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IBKR > SEC Filings for IBKR > Form 10-Q on 9-Nov-2012All Recent SEC Filings

Show all filings for INTERACTIVE BROKERS GROUP, INC.

Form 10-Q for INTERACTIVE BROKERS GROUP, INC.


9-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes in Item 1, included elsewhere in this report. In addition to historical information, the following discussion also contains forward-looking statements that include risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under the heading "Risk Factors" in Amendment No. 1 to our Annual Report on Form 10-K/A filed with the Securities Exchange Commission ("SEC") on August 31, 2012 and elsewhere in this report.

Introduction

IBG, Inc. is a holding company whose primary asset is ownership of approximately 11.9% of the membership interests of the Group.

We are an automated global electronic broker and market maker specializing in routing orders and executing and processing trades in securities, futures and foreign exchange instruments on more than 100 electronic exchanges and trading venues around the world. Since our inception in 1977, we have focused on developing proprietary software to automate broker-dealer functions. The advent of electronic exchanges in the last 22 years has provided us with the opportunity to integrate our software with an increasing number of exchanges and trading venues into one automatically functioning, computerized platform that requires minimal human intervention.

Business Segments

The Company reports its results in two business segments, electronic brokerage and market making. These segments are analyzed separately as we derive our revenues from these two principal business activities as well as allocate resources and assess performance.

и Electronic Brokerage. We conduct our electronic brokerage business through our Interactive Brokers ("IB") subsidiaries. As an electronic broker, we execute, clear and settle trades globally for both institutional and individual customers. Capitalizing on the technology originally developed for our market making business, IB's systems provide our customers with the capability to monitor multiple markets around the world simultaneously and to execute trades electronically in these markets at a low cost, in multiple products and currencies from a single trading account. We offer our customers access to all classes of tradable, exchange-listed products, including stocks, bonds, options, futures, forex and mutual funds traded on more than 100 exchanges and market centers and in 19 countries around the world seamlessly.

During the fourth quarter of 2011, we introduced the Interactive Brokers Information System ("IBIS"), which offers customers a robust suite of informational tools at a fraction of the cost of traditional research platforms. IBIS includes live quotes, newswire feeds, calendars of economic and earnings events, fundamental research data, charts and more in an interface that can be configured to customers' needs. The response from customers has been positive and we continue to devote resources to the further development of this tool with additional content and functions. To provide greater value to our customers we decided to make IBIS available to all of our existing customers free of charge this past quarter.

и Market Making. We conduct our market making business through our Timber Hill subsidiaries. As one of the largest market makers on many of the world's leading exchanges, we provide liquidity by offering competitively tight bid/offer spreads over a broad base of over 913,000 tradable, exchange-listed products. As principal, we commit our own capital and derive revenues or incur losses from the difference between the price paid when securities are bought and the price received when those securities are sold. Because we provide continuous bid and offer quotations and we are continuously both buying and selling quoted securities, we may have either a long or a short position in a particular product at a given point in time. Our entire portfolio is evaluated each second and continuously rebalanced throughout the trading day, minimizing the risk of our portfolio at all times. This real-time rebalancing of our portfolio, together with our real-time proprietary risk management system, enables us to curtail risk and to be profitable in both up-market and down-market scenarios.

When we use the terms "we," "us," and "our," we mean IBG, Inc. and its subsidiaries for the periods presented.

Executive Overview

Third Quarter Results: Diluted earnings per share on a comprehensive basis were $0.30 for the quarter ended September 30, 2012 as compared to comprehensive diluted earnings per share of $0.34 for the same period in 2011.

Reported results on a comprehensive basis reflect the GAAP convention adopted in 2011 that requires the reporting of currency translation results contained in other comprehensive income ("OCI") as part of reportable earnings. Previously, currency translation results were reported only as a component of changes in total equity in the statement of financial condition.


Currency translation effects are largely a result of our currency strategy. We have determined to base our net worth in GLOBALs, a self-defined basket of currencies in which we maintain our equity. Approximately 63% of our equity is denominated in currencies other than U.S. dollars 1 . The effects of our currency strategy appear in two places in the financial statements: (1) as a component of trading gains in the unaudited condensed consolidated statement of comprehensive income and (2) as OCI in the unaudited condensed consolidated statement of financial condition. As described above, the full effect of the GLOBAL is captured in comprehensive income.

