Interactive Brokers: Margin Masters - [Business Breakdowns, EP.216]

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1:41This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Zach Fuss, and today we are breaking down interactive brokers, widely recognized as IBKR. Founded in 1978, interactive brokers evolved from a market maker on the American Stock Exchange to a global, cutting -edge electronic brokerage firm. Its founder, Thomas Pederfri, remains far and away its largest shareholder and has earned his place as one of the wealthiest people in the world. Pederfri came to the U .S. from Hungary as an immigrant who spoke no English and taught himself computer programming in the 70s.

2:21Eventually, he pioneered automated trading and played a crucial role in the digitization of financial markets. Today, we'll explore the journey of IBKR from its early days as Timber Hill to its current status as a publicly traded company with a market cap of nearly $80 billion. We'll dig into how interactive brokers makes money beyond just commissions, including their net interest income and other market -making activities. and we'll explore their reputation for offering low -cost access to a vast variety of global markets and sophisticated trading tools, which has made them a favorite amongst traders and institutional investors.

2:59Additionally, we'll discuss their differentiated tech stack, their global reach, and again, their famously low fees. We'll explore their competitive landscape, the risks they face, and what the future may hold for this brokerage giant. To break down IBKR, I am joined by Freddie Leite and Jacobo DiNardo of Latitude Investment. We hope you enjoy this breakdown of IBKR. So today we got a two -for -one special. We're joined again for the third time by Freddie Leite and his partner, Jacopo, to discuss interactive brokers, which has been a quietly covered business despite the fact that its growth has been so pronounced and it's integral in kind of the way that we interact with the markets today and its growing presence.

3:48I think, Freddy, Jacopo, just to set the stage about the brokerage business, discount brokerages and the broader landscape, maybe we kick it off there and then we can dive deeper into this particular business and why it's so special. Yeah, sure. No, it's great to be back on the show. Thanks for having us. Interactive is a really interesting business. It's one we've owned for about 18 months, been following for a number of years. It's a digital broker, so you can trade stocks and bonds and currencies and options, pretty much anything you like through it. And it started out 50 years ago as by far and away the most technologically led business in the space.

4:20And there's lots of history we can get into, but what they've done through investing in technology and investing in automation and a couple of other strategic advantages is developed by far and away the lowest cost model, the lowest cost to serve with the highest quality output. And this is what's driving the flywheel effect. They're making the highest profitability at the lowest costs, driving huge growth in their customer base. And that compounding is coming without advertising, without marketing, and individual investors are increasingly choosing interactive over all of their competitors. But what's most exciting in this business model in the last five or 10 years has been the doubling up of that compounding effect through the growth in other channels.

4:56So they're growing from other brokers introducing business, they're growing from hedge funds, They're growing through RIAs or what we call IFAs in the UK, and they're really growing internationally. They're a truly global business with a huge market potential and a lot of exciting things to talk about today. I guess a nice place to start when talking about brokerage businesses, just take us through the key revenue streams and how these businesses fundamentally make money. It's relatively simple. There's a lot of complexity when you really dig into it, but at a headline level, they make money in two ways.

5:28They make money through charging commissions on trading, and they make margin through net interest margin. So a spread on cash held on account or margin loans that they make. And it's reasonably straightforward to model this through. They have three and a half million accounts. The average account does about 200 trades per year, and the average commission's about $3. And we times that through, you get to the sort of roughly $600 per account in trading commissions per year, or around $2 billion a year. On the net interest margin, they pay very good rates on cash. It's a real strategic advantage.

6:00They own quite a narrow spread on their funding, but effectively their sort of securities lending and margin business, which is about 11 % of client assets, is financed with customer deposits. And the spread between what they pay on those two equates to a net interest margin of about $800 per account or about $3 billion. And those are relatively stable per account numbers. And so the real driver for this business over time has been and will be account growth. And when we started looking at the business, it had around a million accounts. It's got around three and a half million now, five years later, and they have various different targets to get to 10, 20, or maybe 80 million accounts as time goes by.

6:38And so then when I consider interactive brokers and the broader landscape, you've got Charles Schwab, Fidelity, obviously Robinhood. What are the key differentiating factors about this particular business as opposed to its peer set? When you look at Interactive, it was born out of a person who is first and foremost an engineer and a technologist. And that type of culture has reverberated throughout the firm day one. So when you look at Interactive, it's by far the most automated of all brokers. So when you go on to the app, most of the functions you'll hit on it, including actually eliminating accounts because they exceeded the margin loan, is done automatically by a bot.

