Interactive Brokers: Margin Masters - [Business Breakdowns, EP.216]
45:03 Share

Octus, which was formerly known as Reorg, is today's presenting sponsor on Business Breakdowns. This is an essential credit intelligence and data provider. And they have grown to over 40,000 professionals across leading buy-side firms, investment banks, law firms, advisory firms. And what they're doing is they're taking the human expertise, which is so important in credit,

They're embedding it with AI technology, data and workflow tools. And that's going to allow you to unlock all the things you need, the truths to fuel that decisive action that you need in the credit markets. So head over to Octus.com to learn how they have taken this verified intelligence platform, delivering it at speed and giving you that complete picture across the credit lifecycle.

You can follow Octus on LinkedIn or X. There they will share breaking news and exclusive coverage, and you can find links to everything in the show notes. This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business.

For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you.

To find more episodes of Breakdowns, check out joincolossus.com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers, or affiliates may maintain positions in the securities discussed in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Zach Fuss, and today we're breaking down interactive brokers, widely recognized as IBKR.

Founded in 1978, Interactive Brokers evolved from a market maker on the American Stock Exchange to a global, cutting-edge electronic brokerage firm. Its founder, Thomas Petterfree, remains far and away its largest shareholder and has earned his place as one of the wealthiest people in the world.

Petter Free came to the U.S. from Hungary as an immigrant who spoke no English and taught himself computer programming in the 70s. Eventually, he pioneered automated trading and played a crucial role in the digitization of financial markets.

Today, we'll explore the journey of IBKR from its early days as Timber Hill to its current status as a publicly traded company with a market cap of nearly $80 billion. We'll dig into how Interactive Brokers makes money beyond just commissions, including their net interest income and other market-making activities. And we'll explore their reputation for offering low-cost access to a vast variety of global markets and sophisticated trading tools, which has made them a favorite

amongst traders and institutional investors. Additionally, we'll discuss their differentiated tech stack, their global reach, and again, their famously low fees. We'll explore their competitive landscape, the risks they face, and what the future may hold for this brokerage giant.

To break down IBKR, I am joined by Freddie Laid and Jacopo Di Nardo of Latitude Investment. We hope you enjoy this breakdown of IBKR. So today we got a two-for-one special. We're joined again for the third time by Freddie Laid and his partner Jacopo to discuss interactive brokers, which...

has been quietly covered business despite the fact that its growth has been so pronounced and it's integral in kind of the way that we interact with the markets today and its growing presence. I think Freddie Jacopo, just to

set the stage about the brokerage business, discount brokerages and the broader landscape. Maybe we kick it off there and then we can dive deeper into this particular business and why it's so special. Yeah, sure. No, it's great to be back on the show. Thanks for having us. Interactive is a really interesting business. It's one we've owned for about 18 months, but been following for a number of years. It's a digital broker, so you can trade stocks and bonds and currencies and options. It's

pretty much anything you like through it. And it started out 50 years ago as by far and away the most technologically led business in the space. And there's lots of history we can get into, but what they've done through investing in technology and investing in automation and a couple of other strategic advantages is develop by far and away the lowest cost model, the lowest cost to serve with the highest quality output. And this is what's driving the flywheel effect.

They're making the highest profitability at the lowest costs, driving huge growth in their customer base. And that compounding is coming without advertising, without marketing. And individual investors are increasingly choosing interactive over all of their competitors. But what's most exciting in this business model in the last five or 10 years has been

the doubling up of that compounding effect through the growth in other channels. So they're growing from other brokers introducing business, they're growing from hedge funds, they're growing through RIAs or what we call IFAs in the UK, and they're really growing internationally. They're a truly global business with a huge market potential and a lot of exciting things to talk about today. I guess a nice place to start when talking about brokerage business is

Just take us through the key revenue streams and how these businesses fundamentally make money. It's relatively simple. There's a lot of complexity when you really dig into it, but at a headline level, they make money in two ways. They make money through charging commissions on trading, and they make margin through net interest margin, so a spread on cash held on account or margin loans that they make. And it's reasonably straightforward to model this through.