On a non-comprehensive basis, which excludes the effect of changes in the U.S. dollar value of the Company's non-U.S. subsidiaries, diluted earnings per share were $0.26 for the three months ended September 30, 2012, as compared to $0.48 for the three months ended September 30, 2011.

In light of the weakening of the U.S. dollar against a number of other currencies, adding OCI to net income increased diluted comprehensive earnings per share by $0.04 for the current quarter.

Consolidated: For the three months ended September 30, 2012, our net revenues were $318.6 million and income before income taxes was $172.6 million, as compared to net revenues of $385.6 million and income before income taxes of $217.8 million for the corresponding period in 2011. This decrease was driven by lower trading gains and commissions and execution fees, partially offset by a decrease in execution and clearing fees. The decrease in trading gains was a result of a subdued market making environment as compared to the highly volatile year-ago quarter. As a result of the weakening of the U.S. dollar, currency translation increased trading gains by $41.5 million this quarter compared to a loss of $22.7 million in the year-ago quarter. Commissions and execution fees were lower than those of the year-ago quarter due to lower customer volume in options, futures and stocks. During the same period last year we observed a surge in volumes, driven by concerns over the U.S. debt downgrade and European debt crisis. Higher employee compensation and benefits accounted for an additional $1.5 million of expense, which was largely a result of a one-time discretionary grant of restricted stock units awarded on January 6, 2012 as well as a correction to our method for recognizing expenses related to our 2007 Stock Incentive Plan ("SIP"). The special award was made to provide our employees with greater equity participation in the Company and was designed to give lower compensated employees proportionally higher awards. The corrected accounting treatment accelerates the recognition of SIP-related compensation expense to earlier years and decreases expense recognition in subsequent years, although total expense over the life cycle of the SIP grants is unchanged. 2 General and administrative expenses decreased $3.2 million, primarily on lower bad debt expenses. Our pre-tax margin for the three months ended September 30, 2012 was 54%, as compared to 56% for the corresponding period in 2011.

Brokerage: During the three months ended September 30, 2012, income before income taxes in our electronic brokerage segment decreased 23%, from $105.5 million to $80.8 million. This reflects a decrease in commissions and execution fees and an increase in employee compensation and benefits expense, partially offset by a decrease in execution and clearing fee expenses and a modest increase in net interest income. Commissions decreased by 23% from the year-ago quarter as a result of lower customer volume in options, futures, stocks and forex. Total customer Daily Average Revenue Trades ("DARTs") decreased by 21% from the same period last year. Execution and clearing expenses were 19% lower on decreased customer stock, option and futures volume. The increase in employee compensation and benefits expense is related to increased SIP costs, as discussed above. The increase in net interest income was attributable to an increase in interest earned on customer cash and margin balances compared to the year-ago period. Customer equity grew by 35%, to $31.5 billion, from the year-ago quarter. Pre-tax margin decreased from 55% to 48% for the three months ended September 30, 2011 and 2012, respectively.

Market Making: During the three months ended September 30, 2012, income before income taxes in our market making segment decreased 30%, from $128.5 million to $90.2 million. This reflects a $48.4 million decrease in trading gains from the year-ago quarter. Trading gains were negatively impacted by an unfavorable market making environment in this quarter, with lower exchange traded volumes, lower actual to implied volatility, and tighter bid/offer spreads in options. Currency translation effects increased trading gains $64.2 million compared to the corresponding period in 2011, reflecting a $41.5 million gain compared to a $22.7 million loss. As a result, our trading gains, after removing the effects of currency translation, decreased $112.6 million or 51%, compared to the year-ago quarter. Execution and clearing expenses were 29% lower during the three months ended September 30, 2012 than in the year-ago quarter due to decreases in options, futures and stock volumes of 36%, 38% and 40%, respectively. Pre-tax margin decreased to 59% in the third quarter of 2012 as compared to 63% in the corresponding period of 2011.

Nine Months Results: Diluted earnings per share on a comprehensive basis were $0.71 for the nine months ended September 30, 2012 as compared to comprehensive diluted earnings per share of $1.06 for the same period in 2011.


