Interactive Brokers Group Inc Q1 2010 Earnings Call Transcript

| About: Interactive Brokers (IBKR)

Interactive Brokers Group Inc (IBKR)

Q1 2010 Earnings Call

April 22, 2010 4:30 p.m. ET


Deborah Liston - Director of Investor Relations

Thomas Peterffy - Chairman & Chief Executive Officer

Paul Brody - Group Chief Financial Officer

Q&A Participants

Rich Repetto - Sandler O'Neill

Mac Sykes - Gabelli & Co.

Edward Ditmire – Macquarie

Niamh Alexander – KBW

Sam Hoffman - Lincoln Square

Rob Rotschow – CLSA

James Sheridan - Private Investor


Good day, everyone, and welcome to the Interactive Brokers first quarter 2010 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 head.

Deborah Liston

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

I’d like to remind everyone that today’s discussion may include forward-looking statements. The statements represent the company’s belief regarding future events that by their nature are not certain and outside the company’s control. The company’s actual results and financial condition may differ possibly materially from what’s indicated in these forwarding-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 filings made with the SEC. I 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 afternoon and thank you for joining us. As you will see with our latest results, the market dynamics that were in play during the fourth quarter have spilled into this year and we are off to a slower start than what we were hoping for.

The story of the first quarter of 2010 is not very different from that of the last quarter of 2009. This is true both for our market-making and our brokerage businesses. Our market-making business continued to suffer with diminishing volatilities while our brokerage business continued its rapid growth in customer deposits in spite of the slow and uneventful market.

I will now focus on our performance in the first quarter for each segment. We’ll start with market-making.

During the quarter, the most important factors that influenced our profitability continued to move against us. In this regard not much changed from the previous quarter. Our market-making results will depend on the behavior of bid offer spreads, implied and actual volatilities, volumes and the impact of currency movements and other results as expressed in US dollars.

I am now quoting from the previous quarter’s earnings call. "The lackluster results in market-making in this quarter are largely due to the story of volatilities. 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 to 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 with a long position would generate.

As the volatilities came back down below $40, we began accumulating our customary long volatility position and by the beginning of Q4, we were at our usual position.

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 option position lost value throughout the quarter.

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 first quarter." End of quote.

To continue this story for the first quarter of 2010, implied volatilities continued to decrease from 20 to 16 and actual volatilities have gone even lower, averaging around $14 for the quarter. Actual volatilities were about 70% of implied, meaning that selling options was still a very profitable strategy.

In the last several weeks and months the market seems to have taken on a new behavior. The movement of prices is squeezed into very short periods of time and most of the rest of the time prices just sit there with the S&P500 index moving within a one-point range from one hour to the next.

At least this has been the case up until last Friday. It’s a great market for trading desks who service customers. They can do a trade with the customer and take the next several hours to hedge themselves without worrying that the market may run away from them.

The same is true for quasi market makers who join the NBBO with very good odds for realizing the spread or at least the exchange provided maker rebate. It is largely explained by this phenomenon that according to our own data bid offer spreads on listed options continued to narrow by about 11% from the last quarter. It is also interesting to note that the PHILEX puts this number above 20%.

Spreads have been tightening throughout 2009 and into the first quarter of 2010 primarily due to contracting volatilities and increased competition from high-frequency traders who act as market makers by utilizing customer status to gain advantages over bona fide market makers. These advantages include priority of the same price and not having to pay exchange fees.

Towards the end of last year the ISE and early this year the CBOE instituted new rules for professional traders who submit more than 349 orders per day. They took away their customer priority and began to charge them exchange fees. The result was that many of these traders had gone over to the PHILEX where they retained the existing customer privileges.

Starting as of April 1st the PHILEX is following the same rule. From now on HFTs will no longer receive customer priority anywhere and they will pay the same fees as market makers. The consequences of this rule change will depend upon how effectively it will be enforced.

Now that the PHILEX has joined with the ISe and the CBOE many of these traders have gone to the NYSE Arca Exchange which is a make or take exchange. Here the taker pays $0.45 and the maker receives $0.25.