7:23This doesn't tend to be the case for the competitors. And this has also morphed the broker into being really one that is liked and used first and foremost by experienced traders. The first days of the business was really only used by individuals and what today we call prop traders. These are individuals with account balances that tend to vary between, let's say, $200 ,000 up to a couple million dollars per account of client equity. And this compares, broadly speaking, quite favorably versus other online brokerages. So you'd think someone like Robinhood or eToro would have account balances averaging maybe five to 10 ,000.

8:07So it would be the first brokerage you go to when you learn about trading. And places like Schwab would have higher account balances, but they would be used in a much less frenetic way. As Freddie mentioned, you make about 200 trades a year per account on an interactive and that number might be tens of times even lower if you're using your Fidelity or Schwab account, which tend to be used for slightly different purposes. So obviously 401ks being one of those in the US. So I think it's impossible to really appreciate how differentiated IBKR Interactive Brokers is without spending some time discussing its founder.

8:51Thomas Pederfee came here with effectively nothing, I believe, in the 1960s, and is now one of the wealthiest and relatively unknown Americans. Can you just tell a little bit about his story, how this business came to be, how it's evolved over time, and then how much of the business and how involved Thomas is today? As you said, he was born in Hungary during basically the periods of war in Europe, and he migrated with nothing to the US, pursuing the classic American dream. And the business started out actually as a market -making business for options when Thomas bought a seat on the Chicago Mercantile or Board of Options exchange.

9:35And initially, his broad idea was that of pioneering a way of pricing options. It was at the time when the formulas were coming out from Black & Shoals and when option trading was nothing compared to today. And the company was called Timber Hill, and it was really an option market maker. But if you think about that, the way Thomas approached the business was completely different in the sense that he wanted to automatize everything that could be automatized. And this still permeates the culture of a business today. Interactive doesn't want to be in businesses that eventually cannot be automatized in the future.

10:17On top of it, if you think about the role of the option maker, risk management is at the center of everything you have to do. So you're taking obviously both sides of a trade most of the times, and you're just creating a market for participants. So up to these days, obviously risk management is one of the most important point that differentiates Interactive compared to other brokerages. There's a couple of examples, but the only time they really actually lost some money in a significant way, which is not significant compared to the total amount of equity they have, was when the Swiss Central Bank let the Swiss franc appreciate freely and the company lost about 1 % of their capital at the time.

10:59And recent examples include when interest rates were zero in 2021 and a lot of other online brokers decided that it was the time to take some duration risk to make some more money on net interest income, the company refrained from doing that. So I think when one thinks about the two vectors on why this business is so well managed and managed to succeed, but I think his starts as someone who is fundamentally an engineer and focused on risk management are two very important aspects of the business. And it's worth saying that he's also a very hard -nosed and smart businessman. So whenever he saw that the option market -making business, due to changes in regulation and the market environment after the great financial crisis, was not a business that would earn excess ROEs anymore, he decided actually to close that down to focus entirely on the online brokerage.

11:54And so when you consider the business of online brokerage, there was a pretty big evolution, I'd say, over the course of the last decade, primarily focused on payment for order flow or PFOF. And so what you went from is a world where commissions were $5, $10, $25 per trade to a competitive landscape where many of their peers offered zero commissions. And so I'm curious, despite that, IBKR, while still being a business that charges commissions has seen its growth explode. What is going on? What is the debate around PFOP, which I believe is actually not even a legal business proposition outside of the US?

12:33How do you think about that backdrop as it relates to interactive brokers' ability to continue to take share? We think this is one of their key competitive advantages, that since day one, they've always chosen to have direct market access. So imagine like a Costco model, they're cutting out the wholesaler. They don't have someone else. They don't have to go to a broker. And so when they have linked their system up to every exchange in the world, give or take directly, and so they execute directly at the best price on your behalf. Whereas payment for order flow, which is pretty much just a US phenomenon, these businesses who buy that order flow clearly make a large amount of profit.

13:08And so that has to come out of someone's wallet and implicitly that has to come out of the customer's execution price. And so you can listened to the CEO, Thomas Pefferty, talking quite vociferously about this practice and other banking practices that have yet to be regulated, but it's something that they've always avoided. And it does save them a huge amount and allow them to move much faster than a lot of competitors as well. So it's no higher cost. They don't get the payment for order flow into their revenues like some other businesses do, but they don't need it because they can prove best execution.

13:37They still have lower commissions across the marketplace. They charge far less than others in most cases. And their other draws are their much cheaper margin loans and their much more generous payment for cash on deposit. They basically pay 50 basis points less the local base rate on any cash deposits over a certain threshold. So they're seen correctly as giving back everything they can to customers with a small margin. And then it's just, that's their principal competitive advantage. The second, as Jacopo has already touched on, is the automation of the trading itself, of the risk management, and of the management of the business and all the OPEX, which means that their cost base is just so much thinner than the others.

