Craig Siegenthaler BofA Securities
Good afternoon, everyone. Let's get started. I'm Craig Siegenthaler from Bank of America, and it's my pleasure to introduce Thomas Peterffy. Thomas is the Founder and Chairman of Interactive Brokers. Thomas founded the firm 43 years ago?
Thomas Peterffy
46.
Craig Siegenthaler BofA Securities
46 years ago, okay. And is a pioneer of electronic trading globally. Interactive Brokers is a digital investing platform that spans multiple client segments. This includes hedge funds, prop trading, RIA, broker and its largest segment, individual investor. It also expands around the world versus a lot of its peers, which are really focused here in the U.S. So Thomas, thank you very much for joining us today.
Thomas Peterffy
It's a pleasure.
Craig Siegenthaler BofA Securities
So we're going to start off with technology, research and development. One of the areas that I think is a key competitive advantage for your firm. What makes your tech effort so different? And why can't other e-brokers sort of replicate what you do and are unable to expand globally, like you've been able to do?
Thomas Peterffy
So Interactive Brokers has a unique history. And that explains why the company is so different than others, and that includes our unique approach to building technology.
Prior to funding IBKR with $200,000 of savings 46 years ago. I worked as a computer programmer for 10 years, and that experience have substantially determined my vision for the company. The company would basically be just a collection of computer programs that performed all the unique functionalities that the company has to do in an automated manner with as few people attending to these systems as possible.
Initially, we were market makers of the American Stock Exchange. I first through the program that would be trading options. And as profits started coming in, I would hire other programmers to expand the system to more products and back office and accounting and management reports. The next 4 decades, we're all about building this software and adding more people to building it.
Accordingly, most managers of the company today are software developers. We do not start any new business up until we get it first completely automated. Now as to the international offering, why we are so unique and the only ones basically to do that. As option market makers by the late '80s, we had a fully automated system that would put out bids and offer quotations and receive executions, but on the execution end of this system, we had to employ human traders on the exchange roles who would execute the trades, needing people to implement their trades was an impediment to efficiency and an unnecessary expense.
So in 1990, the first automated options exchange opened in Germany, we saw that as a huge breakthrough for us. They needed liquidity, and I convinced them that if they let us hook up directly to the exchanges computers, we will stream live quotes to them throughout the trading day. And that proved to be a great success and other electronic exchanges as they opened in Europe and Asia, we just replicated that same business model.
So pretty soon, we had memberships and electronic connections to all the major exchanges around the world, except still not in the U.S., which was still open outcry. We had a computerized automated global execution network. So when we started Interactive Brokers in 1993, a brokerage firm, we just put that on top of this network. And this explains our international presence today. Of course, we -- that was followed by years of building compliance and tax reporting software for the individually unique requirements of each different jurisdiction, but that, of course, still goes on to quite some extent.
Craig Siegenthaler BofA Securities
So Thomas, your business model expands across so many different client segments today. And by geography, across so many regions. Can you walk us through the key businesses that you offer today?
Thomas Peterffy
So we have individual investors. We have hedge funds. We have proprietary trading firms, registered investment advisers and introducing brokers. Now introducing brokers are basically just brokers like we are, except they use our platform to do their business. So they, in turn, also have the same customer types, namely individuals, hedge funds, proprietary trading firms and registered advisers. Our customers come from all countries. So we have -- and territories because we are in 204 places, but there are only 194 countries [indiscernible]. So that's where we are.
Craig Siegenthaler BofA Securities
So on December 15, the SEC sent us an early Christmas present with 4 new proposals on equity market structure. What are your initial thoughts on the proposal?
Thomas Peterffy
So I think that proposal is a validation proposal to save money for retail and institutional customers. I just worried that the savings may not be enough to justify the expense of building out a different infrastructure. And I'm somewhat worried about the unknowns that could emerge. I would prefer if the SEC let it up to the industry and the competitive spirit of the participants to deal with these problems.
Craig Siegenthaler BofA Securities
So what do you expect as the impact to the equity market structure in the United States? And also there's likely a negative impact to payment for order flow from the rules as they're written today, how do you think that plays out? And then also what specifically is that -- you think the impact on IBKR's business?
Thomas Peterffy
So I don't think that payment for order flow will necessarily go away. Most brokers do not have their own order routing systems today. So they will have to continue to use somebody else's and they may as well use the current routing destinations of Citadel and Virtu and other similar companies. So the changes are more likely to be on their end, not on the brokers end, but on the execution side.
They will have to go through different machinations to interact with the orders as the new rules we recall for -- and the interaction rate will probably decrease the payment for order flow will decrease. And those orders that they are not interacting with, they will route on behalf of the brokers just as a service. That's what I think is going to happen.