The NYSE is hoping to gain competitive advantage by showing a penny better market than the other exchanges and given best execution rules brokers do have to route there when that is the case even if they have to pay a $0.45 taker fee.

Since the exchange pays the maker $0.25 rather than charging about the same as conventional exchanges do the maker is about $0.50 or half a penny per contract better off. As a result frequently they do have a penny better quote and in a quiet market it makes sense for HFTS to post a bid and offer in the hopes of making a tick or at least to collect the $0.25 rebate.

Now that the SEC came out last week with the proposal that they would limit access fees to a maximum of $0.30, this structure may have to change in the coming months. If they have to lower the access fee to $0.30 from $0.45 then they’ll be able to pay only $0.10 to the makers which may not be enough to get a better quote.

The other two SEC initiatives that may have an impact on our market-making business is the potential prohibition or modification of maker-sponsored access and the requirement to identify large traders.

Under naked sponsored access high-speed traders can buy and sell stocks and options directly on an exchange using the broker's access code with limited oversight. The concern is that the trader could either accidentally or purposefully accumulate a large position that if it went against him he may not be able to pay for or potentially the sponsoring member may not have large enough revenue resources to pay for it either.

Thus, the SEC would require the member to credit vet each of the traders’ orders before submitting it to the Exchange. But that would slow down the communication with the Exchange to a level where the trades might no longer be profitable.

The other initiative is to require that each order be accompanied by a unique number that would identify the originator which order routed to an exchange when the order belongs to a large trader.

As we generally get hurt by market manipulators and other illegal practices, we are in favor of this rule, especially as it would also have exchanges to enforce the professional trader designation.

All of these developments taken together, the loss of priority, having to pay exchange fees, elimination of maker sponsored access and trader identification are all positive for our business because they will put our undeclared competitors on a more even playing field with us.

As far as global option volumes are concerned, they increased 6.8% over the fourth quarter of '09 and by 12% on the year-over-year basis. In the US, the increases were 3.9% and 8% respectively.

This, of course, ignores the ever increasing volume associated with dividend capture trades which we estimate currently constitutes about 5% of US exchange traded option volume.

From the published reports of broker dealers we can surmise that two customer trading volumes in options in fact decreased year-on-year so that the apparent increase was reduced to HFTs.

Our market share decreased to 9.94% from 10.4% globally and for the US we are at 12.98% from 13.34% in the previous quarter.

Now I would like to say a few words about the impact of currency movements. As we've explained many times before, as market makers on many different exchanges around the world, each of our transactions in a stock option or future has a currency component.

Several years ago we decided to hedge that currency component to a self-defined basket that we call the global. We keep our equity in globals. One global we defined as consisting of 55 US cents, 24 EURO cents, 10 Yen, 3 British Pence, 3 Australian cents and 4 Canadian cents.

We chose this basket to roughly reflect the relative importance of various regions to our business mix with the criteria of free convertibility and consideration of political risk. Using this basket also assures us of preserving at least some of our assets and to continue the maintenance of our business even in a hypothetical situation where certain countries or even entire regions undergo financial collapse, nationalization, repudiation of debts or other economically catastrophic events.

Due to our continuous hedging, exchange rate movements have no impact on our earnings or net worth when we account for them in globals. But when we account for them in US dollars there is an impact equal to the change in the value of the basket as expressed in US dollars.

In this past quarter the value of the global relative to US dollars fell by almost 2% for around $90 million. Not all of this is part of reported earnings. Some of it shows up as translation loss and is reported below the line. You can always estimate our translation loss or gain by taking the equity value of each of our non-US subsidiaries and translate from local currency into dollars.

Since Timber Hill Europe is the only large one, approximately 1.5 billion Swiss Francs, multiplying the Swiss Franc loss’s against US dollars by 1.5 billion will give you a good approximation of our translation loss which was about $27 million for the past quarter.

