Interactive Brokers Group, Inc. and Subsidiaries
Notes to Unaudited Condensed Consolidated Financial Statements (Continued)
(dollars in thousands, except shares and per share amounts, unless otherwise noted)
Total share distributions under the SIP and ROI Unit Stock Plan have been as follows:
| | | | | | Shares sold by |
| | | | | | employees to |
| | | | Fair Value at | | meet |
| | | | Date of Grant | | withholding |
| | Total Shares | | ($000's) | | obligations |
| In connection with IPO | 189,617 | | $ 5,681 | | 45,857 |
| 2008 | 458,655 | | 13,881 | | 121,852 |
| 2009 | 680,164 | | 17,898 | | 175,362 |
| 2010 | 1,014,772 | | 23,742 | | 265,971 |
| 2011 | 1,353,910 | | 29,498 | | 370,310 |
The following is a summary of Stock Plan activity for the period from January 1, 2011 through September 30, 2011:
| | Shares |
| | 2007 Stock | | | 2007 ROI Unit | |
| | Incentive Plan | | | Stock Plan | |
| | | | | | |
| Balance, December 31, 2010 | 7,263,140 | | | 544,613 | |
| | | | | | |
| Granted | - | | | - | |
| Forfeited | (88,275 | ) | | (764 | ) |
| Distributed | (1,167,482 | ) | | (186,428 | ) |
| Balance, September 30, 2011 | 6,007,383 | | | 357,421 | |
Estimated future grants under the Stock Incentive Plan are being accrued for ratably during each year under the ASC 718 “Graded Vesting” method. Compensation expense recognized in the unaudited condensed consolidated statements of comprehensive income for the nine months ended September 30, 2011 and 2010, was $27,978 and $27,621, respectively. Estimated future compensation costs for unvested awards at September 30, 2011 are $47.1 million.
Shares granted under the 2007 ROI Unit Stock Plan and the Stock Incentive Plan are subject to forfeiture in the event an employee ceases employment with the Company. The plans provide that employees who discontinue employment with the Company without cause and continue to meet the terms of the plans’ post-employment provisions will forfeit 50% of unvested previously granted shares unless the employee is over the age of 59, in which case the employee would be eligible to receive 100% of unvested shares previously granted. Distributions of remaining shares to former employees will occur annually following the discontinuation of employment over a five (5) year vesting schedule, 12.5% in each of the first four years and 50% in the fifth year. Through September 30, 2011, a total of 14,651 shares have been distributed under these post-employment provisions. These distributions are included in the Stock Plans activity tables above.
11. Commitments, Contingencies and Guarantees
Litigation
The Company is subject to certain pending and threatened legal actions which arise out of the normal course of business. Litigation is inherently unpredictable, particularly in proceedings where claimants seek substantial or indeterminate damages, or which are in their early stages. IBG, Inc. cannot predict with certainty the actual loss or range of loss related to such legal proceedings, the manner in which they will be resolved, the timing of final resolution or the ultimate settlement. Consequently, IBG, Inc. cannot estimate losses or ranges of losses related to such legal matters, even in instances where it is reasonably possible that a future loss will be incurred. Although the results of legal actions cannot be predicted with certainty, it is the opinion of management that the resolution of these actions is not expected to have a material adverse effect, if any, on our business or financial condition, but may have a material impact on the results of operations for a given period.
On February 3, 2010, Trading Technologies International, Inc. ("Trading Technologies") filed a complaint in the United
Interactive Brokers Group, Inc. and Subsidiaries
Notes to Unaudited Condensed Consolidated Financial Statements (Continued)
(dollars in thousands, except shares and per share amounts, unless otherwise noted)
States District Court for the Northern District of Illinois, Eastern Division, against Interactive Brokers Group, Inc., IBG LLC, IBG Holdings LLC, and Interactive Brokers LLC. Thereafter, Trading Technologies dismissed Interactive Brokers Group, Inc. and IBG Holdings LLC from the case, leaving only IBG LLC and Interactive Brokers LLC as defendants ("Defendants"). The operative complaint, as amended, alleges that the Defendants have infringed and continue to infringe twelve U.S. patents held by Trading Technologies. Trading Technologies is seeking, among other things, unspecified damages and injunctive relief. The case is in the pleadings stage. While it is too early to predict the outcome of the matter, we believe we have meritorious defenses to the allegations made in the complaint and intend to defend ourselves vigorously against them. However, litigation is inherently uncertain and there can be no guarantee that the Company will prevail or that the litigation can be settled on favorable terms.
IBG, Inc. accounts for potential losses related to litigation in accordance with ASC 450, Contingencies. As of September 30, 2011 and December 31, 2010, reserves provided for potential losses related to litigation matters were not material.