At Interactive Brokers, we offer a choice to our customers. We can choose IBKR Lite, Zero commissions, and we sell the order for -- payment for order flow. Or we execute the orders within our routing environment, which includes our ATS, dark pools and exchanges and we charge a commission. 94% of our customers chose the latter. Much of our order routing and execution software revolves around getting the best price inside the NBBO. So I cannot imagine that the new rules would make a substantial difference for us.
Craig Siegenthaler BofA Securities
What do you think could come next from the SEC? I know you talked about potential on the option side on the last earnings call. So do you think that could be next?
Thomas Peterffy
Yes, there could very well be a proposal to force option executions to go through different channels. But again, we just recently released our new option routing destination, we call IBUSOPT. Here, customers can indicate the mid price or a price back to the bid or offer or back to the best price as the price at which they want to execute. And we will hold the orders up until we get an opposite side order against. So we can marry the 2 sides.
And we will attempt to do that because all options must be executed those options exchanges. And when we take the cross to the exchange, we at times get interference, which means that on one side, we get a better bidder offer than we were contemplating where we had the 2 orders crossing. And in that case, that side, the other side gets a better price, which is great. So we are already doing a version of what I think the SEC will going to do. So whatever they come up with, I think we will very easily be able to adapt to it. But I'm not so sure that other brokers will be.
Craig Siegenthaler BofA Securities
Let's change it up and move on to your introducing broker business. You've seen a nice acceleration in growth there on the August earnings call. You talked about 2 very large potential wins in the pipeline. What's driving the reacceleration of growth in the IBroker business?
Thomas Peterffy
So I think I already gave you a glimpse of how complex execution systems are. Compliance is not any simpler, especially when all this must take place among many other different jurisdictions and regulatory regimes. This is an issue that many international banks and non-U.S. brokers are faced with today. So these brokers want to make available to their customers U.S. products, where most of the action is today, in addition to the local products and sometimes also some international products. They realized that to build and maintain a system that can do all that would probably cost a lot more than the revenues that they would derive from it, especially since IBKR is -- already offers that service at a very low cost in their country already. So they would have to compete with us.
So the ultimate issue becomes how should they compete with Interactive Brokers. These financial institutions already have all these customers and offer other services to them. And we are happy to provide the technology and the service at a discount so that they would charge the same amount or just a little more than we charge and they'll be running at a profit. And we do not have to bother with getting the clients and providing the AML and the customer service. So it's a win-win on both sides.
Craig Siegenthaler BofA Securities
So how does your pipeline for additional IBroker wins look like today? And I don't want to get ahead of myself because you just launched -- you announced 2 big ones. But how does the forward pipeline look?
Thomas Peterffy
So we're having conversations with several banks and brokers. Their customers will hopefully end up with us as their current providers become introducing brokers much sooner and for less expense than if they try to build it themselves. So as I explained before, it doesn't make sense for them to build it themselves.
Craig Siegenthaler BofA Securities
So you also have a large -- actually not large, but you have a hedge fund prime business. I think you look...
Thomas Peterffy
That large?
Craig Siegenthaler BofA Securities
Well, large. We'll call it large. That's looking to compete against large banks out there. There's large banks have a full suite of products that they can provide to, they also have very large capital bases, which is probably a selling...
Thomas Peterffy
That's right.
Craig Siegenthaler BofA Securities
How do you compete with them?
Thomas Peterffy
So hedge funds are our best customers, and that's because they must make a profit to stay alive on the long run. In order to be able to attract them, we must be able to offer our services on better terms than our competitors do. Superb quality of execution, low margin rates, high interest on excess cash, large and easily accessible short rebates, various certain risk management software. These things are all extremely important to assurance. We can do all this because our very high degree of automation. Hedge funds are the alternate sophisticated investors, and they are the ultimate proof that the best informed investors choose Interactive Brokers.
As far as competing with the large investment banks, while we are very good at the services I just described, we do not do swaps, which are basically just margin loans against very thin collateral because we do not like the risk and funds understand that. They understand that when a prime broker takes a risk on them, that prime broker probably takes a risk on other hedge funds too, and some of them turn out to be our CAGRs. So when you -- when your hedge fund, then you want to be a very safe broker, your best bet is Interactive Brokers. We have $12 billion of capital, and we don't take any third-party counterparties.
So we also do not provide capital intro, although we do provide some on our website as hedge fund can display their AUMs and returns and on our hedge fund marketplace. And when the user clicks on it, they can provide other information and arrange for meetings. We do not sponsor these meetings or we do not sponsor meet and greet dinners or events. But most large hedge funds have 2 or 3 or even more prime brokers, and they use each one for the best of what they offer, and we fit very well in there.
Craig Siegenthaler BofA Securities
So how are you looking to grow your hedge fund business at this point? And how important is the capital base? Because I know a lot of us would like you to raise the dividend or buy back stock...