They have 3.5 million accounts. The average account does about 200 trades per year, and the average commission is about $3. When you times that through, you get to roughly $600 per account in trading commissions per year, or around $2 billion a year. On the net interest margin, they pay very good rates on cash. It's a real strategic advantage. They own quite a narrow spread on their funding. But effectively, their securities lending and margin business

which is about 11% of client assets, is financed with customer deposits. And the spread between what they pay on those two equates to a net interest margin of about $800 per account or about $3 billion. And those are relatively stable per account numbers. And so the real driver for this business over time has been and will be account growth. And when we started looking at the business, it had around a

million accounts. It's got around three and a half million now, five years later, and they have various different targets to get to 10, 20, or maybe 80 million accounts as time goes by. And so then when I consider interactive brokers and the broader landscape, you've got Charles Schwab, Fidelity, obviously Robinhood. What are

the key differentiating factors about this particular business as opposed to its peer set when you look at interactive it was born out of a person who is first and foremost an engineer and a technologist and that type of culture has reverberated throughout the firm day one so when you look at interactive it's by far the most automated of all brokers so when you go on to

In the app, most of the functions you'll hit on it, including actually eliminating accounts because they exceeded the margin loan, is done automatically by...

bought. This doesn't tend to be the case for the competitors. And this has also morphed the broker into being really one that is liked and used first and foremost by experienced traders. The first days of the business was really only used by individuals and what today we call prop traders. These are individuals with account balances that tend to vary between, let's say, $200,000 up to a couple million dollars.

per account of client equity. And this compares, broadly speaking, quite favorably versus other online brokerages. So you'd think

Someone like Robinhood or eToro would have account balances averaging maybe 5,000 to 10,000. So it would be the first brokerage you go to when you learn about trading. And places like Schwab would have higher account balances, but they would be used in a much less frenetic way. As Freddie mentioned, you make about 200 trades a year per account on an interactive basis.

And that number might be tens of times even lower if you're using your Fidelity or Schwab account, which tend to be used for slightly different purposes. So obviously 401ks being one of those in the US. So I think it's impossible to really appreciate how differentiated IBKR Interactive Brokers is without spending some time discussing its founder.

Thomas Petterfi came here with effectively nothing, I believe, in the 1960s and is now one of the wealthiest and relatively unknown Americans. Can you just tell a little bit about his story, how this business came to be, how it's evolved over time, and then how much of the business and how involved Thomas is today? As you said, he was born in Hungary during basically the period of war in Europe, and he migrated with nothing to the U.S., pursuing

the classic American dream. And the business started out actually as a market-making business for options when Thomas bought a seat on the Chicago Mercantile or Board of Options Exchange. And initially, his broad idea was

that of pioneering a way of pricing options. It was at the time when the formulas were coming out from black and shoals and when option trading was nothing compared to today. And the company was called Timber Hill and it was really an option market maker.

If you think about that, the way Thomas approached the business was completely different in the sense that he wanted to automatize everything that could be automatized. And this still permeates the culture of a business today. Interactive doesn't want to be in businesses that eventually cannot be automatized in the future. On top of it, if you think about the role of the option maker, risk management is at the center of everything.

you have to do. So you're taking obviously both sides of a trade most of the times, and you're just creating a market for participants.

So up to these days, obviously, risk management is one of the most important points that differentiates Interactive compared to other brokerages. There's a couple of examples, but the only time they really actually lost some money in a significant way, which is not significant compared to the total amount of equity they have, was when the Swiss Central Bank let the Swiss franc appreciate three

Freely and the company lost about 1% of their capital at the time. And recent examples include when interest rates were zero in 2021 and a lot of other online brokers decided that it was the time to take some duration risk to make some more money on net interest income. The company refrained from doing that. So I think when one thinks about the two vectors on why this business is so well managed and managed to succeed, but I think historically,

his starts as someone who is fundamentally an engineer and focused on risk management are two very important aspects of the business. And it's worth saying that he's also a very hard-nosed and smart businessman. So whenever he saw that the option market making business due to changes in regulation and the market environment after the great financial crisis was not a business that would earn

excess ROEs anymore, he decided actually to close that down to focus entirely on the online brokerage. And so when you consider the business of online brokerage, there was a pretty big evolution, I'd say, over the course of the last decade, primarily focused on payment for order flow or PFOF. And so what you went from is a world where commissions were $5, $10, $25 per trade to a competitive landscape where many of their peers offered zero commissions.