1 For a full description of our currency strategy, please see pages 57 - 58, Foreign Currency Exposure.
2 The corrected accounting method is explained in Note 21 to our audited consolidated financial statements in our Amended Annual Report on Form 10-K/A for 2011, filed with the SEC on August 31, 2012.


On a non-comprehensive basis, which excludes the effect of changes in the U.S. dollar value of the Company's non-U.S. subsidiaries, diluted earnings per share were $0.70 for the nine months ended September 30, 2012, as compared to $1.09 for the nine months ended September 30, 2011.

In light of the weakening of the U.S. dollar against a number of other currencies, adding OCI to net income increased diluted comprehensive earnings per share by $0.01 for the nine months ended September 30, 2012.

Consolidated: For the nine months ended September 30, 2012, our net revenues were $883.4 million and income before income taxes was $430.8 million, as compared to net revenues of $1,050.4 million and income before income taxes of $588.9 million for the corresponding period in 2011. This decrease was driven by lower trading gains and commissions and execution fees and an increase in employee compensation and benefits expense, partially offset by a decrease in execution and clearing expenses. Trading gains decreased 28% in the nine months ended September 30, 2012, as compared to the corresponding period last year due to an unfavorable market making environment and a negative $25.3 million swing in currency translation. The swing in currency translation from a gain to a loss, accounted for 18% of the decline in trading gains from the year-ago period. Currency translation effects are reported as part of trading gains in the Market Making segment. Commissions and execution fees were 11% lower than those of the year-ago period as a result of lower customer stock, options and futures volume. As noted above, during the same period last year we observed a surge in customer trading volumes, driven by concerns over the U.S. debt downgrade and European debt crisis. Employee compensation and benefits expense increased 12% compared to the year-ago period. The increase in employee compensation and benefits expense was largely a result of a special discretionary stock grant of restricted stock units awarded on January 6, 2012, as well as a correction to our method for recognizing expenses related to SIP. The corrected accounting treatment accelerates the recognition of SIP-related compensation expense to earlier years and decreases expense recognition in subsequent years, although total expense over the life cycle of the SIP grants is unchanged. Our pre-tax margin for the nine months ended September 30, 2012 was 49%, as compared to 56% for the corresponding period in 2011.

Brokerage: During the nine months ended September 30, 2012, income before income taxes in our electronic brokerage segment decreased 11%, from $284.6 million to $254.4 million. This reflects declines in commissions and execution fees and an increase in employee compensation and benefits expenses, partially offset by a decrease in execution and clearing fee expenses. As noted above, the increase in employee compensation and benefits expense was largely a result of an increase in SIP expenses recognized in the current period. Commission and execution fees decreased by 11% from the year-ago period, as a result of lower total customer volume in stocks, options and futures on a 6% decrease in DARTs. Execution and clearing expenses were 12% lower on decreased total customer volume in stocks, options and futures. Net interest income increased 4% due to higher net fees and interest from securities borrowed and loaned transactions, partially offset by a decrease in net interest earned on customer cash and margin balances. Customer equity grew by 35%, to $31.5 billion, from the year-ago quarter. Pre-tax margin decreased from 54% to 51% for the nine months ended September 30, 2011 and 2012, respectively.

Market Making: During the nine months ended September 30, 2012, income before income taxes in our market making segment decreased 44%, from $322.4 million to $180.2 million. This reflects a $146.4 million decrease in trading gains from the year-ago period. The decrease in trading gains was driven by lower exchange traded volumes and low actual to implied volatility. Currency translation effects further decreased trading gains by $25.3 million, compared to the corresponding period in 2011, reflecting a $0.5 million loss in the nine months ended September 30, 2012 compared to a $24.8 million gain in the year-ago period. Execution and clearing expenses were 7% lower during the nine months ended September 30, 2012 than the year-ago period due to decreases in options, futures and stock trading volume of 3%, 20% and 23%, respectively. Pre-tax margin decreased to 46% in the nine months ended September 30, 2012 as compared to 61% in the corresponding period of 2011.


The following tables present historical trading volumes for our business. Volumes are among several drivers in our business.

