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IBKR > SEC Filings for IBKR > Form 10-Q on 8-Nov-2013All Recent SEC Filings

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Form 10-Q for INTERACTIVE BROKERS GROUP, INC.


8-Nov-2013

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 our Annual Report on Form 10-K filed with the Securities Exchange Commission ("SEC") on March 8, 2013 and elsewhere in this report.

Introduction

IBG, Inc. is a holding company whose primary asset is ownership of approximately 12.4% of the membership interests of the Group.

We are an automated global electronic broker and market maker specializing in executing and clearing trades in securities, futures, foreign exchange instruments, bonds and mutual funds on more than 100 electronic exchanges and trading venues around the world and offering custody, prime brokerage, stock and margin borrowing services. 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 23 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.

· 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 award-winning 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 22 countries around the world seamlessly.

Our customer base is diverse, with respect to geography and segments. Currently, more than half of our customers are located outside the U.S., residing in over 190 countries. More than 40% of our customers are institutional accounts, including hedge funds, financial advisors, proprietary trading desks and introducing brokers. We have developed specialized products and services that have been successful in attracting these accounts. For example, we offer prime brokerage services including capital introduction and securities lending to hedge funds; and our model portfolio technology, automated share allocation and rebalancing tools are particularly attractive to financial advisors. The IB Money Manager Marketplace allows wealth advisors to search for money managers and assign them to client accounts based on their investment strategy. In addition, IBEmployeeTrackSM is widely used by compliance officers of financial institutions to streamline the process of tracking their employees' brokerage activities.

We also provide information services through the Interactive Brokers Information System ("IBIS"). IBIS offers subscribers and our brokerage customers a robust suite of informational tools at a fraction of the cost of traditional research platforms. It 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. IBIS is available to our cleared customers free of charge.

· 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 866,000 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 $0.39 for the quarter ended September 30, 2013 as compared to comprehensive diluted earnings per share of $0.30 for the same period in 2012.

Reported results on a comprehensive basis reflect the GAAP convention that requires the reporting of currency translation results contained in other comprehensive income ("OCI") as part of reportable earnings.

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. As a result, approximately 62% 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 $0.32 for the three months ended September 30, 2013, as compared to $0.26 for the three months ended September 30, 2012.

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 $0.07 for the current quarter.

Consolidated: For the three months ended September 30, 2013, our net revenues were $326.3 million and income before income taxes was $196.4 million, as compared to net revenues of $318.6 million and income before income taxes of $172.6 million for the corresponding period in 2012. This increase was driven by higher commissions and execution fees and higher net interest income, partially offset by a decrease in trading gains. Commissions and execution fees increased from the year-ago quarter, reflecting growth in customer accounts and higher average trading activity per customer. The decrease in trading gains was a result of a continued lackluster market making environment marked by low volatility and lower actual to implied volatility. As a result of the weakening of the U.S. dollar and our currency diversification strategy, currency translation increased trading gains by $46.2 million this quarter compared to a gain of $41.5 million in the year-ago quarter. Our pretax margin for the three months ended September 30, 2013 was 60%, as compared to 54% for the corresponding period in 2012.

Brokerage: During the three months ended September 30, 2013, income before income taxes in our electronic brokerage segment increased 34%, to $108.4 million from $80.8 million, in the three months ended September 30, 2012, driven by increased commissions and execution fees and higher net interest income. Commissions increased by 20% from the year-ago quarter on higher customer volume in options, futures and stocks and continued account growth. Total customer Daily Average Revenue Trades ("DARTs") increased by 21% from the same period last year. The increase in net interest income was attributable to higher net interest earned on larger customer cash and margin balances compared to the year-ago period as well as an increase in net fees earned from securities borrowed and loaned transactions. Customer equity grew by 31%, to $41.4 billion, from the year-ago quarter 2 . Pretax margin increased from 48% to 56% for the three months ended September 30, 2012 and 2013, respectively, as we continue to leverage our highly automated brokerage model.