And so I'm curious, despite that, IBKR, while still being a business that charges commissions, has seen its growth explode. What is going on? What is the debate around PFOF, which I believe is actually not even a legal business proposition outside of the U.S.? How do you think about that backdrop as it relates to Interactive Brokers' ability to continue to take share?

We think this is one of their key competitive advantages, that since day one, they've always chosen to have direct market access. So imagine like a kind of Costco model, they're cutting out the wholesaler. They don't have someone else. They don't have to go to a broker. And so when they have linked their system up to every exchange in the world, give or take directly, and so they execute directly at the best price on your behalf. Whereas payment for order flow, which

is pretty much just a US phenomenon, these businesses who buy that order flow clearly make a large amount of profit. And so that has to come out of someone's wallet and implicitly that has to come out of the customer's execution price.

You can listen to the CEO, Thomas Pefty, talking quite vociferously about this practice and other banking practices that have yet to be regulated, but it's something that they've always avoided. It does save them a huge amount and allow them to move much faster than a lot of competitors as well. It's no higher cost. They don't get the payment for order flow into their revenues like some other businesses do, but they don't need it because they can prove best execution. They still have lower commissions across the marketplace. They charge far less than others.

in most cases. Their other draws are their much cheaper margin loans and their much more generous payment for cash on deposit. They basically pay 50 basis points less the local

base rate on any cash deposits over a certain threshold. So they're seen correctly as giving back everything they can to customers with a small margin. And then it's just, that's their principal competitive advantage. The second, as Jacopo has already touched on, is the automation of the trading itself, of the risk management, and of the management of the business and all the OPEX, which means that their cost base is just so much thinner than the others. So they're able to continuously reinvest in price.

I think one of the things that's interesting is if you look at the headcount of IBK, our relative, its peers, it obviously speaks to their interest in making sure that everything is

tech enabled. I will say amongst some investors who use the platform, they do complain about the lack of customer service at times, but it's what allows them to offer such incredible low cost execution. And then the other aspects of it being really your ability to use leverage at a very low cost of capital. Can we just talk about how they use their balance sheet in a way that provides such a structural cost advantage relative to their peer set?

Fundamentally, there's a couple of points here to be made. The first one is a bit like Jamie Dimon at JPMorgan talks about having a fortress balance sheet in financials is of paramount importance to succeed over time. It allows to obviously survive crises if they happen. Interactive has a similar approach. If you look at the balance sheet today,

At the end of 2025, there's probably going to be about $18 billion of excess capital, which is about 95% of the total capital they have.

That allows them, obviously, to grow the business in a fairly serene way without necessarily participating in the ups and downs of the market. And the second point being when offering low-cost margin loans, it stems partly from that and partly from, again, going back to the automation point. The big risk when offering margin loans is that

Eventually, those accounts will need to be basically closed because with a market drawdown, the fall in value is superior to that of a margin loan. And there's plenty of examples around, the latest one actually coming from Archegos, where even at investment banks, which one would think are fairly well invested in technology, still require quite a lot of human involvement and personal calls in order to make that decisions.

That never happens at Interactive because everything is automatized and the account, if it doesn't post the required collateral within a very short period of time, is automatically liquidated and eliminated. And if you think about that dynamic, that is exactly what allows Interactive two things. One is to underprice competition in terms of cost. For the margin loan, it's about half the cost of Fidelity or Schwab or whoever else competes in the U.S.

And it also allows them to offer slightly more leverage than competition without really affecting the total risk. If you're able to cancel that account or to close down that account fairly quickly, and you're also able to mitigate the risk of loss from that account in a better way than competitors, that allows, again, to foster that competitive advantage coming from lower costs and obviously higher automation.

And so I think it would be helpful to illustrate how this manifests by demonstrating what an account looks like and how a customer uses the business to

For example, let's say you have someone that's a professional trader that has a million dollar account and maybe is running at two or three million dollars of gross long and short. They're obviously borrowing and lending securities. What does it look like? And then how does that translate into the different revenue line items? So the commission revenue, the net interest income, the fees and services that they provide.

just to really drive home how people interact with this business and its ability to be differentiated on every service that it provides to its key customers. The difficulty here is that one does need to disaggregate a little bit. We've been discussing this as an online broker, which makes it feel very much like it's aimed entirely at individuals logging onto a website or an app. The truth is more than 50% of the business and a large portion of the growth in the business, although individuals are still growing very nicely,

is the other three main cohorts, which are white-labelling the platform and service for RIAs, advisors around the world, prop traders and hedge funds. They're now the fifth largest prime broker in the world. So they're larger than many of the big banks you could name from a standing start about 10 years ago.