TRADE VOLUMES:
(in 000's, except %)                                         Brokerage
                  Market              Brokerage                    Non                                     Avg. Trades
                  Making           %    Cleared           %    Cleared             %      Total          %    per U.S.
Period            Trades      Change     Trades      Change     Trades        Change     Trades     Change Trading Day
2007              99,086                 72,931                 16,638                  188,655                    752
2008             101,672          3%    120,195         65%     16,966            2%    238,833        27%         944
2009              93,550         -8%    127,338          6%     13,636          -20%    234,524        -2%         934
2010              75,169        -20%    133,658          5%     18,732           37%    227,559        -3%         905
2011              63,602        -15%    160,567         20%     19,187            2%    243,356         7%         968

3Q2011            19,602                 45,879                  5,273                   70,754                  1,106
3Q2012            14,405        -27%     36,246        -21%      3,435          -35%     54,086       -24%         865

CONTRACT AND SHARE VOLUMES:
(in 000's, except %)

TOTAL                        Options          %     Futures          %        Stocks          %
Period                   (contracts)     Change (contracts)     Change      (shares)     Change
2007                         673,144                 83,134               47,324,798
2008                         757,732        13%     108,984        31%    55,845,428        18%
2009                         643,380       -15%      82,345       -24%    75,449,891        35%
2010                         678,856         6%      96,193        17%    84,469,874        12%
2011                         789,370        16%     106,640        11%    77,730,974        -8%

3Q2011                       254,904                 31,835               20,598,631
3Q2012                       169,745       -33%      24,020       -25%    15,364,650       -25%

MARKET MAKING                Options          %     Futures          %        Stocks          %
Period                   (contracts)     Change (contracts)     Change      (shares)     Change
2007                         447,905                 14,520               24,558,314
2008                         514,629        15%      21,544        48%    26,008,433         6%
2009                         428,810       -17%      15,122       -30%    26,205,229         1%
2010                         435,184         1%      15,371         2%    19,165,000       -27%
2011                         503,053        16%      15,519         1%    11,788,769       -38%

3Q2011                       171,731                  4,835                3,921,841
3Q2012                       110,549       -36%       3,007       -38%     2,347,903       -40%

Notes:



1. Futures contract volume includes options on futures

2. In Brazil, an equity option contract typically represents one share of the underlying stock; however, the typical minimum trading quantity is 100 contracts. To make a fair comparison to volume at other exchanges, we have adopted a policy of reporting Brazilian equity options contracts divided by their trading quantity of 100.


CONTRACT AND SHARE VOLUMES, continued:
(in 000's, except %)

BROKERAGE TOTAL
                      Options      %     Futures      %        Stocks      %
Period            (contracts) Change (contracts) Change      (shares) Change
2007                  225,239             68,614           22,766,484
2008                  243,103     8%      87,440    27%    29,836,995    31%
2009                  214,570   -12%      67,223   -23%    49,244,662    65%
2010                  243,672    14%      80,822    20%    65,304,874    33%
2011                  286,317    18%      91,121    13%    65,942,205     1%

3Q2011                 83,173             27,000           16,676,790
3Q2012                 59,196   -29%      21,013   -22%    13,016,747   -22%

BROKERAGE CLEARED
             Options      %     Futures      %        Stocks      %
Period   (contracts) Change (contracts) Change      (shares) Change
2007          51,586             66,278           20,353,584
2008          77,207    50%      85,599    29%    26,334,752    29%
2009          93,868    22%      66,241   -23%    46,627,344    77%
2010         103,054    10%      79,144    19%    62,077,741    33%
2011         145,993    42%      89,610    13%    63,098,072     2%

3Q2011        43,994             26,601           15,846,432
3Q2012        37,174   -16%      20,686   -22%    12,594,066   -21%

Notes:



1. Futures contract volume includes options on futures

BROKERAGE STATISTICS
(in 000's, except % and where noted)
                                                                     3Q2012            3Q2011         % Change
  Total Accounts                                                        205               184              11%
  Customer Equity (in billions)                                       $31.5             $23.3              35%
*

  Cleared DARTs                                                         369               457             -19%
  Total Customer DARTs                                                  390               495             -21%

Cleared Customers (in $'s, except DART per account)
  Commission per DART                                                 $4.23             $4.29              -1%
  DART per Avg. Account                                                 456               640             -29%
(Annualized)
  Net Revenue per Avg. Account                                       $3,216            $4,024             -20%
(Annualized)