Thomas Peterffy
Yes. So you can't have it both ways. You want capital base or you want dividend. No, we keep the dividend -- I mean we don't pay -- we don't raise the dividend. We hold on to the capital. We believe that the market is -- favors growth on the expense of dividends, and we have similar sentiment. So we are growing extremely fast in this space. We are currently #6. Next time Preqin comes out, they rate prime brokers annually. Next they come out will be #4 behind Morgan Stanley, Goldman Sachs and JPMorgan. Sorry, Bank of America.
Craig Siegenthaler BofA Securities
So let's move on your 2 commission models. IBKR Pro and your Zero commission business, IBKR Lite. You touched on them briefly. But how is the organic growth in this business changed from the 2021 bull market to the 2022 bear market? And do you see Lite or Pro as being the primary source of growth going forward?
Thomas Peterffy
No. No. Now Lite is negligible. It comprises only about 6% of our accounts and a much smaller percentage of our trades. Choosing Lite on our platform, which was built to provide the best execution possible is probably not the best choice. But there are some retail customers who insist on it, and so we'll let them have it reluctantly.
Superior execution is the strongest feature of our platform, especially if we are successful in building our crossing mechanisms for stocks and options as I just described. We would be remiss if we had not tried to guide our customer towards taking advantage of these features.
Craig Siegenthaler BofA Securities
So where has your individual investor growth come from in 2022 when you think about the different geographies? And did you see a big change in '22 versus the prior years, the bull market years '20 and '21?
Thomas Peterffy
So our retail growth comes from individual customers and introducing brokers. In '22, our growth was 28% and 16%, respectively, in these 2 groups. And this year, so far, we are at 24% and 19%, but we expect both sources to pick up strength as they go further into the year. Our high interest payment, currently 4.08% on [ IDO cash ] and our associated ad campaign around that is what will generate further growth in those sources.
And of course, the more orders we get, the better our executions will become on both stocks and options because we have a greater chance of being able to cross them near the mid-price. This will be our ultimate strength that we will emphasize throughout the years to come.
Craig Siegenthaler BofA Securities
So you just said that you expect retail growth to kind of reaccelerate towards the back half of this year. And you gave us guidance on the call of long-term organic growth across the business, 20% to 40%. We're close to lower end now just because we're in a bear market. But what would it take to get back to those great levels we saw in like '21, which are actually above the high end of that range?
Thomas Peterffy
So '21 and early '22 are different times. It was a mean -- meme stock mania, which I hope will never return because a lot of people lose a lot of money. And in my view, this is bad for the industry. It's not helpful for making people understand how the economy works, and our capital market works and what the purpose of the capital markets is in the economy.
Interactive Brokers' high growth rate of new clients in that period was partly due -- partly a byproduct of the high growth of these accounts in the entire industry as many new less sophisticated investors who open brokerage accounts, and we got our share. Our current and future growth is and will be due to unique capabilities we offer to customers so that it is not a result of industry-wide growth.
Concerning institutional customers, our highest growth accounts, as I said, are the hedge funds and closely followed by proprietary investment groups.
Craig Siegenthaler BofA Securities
So I wanted to talk about lending for a second. And you don't offer a lot of products there, but you have stock lending, margin lending. I wanted to figure out if these products are pretty well established across your platform? Or if there is a cross-sell opportunity for higher adoption rates with these products across your clients?
Thomas Peterffy
So we do not look at this as cross-selling. We try to get all of our customers to sign up to our program of lending fully-paid shares where we split the proceeds 50-50 with them. We also try to sell people on our very low margin rates that are just 50 basis points over the Fed fund rates for larger amounts. We also try to showcase our online shortable inventory and displayed lending rates to everyone who is willing to look at it. This feature is becoming extremely popular among hedge fund customers.
This is a unique feature in the industry because everywhere else, you have to call the lending desk -- the stock lending desk, and hope that they don't screw you for more than you expect them. And so that's what happens.
Craig Siegenthaler BofA Securities
Interest income has been a key growth driver and upside to earnings over recent quarters. It's benefited from higher interest rates. We want to see if you could talk about your sensitivity to higher rates, especially on a go-forward basis.
Thomas Peterffy
At this point, every 25 basis points in Fed fund rates adds about $50 million to $60 million to our bottom line. This is because the account holders whose account value is less than $100,000, we pay proportionally less than 50 basis points under the Fed funds. And we pay no interest on the first $10,000 in any account. So accordingly, we have about $20 billion, $25 billion that you could say we pay nothing done or it's the equivalent of having $20 billion to $25 billion that we pay nothing done. Because overall, the cash holdings of our customers is $101 billion.