In fact, if all the subsidiaries are considered, the translation loss for the first quarter was $21 million. Finally, we did have some small losses associated with corporate announcements, but they were not significant and we continue to be encouraged by the SEC's efforts to curb insider trading.

As far as the latest developments on financial reforms are concerned, as I read the proposed Senate bill it seems that OTC derivatives and especially equity derivatives that do not have industrial use will be forced onto exchanges and into a clearing house. But even if that does not happen and these trades remain OTC, there are new capital requirements associated with the resulting positions.

Firms that are regulated by the Fed, the FDIC or the comptroller of the currency get their capital requirements from them. But other firms who are not regulated by prudential regulators will have to conform to capital requirements imposed by the SEC and the CFTC.

We think that these rising capital requirements associated with equity-based and currently OTC derivatives represent a great opportunity for us. As the capital requirements increase, other firms will not be able to carry all the positions they have been carrying. The prices or markups will rise and the lower markup business will be rubbed off.

Since we know how to price these and we have plenty of excess capital to carry the positions we'll be happy to pick up this business.

Now I will turn my discussion to our brokerage segment. I'm happy to be able to tell you that the growth of our brokerage business continues unabated. Year-over-year customer accounts increased by 21% to 140,000.

Our customers' equity grew at a very impressive 74% year-over-year and 10% sequentially to a total of $16.7 billion. This remains far ahead of the growth rate published by our competitors.

The customer's equity continue to grow along with our reputation as being the best broker for sophisticated, high-volume traders that need to obtain the best execution price and pay the lowest possible costs.

I'm proud to say that we have carefully built a savvy 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 43% to an average of $119,000 per account even though more than 60% of our customer accounts are still small, having less than $25,000.

Our customer DARTs have weathered the past year fairly well. Our cleared DARTs decreased only about 1% from the hectic pace of last year but increased 6% sequentially. Our brokerage profit margin came in at 50% for the quarter compared to 48% in the previous quarter.

Growing our global brokerage business is our primary objective. While still 85% of our client trades are executed in the United States, 52% of our brokerage commissions are generated by clients residing outside the United States with China, including Hong Kong, Canada, Germany and Australia being the most important locations followed by the UK, Holland and the rest of Continental Europe.

Due to having an internationally diversified customer base, our currency dealing platform has assumed the growing importance for our customers. We compete by providing the tightest quotes in the business. Our quotes are frequently just half a pip wide and we charge a small commission on each trade.

Now that we stream our quotes to the iPhone and Blackberry, customers and non-customers alike can compare our quotes to their bank or broker's quotes. This includes you on this conference call. Please look at our quotes. You will be amazed by how tight they are.

Our customers can open accounts with us based in their home currency and trade products all over the world no matter what currency those products are traded in. We convert the needed currencies for them so that it is entirely seamless to the customer and it is our very tight quotes that enable us to provide this service very, very inexpensively.

This past quarter we became members of the Tokyo Stock Exchange and we are working on activating the membership for executing customer trades for both Japanese and non-Japanese customers alike.

We are continuing our push towards building the global platform that financially sophisticated people all over the world know has more products at better prices than any other broker.

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

Paul Brody

Thank you, Thomas. Welcome, everyone. Thanks for joining the call. I will review the summary of results and then we will discuss the segments before taking questions.

The challenging conditions in market-making that continued during the latter part of 2009 have, for the second consecutive quarter, weighed on our operating results. Pre-tax profits were down along with the contribution of our market-making segment to the overall results. Nonetheless, our first quarter results in market-making showed a marginal improvement from those of the fourth quarter.

In contrast, electronic brokerage continues to post strong earnings driven by a steadily increasing number of customers bringing in primarily commission revenue but also a steady rise in net interest income.

Overall operating metrics were mixed this quarter but were stolid in brokerage. Average overall daily trade volume was 907,000 trades per day, down 7% from the year ago quarter but up 2% over the fourth quarter.

Market-making trade volume was down 21% from the prior year quarter reflecting decreases across options, futures and stock. However, electronic brokerage metrics continued at a strong pace with substantial increases in the number of customer accounts and in customer equities.