Guarantees
Certain of the Operating Companies provide guarantees to securities clearing houses and exchanges which meet the accounting definition of a guarantee under ASC 460, Guarantees. Under the standard membership agreement, members are required to guarantee collectively the performance of other members. Under the agreements, if another member becomes unable to satisfy its obligations to the clearinghouse, other members would be required to meet shortfalls. In the opinion of management, the Operating Companies’ liability under these arrangements is not quantifiable and could exceed the cash and securities they have posted as collateral. However, the potential for these Operating Companies to be required to make payments under these arrangements is remote. Accordingly, no contingent liability is carried in the unaudited condensed consolidated statements of financial condition for these arrangements.
In connection with its retail brokerage business, IB LLC performs securities and commodities execution, clearance and settlement on behalf of its customers for whom it commits to settle trades submitted by such customers with the respective clearing houses. If a customer fails to fulfill its obligation, IB LLC must fulfill the customer’s obligation with the trade counterparty. No contingent liability is carried on the unaudited condensed consolidated statements of financial condition for such customer obligations.
Other Commitments
Certain clearing houses and clearing banks and firms used by certain Operating Companies are given a security interest in certain assets of those Operating Companies held by those clearing organizations. These assets may be applied to satisfy the obligations of those Operating Companies to the respective clearing organizations.
12. Segment and Geographic Information
IBG, Inc. operates in two business segments, market making and electronic brokerage. The Company conducts its market making business principally through its Timber Hill subsidiaries on the world’s leading exchanges and market centers, primarily in exchange-traded equities, equity options and equity-index options and futures. IBG, Inc. conducts its electronic brokerage business through its Interactive Brokers subsidiaries, which provide electronic execution and clearing services to customers worldwide.
There are significant transactions and balances between the Operating Companies, primarily as a result of certain Operating Companies holding exchange or clearing organization memberships, which are utilized to provide execution and clearing services to affiliates. Charges for transactions between segments are designed to approximate full costs. Intra-segment and intra-region income and expenses and related balances have been eliminated in this segment and geographic information to accurately reflect the external business conducted in each segment or geographical region. Corporate items include non-allocated corporate income and expenses that are not attributed to segments for performance measurement, corporate assets and eliminations.
Interactive Brokers Group, Inc. and Subsidiaries
Notes to Unaudited Condensed Consolidated Financial Statements (Continued)
(dollars in thousands, except shares and per share amounts, unless otherwise noted)
Management believes that the following information by business segment provides a reasonable representation of each segment’s contribution to total net revenues and income before income taxes for the three and nine months ended September 30, 2011 and 2010, and to total assets as of September 30, 2011 and December 31, 2010:
| | | Three months ended | | | | Nine months ended | |
| | | September 30, | | | | September 30, | |
| | | 2011 | | | | 2010 | | | | 2011 | | | | 2010 | |
| Net revenues: | | | | | | | | | | | | | | | |
| Market making | $ | 204,363 | | | $ | 170,739 | | | $ | 532,427 | | | $ | 335,164 | |
| Electronic brokerage | | 191,716 | | | | 129,368 | | | | 525,091 | | | | 401,141 | |
| Corporate and eliminations | | (10,553 | ) | | | (969 | ) | | | (7,164 | ) | | | (461 | ) |
| Total net revenues | $ | 385,526 | | | $ | 299,138 | | | $ | 1,050,354 | | | $ | 735,844 | |
| | | | | | | | | | | | | | | | |
| Income before income taxes: | | | | | | | | | | | | | | | |
| Market making | $ | 128,514 | | | $ | 103,987 | | | $ | 322,366 | | | $ | 113,332 | |
| Electronic brokerage | | 105,509 | | | | 63,484 | | | | 284,568 | | | | 200,180 | |
| Corporate and eliminations | | (16,266 | ) | | | (5,551 | ) | | | (18,061 | ) | | | (14,603 | ) |
| Total income before income taxes | $ | 217,757 | | | $ | 161,920 | | | $ | 588,873 | | | $ | 298,909 | |
| | | September 30, | | | | December 31, | | |
| | | 2011 | | | | 2010 | | |
| Segment assets: | | | | | | | | |
| Market making | $ | 16,945,434 | | | $ | 14,609,564 | | |
| Electronic brokerage | | 20,436,245 | | | | 17,356,632 | | |
| Corporate and eliminations | | (4,230,558 | ) | | | (3,467,428 | ) | |
| Total assets | $ | 33,151,121 | | | $ | 28,498,768 | | |
In connection with its ongoing review and analysis of the costs of operating its businesses, commencing in the second quarter of 2011, IBG LLC has increased its allocation of corporate expenses to the operating segments in the form of intercompany administrative fees to include non-cash compensation, primarily SIP costs. Increased intercompany administrative fees, which are eliminated in consolidation, affect the operating segments’ income before income taxes. The effect for the three and nine months ended September 30, 2011 was an increase in net costs charged to the Electronic Brokerage segment of $2.1 million and $4.2 million, and to the Market Making segment of $1.5 million and $3.1 million, respectively, offset by increases in intercompany fee revenue recognized in the Corporate segment.