They're growing far faster than the market for Prime because they are seen as more attractive to the hedge fund groups in general. And then the final one, which is just worth touching on, is what they call introducing brokers. And you can think about this as another bank or another brokerage business who is outsourcing and cancelling their own internal technology investments. As an example, they just brought on HSBC globally, and then they're going to plug in the underlying trading capability of

of interactives. And I would think about this in the same way that a lot of people have become comfortable with outsourcing admin or custody to JP Morgan or these large custody banks like Northern Trust. A large number of these huge global institutions, as opposed to investing in the technology, are renting it implicitly from interactive. And that is where a lot of the growth is coming from. So what we see at an account level is slightly averages of those things. We can make some assumptions about

where the margin skews towards the hedge funds and the prop traders, and obviously away from a lot of the RIA business. But what you see is an average account balance that, even when it was individual-led, was much higher than most other firms. And very normal, typical to have $100,000, $150,000, $200,000 as the average account balance. Against that, there are two other interesting assets, which are the margin loans, which we've discussed, which used to be far higher, actually, and have come down as a percentage of equity.

over the last 10 years, but are ticking up again at the moment in the short term at about 10% to 12% of assets. So if you've got a $200,000 account, you might have $20 of margin loans against

some securities in there on leverage. What's also been very popular with all of the brokerage platforms, including Interactive, has been securities lending. And again, as we've probably become boring saying, this is fully automated. So you can sign in if you want to. Your securities, your stocks can be lent out to people who wish to borrow them.

And to short them, they're still fully tradable. They're fully collateralized from our perspective as shareholders by cash. And the client earns most of that lending fee. And again, there's a small but very honest spread, which is all transparent. So they have a similar amount of securities lending about that sort of for a $200,000 account, about $20,000 of lending. So 10% of the base. So that's the kind of average. But we do believe it skews a lot.

a lot of the introducing business and a lot of the RIAs, we think are probably using less, probably trading less as well under that sort of 200 trades per year. And then really the majority of this stock lending

margin loan, and even the turnover, the number of trades or darts as they call them, daily average revenue trades, if anyone's reading the annual report after this, that skews towards the hedge fund business. So it's a variety of different clients all benefiting from the same low-cost platform, but they're using it in different ways. When you look at this business as P&L, and I'm looking at 2024 as a reference,

You have about $1.7 billion in commissions, which results in around $2 billion of non-interest related income. And then the rest $3 billion is that net interest income, that NIM, resulting in about $5 billion of revenue. How do you think about how that should evolve over time, the mix in quality as it relates to the evolution of their customer base, which you just mentioned?

And then a second question related to that, when you see a business that's as significant an earner on net interest margin, you beg the question as it relates to interest rates and how they impact the business and what would happen in an environment where rates were going down versus going up. Just curious on those two items, really revenue mix and NIM as the business evolves over time. There's quite a few ways to cut it. This is clearly a cyclical business. It

It grows very rapidly and account growth that had been around 25% per year is inflecting up towards 30% and 35% per year at the moment as the flywheel gathers ahead of steam. The most important thing that I want to compel you to understand from our perspective is that it's account growths that matter. And if you need to believe account growths are what matter, then one needs to believe there's sort of stability in

the other things like the amount of trading and the revenue per account. And so when we've interrogated the number of trades that's been going on, as the mix has changed and the accounts have been growing, the trades per year have been falling. And again, one would expect hedge funds are trading many times a day, but RIAs and introducing brokers in particular are probably trading less than the 200%

average trades per year. We expect and we've observed over the last five or 10 years a 5% to 10% decline in trades per year. If the growth is similarly skewed between the different cohorts over the next few years, obviously in periods of volatility one trades more, in periods of low volatility one trades less, but as a trend we put a deflation, if you like, in the number of trades per year. I think there's probably a small amount of potential deflation to come through from commissions, but

But the management team have talked about flat average commission levels from here, and it really does depend on mix. Again, a crypto trade is a very different commission level or an option compared to trading Google shares. The way it's worked is you have that kind of average $500, $600 per account of commission. It'll probably trade a little bit lower, maybe 5% down per year on an average basis, and then be cyclical with client equity.