Share and contract volume was up in all major product classes. Total customer DARTs were up 2% and clear customer DARTs were down less than 1%. Orders from clear customers who clear and carry their positions in cash with us and contribute more revenue remained steady at 90% of total dart.

Net revenues were $211 million, down 29% on the year ago quarter. Within that, trading gains were $81 million, down 55% from the same period in '09. Commissions and execution fees were $92 million, up 9%.

Net interest income was $22 million, up 113% from the first quarter of '09. This came primarily from electronic brokerage, which I will discuss in more detail when I review the segment. Other income was $17 million, down 22%.

Non-interest expenses were $146 million, an increase of 13% on the year ago quarter, driven by higher variable costs and compensation expenses. Our aggressive expense management has kept our other fixed costs roughly unchanged.

Within the non-interest expense category, execution and clearing expenses were $70 million, an increase of 14% from the year ago quarter. This rise in variable costs came from both market-making and brokerage as certain US options exchanges increased their fees.

Compensation expenses were $51 million, an 18% increase over the year ago quarter reflecting growth in staff count and in part the continued phase in of expenses related to our employee stock incentive plan.

At March 31st, our total headcount was 815, an increase of 7% from March 31st '09 and 2% from the year-end '09 count. We continue to expand staff at a measured pace, somewhat slower than recent years and 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 69% and out of this number execution and clearing expense accounted for 33% and compensation expense accounted for 24%.

Our fixed expenses were 36% of net revenues, which is well above our target range and a direct result of lower revenues in the quarter. However, these measures show a marginal improvement from the fourth quarter of '09.

Pre-tax income was $65 million, down 61% from the same quarter last year. For the quarter, market-making represented 8% of pre-tax income and brokerage represented 92%.

Clearly these proportions shift largely based on the performance of our market-making business. For the year ago quarter they were 72% market-making and 28% for brokerage. So while this is a reflection of the poorer results in market-making it also reveals a robust quarter in the brokerage business.

For the first quarter our overall pre-tax profit margin was 31% as compared to 56% in the first quarter of '09 and 26% in the trailing quarter. Market-making pre-tax profit margin was 7%, down from 65% in the year ago quarter. Brokerage pre-tax profit margin was 51%, up from 42% a year ago.

It is apparent that the diversification between market-making and brokerage provides us with some stability of revenue stream in addition to leveraging the same underlying technology.

Diluted earnings per share were $0.09 for the quarter as compared to $0.30 for the first quarter of '09 and $0.06 for the trailing quarter.

Turning to the balance sheet, our balance sheet remains highly liquid with 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 our balance sheet. This provides us with a buffer should we need immediately available funds for any reason.

We also continue to maintain well over $1 billion in excess regulatory capital in our broker dealer companies around the world. Long-term debt to capitalization at March 31st was 4.3% and our consolidated equity capital at March 31, 2010, was $4.88 billion.

Looking at market-making, trading gains from market-making for the first quarter of 2010 were $80 million, down 55% on the year ago quarter. Net interest income for market-making was $1 million, an increase of $2 million from the roughly flat net interest of the year ago quarter.

Net revenues for market-making were $83 million, down 55% for the first quarter of '09. Despite lower trading volumes, the variable costs of execution and clearing, our largest expense category amounting to 53% of non-interest expenses increased 21% for the first quarter of '09 to $41 million.

As I mentioned earlier, certain US options exchanges increased their fees and also the first quarter of '09 included a non-recurring refund of exchange fees. Pre-tax income from market-making was $6 million, down 95% on the year ago quarter.

Turning to electronic brokerage, customer and share contract volumes were strong across all product classes, up from the year ago quarter by 23% in options, 4% in futures and 76% in stocks. The stock volume has been partly impacted by increased volume in low priced stocks traded by our brokerage customers.

Customer accounts grew by 21% over the total at March 31st '09 and by 4% in the latest quarter. Total customer DARTs were 364,000, up 2% from the first quarter of '09 and 5% sequentially. Our clear customer DARTs, which generate direct revenues for the brokerage business, were 328,000, down 1% on the year ago quarter but up 6% sequentially.