Interactive Brokers Group, Inc. and Subsidiaries
Notes to Unaudited Condensed Consolidated Financial Statements (Continued)
(dollars in thousands, except shares and per share amounts, unless otherwise noted)
The Company operates its automated global business in U.S. and international markets on more than 90 exchanges and market centers. A significant portion of IBG, Inc.’s net revenues are generated by subsidiaries operating outside the United States. International operations are comprised of market making and electronic brokerage activities in 27 countries in Europe, Asia, North America and South America. The following table presents total net revenues and income before income taxes by geographic area for the three and nine months ended September 30, 2011 and 2010:
| | | Three months ended | | | | Nine months ended | |
| | | September 30, | | | | September 30, | |
| | | 2011 | | | | 2010 | | | | 2011 | | | | 2010 | |
| Net revenues: | | | | | | | | | | | | | | | |
| United States | $ | 237,494 | | | $ | 229,496 | | | | $ 747,795 | | | | $ 573,428 | |
| International | | 159,166 | | | | 73,423 | | | | 313,422 | | | | 166,054 | |
| Corporate and eliminations | | (11,134 | ) | | | (3,781 | ) | | | (10,863 | ) | | | (3,638 | ) |
| Total net revenues | $ | 385,526 | | | $ | 299,138 | | | | $ 1,050,354 | | | | $ 735,844 | |
| | | | | | | | | | | | | | | | |
| Income before income taxes: | | | | | | | | | | | | | | | |
| United States | $ | 137,610 | | | $ | 147,317 | | | | $ 475,192 | | | | $ 311,445 | |
| International | | 96,913 | | | | 22,779 | | | | 135,125 | | | | 5,072 | |
| Corporate and eliminations | | (16,766 | ) | | | (8,176 | ) | | | (21,444 | ) | | | (17,608 | ) |
| Total income before income taxes | $ | 217,757 | | | $ | 161,920 | | | | $ 588,873 | | | | $ 298,909 | |
13. Regulatory Requirements
At September 30, 2011, aggregate excess regulatory capital for all of the Operating Companies was $2.33 billion.
TH LLC and IB LLC are subject to the Uniform Net Capital Rule (Rule 15c3-1) under the Exchange Act and the CFTC’s minimum financial requirements (Regulation 1.17). At September 30, 2011, TH LLC had net capital of $665,758, which was $619,324 in excess of required net capital of $46,434, and IB LLC had net capital of $1,212,347, which was $1,050,809 in excess of required net capital of $161,538.
THE is subject to the Swiss National Bank eligible equity requirement. At September 30, 2011, THE had eligible equity of $525,821, which was $282,883 in excess of the minimum requirement of $242,938.
THSHK is subject to the Hong Kong Securities Futures Commission liquid capital requirement, THA is subject to the Australian Stock Exchange liquid capital requirement, THC and IBC are subject to the Investment Industry Regulatory Organization of Canada risk adjusted capital requirement, IBUK is subject to the U.K. Financial Services Authority financial resources requirement, IBI is subject to the National Stock Exchange of India net capital requirements and IBSJ is subject to the Japanese Financial Supervisory Agency capital requirements.
At September 30, 2011, all of the Operating Companies were in compliance with their respective regulatory capital requirements.
Regulatory capital requirements could restrict the Operating Companies from expanding their business and declaring dividends if their net capital does not meet regulatory requirements. Also, certain entities within IBG, Inc. are subject to other regulatory restrictions and requirements.
Interactive Brokers Group, Inc. and Subsidiaries
Notes to Unaudited Condensed Consolidated Financial Statements (Continued)
(dollars in thousands, except shares and per share amounts, unless otherwise noted)
14. Related Party Transactions
Receivable from affiliate represents amounts advanced to IBG Holdings LLC and payable to affiliate represents amounts payable to IBG Holdings LLC under the Tax Receivable Agreement (Note 4).
Included in receivable from and payable to customers in the accompanying unaudited condensed consolidated statements of financial condition as of September 30, 2011 and December 31, 2010 were account receivables of directors, officers and their affiliates of $987 and $41 and payables of $627,162 and $748,460, respectively. Included in senior notes payable at September 30, 2011 and December 31, 2010 were senior notes purchased by directors and their affiliates of $1,485 and $10,443, respectively.
15. Subsequent Events
The Company has evaluated subsequent events for adjustment to or disclosure in its unaudited condensed consolidated financial statements through the date the unaudited condensed consolidated financial statements were issued.