But if account growth is 35% or anything along those lines, that will dwarf any reinvestment backing price. That's the easier one, is the commissions. And obviously, you can take your own view on average client equity and average equity market performance over the long term.

when you factor those things in too, they offset that reduction normally. On the NIM, and I think this is probably one of the greatest misunderstandings in the business, and it was certainly what gave us the opportunity to invest in it 18 months ago, is the actual sensitivity. If you think about the alternative, if you think about a business like Schwab, which only a couple of years ago almost needed effectively a wholesale rights issue,

because it had what was effectively a run on its funding source, because they weren't paying anything on their customers' cash. And customers, when interest rates went up, started saying, we'd better go to a bank or we'd better go to a money market fund. And they robbed Schwab of that source of

of cash and funding. The arrangement between interactive brokers and their customers is just far more honest and it's very transparent. And it's, as I said, on any large balance, more than $10,000, which is about two thirds of their entire customer cash. They just pay the local market base rate, less 50 basis points. That results in a far lower risk, firstly, to the point about Thomas Pefty's risk of

conservation. Clients are probably not going to leave because they get 50 bps more elsewhere, even if they could. But secondarily, it's actually less interest rate sensitive than you think. Because if rates go down by 50 basis points, they still just take 50 basis points on a spread. And so they do disclose that overall interest rate sensitivity. And for 100 basis point move down in interest rates around the globe, and again, this is a global business, probably 40% US, Jacopo's nodding at me,

but it's global in nature. But if global interest rates fell 100 base points, NIM would fall by 10%. And again, that's NIM per account. So if you're growing your accounts at 30%, 35%, it will more than offset a multiple of times that net interest sensitivity. So that's why we focus so obsessively on the business model and the potential for account growth. From a NIM perspective, Zach...

What's also pretty interesting is obviously margin loans tend to be higher yielding products, maybe pay 100 basis points more than what they get on cash on the asset side. And these tend to be cyclical, but move in the opposite way of interest rates. So for example, if interest rates were to go back down to levels that we observed in 2019 or 2020 or 2021, the amount of

of leverage that investors are usually willing to take on is slightly higher. So the margin loan per account was materially higher back then. And so in the mix, as interest rates fall, we would also expect

margin loans to pick back up, helping a little bit with an inflow. If you go back in time, 2019, 2020 were pretty difficult years for whoever was exposed to rising interest rates. And the company was still making maybe 30 basis points less than today in net interest income. They have proven themselves in a way through cycle to be able to earn a fairly attractive spread on assets and liabilities. And so you guys had mentioned the impact

the international opportunity here and where some of the growth is coming from. Obviously, we

We've seen through the COVID backdrop, participation in capital markets and investing, exploding perhaps the advent of Robinhood as an on-ramp for that, but also just the financialization of Western economies. What are the growth opportunities for this business? And I ask that in the context of on their earnings calls, they're very often asked if there's any M&A opportunities. And because they operate at such low costs, they're

and they provide such attractive margin loans to customers, the pro forma earnings of acquisitions make the math very difficult for them. And so I guess weighing organic versus acquisitive growth, where they're going to see their business continue to expand. Interested, you picked up on that comment too, because it's one we've discussed in the past, which is this idea that if we buy a business, but then we take it to our spreads and our offering,

the underlying revenue and profits would collapse in that business. So they're not able to pay what the owner thinks they can pay, because if they give back to customers as much as they give back in their main business, it would be a very different profit level. And so that to us is incredibly telling. They are open to acquisitions. They have done them in the past, but there's nothing out there which would make sense. And so they're going to grow organically. They have one of the lowest advertising budgets of all of the online brokers. And

and despite that have outgrown anyone we look at. They're growing organically. They're growing because their rates are just better than everybody else's. And if you are trading any meaningful amount of capital, I'm not here to sell it, but I'm sure some people listening to this will be trading their own shares. And it's worth a look because it's a meaningful saving to go to a business like this. And I think...