Customer equity grew to $16.7 billion, up 74% from the year ago quarter and up 10% sequentially. The source of this growth continues to be a steady inflow of new accounts and customer deposits and, to some extent, customer profit. This reflects the continuing trend of customers transferring their accounts to interactive brokers for safety and security as well as for our advanced execution services.

New software and staff who specialize in the customer onboarding process continue to achieve higher new customer funding rates. Trade volumes resulted in revenue from commissions and execution fees of $92 million, an increase of 9% from the year ago quarter and 3% sequentially.

Net interest income rose to $20 million, up 98% from the first quarter of '09. Our growing customer cash balance has more than offset the effects of low benchmark interest rates which have continued to compress the spreads earned by our brokerage unit on customer credit balances.

Average US interest rates measured by the overnight Fed funds rate were about 0.13% during the first quarter of 2010 as compared to 0.18% during the first quarter of '09. Over the same time period, our customer cash balances increased by 30% and customer margin borrowing increased by 119%. As a result, our net interest income rose to 15% of net revenues from 9% in the year ago quarter.

Net revenues from brokerage were $127 million for the quarter, up 18% from the first quarter of '09 and up 2% sequentially. As with our market-making segment, execution and clearing fees account for a large part, in this case 46%, of our non-interest expenses in brokerage.

Based on the mix of trade volumes across product and customer types, these variable costs increased to $29 million for the quarter, up 6% on the year ago quarter and 4% sequentially.

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

Pre-tax income from electronic brokerage was $64 million for the first quarter, up 42% on the year ago quarter and up 5% sequentially. We continue to believe that the fundamental factors for continuing to grow our low-cost automated brand of brokerage are in place and we are encouraged by the steady expansion of the customer base.

Now I will turn the call back over to our moderator and we will take questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from the line of Rich Repetto - Sandler O'Neill.

Rich Repetto - Sandler O'Neill

I guess the first question is, Thomas, when you explained what was going on from the regulatory standpoint - I'm trying to understand if the caps do get enforced will that eliminate the maker taker model? It seems like you're optimistic that if the caps are in place you would benefit.

I'm contrasting that it looks like the option business is looking more like equities every day. The maker taker model has sort of sustained itself there.

Thomas Peterffy

Well, all we're talking about is reducing the $0.45 taker fee to $0.30, which is what it is on equities. So what happens, as I tried to explain - I don't know if I was clear enough - that when the taker pays $0.45, the exchange rebates $0.25 to the maker.

So now the maker receives $0.25 if he makes a market on Arca versus paying $0.25 if he makes the market on say the CBOE of ISE or wherever. So he is net $0.50 better off. Now that $0.50 advantage sometimes enables him to quote a penny better market. When he does so then the best execution routing obligation of the broker forces the broker to route the order that would take liquidity NYSC Arca.

But then the broker, of course, has to pay the $0.45 which he either does or doesn't collect from the customer. So now if the cap goes into effect and the $0.45 maker fee is reduced to $0.30 then the exchange obviously has to get that $0.15 from somewhere and where they would get it from is the only place they can get it from, namely to pay $0.15 less rebate to the maker.

So the maker now will only get a $0.10 rebate instead of the $0.25 rebate and that $0.10 may not be enough for him to quote a penny better market with the same frequency as he did up until now. I don't know if that clarified.

Rich Repetto - Sandler O'Neill

I think I understand it very - I think you explained it very clearly. The prices that they're getting, when you go for a price you're paying a much bigger take fee and it's getting reimbursed to these people that are making the quotes.

But I guess the follow-on question is that I was hearing in channel checks of competition just as you described the last couple quarters that you had competitors just making markets in select securities even to the point of just making markets on one side. I guess if you did go to a 1030 SEC mandated sort of cap you're believe that that would eliminate a lot of that competition or reduce a lot of it?

Thomas Peterffy

I don't know if a lot but it will certainly eliminate some.