On October 27, 2011, the Company declared a cash dividend of $0.10 per common share, payable on December 14, 2011 to shareholders of record as of December 1, 2011.
As of September 30, 2011, the Company held an investment in common stock of MF Global Holdings Ltd., (“MF”) with a fair value of $16.7 million. MF filed for bankruptcy on October 31, 2011. In response, the Company reduced the fair value of this investment and subsequent investments to zero, recognizing an unrealized loss of $28.8 million.
No other recordable or disclosable events occurred.
*****
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 SEC on February 28, 2011 and elsewhere in this report.
Introduction
IBG, Inc. is a holding company whose primary asset is ownership of approximately 11.5% 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 90 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 21 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 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 90 exchanges and market centers and in 19 countries around the world seamlessly. |
| | | In this quarter, 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 initial response has been positive and we will continue to devote resources to the further development of this tool with additional content and functions. |
| | · | 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 807,000 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 were $0.50 for the three months ended September 30, 2011, 92% higher than the $0.26 earned for the three months ended September 30, 2010.
On a comprehensive basis, which includes the full effect of currency translation, the Company reported diluted earnings per share of $0.36 for the quarter ended September 30, 2011 as compared to diluted earnings per share of $0.52 for the same period in 2010. This decrease was due to the strengthening of the U.S. dollar relative to other currencies, which reduced the value of the Company’s non-U.S. subsidiaries as measured in U.S. dollars.
Reporting Comprehensive Income reflects the Company’s early adoption of newly issued U.S. GAAP guidance that requires the presentation of a Statement of Comprehensive Income, which replaced the Statement of Income. The Statement of Comprehensive Income reports all currency translation results, including the portion that was previously only reported as a component of Other Comprehensive Income (“OCI”) on the Statement of Financial Condition. In prior periods we reported non-GAAP measures for the purpose of incorporating all currency translation gains and losses in the Statement of Income. This reporting method is now required under U.S. GAAP guidance.
Currency translation effects are largely a result of our currency strategy. We have determined to base our net worth in GLOBALs, a basket of major currencies in which we hold our equity. In this quarter, our currency hedging program decreased our profits as the U.S. dollar value of the GLOBAL decreased by approximately 2.5%. The effects of currency hedging are reported as components of (1) Market Making Trading Gains and (2) Other Comprehensive Income, described above.
In light of the strengthening of the U.S. dollar against a number of other currencies, adding OCI to Net Income decreased diluted comprehensive earnings per share by $0.14 for the current quarter. Diluted earnings per share were impacted by a tax benefit that the Company recognized during preparation of the 2010 income tax returns. In connection with the special dividend paid by our Swiss operating company in December 2010, we were able to capture additional foreign tax credits that resulted in an estimated $0.12 increase in diluted earnings per share which is reported in the quarter ended September 30, 2011.
Consolidated: For the three months ended September 30, 2011, our net revenues were $385.6 million and income before income taxes was $217.8 million, as compared to net revenues of $299.1 million and income before income taxes of $161.9 million for the corresponding period in 2010. Net interest income increased 91% in the three months ended September 30, 2011, as compared to the corresponding period last year driven by increases in customer cash balances and fully-secured margin borrowings. Trading gains increased 15% in the three months ended September 30, 2011, as compared to the corresponding period last year due to a more favorable trading environment that featured higher actual-to-implied volatility, higher trading volumes and wider bid-offer spreads. Currency fluctuations had a negative impact on trading gains for the current quarter, as the U.S. dollar strengthened relative to other key currencies. Commissions and execution fees were 45% higher than those of the year-ago quarter as a result of increased customer volume. Our pre-tax margin for the three months ended September 30, 2011 was 56%, as compared to 54% for the corresponding period in 2010.
Brokerage: During the three months ended September 30, 2011, income before income taxes in our electronic brokerage segment increased 66% as compared to the corresponding period in 2010. This reflects increases in commissions and execution fees and net interest income. Commissions grew by 45% from the year-ago quarter, while execution and clearing expenses were 40% higher primarily due to increased customer volume. The increase in net interest income was attributable to increases in interest earned on larger customer cash balances and fully secured margin borrowings and net fees from securities borrowed and loaned transactions. In this quarter we introduced to customers our Stock Yield Enhancement Program, which provides an opportunity for customers with fully-paid stock to allow IB to lend it out. In exchange for lending out their stock, our customers receive 50% of the stock loan fees. IB places cash collateral securing the loans in the customers’ accounts. Pre-tax margin increased from 49% to 55% for the three months ended September 30, 2010 and 2011, respectively. Total Daily Average Revenue Trades (“DARTs”) for cleared and execution-only customers increased 39% to approximately 495,000 during the three months ended September 30, 2011, as compared to approximately 355,000 during the three months ended September 30, 2010. Customer equity grew by 23%, to $23.3 billion, from the year-ago quarter.