Craig Siegenthaler BofA Securities
Thomas, your operating efficiency is kind of the via financial services. Your operating margins are in the mid-60s to even low 70s on a quarter-by-quarter basis. Is this -- are -- we essentially at a peak level? Or is there ability to even drive higher operating leverage from these points, especially with net interest income growing, which is a very high-margin source for that?
Thomas Peterffy
So in the last quarter, our net pretax margin was 71%. It's hard to go much above that. But we will try to and we'll probably -- it's 72% or 73%, but that's about it. It's difficult to go above that.
Craig Siegenthaler BofA Securities
You have to pay to people.
Thomas Peterffy
We are by far the highest in that respect on The Street or probably in any business.
Craig Siegenthaler BofA Securities
What impact are you seeing with inflation today on your cost basis because with that margin, it doesn't look like you're seeing a ton to date?
Thomas Peterffy
Yes. So we raised compensation at the end of '22 by about 8% on the average. This included merit and inflation raises. We are, of course, determined to compete for technological talent that helps us to continue to build out our automated technology as we expand to new geographies and new products. In addition, we have substantial new expenses associated with renting and furbishing new offices all over the world.
And so as we build out to, say, a future of anywhere, in any country where there are more and more -- where we get more and more customers, we decide to put in local office. And I think they find -- the local customers find that important -- that association is important so that they deal with a local broker rather than an American broker.
Craig Siegenthaler BofA Securities
Thomas, we are on this a little bit earlier, but you continue to build capital. Is there a line in a certain point where you would say, that's enough, let's start returning capital to shareholders?
Thomas Peterffy
So just a few minutes before, you asked if we have enough capital for the hedge funds that have more capital. So yes. I mean, no, we -- I said at that time, we are not going to return beyond the $0.10 quarter dividend that we are paying and have been paying for -- or it seems like ever since we started.
Craig Siegenthaler BofA Securities
I had a question on the global trader app. How has really early adoption trended for that? And does that offer crypto functionality today?
Thomas Peterffy
It does offer crypto functionality. But of course, we do not cost to the crypto. We have -- I hate to say this, but we have Paxos cost crypto and SEC just announced investigation against Paxos, I think, this morning. But I mean, customers are aware that we do not cost to the crypto. Otherwise the Global Trader is a very popular download, especially since we added 24-hour options trading capability. So almost 24 -- 23 and something. And so people around the world who especially who are on the other side of the globe and are sleeping when our exchanges are open are very happy with this new functionality.
Craig Siegenthaler BofA Securities
So Thomas, we all enjoy you on the earnings calls and joining us at conferences. I ask this in a nice way, but New York City traffic is back. If you were hit by a bus, what would happen to IBKR at that point?
Thomas Peterffy
So that's exactly the reason I moved to Palm Beach. There are no buses in Palm Beach. But as many of you know, Milan Galik has taken over as CEO of the firm about 3 years ago. I think he's doing a terrific job, much better than I could do. He's only 56 years old. He has worked at the company for over 30 years and having started as a software developer, he has a good 15 years left in him I think. As a stockholder, I would much more worry about him getting hit by a bus than myself.
Craig Siegenthaler BofA Securities
So I wanted your perspective because we've seen some transactions in the past, I think, more recent Morgan Stanley trade. But what are your perspective because your business is much more diverse in the trades. But do you think IBKR could make a good fit inside of a larger financial institution?
Thomas Peterffy
Definitely. I think there is -- there will be a large globally integrated, highly automated financial services organization, which will most likely be called IBKR.
Craig Siegenthaler BofA Securities
Great. With that, we do have a few moments. Would you mind taking a questions from audience? So if there's any questions, please raise your hand.
Unknown Analyst
I'd love to get your thoughts on explosion on option activity, especially the daily options and also just single stock ETFs in terms of what that means for retail investors?
Thomas Peterffy
Slowdown in daily options? The growth in daily options, right. Okay. So daily options are attractive because they are best at payoff at the end of the day, if they do or they -- or you know if you won or lost. But I think it does have -- they do have serious justifications. And I mostly see that as if you are an institutional trader and as many decide to buy a portfolio of stocks.
In the course of the day, that's very difficult to implement, especially if you have quite a number of stocks in that portfolio. But it's very easy for you to pick up an S&P 500 option or 1,000 S&P 500 options because they are very liquid. And so therefore, you can put in the order for the portfolio as market on close. And then you will get the S&P closing price on all those stocks. And that's exactly where your option will expire. So that's a very, very good way of implementing the trading of portfolios, whether you want to buy them or sell them, right?
Craig Siegenthaler BofA Securities
And with that, I think we are out of questions and out of time. So Thomas, on behalf of all of us at Bank of America. I just want to say thank you very much for joining us.
Thomas Peterffy
Thank you very much.