Rich Repetto - Sandler O'Neill

The last question on the brokerage, which is growing rapidly, could you just tell - it seems like you're beating - you changed your pricing to the two sort of packages. Are you taking customers from any specific area? Some of your peers, their results have really waned, let's say, or softened. Is there any particular broker in the US that you're gaining on more rapidly?

Thomas Peterffy

Rich, as I always say, every quarter when I ask this question, with the exception of one broker in the United States, there are no brokers who do not lose more customers to us than we lose to them. So there is just one broker who that is not true for. For everybody else we net gain customers from.

Rich Repetto - Sandler O'Neill

Could I ask who that one broker is?

Thomas Peterffy

You can but I won't answer.


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

Mac Sykes - Gabelli & Co.

I was wondering if you could sort of quantify the opportunity that you mentioned with the new capital requirements for the firms and then how would those revenues flow? What segment would they flow to?

Thomas Peterffy

I would be stabbing in the dark but obviously it would flow to market-making except to the extent that this potential regulation would also boost the business of One Chicago where we own 40%, so up-trading for stock certainly would go to One Chicago.

If it has to go onto an exchange or if it remains OTC we'll be happy to carry the swap positions and take their cuts on it, whatever it is going to be. All I know is that it's going to be substantially more than it is now and it is kind of confusing as to what it is now because if you are a regulated banking entity then I'm not exactly clear how much it is.

But I’m told it will rise and if you are not currently a regulated banking entity you don't even have any capital requirements as long as you do this from an offshore entity. But I understand that these offshore entities will no longer be allowed to function.

Mac Sykes - Gabelli & Co.

Have you seen any change in operations in some of these firms in light of this potential regulation?

Thomas Peterffy

All I hear is that there is very substantial interest of one Chicago that many of the firms are working on connecting to them.

Mac Sykes - Gabelli & Co.

Then just think about the effect of capital now with the market-making segment. Has that changed your view in the last couple of quarters in thinking about having as much capital there? What would be your other options for deploying the excess derivative opportunity you mentioned?

Thomas Peterffy

Well, other than this there isn't a heck of a lot. Maybe we expect though that this could become a very big business and that there will be a very good yield on capital.

Mac Sykes - Gabelli & Co.

Two last questions, I saw the commission per DART went up to 4.40 from 3.96. Was that just a function of more bulkier trades or was there a change in the mix that was more profitable?

Thomas Peterffy

Well, it's a function of two things. One is that the trades are getting larger and second that our currency trading platform is gaining more volume and our currency commissions are a minimum of $5 a trade, so they tend to bring up the average commission.

Mac Sykes - Gabelli & Co.

Just my last question, I don't know if you can answer this. Do you think you can quantify the impact from say the Federal funds rate going to 1%, how much that would mean in sort of earnings per share given where your balances are?

Thomas Peterffy

Yes, I can. The way we do this is that we do not pay any interest on customer deposits to the extent of the first $10,000. Over and above $10,000 we pay 0.50% less than the Fed fund rate.

So if the Fed fund rates were to rise by 0.25% we would get the full benefit of that. But if they were to rise by 0.50% we would no longer get the full benefit because some of it would be rebated to the customers and from there on we would benefit very little, only to the extent of the first $10,000 per account.

So this creates a circumstance where in the first 0.25% increase we would gain $16 million, the second 0.25%, $6 million and from there $5 million per 0.25%.


Your next question comes from the line of Edward Ditmire - Macquarie.

Edward Ditmire - Macquarie

I have two questions. First of all, can you comment at all on how implementing the professional trader classification impacted results in the first quarter and exchanges that did implement that rule?

Secondly, can you compare and contrast the environment and how competition is going in the US market compared to international markets in market-making?

Thomas Peterffy

Well, initially, our market share increased when the rule was implemented on the exchanges that it was implemented on. I'm in a tough spot now because I'm not 100% sure of the answer but I believe that the increased market share remains increased but we lost substantial market share on the PHLEX and later on NYSC Arca.