14:16So they're able to continuously reinvest in price. I think one of the things that's interesting is if you look at the headcount of IBKR relative its peers, it obviously speaks to their interest in making sure that everything is tech enabled. I will say amongst some investors who use the platform, They do complain about the lack of customer service at times, but it's what allows them to offer such incredible low cost execution. And then the other aspects of it being really your ability to use leverage at a very low cost of capital. Can we just talk about how they use their balance sheet in a way that provides such a structural cost advantage relative to their peer set?

14:56Fundamentally, there's a couple of points here to be made. The first one is a bit like Jamie Dimon at JP Morgan talks about having a fortress balance sheet in financials is of paramount importance to succeed over time. It allows to obviously survive crises if they happen. Interactive has a similar approach. If you look at the balance sheet today, at the end of 2025, there's probably going to be about $18 billion of excess capital, which is about 95 % of the total capital they have. that allows them obviously to grow the business in a fairly serene way without necessarily participating in the ups and downs of the market.

15:39And the second point being when offering low cost margin loans, it stems partly from that and partly from, again, going back to the automation point. The big risk when offering margin loans is that eventually those accounts will need to be basically closed because with a market drawdown, the fall in value is superior to out of a margin loan. And there's plenty of examples around the latest one actually coming from Archegos, where even at investment banks, which one would think are fairly well invested in technology, still require quite a lot of human involvement and personal calls in order to make decisions.

16:16That never happens at Interactive because everything is automatized and the account, if it doesn't post the required collateral within a very short period of time is automatically liquidated and eliminated. And if you think about that dynamic, that is exactly what allows interactive two things. One is to underprice competition in terms of cost for the margin loan. It's about half the cost of Fidelity or Schwab or whoever else competes in the US. And it also allows them to offer slightly more leverage than competition without really affecting the total risk. If you're able to cancel that account or to close down that account fairly quickly, and you're also able to mitigate the risk of loss from that account in a better way than competitors, that allows, again, to foster that competitive advantage coming from lower costs and obviously higher automation.

17:12And so I think it would be helpful to illustrate how this manifests by demonstrating what an account looks like and how a customer uses the business. For example, let's say you have someone that's a professional trader that has a million dollar account and maybe is running at two or three million dollars of gross, long and short. They're obviously borrowing and lending securities. What does it look like? And to the different revenue line items. So the commission revenue, the net interest income, the fees and services that they provide just to really drive home how people interact with this business and its ability to be differentiated on every service that it provides to its key customers.

17:58The difficulty here is that one does need to disaggregate a little bit. We've been discussing this as an online broker, which makes it feel very much like it's aimed entirely at individuals logging onto a website or an app. The truth is more than 50 % of the business and a large portion of the growth in the business, although individuals are still growing very nicely, is the other three main cohorts, which are white labeling the platform and service for RIAs, advisors around the world, prop traders and hedge funds. They're now the fifth largest prime broker in the world. So they're larger than many of the big banks you could name from a standing start about 10 years ago.

18:32They're growing far faster than the market for prime because they are seen as more attractive to the hedge fund groups in general. And then the final one, which is just worth touching on, is what they call introducing brokers. And you can think about this as another bank or another brokerage business who is outsourcing and cancelling their own internal technology investments. As an example, they just brought on HSBC globally, and then they're going to plug in the underlying trading capability of interactives. I would think about this in the same way that a lot of people have become comfortable with outsourcing admin or custody to JP Morgan or these large custody banks like Northern Trust.

19:07a large number of these huge global institutions, as opposed to investing in the technology, are renting it implicitly from Interactive. And that is where a lot of the growth is coming from. So what we see at an account level is slightly averages of those things. We can make some assumptions about where the margin skews towards the hedge funds and the prop traders and obviously away from a lot of the RIA business. But what you see is an average account balance that, even when it was individual -led, was much higher than most other firms. And very normal, typical to have $100 ,000, $150 ,000, $200 ,000 as the average account balance.

19:43Against that, there are two other interesting assets, which are the margin loans, which we've discussed, which used to be far higher actually and have come down as a percentage of equity over the last 10 years, but are ticking up again at the moment in the short term at about 10 % to 12 % of assets. So if you've got a $200 ,000 account, you might have $20 of margin loans against some securities in there on leverage. What's also been very popular with all of the brokerage platforms, including Interactive, has been securities lending. And again, as we've probably become boring saying, this is fully automated.