At the moment, what they're getting asked more about is this sort of potential for growth in the more B2B channels that we've discussed, the RIAs, the hedge funds, and the introducing brokers. But notwithstanding that, individual accounts are growing very rapidly too. So the mix isn't changing very quickly. And when we think about growth potential, I mentioned earlier a few different sort of big, hairy, audacious sort of goals for the management team. Schwab have, I think, 25 million accounts globally.

principally in the US. I think Fidelity is something around that level. They are smaller on average. So there's a tail of those accounts which would be less profitable for this business. But three and a half or four million accounts that we have today is still a fraction of that domestically. And they talk about 20 million globally as a sort of first stop in their growth story. And then at a sort of later stage, they talk about this 80 million number because in a couple of countries where they operate, they are already at sort of 1% of the population. And that would be that sort of level.

penetration. And the key thing to that potential is people will still continue to trade a lot, whatever happens with markets. Becoming more digital and outsourcing within the B2B channel will probably continue for the next 5, 10 and 20 years. Big question is, can someone compete with this?

Can someone come away to stop them organically growing share? Given the counter-positioning and that first comment about acquisitions and the competitors, to reinvest to try to build the direct market access and to invest in prices and costs and automation like this business has?

everyone's folding and using this business instead of trying to compete with it. To your comment of more participation into financial markets by all sorts of individuals, especially after COVID, we believe that to be a pretty good tailwind too, because

As we said at the beginning, someone who is inexperienced and might have a smaller account balance, he might start a Robinhood account or eToro or whatever else he can get his hands off, depending on the jurisdiction. But after a certain period of time, after becoming more accustomed to trading, and honestly, after having increased his own disposable income, we do believe that

The proposition of joining Interactive, especially as an active trader, is so much better than anything that's around there. But we do see a lot of these customers eventually dropping to Interactive over time as soon as the account balances reach $100,000 or $200,000. And if I can just add one more thing. You mentioned earlier, some people are upset with the customer service. We see a lot of analogies between this business and other low-cost businesses that

we look at. One would be sort of Ryanair. And I think it's really compelling to see that business, another business we like, where Michael O'Leary said, I didn't realise looking after customers would make me so much profit. And he started making the customer experience more pleasant. I think they're doing that at Interactive too. They've had this up

obsessive focus on costs and automation for 50 years, including in their prime brokerage business. But they've just rolled out what they call the sort of white glove service, which is a very manual, independent director looking after your account as a hedge fund. And I expect a bit more of that over time coming back into the business on the customer service too, which slightly opens up their market.

One final thing they're doing as well is really relaunching their app, which will come in and help that customer acquisition that Jacopo said of those who are out there learning the ropes in apps like eToro and Robinhood, but may want to grow up into interactive later.

And so we touched upon it in relation to M&A, but clearly a business that's generating as much excess free cash flow as this one, capital allocation becomes increasingly important. What is their demonstrated strategy as it relates to redeploying the cash that they're generating on an ongoing basis if M&A is not available to them? This is a very important question, especially as the business will eventually mature. And in fact,

At the moment, the only capital return we are receiving is a dividend yield that's usually targeted to be

about 0.5% to 1% of the total market capitalization. And there's a couple of things, though, to keep in mind. I think the company wants to keep a balance sheet that's as strong as it can be, mostly to develop the prime brokerage and hedge funds business. And one of the reasons being that the companies they do compete against, BMO's like Goldman, Morgan Stanley, UBS, and Bank of America,

are materially larger financial institutions. So to win over customers and hedge funds that manage one to $5 billion of assets, they do need potentially stronger balance sheet than what we actually could imagine ourselves.

The second point comes actually with the company structure. It is a publicly listed company, but still today, insiders own roughly 80% of the stock, of which most of it, 75%, is still Thomas, but the CEO and CFO also have a significant stake in the business.

