Interactive Brokers is an automated electronic broker-dealer. Because they automate virtually everything they do, their cost structure is lower than their competitors. This results in Interactive Brokers having the lowest prices and highest margins in the brokerage industry. They also have fewer conflicts of interest than their competitors. All orders are sent directly to the exchanges or internally matched between clients. They don’t sell orders—like the retail brokers—and they don’t trade against their own clients—like the big banks.
Interactive Brokers is more akin to a tech firm than a traditional retail broker such as Schwab or TD Ameritrade. Interactive Brokers was founded by a programmer, Thomas Peterffy, and the man overtaking him as CEO, Malin Galik, has been a software engineer at Interactive Brokers for 28 years. Peterffy has said before that around 50% of all employees are programmers.
Thanks to this company culture, they have built their own software and algorithms to manage all customer orders automatically. This is no small feat. Pretty much every other retail broker in the world is more like a sales organization. Those brokers sell their customer orders to others because they don’t have the technology to handle orders themselves. This is what differentiates Interactive Brokers from their competitors. They have the best technology and that gives them the lowest pricing.
Because of this technology and pricing advantage, Interactive Brokers has grown to be the leading broker among serious individual investors, active traders, and small funds. If someone is knowledgeable enough about investing to understand this pricing advantage, but too small for the big banks, they should probably use Interactive Brokers. When I first wrote up the company a couple years ago, my thesis revolved around them being able to expand this niche to compete with the big banks for larger hedge fund clients.
While I still believe that thesis is possible, earning commissions from direct clients is slowly becoming less important. Don’t get me wrong, people like me trading on their platform will always be a meaningful part of their business, but their revenue sources have evolved the past couple years.
Interactive Brokers breaks their customers into five segments: hedge funds, prop firms, individuals, financial advisors / RIAs, and introducing brokers. As of late, the introducing broker segment has been growing far faster than the rest of the business.
The introducing broker segment is made up of other retail brokers that use Interactive Broker’s technology to manage their order flow. Those brokers realize there’s no chance of them replicating Interactive Broker’s trading platform, so it’s easier to just white label it.
While the account growth is good, the bottom line is that introducing broker clients trade less often and make Interactive Brokers less money than direct clients (this is because commissions are shared with the other retail broker). Given those are two of the most important KPIs in the business, that’s not good. Calculating how much Interactive Brokers earns from client trading is pretty simple:
Number of accounts * Trades per day * Commission per trade
While account growth has actually accelerated the past two years, trades per day and commission per trade are both in decline thanks to the introducing broker growth.
And it’s inevitable that account growth will slow as the company matures. This is a problem. Commissions from client trading makes up 40% of net revenue, and the three factors that make up commissions are trending in the wrong direction. Even with account growth remaining in the teens, it’s hard for them to generate a lot of commission growth when two of the three factors—trades per day and commission per trade—appear to be in structural decline.
The introducing broker segment has been growing so fast in large part because of Asia—and China specifically. One of the largest trends in the world the past twenty years has been China’s exploding middle class. Just in the ten years from 2008 to 2017, China’s average yearly wage went from 29,229 yuan to 74,318 (for a compounded annual growth rate of 9.8%). As the Chinese have gotten wealthier, their desire to invest and trade has also increased.
Thus, there has been a wave of new Chinese brokers that have launched over the past ten years. However, the technology needed to start a new broker is quite significant. It’s far easier to outsource all of that to Interactive Brokers—and that’s exactly what many Chinese brokers are doing.
As of yearend 2018, 16% of Interactive Broker’s accounts are from Mainland China. Frighteningly, Chinese account growth dropped by 70% in Q4 2018. While I always appreciate how candid Peterffy is on conference calls, he didn’t instill much confidence in a resolution on their recent call. He guessed that the account growth drop-off could be due to the Chinese stock market struggling or the US-China trade war, but he really wasn’t sure.
I do not know how the capital controls are connected with the trade fight. So, we sense that there is some connection. We sense that the capital controls get harder as the trade fight gets harder. But we cannot promise you that if the trade fight resolves itself, the capital controls will be lifted.
The growth explosion Interactive Brokers has experienced in China is both a good and bad thing in my eyes. Obviously, the account growth is great. But the more revenue they generate from China, the bigger that risk becomes.
The Chinese government has proven many times that they want their industry leading companies to be domestic firms, not international. I worry that at some size of success, the Chinese government could act out against Interactive Brokers. It does make me feel better that all of their business in China is through introducing brokers. There is no client-facing Interactive Brokers platform in China.
Despite all of the above, Interactive Brokers just achieved their highest pretax margin in history (below chart adjusted for one-time events in 2013 and 2015).
I believe this is possible because they are structurally a higher margin business now than they were a few years ago. While introducing brokers hurt two of Interactive Broker’s most important KPIs, these clients do bring some positive attributes. Because Interactive Brokers only routes trades and doesn’t handle customer service or anything like that, introducing broker clients are very high margin. The return on incremental capital required for each new broker should be extremely high.
Next, the Fed increasing interest rates the past few years has had a material effect on Interactive Broker’s business. As interest rates increase, they earn more on the billions of dollars of investor assets that they hold. In 2017 and 2018, net interest income generated more revenue than commissions from client trading.
Importantly, Peterffy expects this transition to continue:
We believe our continued success in asset gathering should lead to larger contributions from interest sensitive assets going forward.
Finally, Interactive Brokers is attempting to gain more share of their customers’ wallets. They have introduced the ability to deposit paychecks straight into accounts, pay bills directly from account balances, and a MasterCard debit card. And given Interactive Brokers pays a higher interest rate on cash than most other institutions, it does make sense for users to park more money there. While I don’t know if any of these efforts will ever become meaningful to the bottom line, they should all be high margin.
The next few years should be very telling for the future of Interactive Brokers. When I model out five years of account growth slowdown and continued declines in trades per day and commissions per trade, it’s difficult for the business to overcome that and still grow at a high rate. On the other hand, if they are able to stop or reverse those trends in trades per day and commissions per trade, it’s not unrealistic for them to have many more years of 20%+ growth ahead of them. And if their business continues to transition to higher margin sources of revenue, top-line growth matters less and less anyway.