Interactive Brokers $IBKR - Can a Tech-First Brokerage Move Upmarket?
Thanks to all who are reading this week - criticism is welcome.
The downside of being a broker is that markets doing well doesn’t necessarily mean your business is doing well. The past year has been proof of this: performance has been so concentrated in the Magnificent 7 that, broadly speaking, investors are buying and holding rather than trading frequently, a strategy that doesn’t result in a lot of commissions revenue! For an ex-growth brokerage that roughly grows in-line with GDP, the best market environment involves some combination of the following:
- Volatility. When markets are volatile people trade more.
- High-interest rates. High-interest rates are beneficial for a few reasons: the cash people have sitting in their accounts earns more than it typically would in treasuries, and a higher rate can be charged to those selling short securities or buying on margin.
- A risk-on environment. In a risk-on environment customers are more likely to buy things on margin, which in turn generates more fees.
- A multitude of stocks that either have heavy short-interest or low float, and ideally some combination of the two. The more heavily shorted a stock is, the less stock there is available for short-sellers to borrow, and the higher the rate a broker can charge. In IPOs with lock-up periods for existing owners, as is often the case, the same dynamic is at play. Consequently, an environment like 2021 where companies with questionable business models went public is, in theory, a great time to be a broker.1
- Mass lockdowns where customers have a gamified mobile app. This is a facetious point, but those with a lot of time on their hands staring at an app that makes it enticing to buy and sell stocks constitute great customers, albeit with lower trading sums at play than institutional clients.
These factors all come with a litany of caveats. Volatility’s beneficial until it occurs suddenly in a stock that many have bought on margin and now can’t get out of fast enough. High interest rates are beneficial for cash balances but also mean speculation has a higher return hurdle if it’s to be more attractive than treasuries. Heavily shorted stocks are a boon to business until a group of retail investors don’t like that billionaires are betting on the collapse of a company and so all pile into the stock, causing many hedge funds to swear off shorting permanently.
Interactive Brokers is a compelling brokerage case study for a few reasons, including its founder’s entertaining commentary on earnings calls.2 Coinbase gives you a look at only one asset class, Robinhood is really just an index for retail investor sentiment, and the large prime brokers are a better lens to study what the more institutional money is up to. IB began in the 70s as an options market maker, a business it then sold to Two Sigma in 2017. It serves a broad range of customers, from the individual retail investor to more sophisticated prop traders to hedge funds. This puts it in a difficult marketing position of trying to appeal to both the prospective retail investor with a bit of extra disposable income and the hedge fund launching with a billion in assets under management. This is a harder approach for a broker than it is for a venture backed business, as its founder explained on two recent earnings calls:
‘Interactive Brokers has been successful in attracting smaller hedge funds. These are typically the hedge funds that the bigger primes declined to do business with because of the higher cost structure that they have. And then what we find is as the hedge funds get bigger, they start to look around and consider these larger competitors of ours. We would obviously like to reverse that trend, but it's not going to be easy. Part of the problem that we are dealing with is that the large primes are banks that have been in business for 100 years or more and they have created a very significant brand recognition. That is what we are up against. So, we hope that the significant amount of capital that we have on our balance sheet will be attractive for the manager that looks at our large competitors, they will consider us because they will walk away with the belief that their assets are safe with us.’ (Q4, 2023 Earnings Call).
‘We are not looking to increase the dividend. We are looking to increase the amount of money we have because it gives us greater— it gives our clients a greater sense of security. And as you have heard, we are hoping to get larger and larger investors to come with us and that security cushion is very important to them, especially since we are not a systemically y important counterparty’ (Q3, 2023 Earnings Call).