So as far as the cap is concerned it's doing its thing. It's doing what we expected it to do. But as long as there are other places to go to, it overall didn't have as much as we were hoping it would. But now that there are no other places to go to or maybe there is not the other places to go to, we expect to gain the benefit of that.

Obviously the large trader identification would be very helpful in the enforcement of these rules.

Now, your second question was how competition in market-making evolved in exchanges outside the United States. Competition has increased worldwide, more or less uniformly, I would say just as much in Europe as in the United States and slightly less in Asia than in the United States.

Edward Ditmire - Macquarie

Just a follow-up on that if I can, in particular we've talked a lot about the particular market structure elements in the US market that have given trouble, in particular high-frequency traders that might be arbitraging the customer classification. I'm not familiar with how the rules might be different in international markets like Europe. Is there any similar dynamic there or is there a more simple kind of reflection of just broadly increased competition?

Thomas Peterffy

Well, the big difference, especially in Europe, is that banks and brokers can do the trades upstairs and put it up at the exchange after the close. So basically there is less competition there on size of which you do the deal but there is obviously more competition for getting the customer in the door.


Sir, I’m showing no further questions in the queue. Actually, sir, I'm showing we do have questions now. Your next question comes from the line of Rich Repetto - Sandler O'Neill.

Rich Repetto - Sandler O'Neill

One follow-up, it seems from what I’m hearing there's two dynamics. One is certainly competition and the other being the environment of the volatility. But I guess the question is could you just subjectively sort of break out what's impacting you more. Is it competition or is the idea that the Vix has dropped over the last year from the high levels down to 17, 18?

Thomas Peterffy

Well, the two things seem to go hand-in-hand to the extent that it is easier for each of these to compete in a low-volatility environment than in a high-volatility environment because the prices when they are steady you can go in and copy the NBBO and sit there and if you get executed one side you have no immediate worries and you can wait until somebody comes in and maybe does the other side with you.

When the market moves around very rapidly you're not so cool in putting in a quote because you don't know what to do when somebody trades with you. So it's a situation where low volatilities generate more competition for us. So it would be hard for me to separate which is more important. But obviously we would like to see a greater effective or actual volatility in the marketplace.

But it's extremely important for us, remains extremely important for us is a situation where the actual volatility is more in line with the implied one because, as you know, we buy options and they imply volatility and we create a hedge against the effective one.

Rich Repetto - Sandler O'Neill

Would you say that impact of the actual to the implied volatility is still much less than - I see how you can't probably differentiate because low volatility breeds more competition. But the actual to implied, if that healed itself would that be a third of the sort of the headwind that you're facing in market-making?

Thomas Peterffy

Well, I don't quite know how to characterize the headwind itself. It certainly won't impact on the currency translation. So I think that actual to implied volatility is at least as important as competition, if not more.


Your next question comes from the line of Niamh Alexander - KBW.

Niamh Alexander - KBW

If I could, Paul, just to clarify the FX costs you've given as a $19 million and as a $21 million. The $21 million, that was kind of the total comprehensive or impact to balance sheet. There was an income statement impact. Is that correct at the balance?

Paul Brody

Yes, that's right. That's what Thomas was describing.

Niamh Alexander - KBW

So that income statement, in fact, was close to $70 million.

Paul Brody

$69 million. It's the earnings component, yes.

Niamh Alexander - KBW

The other question, just to clarify, Thomas - thank you for the sensitivities to the higher rates. That's really helpful. But just to be clear, that was a revenue or an operating income number? It's a revenue?

Thomas Peterffy

That would be revenue with now expenses associated.

Niamh Alexander - KBW

Then the other thing I just wanted to go back to was we've been - the last several quarters you've seen the emergence of the high-frequency guys moving into options and even as the rules have changed against them, I'm not sure - it's hard to call whether they're go away or not.

So if you stand back and look at your options market-making business where do you see kind of the margin potential leveling out because we seem to be kind of still transitioning but you've gone from a high 65% operating margins down to the 30s. Is it back towards kind of - can you get yourself back to a 40%, 50% range in a new competitive market environment do you feel?