Market Making: During the three months ended September 30, 2013, income before income taxes in our market making segment decreased 3%, to $87.5 million from $90.2 million, in the three months ended September 30, 2012. This reflects a $26.5 million decrease in trading gains from the year-ago quarter. Removing the effects of currency translation, the Market Making segment produced $41.3 million pretax income in this quarter, compared to $48.7 million for the same period last year. Trading gains were negatively impacted by a lackluster market making environment with low volatility and lower actual to implied volatility. The average CBOE Volatility Index, or VIX®, declined by 12% from the year-ago quarter.

Execution and clearing expenses were 31% lower during the three months ended September 30, 2013 than in the year-ago quarter due to lower options trading volume, which was down 16% from the year-ago quarter. Pretax margin increased to 67% in the third quarter of 2013 from 59% in the corresponding period of 2012. Excluding currency translation effects, pretax margin was 49%, as compared to 43% in the prior year quarter. The increase in pretax margin was attributable to a 33% decrease in fixed expenses and currency translation gains.

Nine Months Results: Diluted earnings per share on a comprehensive basis were $0.59 for the nine months ended September 30, 2013 as compared to comprehensive diluted earnings per share of $0.71 for the same period in 2012.

1 For a full description of our currency strategy, please see pages 54 - 55, Foreign Currency Exposure.

2 Approximately 10% of the $9.9 billion increase in customer equity was due to the reclassification of certain related accounts from "non-customer" to "customer", which are regulatory distinctions.


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 $0.67 for the nine months ended September 30, 2013, as compared to $0.70 for the nine months ended September 30, 2012.

In light of the overall strengthening of the U.S. dollar against a number of other currencies, adding OCI to net income decreased diluted comprehensive earnings per share by $0.08 for the nine months ended September 30, 2013.

Consolidated: For the nine months ended September 30, 2013, our net revenues were $826.3 million and income before income taxes was $412.5 million, as compared to net revenues of $883.4 million and income before income taxes of $430.8 million for the corresponding period in 2012. This decrease was driven by lower trading gains, partially offset by an increase in commissions and execution fees and an increase in net interest income. The decrease in trading gains was a result of a subdued market making environment and negative currency translation effects as compared to the nine months ended September 30, 2012. As a result of the strengthening of the U.S. dollar, currency translation decreased trading gains by $57.3 million for the first nine months of the year compared to a negative impact of $0.5 million in the year-ago period. Commissions and execution fees increased from the same period last year due to higher customer volume. The reduction in expenses was attributable to lower execution and clearing fees and lower employee compensation and benefits, as compared to the year-ago period. Our pretax margin for the nine months ended September 30, 2013 was 50%, as compared to 49% for the corresponding period in 2012.

Brokerage: During the nine months ended September 30, 2013, income before income taxes in our electronic brokerage segment increased 35%, to $342.7 million from $254.4 million, in the nine months ended September 30, 2012. The drivers were increased commissions and execution fees and net interest income, partially offset by an increase in execution and clearing fee expenses. Commissions increased by 22% from the year-ago period on higher customer volume in options, futures and stocks. Total DARTs from cleared and execution only customers increased by 16% from the same period last year. Execution and clearing expenses were 12% higher on increased customer volume. The increase in net interest income was attributable to larger customer cash and margin balances compared to the year-ago period as well as an increase in net fees earned from securities borrowed and loaned transactions. Pretax margin increased from 51% to 57% for the nine months ended September 30, 2012 and 2013, respectively.

Market Making: During the nine months ended September 30, 2013, income before income taxes in our market making segment decreased 63%, to $66.1 million from $180.2 million, in the nine months ended September 30, 2012. This reflects a $170.7 million decrease in trading gains from the prior year period. Removing the effects of currency translation, the Market Making segment produced $123.4 million pretax income in the first nine months of 2013, as compared to $180.7 million for the same period last year. Trading gains were negatively impacted by an unfavorable market making environment with low volatility.

Currency translation effects decreased trading gains by $56.8 million more than in the corresponding period in 2012, reflecting a $57.3 million loss compared to a $0.5 million loss in the first nine months of 2012. Execution and clearing expenses were 28% lower during the nine months ended September 30, 2013 than in the prior year period due to an 11% decrease in options volume. Pretax margin decreased to 30% for the first nine months of 2013, as compared to 47% in the corresponding period of 2012. Excluding currency translation effects, pretax margin was 44%, as compared to 47% in the prior year period.