Market Making: During the three months ended September 30, 2011, income before income taxes in our market making segment increased 24%, from $103.9 million to $128.5 million. The 22% increase in trading gains was driven by higher actual-to-implied volatility, higher trading volumes and wider bid-offer spreads. Trading gains rose despite a negative impact of $66.5 million in currency translation effects as compared to the year-ago quarter. Execution and clearing expenses were 27% higher during the three months ended September 30, 2011 than the year-ago quarter due to higher futures and options trading volumes. Pre-tax margin increased to 63% in the first quarter of 2011 as compared to 61% in the corresponding period of 2010.
We actively manage our global currency exposure by maintaining our equity in proportion to a defined basket of major currencies. Roughly half of our equity is denominated in currencies other than U.S. dollars. The U.S. dollar’s strengthening relative to other key currencies during this quarter had an estimated $108.7 million negative effect on our Comprehensive Income and an estimated $22.7 million negative effect on our reported market making earnings, as reported in U.S. dollars. Further discussion of our approach to managing foreign currency risk is contained in Part I, Item 3 of this Quarterly Report on Form 10-Q entitled “Quantitative and Qualitative Disclosures about Market Risk.”
Nine Months Results: Diluted earnings per share were $1.10 for the nine months ended September 30, 2011, 150% higher than the $0.44 earned for the nine months ended September 30, 2010.
On a comprehensive basis, which includes the full effect of currency translation, diluted earnings per share were $1.07 for the nine months ended September 30, 2011 as compared to diluted earnings per share of $0.58 for the same period in 2010.
Consolidated: For the nine months ended September 30, 2011, our net revenues were $1,050.4 million and income before income taxes was $588.9 million, as compared to net revenues of $735.8 million and income before income taxes of $298.9 million for the corresponding period in 2010. Trading gains increased 57% in the nine months ended September 30, 2011, as compared to the corresponding period last year due, in part, to wider bid/offer spreads in options as well as a reversal in translation losses to translation gains. Net interest income increased 106% in the nine months ended September 30, 2011, as compared to the corresponding period last year, driven by increases in customer cash balances and fully-secured margin borrowings. Commissions and execution fees increased by 20%, commensurate with the increase in customer accounts, as compared to the corresponding time period last year. Our pre-tax margin for the nine months ended September 30, 2011 was 56%, compared to 41% for the corresponding period in 2010.
Interactive Brokers Group, Inc. and Subsidiaries
Notes to Unaudited Condensed Consolidated Financial Statements (Continued)
(dollars in thousands, except shares and per share amounts, unless otherwise noted)
Brokerage: During the nine months ended September 30, 2011, income before income taxes in our electronic brokerage segment increased 42% as compared to the corresponding period in 2010. This reflects an increase in net interest income, and higher commission revenues, partially offset by higher execution and clearing expenses as compared to the corresponding period last year. The increase in net interest income was attributable to increases in interest earned on larger customer cash balances and fully secured margin borrowings as well as an increase in net fees earned on securities borrowed and loaned transactions. Pre-tax margin increased from 50% to 54% for the nine months ended September 30, 2010 and 2011, respectively. Total DARTs for cleared and execution-only customers increased 17% to approximately 443,000 during the nine months ended September 30, 2011, as compared to approximately 380,000 during the nine months ended September 30, 2010. The number of customer accounts grew 22% from the year-ago quarter. Customer equity grew by 23%, to $23.3 billion, from the year-ago quarter.
Market Making: During the nine months ended September 30, 2011, income before income taxes in our market making segment increased 185%, from $113.3 million to $322.4 million, as compared with the corresponding period in 2010. This was primarily driven by an increase in trading gains, a substantial component of which is a positive shift in currency translation effects of $122.0 million as compared to the year-ago period. Execution and clearing expenses were 11% lower during the nine months ended September 30, 2011 than the same period last year due to increased executions at venues that pay participants to provide liquidity. As a market maker under the make-or-take pricing model we are paid for providing liquidity instead of being charged. Pre-tax margin increased to 61% in the first nine months of 2011 as compared to 34% in the corresponding period of 2010.