* Excluding non-customers (e.g. Directors and Officers)


Business Environment

During the third quarter, we continued to see a decline in trading volumes on exchanges worldwide. We believe this was due, in part, to economic uncertainty in the global markets and weakened investor confidence. High profile events such as the August trading loss by Knight Capital have contributed to regulators' sense of urgency to understand the effects algorithmic trading and high frequency traders ("HFTs") are having on the markets and investors, prompting a widespread review of market structure. Regulators and exchanges have already enacted several changes and continue to consider new rules that limit manipulative trading strategies by HFTs that may undermine the integrity of the financial markets and contribute to systemic risk.

The decrease in trading volumes from the third quarter of 2011 to this quarter was especially pronounced due to the unusual spike in volatilities and trading volumes that occurred in the third quarter of last year around news of the U.S. debt downgrade and intensifying concerns over the European debt crisis. While the slowdown in trading volumes has impacted our brokerage business, our customer activity levels have not declined to the same extent as those of other industry participants. Year over year, our daily average revenue trades for cleared customers decreased 19%. By comparison, according to data received from exchanges worldwide, volumes in exchange-listed equity-based options decreased by approximately 22% globally and decreased by approximately 27% in the U.S., as compared to the corresponding quarter in 2011.

Despite lighter trading volumes, we continued to see steady growth in the number of customer brokerage accounts and customer equity, which increased 11% and 35%, respectively, over the third quarter of 2011. Among the factors driving customer growth are low trading costs and financing rates, price execution quality and our financial stability.

Other conditions that impact our market making trading gains deteriorated during the third quarter compared to the same period in 2011, including reduced volatilities and narrower options bid/offer spreads. However, these negative impacts to trading gains were largely offset by exchange rate movements that benefited our results.

Our market making profits are generally correlated with market volatility since we typically maintain an overall long volatility position, which protects us against a severe market dislocation in either direction. Based on the VIX, the CBOE's market volatility index, the average volatility during the third quarter was approximately 47% lower than it was in the third quarter of 2011. The ratio of actual to implied volatility is also meaningful to our results. Because the cost of hedging our positions is based on implied volatility, while our trading profits are, in part, based on actual market volatility, a higher ratio is generally favorable and a lower ratio generally has a negative effect on our trading gains. This ratio averaged approximately 71% during the third quarter, as compared to 81% in the second quarter of 2012 and 111% in the year-ago quarter.

Our trading gains generally benefit from wider bid/offer spreads on exchange traded instruments. In the U.S., bid/offer spreads on exchange-traded options have been gradually widening since reaching a historic low in the third quarter of 2010. We believe this trend can be attributed to the heightened scrutiny of high frequency trading firms since the May 2010 Flash Crash. However, this widening trend has been nonlinear, and bid/offer spreads in the third quarter were approximately 4% narrower than the corresponding period in 2011, as reported by the NASDAQ OMX PHLX market.

Currency movements positively impacted our results in the third quarter. As a global market maker trading on exchanges around the world in multiple currencies, we are exposed to foreign currency risk. We actively manage this exposure by maintaining our net worth in GLOBALs, a defined basket of currencies. Because we report our financial results in U.S. dollars, the change in the value of the GLOBAL to the U.S. dollar affects our earnings. During the third quarter of 2012, the value of the GLOBAL as expressed in U.S. dollars increased 1.3% compared to the previous quarter which positively affected our comprehensive earnings and offset the negative impacts of lower volatilities and narrower spreads this quarter.

During the third quarter of 2012 we accounted for approximately 9.9% of the exchange-listed equity-based options (including options on ETFs and stock index products) volume traded worldwide and approximately 13.4% of exchange-listed equity-based options volume traded in the U.S. This compares to approximately 11.5% of the exchange-listed equity-based options volume traded worldwide and approximately 15.3% of the exchange-listed equity-based options volume traded in the U.S. in the third quarter of 2011. It is important to note that market share is not directly correlated with our profits.

See the tables on pages 37 - 38 of this Quarterly Report on Form 10-Q for additional details regarding our trade volumes, contract and share volumes and brokerage statistics.

. . .

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