Subsequent Event, anticipated increase in customer bad debt reserve

Recently, a small number of our brokerage customers took relatively large positions in four securities listed on the Singapore Exchange. In early October, within a very short timeframe, these securities lost over 90% of their value. The customer accounts were margined and fell into deficits to the extent of approximately $68 million in aggregate, as measured shortly after the event. The maximum aggregate loss, which would occur if the securities' prices all fell to zero and none of the debts were collected, would be approximately $84 million. We are currently pursuing the collection of the debts. The ultimate effect of this incident on our results will depend upon market conditions and the outcome of our debt collection efforts.


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
2009             93,550           127,338            13,636             234,524                  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
2012             60,421    -5%    150,000    -7%     16,118     -16%    226,540     -7%          904

3Q2012           14,405            36,246             3,435              54,086                  865
3Q2013           15,522     8%     42,597    18%      4,586      34%     62,705     16%          987

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

TOTAL        Options        %       Futures        %         Stocks        %
Period   (contracts)   Change   (contracts)   Change       (shares)   Change
2009         643,380                 82,345              75,449,891
2010         678,856       6%        96,193      17%     84,469,874      12%
2011         789,370      16%       106,640      11%     77,730,974      -8%
2012         698,140     -12%        98,801      -7%     65,872,960     -15%

3Q2012       169,745                 24,020              15,364,650
3Q2013       153,153     -10%        29,666      24%     22,989,713      50%



MARKET MAKING       Options        %       Futures        %         Stocks        %
Period          (contracts)   Change   (contracts)   Change       (shares)   Change
2009                428,810                 15,122              26,205,229
2010                435,184       1%        15,371       2%     19,165,000     -27%
2011                503,053      16%        15,519       1%     11,788,769     -38%
2012                457,384      -9%        12,660     -18%      9,339,465     -21%

3Q2012              110,549                  3,007               2,347,903
3Q2013               93,254     -16%         4,263      42%      3,169,320      35%

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
2009                  214,570                 67,223              49,244,662
2010                  243,672      14%        80,822      20%     65,304,874      33%
2011                  286,317      18%        91,121      13%     65,942,205       1%
2012                  240,756     -16%        86,141      -5%     56,533,495     -14%

3Q2012                 59,196                 21,013              13,016,747
3Q2013                 59,899       1%        25,403      21%     19,820,393      52%



BROKERAGE CLEARED       Options        %       Futures        %         Stocks        %
Period              (contracts)   Change   (contracts)   Change       (shares)   Change
2009                     93,868                 66,241              46,627,344
2010                    103,054      10%        79,144      19%     62,077,741      33%
2011                    145,993      42%        89,610      13%     63,098,072       2%
2012                    144,539      -1%        84,794      -5%     54,371,351     -14%

3Q2012                   37,174                 20,686              12,594,066
3Q2013                   42,668      15%        25,017      21%     18,820,414      49%

Note:

1.   Futures contract volume includes options on futures.

BROKERAGE STATISTICS
(in 000's, except % and where
noted)
                                             3Q2013              3Q2012   % Change
  Total Accounts                                231                 205        13%
  Customer Equity (in billions)               $41.4               $31.5        31%
*

  Cleared DARTs                                 426                 369        15%
  Total Customer DARTs                          471                 390        21%



Cleared Customers (in $'s,
except DART per account)
  Commission per DART                         $4.32               $4.23         2%
  DART per Avg. Account                         469                 456         3%
(Annualized)
  Net Revenue per Avg. Account               $3,291              $3,216         2%
(Annualized)



* Excludes non-customers. Approximately 10% of the $9.9 billion increase in customer equity was due to the reclassification of certain related accounts from "non-customer" to "customer", which are regulatory distinctions.