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 |
| 2006 | 66,043 | | 51,238 | | 12,828 | | 130,109 | | 518 |
| 2007 | 99,086 | 50% | 72,931 | 42% | 16,638 | 30% | 188,655 | 45% | 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 |
| | | | | | | | | | |
| 3Q2010 | 17,796 | | 31,894 | | 4,746 | | 54,436 | | 851 |
| 3Q2011 | 19,602 | 10% | 45,879 | 44% | 5,273 | 11% | 70,754 | 30% | 1,106 |
CONTRACT AND SHARE VOLUMES:
(in 000’s, except %)
TOTAL
| | Options | % | Futures* | % | Stocks | % |
| Period | (contracts) | Change | (contracts) | Change | (shares) | Change |
| 2006 | 563,623 | | 62,419 | | 34,493,410 | |
| 2007 | 673,144 | 19% | 83,134 | 33% | 47,324,798 | 37% |
| 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% |
| | | | | | | |
| 3Q2010 | 163,298 | | 24,094 | | 18,665,413 | |
| 3Q2011 | 254,904 | 56% | 31,835 | 32% | 20,598,631 | 10% |
* Includes options on futures
CONTRACT AND SHARE VOLUMES, continued:
(in 000’s, except %)
MARKET MAKING
| | Options | % | Futures* | % | Stocks | % |
| Period | (contracts) | Change | (contracts) | Change | (shares) | Change |
| 2006 | 371,929 | | 14,818 | | 21,180,377 | |
| 2007 | 447,905 | 20% | 14,520 | -2% | 24,558,314 | 16% |
| 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% |
| | | | | | | |
| 3Q2010 ** | 107,602 | | 4,225 | | 4,411,226 | |
| 3Q2011 ** | 171,731 | 60% | 4,835 | 14% | 3,921,841 | -11% |
BROKERAGE TOTAL
| | Options | % | Futures* | % | Stocks | % |
| Period | (contracts) | Change | (contracts) | Change | (shares) | Change |
| 2006 | 191,694 | | 47,601 | | 13,313,033 | |
| 2007 | 225,239 | 17% | 68,614 | 44% | 22,766,484 | 71% |
| 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% |
| | | | | | | |
| 3Q2010 | 55,696 | | 19,869 | | 14,254,187 | |
| 3Q2011 | 83,173 | 49% | 27,000 | 36% | 16,676,790 | 17% |
* Includes options on futures
** In Brazil, an equity option contract typically represents 1 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 CLEARED
| | | Options | % | Futures* | % | Stocks | % |
| Period | | (contracts) | Change | (contracts) | Change | (shares) | Change |
| 2006 | | 32,384 | | 45,351 | | 12,492,870 | |
| 2007 | | 51,586 | 59% | 66,278 | 46% | 20,353,584 | 63% |
| 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% |
| | | | | | | | |
| 3Q2010 | | 22,930 | | 19,399 | | 13,455,306 | |
| 3Q2011 | | 43,994 | 92% | 26,601 | 37% | 15,846,432 | 18% |
* Includes options on futures
BROKERAGE STATISTICS:
(in 000’s, except % and where noted)
| | 3Q2011 | | 3Q2010 | | % Change |
| Total Accounts | 184 | | 151 | | 22% |
| Customer Equity (in billions) * | $23.3 | | $18.9 | | 23% |
| | | | | | |
| Cleared DARTs | 457 | | 320 | | 43% |
| Total Customer DARTs | 495 | | 355 | | 39% |
| | | | | | |
| Cleared Customers (in $'s, except DART per account) | | | | | |
| Commission per DART | $4.29 | | $4.17 | | 3% |
| DART per Avg. Account (Annualized) | 640 | | 544 | | 18% |
| Net Revenue per Avg. Account (Annualized) | $4,024 | | $3,251 | | 24% |
* Excluding non-customers
During the third quarter, the global financial markets were disoriented by economic uncertainty about the U.S. debt ceiling and concerns over European government debt. These events resulted in heightened volatility and trading volumes, which created a favorable environment for both our brokerage and market making businesses.
In the brokerage segment, our customers took advantage of higher volatility and increased their trading activity. We also continued to see steady growth in our brokerage accounts, which increased 22% over the prior year.
A summary of market conditions that affected our business this quarter follows:
Global trading volumes. According to data received from exchanges worldwide, volumes in exchange-listed equity-based options increased by approximately 46% globally and 49% in the U.S., as compared to the corresponding quarter in 2010. During the third quarter of 2011 we accounted for approximately 11.5% of the exchange-listed equity-based options (including options on ETFs and stock index products) volume traded worldwide and approximately 15.3% of exchange-listed equity-based options volume traded in the U.S. This compares to approximately 10.6% of the exchange-listed equity-based options volume traded worldwide and approximately 14.0% of the exchange-listed equity-based options volume traded in the U.S. in the third quarter of 2010. It is important to note that this metric is not directly correlated with our profits.
See the tables on pages 32 – 34 of this Quarterly Report on Form 10-Q for additional details regarding our trade volumes, contract and share volumes and brokerage statistics.