20:17So you can sign in if you want to. Your securities, your stocks can be lent out to people who wish to borrow them and to short them. They're still fully tradable. They're fully collateralized from our perspective as shareholders by cash. and the client earns most of that lending fee. And again, there's a small but very honest spread, which is all transparent. So they have a similar amount of securities lending, about that sort of for a $200 ,000 account, about $20 ,000 of lending, so 10 % of the base. So that's the kind of average, but we do believe it skews a lot. A lot of the introducing business and a lot of the RIAs, we think are probably using less, probably trading less as well, under that sort of 200 trades per year.

20:58And then really the majority of this stock lending, margin loan, and even the turnover, the number of trades or darts, as they call them, daily average revenue trades, if anyone's reading the annual report after this, that skews towards the hedge fund business. So it's a variety of different clients, all benefiting from the same low cost platform, but they're using it in different ways. When you look at this business as P &L, and I'm looking at 2024 as a reference, You have about $1 .7 billion in commissions, which results in around $2 billion of non -interest related income. And then the rest $3 billion is that net interest income, that NIM, resulting in about $5 billion of revenue.

21:42How do you think about how that should evolve over time, the mix in quality as it relates to the evolution of their customer base, which you just mentioned? And then a second question related to that, when you see a business that's as significant an earner on net interest margin, you beg the question as it relates to interest rates and how they impact the business and what would happen in an environment where rates were going down versus going up. Just curious on those two items, really revenue mix and NIM as the business evolves over time. There's quite a few ways to cut it. This is clearly a cyclical business.

22:16It grows very rapidly and account growth that had been around 25 % per year is inflecting up towards 30 % and 35 % per year at the moment as the flywheel gathers ahead of steam. The most important thing that I want to compel you to understand from our perspective is that it's account growths that matter. And if you need to believe account growths are what matter, then one needs to believe there's sort of stability in the other things like the amount of trading and the revenue per account. And so when we've interrogated the number of trades that's been going on, as the mix has changed and the accounts have been growing, the trades per year have been falling.

22:51And again, one would expect hedge funds are trading many times a day, but RIAs and introducing brokers in particular are probably trading less than the 200 average trades per year. And so we expect, and we've observed over the last five or 10 years, a kind of 5 % to 10 % decline in trades per year. So if the growth is similarly skewed between the different cohorts over the next few years, obviously in periods of volatility, one trades more. In periods of low volatility, one trades less. But as a trend, we put a deflation, if you like, in the number of trades per year. And I think there's probably a small amount of potential deflation to come through from commissions.

23:29But the management team have talked about flat average commission levels from here. And it really does depend on mix. Again, a crypto trade is a very different commission level or an option compared to trading Google shares. The way it's worked is you have that kind of average $500, $600 per account of commission. It'll probably trade a little bit lower, maybe 5 % down per year on an average basis, and then be cyclical with client equity. But if account growth is 35 % or anything along those lines, that will dwarf any reinvestment backing price. That's the easier one is the commissions. And obviously, you can take your own view on average client equity and average equity market performance over the long term.

24:09When you factor those things in too, they offset that reduction normally. On the NIM, and I think this is probably one of the greatest misunderstandings in the business, and it was certainly what gave us the opportunity to invest in it 18 months ago, is the actual sensitivity. If you think about the alternative, if you think about a business like Schwab, which only a couple of years ago almost needed effectively a wholesale rights issue, because it had what was effectively a run on its funding source, because they weren't paying anything on their customers' cash. And customers, when interest rates went up, started saying, we'd better go to a bank or we'd better go to a money market fund.

24:41And they robbed Schwab of that source of cash and funding. The arrangement between interactive brokers and their customers is just far more honest and it's very transparent. And it's, as I said, on any large balance, more than $10 ,000, which is about two thirds of their entire customer cash, they just pay the local market base rate less 50 basis points. That results in a far lower risk, firstly, to the point about Thomas Pefty's risk conservation. Clients are probably not going to leave because they get 50 bits more elsewhere, even if they could. But secondarily, it's actually less interest rate sensitive than you think.

25:14Because if rates go down by 50 basis points, they still just take 50 basis points on a spread. And so they do disclose that overall interest rate sensitivity and for 100 basis point move down in interest rates around the globe. And again, this is a global business, probably 40 % US. Jacopo's nodding at me, but it's global in nature. If global interest rates fell 100 base points, NIM would fall by 10%. And again, that's NIM per account. So if you're growing your accounts at 30, 35%, it will more than offset a multiple of times than a net interest sensitivity. So that's why we focus so obsessively on the business model and the potential for account growth.