Business Environment

During the third quarter, we continued to see strong growth in customer accounts, margin balances and customer equity. Customer accounts grew by 13%, which exceeded the growth rate of other large eBrokers. Margin balances grew 38% year over year as customers took advantage of our low financing rates. As an example, the highest borrowing rate we charged customers on U.S. dollar balances, on average, was 1.59% for the third quarter of 2013. Market values continued to rise as U.S. indexes added to their strong gains from the first half of the year, with the S&P 500 Index climbing 17% over its year-ago level. This partially contributed to our 31% increase in customer equity, with the remaining increase driven by new account growth as well as existing accounts transferring more assets to our platform.

Exchange traded volumes and volatility levels were more subdued than in the second quarter of this year, during which there was a temporary increase in market activity. Compared to the year ago quarter, volatility levels were significantly lower and exchange traded volumes were slightly higher. In general, volatility and trading volumes are directly correlated to the profits of our brokerage and market making businesses. This environment weighed on trading gains and commission revenues during the quarter when comparing our results on a sequential basis.

We maintained our position as the largest U.S. electronic broker as measured by number of customer revenue trades. Our customers' trading activity continued to outpace the industry, with a 21% year-over-year increase in DARTs. By comparison, global trading volumes in exchange-listed equity-based options increased by 2% both globally and in the U.S., as compared to the corresponding quarter in 2012, according to data received from exchanges worldwide.

This environment of historical low volatility depressed our market making earnings, although our trading gains were boosted this quarter by positive currency movements as described below. 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 average volatility during the third quarter was approximately 12% lower than it was in the third quarter of 2012 and 4% lower than the previous quarter. 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 of actual to implied volatility is generally favorable and a lower ratio generally has a negative effect on our trading gains. This ratio averaged approximately 63% during the third quarter, as compared to 95% in the second quarter of 2013 and 71% in the year-ago quarter.

Currency movements positively impacted our performance as the U.S. dollar weakened against a number of the currencies in the GLOBAL, a self-defined currency basket in which we base our equity. 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. Because we report our financial results in U.S. dollars, the change in the value of the GLOBAL expressed in U.S. dollars affects our earnings. As of September 30, 2013, 62% of the GLOBAL was comprised of foreign currencies. During the third quarter of 2013, the value of the GLOBAL as expressed in U.S. dollars increased 1.5% from the previous quarter-end, which positively affected our comprehensive earnings and partially offset the negative impact of lower year-over-year volatilities this quarter.

During the third quarter of 2013 we accounted for approximately 8.7% of the exchange-listed equity-based options (including options on ETFs and stock index products) volume traded worldwide and approximately 11.7% of exchange-listed equity-based options volume traded in the U.S. This compares to approximately 9.9% of the exchange-listed equity-based options volume traded worldwide and approximately 13.4% of the exchange-listed equity-based options volume traded in the U.S. in the third quarter of 2012. Note that market share is not directly correlated with our profits.

See the tables on pages 35-36 of this Quarterly Report on Form 10-Q for additional details regarding our trade volumes, contract and share volumes and brokerage statistics.


Certain Trends and Uncertainties

We believe that our continuing operations may be favorably or unfavorably impacted by the following trends that may affect our financial condition and results of operations.

† Over the past several years, the effects of market structure changes, competition (in particular, from HFTs) and market conditions have, during certain periods, exerted downward pressure on bid/offer spreads realized by market makers.

† Retail broker-dealer participation in the equity markets has fluctuated over the past few years due to investor sentiment, market conditions and a variety of other factors. Retail transaction volumes may not be sustainable and are not predictable.

† The practice of internalization of order flow by brokers and the expanded use of so-called "dark pools", which may exclude certain market participants from interacting with marketable orders, may reduce liquidity and transparency in the securities markets.

† In recent years, in an effort to improve the quality of their executions as well as increase efficiencies, market makers have increased the level of automation within their operations, which may allow them to compete more effectively with us.

† Regulatory and legislative authorities have increased their scrutiny of equity and option market makers, hedge funds and soft dollar practices. New legislation or modifications to existing regulations and rules could occur in the future.

† Consolidation among market centers may adversely affect the value of our smart routing software.

† A driver of our market making profits is the relationship between actual and implied volatility in the equities markets. The cost of maintaining our conservative risk profile is based on implied volatility, while our profitability, in part, is based on actual volatility. Hence, our . . .

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