Thomas Peterffy

I certainly feel that 50% is realistic.

Niamh Alexander - KBW

That’s coexisting with high-frequency traders in the market going forward.

Thomas Peterffy



Your next question comes from the line of Sam Hoffman - Lincoln Square.

Sam Hoffman - Lincoln Square

I actually have three. The first is just following up on a couple of questions that were just asked. If the competition went away entirely due to the market developments that you were talking about, at current levels of volatility and reasonable levels of actual versus implied volatility, do you think you could get back to the 2009 levels of profitability in terms of the average gain that you'd make on each market-making contract?

Thomas Peterffy


Sam Hoffman - Lincoln Square

Second question is you had talked in the past about a concern that there might be a transaction tax implemented and I wanted to know if you could provide any update that you had on that possibility.

Thomas Peterffy

My information is that it has gone to sleep. I know that the - I do not know the official name of the office of congress that was looking at this and interviewed me on the question and I explained to them the enormous impact that that would have and how it would defeat the purpose because they wouldn't actually get to collect practically anything. They seemed to have had the same view that I had. So it doesn't look like it passed.

Sam Hoffman - Lincoln Square

Finally, just on capital redeployment, you have a certain amount of excess regulatory capital in the broker dealer that it sounds like you're looking to maintain and then you have the ability to deploy capital into the growth areas that you talked about.

In terms of the additional excess capital can you give us any updates in terms of potential redeployment into dividends, share repurchases or whether you'd look to make acquisitions?

Thomas Peterffy

Well, our hope is that the new regulations will enable us to employ our capital of pretty high yield. So we are not - that is what we are focusing on and that's what we want to do.


Your next question comes from the line of Rob Rutschow - CLSA.

Rob Rutschow - CLSA

I was just curious if you might have a feel for what your market share is among the sort of professional-type traders that you target on the broker side.

Thomas Peterffy

I think it's very tiny because basically we are targeting financial professionals and if I sit down and think about it, the last time I did I somehow came up with a figure of 3 million, that there would be 3 million people around the world that would benefit from being our customer and we only have, well, less than 100,000 of them because not all of our customers are financial professionals.

Rob Rutschow - CLSA

So, I mean, the strategy of going after those types of traders is really still very much green field at this point.

Thomas Peterffy

I'm sorry. What was the question?

Rob Rutschow - CLSA

Well, just there's no change in strategy for the brokerage business given that you have such low market share. I mean, there's no thoughts of going after retail or anything like that.

Thomas Peterffy

No, absolutely not. No, we are trying to go after the financial professionals both for a personal and an institutional account. Usually what we find is that people who have their personal accounts with us eventually begin to come up to the idea that maybe wherever they work they should consider using us as their broker.


Your next question comes from the line of Edward Ditmire - Macquarie.

Edward Ditmire - Macquarie

Last quarter you had actually said what the dollar amount of impact from the fall in volatility over the quarter was and the long volatility position.

Thomas Peterffy

$27 million.

Edward Ditmire - Macquarie

$27 million?

Thomas Peterffy



Your next question comes from the line of James Sheridan - Private Investor.

James Sheridan - Private Investor

Thomas, would you discuss the impact of penny pricing on the bid offer spread?

Thomas Peterffy

I do not know the answer to that question. It stands to reason that since options that trading pennies have a lower bid offer spread, the more classes join. The penny class is the overall bid offer spread will come down but I haven't actually done the calculations.

James Sheridan - Private Investor

Can you remind us where we are in the life cycle of rolling out the different classes?

Thomas Peterffy

I think we have - the rollouts are months or per quarter. I don't know. Sorry. It's public information. I have no idea what -- .

Deborah Liston

Actually, we give it in our 10-Q. You can take a look at the last 10-Q that we filed and it's in the business environment section.


I'm showing no further questions on the call.

Deborah Liston

Great. Thank you. We'd like to thank everyone for participating today and just to let you know, this call will be available for a replay on our website. Thanks for your time.


Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect. Everyone have a great day.

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