And therefore, launching extremely big special dividends or share repurchase programs is not necessarily doable until the float of a business is increased. So we, like many other external investors, we are looking at the topic

We do believe over time, as Thomas, as he rightly says, is not immortal and he's approaching or above 80 years of age. We will see how that evolves. But it is something that we do like to an extent, because if you think about ways of maturing as a business, the final phase when growth slows down,

and is not what it used to be 20 years ago, any business has a choice to make, which can be growing again through M&A whenever it is possible or returning excess cash to shareholders. And

We are not even close to there, as Freddie has discussed. There's a potential over time to probably 20x the number of customers on the platform. But once that is done, having excess capital to return to shareholders, as the structure has probably changed by then, is an option. But as investors, we do like to have. There's other businesses that are in that situation. I guess Berkshire Hathaway being an enormous one, which...

is in a similar position with an incredible amount of cash and treasuries sitting on the balance sheet. And so when you're evaluating financial businesses, there's always a debate about how to properly value them. And without asking you guys to opine upon the valuation itself, what do you think are the most important metrics here in it being return on equity, price to book, PE? How do you go about valuing a business like this?

It's really a combination of everything you've mentioned. I think to an extent today, the ROE of a business, we can look at it in two ways. One is obviously including the excess capital and one is excluding it. One thing you realize quite quickly is actually how capital-light it is compared to normal financials, especially when you back out the excess capital. So it might make 15% to 20% ROE, including the 19 billions of

excess capital, but it might make 10, 15 times as much, excluding that. Earnings is, and price to earnings, normalized earnings are also another way we look at it. So sticking in our own assumptions, obviously, of accounts growth and trades per account and commissions, and then looking at what a normalized and average net interest income could be given the prevailing rates

interest around the world. But as you say, it is not one of the simplest businesses to value on either of two metrics. So we do focus really on both and see how both interact with each other. At the same time, we do not feel yet confident enough to assume a significant capital return of the excess capital. So we let it build in our model with our mind going 5, 10, 15, 20 years from now, what will that capital eventually earn? But

So far, I think they've proven to be fairly good stewards of it. One other way to think about it is to invert it. Given the competitive advantages, given the demonstrable success across these verticals, which are all very nascent, given the arguments we've made around the limited reduction in revenue per account, either from NIM sensitivity, which will bob around, or from the commissions and trading per account, you're making roughly $1,500 an account in revenues at the moment. What's the probability that

they can get to 10 or they can get to 20, thus making 15 or $30 billion in revenues. And they make a 75% operating margin. I think they make a 75% net margin. It'll probably be around there. It could go up a little higher, but that's with their generous offering back. You're talking about a very profitable, rapidly growing business. And the question one really needs to

to ask is, who's going to stop that happening? Is there a competitor in the marketplace that will stop that? If not, how fast or how slow will it happen is the bigger question. And something Thomas has said is, we can grow at 30% with no advertising. We can probably grow at 40-50% if we do more targeted advertising. But they're not looking to do that right now. But I do think they could accelerate the account growth if they wanted to, because there's a lever they haven't pulled yet.

Obviously, much of what has been said about this business has been overwhelmingly positive. But when you're dealing with a business that interacts with leverage, margin, long and short side of the investment industry, there's inherent risks. I would love to hear about how you guys assess those risks and maybe some of the stress tests the business has faced, even as recent as 2020.

A few weeks ago, we saw the broader market sell off 10%, 15%, 20%. And what that meant for their business, I think, would show kind of the resilience and durability of the model that they have here. Yeah, I think one of the key things to remember, if anyone else goes away from this and analyzes the business, is that this was a market-making business in a large part as well in the past. So it's very different to 2009 and 2014 was the day where they really exited most of that business. So this is now a middleman, a broker in

in a far more than the sort of asset risk. So the risk, as you say, slightly lies in that margin loan piece and their ability to risk manage and collateralise against those loans. Because obviously when they make these loans or they do the securities lending, they take and hold collateral. And something Jacopo mentioned earlier,

These accounts are stopped out automatically now as if and whenever they get too close to that margin limit. And so it's all an automated process. They claim to have very good risk management systems, but I've never met a financial business that doesn't claim to have good risk management systems. So your question again is right. How have they fared through the last decade of quite a lot of stress tests, I'd argue, whether COVID or...

big drawdowns in 2022 in the very popular stocks or the recent hit. Their largest loss was really from a very strange sort of move in the Swiss franc 10 or 12 years ago, maybe even 14 years ago, where they lost about 1% of their equity capital today. So a very bearable amount for a business that is multiple times overcapitalized. And through the recent turmoil of the last three to four or five years, it's de minimis. The