Bid/Offer Spreads. After reaching a historic low in the third quarter of 2010, bid/offer spreads on U.S. exchange-traded options have been gradually widening over the past year. As reported by the NASDAQ OMX PHLX market, bid/offer spreads in the third quarter were approximately 68% wider than the corresponding period in 2010. We believe this increase can be partly attributed to the heightened scrutiny over high frequency trading firms that began after the May 2010 “flash crash.” Regulators and exchanges began enacting new rules last year that eliminated some of the advantages high frequency traders (“HFT’s”) had over registered market makers. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law last summer, is also expected to impose strict regulations on the hedge fund industry.
Volatility. 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 Chicago Board Options Exchange Volatility Index (“VIX”), the average volatility during the third quarter was approximately 26% higher than it was in the third quarter of 2010, and the highest it has been since the second quarter of 2009.
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 111% during the third quarter, approximately 50% higher than it was in both the second quarter of 2011 and the year-ago quarter.
Currency fluctuations. 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 keeping our net worth in proportion to a defined basket of major currencies (the “GLOBAL”). 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 2011, the value of the GLOBAL declined 2.5% compared to the previous quarter which negatively affected our comprehensive earnings. On a year-to-date basis the changes in the value of the GLOBAL, as expressed in U.S. dollars, for both 2011 and 2010 were small.
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. |
| | · | 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. |
| | · | Further consolidation among market centers this 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 profitability is increased when actual volatility runs above implied volatility and it is decreased when actual volatility falls below implied volatility. Implied volatility tends to lag actual volatility. |
See “Risk Factors” in Part I, Item 1A of the Company’s Annual Report on Form 10-K filed with the SEC on February 28, 2011 and elsewhere in this report for a discussion of other risks that may affect our financial condition and results of operations.
Results of Operations
The tables in the period comparisons below provide summaries of our revenues and expenses. The period-to-period comparisons below of financial results are not necessarily indicative of future results. The following table sets forth our unaudited consolidated results of operations for the indicated periods:
| | | | Three Months | | Nine Months |
| | | | Ended September 30, | | Ended September 30, |
| | | | 2011 | | 2010 | | 2011 | | 2010 |
| | | | (in millions except share and per share data) |
| | | | | | | | | | |
| Revenues: | | | | | | | |
| | Trading gains | $193.8 | | $168.7 | | $514.7 | | $326.9 |
| | Commissions and execution fees | 130.6 | | 90.1 | | 346.3 | | 289.4 |
| | Interest income | 73.8 | | 42.4 | | 211.8 | | 120.0 |
| | Other income | 10.7 | | 13.9 | | 43.1 | | 48.4 |
| | | | | | | | | | |
| | | Total revenues | 408.9 | | 315.1 | | 1,115.9 | | 784.7 |
| | | | | | | | | | |
| | Interest expense | 23.3 | | 16.0 | | 65.5 | | 48.9 |
| | | | | | | | | | |
| | | Total net revenues | 385.6 | | 299.1 | | 1,050.4 | | 735.8 |
| | | | | | | | | | |
| Non-interest expenses: | | | | | | | |
| | Execution and clearing | 82.1 | | 61.9 | | 214.4 | | 207.1 |
| | Employee compensation and benefits | 56.2 | | 49.6 | | 161.2 | | 149.6 |
| | Occupancy, depreciation and amortization | 9.0 | | 9.1 | | 27.3 | | 27.5 |
| | Communications | 5.7 | | 5.9 | | 17.8 | | 17.6 |
| | General and administrative | 14.8 | | 10.7 | | 40.8 | | 35.1 |
| | | | | | | | | | |
| | | Total non-interest expenses | 167.8 | | 137.2 | | 461.5 | | 436.9 |
| | | | | | | | | | |
| Income before income taxes | 217.8 | | 161.9 | | 588.9 | | 298.9 |
| | | | | | | | | | |
| Income tax expense | 15.3 | | 13.1 | | 46.5 | | 25.7 |
| | | | | | | | | | |
| Net income | 202.5 | | 148.8 | | 542.4 | | 273.2 |
| | | | | | | | | | |
| | Less net income attributable to non-controlling interests | 180.0 | | 137.7 | | 494.1 | | 254.4 |
| | | | | | | | | | |
| Net income available for common shareholders | $22.5 | | $11.1 | | $48.3 | | $18.8 |
| | | | | | | | | | |
| | | | | | | | | | |
| Earnings per share: | | | | | | | |
| | Basic | $0.50 | | $0.26 | | $1.11 | | $0.45 |
| | Diluted | $0.50 | | $0.26 | | $1.10 | | $0.44 |
| | | | | | | | | | |
| Weighted average common shares outstanding: | | | | | | | |
| | Basic | 44,832,545 | | 42,222,449 | | 43,370,291 | | 41,750,973 |
| | Diluted | 45,208,557 | | 42,784,799 | | 43,832,558 | | 42,401,307 |
Three Months Ended September 30, 2011 Compared to the Three Months Ended September 30, 2010
Net Revenues
Total net revenues for the quarter ended September 30, 2011 increased $86.5 million or 29%, to $385.6 million from $299.1 million during the quarter ended September 30, 2010. The increase in net revenues was primarily due to increases in commissions and execution fees, trading gains, and net interest income compared to the year-ago quarter. Increased customer cash and margin balances of 39% and 67% respectively, contributed to an increase of $24.1 million in net interest income. In our market making segment, an increase of $35.2 million in trading gains was driven by wider bid/offer spreads on options, an increase in the ratio of actual to implied volatility, higher trading volumes and an increase in average volatility, as measured by the VIX, as compared to the year-ago quarter. Trading volume is an important driver of revenues and costs for both our electronic brokerage segments and market making segments. During 2011, options and futures contracts and stock shares volume executed by our subsidiaries increased by 56%, 32% and 10% respectively. Increases in options and futures contract volumes were observed in both segments, as general market volumes rose, while market making stock share volume declined 11% and brokerage stock share volume increased 17%.
