question. At this time, it is 10% and we are not thinking about changing it in the near future.

Ed Ditmire – Macquarie

Okay. Then, a follow-up. This is for Paul. Did you mention specifically, how much capital -- equity capital is in the broker unit at the end of the second quarter?

Paul Brody

I didn’t but it’s about 1.8 billion.

Ed Ditmire – Macquarie

Okay. I’ll get back in the queue. Thank you.

Operator

Thank you. Our next question comes from Justin Hughes from Philadelphia Financial.

Justin Hughes – Philadelphia Financial

Good afternoon. Sorry to keep bringing this up but let me just ask it a different way, a more direct but at the end of 2010, when it looked like dividend tax rates were going to go up, you guys paid a special dividend most likely really at the end of 2012 and there’ll be a lot of same speculation. If it looks like dividend rates are going to go up next year, would you consider another special?

Thomas Peterffy

We will keep our options open. Yes, we could. We will consider, if it looks like dividend rates are going to go up, we will consider.

Justin Hughes – Philadelphia Financial

Okay.

Thomas Peterffy

But don’t forget that the dividend, as internal holders of stock, we do not pay taxes on the dividend because to us it’s a return of equity. We pay taxes on the earnings as we go along. And we pay that whether we draw the money from the company or leave it in the company.

Justin Hughes – Philadelphia Financial

Okay. But I assume you managing the company in the best interest of all?

Thomas Peterffy

That is correct. Yes.

Justin Hughes – Philadelphia Financial

Okay. Thank you.

Operator

Thank you. Our next question comes from Niamh Alexander from KBW.

Niamh Alexander – KBW

Hi. Thanks for taking my question. And if I could touch back on to the issue outstanding with the SEC, I think the change you made was with regards to and the ability to convert the partner units into cash and the right to kind of pay cash or stock.

So, going forward, similar to what you did last year, should we expect that if or remember is decide to kind of redeem their annual rights to kind of redeem the partner units, but you would kind of issue some stock into the market to raise cash to buy those out, because that had a nice little leveler on the public earnings last year, when you kind of just increased that relative public ownership. Is that at a similar level to think about think about this year?

And then the second question is how do you uphold those numbers and do you expect maybe to be at a similar level?

Paul Brody

I think it’s fair to say that the expectations of future redemptions, this is what you are referring to, will be done in terms of share transactions. We are not excluded from doing the cash out transaction. Recently accounting issue came up was sort of a very technical interpretation of contractual terms.

It was never an expectation to employ that method forever. And we have no indications at this time as to what the appetite for future redemptions might be. Presumably, there would be some appetite from minority members as there has been in the past. So we can’t say it now.

Niamh Alexander – KBW

Okay. Fair enough. Thanks Paul. And then if I could just touch on Europe, Thomas because you mentioned the environment got, I guess the stability kind of deteriorated a little bit and you pulled back in the market maker. Are you still kind of in that wait-and-see mode there that we should kind of expect a more paced performance in the next couple of quarters as well, until who knows when we get the ultimate improvement. But does it feel kind of still very difficult that you want to kind for remain out of the longer dated product and risk like that?

Thomas Peterffy

I was specifically talking about Europe, yes. We don’t want to be very much exposed to the various clearing houses and banks because we had a -- we can’t say with any certainty what could happen there. It’s better to be safe than sorry, just as simple.

Niamh Alexander – KBW

Fair enough. Thanks Thomas. And then, could you just help me understand, I guess back to Justin’s and everyone else’s questions, because the $1 million question here is you did suggest a large distribution of capital, last time there wasn’t tax changes, is there anything different in the environment or in your business right now or opportunities that you think are closer to that might change the level of distribution that versus the prior time?

Thomas Peterffy

I think if you ask this question over the next conference, next earnings conference, I think may be able to tell you something more.

Niamh Alexander – KBW

Okay. Fair enough. Thanks Thomas.

Operator

Thank you. Our next question comes from Matthew Heinz from Stifel Nicolaus.

Matthew Heinz – Stifel Nicolaus

Good evening. Wonder if I could just go back to the OTC opportunities you spoke about. Just wondering if you’ve done any kind of early due diligence on some of the venues out there that are likely to become substance, how they might match with your existing technology?

Thomas Peterffy

Well, they keep on looking, yes, but nothing definite so far.

Matthew Heinz – Stifel Nicolaus

Okay. And then kind of on the account growth side, it seems like for the last several quarters, the financial advisor segment has been kind of the leader there. And I’m wondering if you are concerned at all that segment might be dragging down the overall activity rate of the brokerage business and if that concerns you long-term with regard to margins?

Thomas Peterffy

Well, it is dragging down the activity rate, but nevertheless every additional -- like you said, financial advisor account is a plus as to earnings. It may drag down the rate but it increases the overall income.

Matthew Heinz – Stifel Nicolaus

Okay. Thanks very much.

Operator

Thank you. Our next question comes from Mac Sykes from Gabelli & Company.

Mac Sykes – Gabelli & Company

Good evening, gentlemen. Tom, excluding your comments about the OTC potential opportunity, can you imagine in the next five years an opportunity in brokerage or maybe to explain globally where you would want access to the levels capital and Market Making?

Thomas Peterffy

I’m sorry, Mac. Can you repeat it?

Mac Sykes – Gabelli & Company

Right. So, I mean, can you imagine just for your brokerage unit say in the next five years, where you would want perhaps to have better access to capital than you do have in Market Making right now, opportunities excluding the OTC comments that you had made before?

Thomas Peterffy

That we would want access to more capital than we currently have?

Mac Sykes – Gabelli & Company

Correct.

Thomas Peterffy

I’ll tell you frankly I do not understand why -- what is that kind of brokerage business where brokers need more capital than we have, I can’t see it.

Mac Sykes – Gabelli & Company

No. I was thinking just in terms of your brokerage operations.

Thomas Peterffy

You have asked this question, I think a quarter or two ago and I didn’t understand it at that time and I still don’t understand it.

Mac Sykes – Gabelli & Company

Well, I was just thinking about in terms of building out globally in terms of opportunities just to build your footprint instead of organically through acquisition or something like that?

Thomas Peterffy

No, we are not looking at acquisitions because we find that it is smoother and easier to manage internal growth than taking on an acquisition and get things discombobulated like some other brokers -- that it happens to some other brokers who then go into various troubles like look at MF Global, for example.

Mac Sykes – Gabelli & Company

My second question is I was wondering if you could provide some context around competition for active trading accounts now versus when you first went public, perhaps what has changed in terms of the marketplace for acquisition?

Thomas Peterffy

You mean in brokerage or in Market Making?

Mac Sykes – Gabelli & Company

In brokerage, for active trading accounts versus what you…

Thomas Peterffy

The people that are going after the active trading accounts are all much smaller and I find it surprising that the people just never learn, that they keep on -- they transfer their -- transfer their pension accounts to apex. It’s hard for me understand that they do not worry about safety of their funds. But I think most people with good commonsense are going to choose us even though our -- some of our charges maybe a little bit higher.

Mac Sykes – Gabelli & Company

Thank you.

Operator

Thank you. This concludes our Q&A session. I’d like to hand the conference over for any closing remarks.

Deborah Liston

Thanks, Operator. And I would like to thank everyone for participating today. And just a reminder, this call is going to be available for replay in a little bit on our website. Thanks again for your time.

Operator

Thank you. Ladies and gentlemen, thank you for participating in today’s conference. This concludes your program for today. You may all disconnect. And have a wonderful day.

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