The risks from margin, the losses, the bad account balances, it's not been an issue for the business. So the risk management system exposed has clearly been working. If you think about how...

financial businesses run into trouble is some sort of liquidity mismatch that exists between assets and liabilities. And I think in that, in new investors to the company, it should take quite a bit of comfort that most of the assets are really 30 days in duration. Now, some of that is a function of how the yield curve has been looking for the past four or five years, which

which is flat to inverted. So there was no point in taking interest rate risk and duration risk, the capital of a business. But in general, I think the company has always taken a prudent approach to risk management. I think that again stems from probably Thomas's beginning as a market-making entrepreneur.

risk manager. And if you think about the mother of all stress tests, which was the great financial crisis, when the business still owned a market-making business, one of the leading market-making business in options, the company decided,

quite early on in 2007 to stop making prices to customers in long-dated options, which eventually ended up being part of a market that not a lot of people talk about today, but was entirely in liquid and where losses just piled up. So I think analyzing the liquidity of a balance sheet and...

in general risk management choices is where one can get comfortable that downside risks are fairly well managed. In terms of long-term risks, Freddie mentioned a little bit about competitive landscape and how it might evolve. I would add one to it, which is

As you mentioned before, Zach, there has been a huge increase in participation in financial markets. Some of it is very healthy. New generations are learning earlier how to invest, and some of it is more akin to really gambling. And if you think about that and the ramification it might have in terms of regulations in the future, or if losses actually pile up for retail investors, this is an area that is worth bearing in mind. You might have noticed

But in the past 18 months, they've been talking a little bit more about their new product called

called ForecastX, which basically allows, it's almost like a sports betting platform on economic events that allows customers to really express an opinion that is a yes or no on individual outcomes. It might be about inflation, about payrolls. And the simple fact that the CFTC initially didn't allow those products to go out because they were too akin to

Sports betting tells you that there is a component in financial markets today that goes through online brokerages that is more similar to gambling rather than what we would normally consider investing. And so a corollary to that last question is one that we always conclude with. Lessons learned when you guys evaluate this business that can be applied to others and from an operational perspective.

the way that management runs this business that you think can be applied to other businesses to help drive better shareholder returns?

When we're looking at what gives our businesses a competitive and strategic advantage over their industry and that will endure for the long term, one of the really best ones, and we've only got a handful of these that have this competitive advantage, is this low-cost, high-service model. And service in this case means better access to markets, quicker trading, neater valuations. Not yet. Someone on the end of the phone, but we'll wait and see on that. But so this low-cost-to-serve, high-quality product...

It's brilliant because it's so hard to compete with. This is one of the best examples that we have found, and obviously others being things like Ryanair, Costco, and a few other businesses on our list. And I think it leads to 10, 20, 30 years of potential advantage, which will come through in this case through account growth.

And so that's been the primary one. And I think when you've dug back as long as you can in the history, and there's quite a bit written about this business over the last 48 years, this obsession with technology, automation and costs has been there from day one. And so that's a softer point, but it's around the culture of a business. It doesn't have to be founder-led, but it's often founder-led.

but it's certainly got to be someone with skin in the game. And it's got to be someone who's intrinsically demands that of a business. I don't think it's something that you can come through with an MBA and just say, oh, I'm going to go for a low cost model. I think it's got to be something that's really in you. And I think the final thing that this business helped teach us is just how cheap very high quality cyclical businesses can become because people misunderstand or fear cyclicality in what is otherwise a very strong growth business. This

This was trading on 12 or 13 times earnings, delivered earnings, only 18 months ago. It's a little more expensive now, but it's still inexpensive. The way we look at these things, which is with all cyclicals, you'll always get a good chance. You can find the great cyclical. You might have to wait three or five years, but you'll always get a great chance. And the great ones are worth waiting for. Well, Freddie, Jacopo, I appreciate you guys coming on so much to discuss IBKR.

Around 50 years ago, Thomas Petterfie came here with effectively nothing and has built what is today, I believe, a $75 billion plus business of which he owns the vast majority of. It's a really interesting story from both a business history, but also business performance perspective. I really appreciate you guys coming on to help tell it. Great to speak to you.

To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out JoinColossus.com. That's J-O-I-N-C-O-L-O-S-S-U-S dot com.