Said differently, Interactive Brokers is experiencing the effects of regulatory capture in action. As a prime broker, the company ranks number 5 in terms of the number of upstart hedge funds it captures as customers every year. But the average hedge fund IB attracts is far smaller than what competitors like Morgan Stanley pull in, with typical AUM sitting at around 8mm. It’s challenging to imagine a scenario where this gap can significantly close. All else being equal, it makes sense for a large fund manager to pick a prime broker that the government will step in and save should things go severely pear shaped. IB can try and compete on price, but the service it provides is mission critical enough that, as Bezos once said of cloud computing, ‘Cost savings is the gravy, not the steak.’ Moreover, Interactive Brokers has a branding issue that goes beyond not having existed for 100 years. It’s not easy to appeal to sophisticated hedge funds when the first few pages of your company’s annual report cover your Online Traders Academy and that you were the recipient of a NerdWallet award. There are many reasons that Morgan Stanley bought eTrade rather than building something internally, but one is that attracting retail investors requires a very different pitch to attracting Lone Pine Capital. It’s possible that it’s just too hard to serve all segments of the market. That’s not to say that serving smaller hedge funds can’t be a nice business.3 While it’s higher churn, it’s a market segment that the systemically important prime brokers don’t have an interest in catering to. That being said, it’s hard to get as excited about IB if it can’t move upmarket. Cash that’s hoarded on the balance sheet to attract bigger fish is cash that can’t be returned to shareholders via dividends or buybacks.4
Interactive Brokers pitches itself as a technology first business, which over the long-run is a good thing. The more technology you can implement, the less people you have to hire, the lower your cost base is, the less you can charge customers, the more you’re in a position to make intentional decisions around optimizing for margins vs market share. In the short term, however, it can still be a relatively expensive, margin-compressing undertaking, particularly when technology salaries continue climb higher. Especially in a tech talent war, companies are competing on more than just salaries, which is an issue for IB. Its market making business was sold for good reason: the competitive dynamics had changed significantly, it wasn’t not terribly predictable year to year, and it pulled down overall margins. Businesses with such characteristics don’t command all that high of a multiple! The founder was also unwilling to participate in payment for order flow given it could involve not giving its brokerage customers the best possible price. The downside of selling its market making arm, however, is twofold:
1. Getting out of the market making business likely affects the company’s ability to recruit top talent. It’s difficult to imagine a Princeton engineering graduate taking a job offer from Interactive Brokers over Jane Street or Citadel. It’s admirable that management refused to participate in payment for order flow, but there is a real trade off in terms of the talent they can attract. That being said, it’s of course possible that over the long-term that trade-off more than pays off with the amount of customer goodwill generated.
2. Peterffy, IB’s founder, often speaks about how the brokerage business significantly benefited from the technological expertise the company acquired as a market maker.5 This technological muscle may atrophy now that IB no longer plays in that arena. This is especially the case if point (1) is true.
There’s another factor worth keeping in mind when thinking about Interactive Brokers’ margins, which has to do with the company being in the brokerage business rather than the software-as-a-service business. The company’s pre-tax margins came in at 71% for the 2023 fiscal year, the highest in the industry. Management’s confident that margins can stay at this level even if the Fed lowers interest rates. There’s reason to be skeptical of this: margins never hit 70% even during the 2021 retail bonanza. There’s also a second reason for skepticism: the company lets clients buy on margin, which at times goes very wrong. IB’s 2019, 2016, and 2013 annual reports all detail instances of a stock or future its customers bought on margin that then plummeted in value, wiping out those customers’ deposits and then some. The financial impact of these events is not insignificant, and in the 2016 instance led to a cumulative loss of over 100mm. To some extent these losses are a cost of doing business, but it’s a cost worth keeping in mind when looking at any brokerage, no matter how tech-enabled it may be.
Disclaimer: The information in this post is not intended to be and does not constitute investment or financial advice. You should not make any decision based on the information presented without conducting independent due diligence.
For a short-thesis partially based on less stringent than usual IPO lock-up periods, see Guasty Winds piece on Better.com.
IB’s founder has laughed at sell-side questions asking where rates are going and, when asked what the company would do with the excess cash on its balance sheet, said: “Very strange that you should ask that question at the time that many of our peers appear to have insufficient amounts of capital. So no, we are very proud to have as much capital as we do, and we hope to keep growing it.”
Depending on how much capital you think is required to start a competitive hedge fund you may disagree with this point!
IB has another problem in that its stock has very little float, making substantial buybacks a real challenge.