Trading Gains. Trading gains for the quarter ended September 30, 2011 increased $25.1 million, or 15%, to $193.8 million from $168.7 million for the quarter ended September 30, 2010. As market makers, we provide liquidity by buying from sellers and selling to buyers. During the quarter ended September 30, 2011, our market making operations executed 19.6 million trades, an increase of 10% as compared to the number of trades executed in the quarter ended September 30, 2010. Options contracts increased 60%, futures contracts increased 14% and stock shares decreased by 11% for the quarter ended September 30, 2011 as compared to the year-ago quarter. Trading gains were positively impacted by a 26% increase in average volatility, as measured by the VIX, which increased to
30.6, for the three months ended September 30, 2011 as compared to the year-ago quarter; as well as a 48% increase in the ratio of actual to implied volatility to 111% for the three months ended September 30, 2011 as compared to the same period last year. Bid/offer spreads on U.S. exchange-traded options, as reported by the NASDAQ OMX PHLX market, were approximately 68% wider during the third quarter of 2011 than during the corresponding period in 2010.
As part of managing our overall exposure to foreign currency fluctuations, we maintain a portion of our capital in a basket of currencies we call the GLOBAL. Currency translation effects as a result of holding our equity in GLOBALs had an estimated negative impact on our trading gains of $66.5 million for the three months ended September 30, 2011 as compared to the year-ago period. A discussion of our approach to managing foreign currency exposure is contained in Part I, Item 3 of this Quarterly Report on Form 10-Q entitled “Quantitative and Qualitative Disclosures about Market Risk.”
Included in trading gains are net dividends, net bond trading interest and currency translation gains and losses from market making activities:
Dividend income and expense arise from holding market making positions over dates on which dividends are paid to shareholders of record. When a stock pays a dividend, its market price is generally adjusted downward to reflect the value paid to the shareholders of record, which will not be received by those who purchase stock after the ex-dividend date. Hence, the apparent gains and losses due to these price changes, reflecting the value of dividends paid to shareholders, must be taken together with the dividends paid and received, respectively, to accurately reflect the results of our market making operations.
Commissions and Execution Fees. Commissions and execution fees for the quarter ended September 30, 2011 increased $40.5 million, or 45%, to $130.6 million, as compared to the quarter ended September 30, 2010. The increase was driven by higher trade volume from our customers. Customer volume in options and futures contracts and stock shares increased by 49%, 36% and 17%, respectively, for the quarter ended September 30, 2011 from the corresponding period in 2010. Total DARTs for cleared and execution-only customers for the quarter ended September 30, 2011 increased 39% to approximately 495,000, as compared to approximately 355,000 during the quarter ended September 30, 2010. DARTs for cleared customers, i.e., customers for whom we execute trades as well as clear and carry positions, increased 43% to approximately 457,000, for the quarter ended September 30, 2011, as compared to approximately 320,000 for the quarter ended September 30, 2010. The number of customer accounts grew by 22% to approximately 184,000 at September 30, 2011, as compared to approximately 151,000 at September 30, 2010. Average commission per DART for cleared customers, for the quarter ended September 30, 2011, increased by 3% to $4.29, as compared to $4.17 for the quarter ended September 30, 2010.
Interest Income and Interest Expense. Net interest income (interest income less interest expense) for the quarter ended September 30, 2011 increased $24.1 million, or 91%, to $50.5 million, as compared to the quarter ended September 30, 2010. Net interest income was derived primarily from the electronic brokerage segment during the quarter ended September 30, 2011. Net interest earned by electronic brokerage increased $20.5 million, or 82%, to $45.4 million, as compared to the quarter ended September 30, 2010. Average customer cash balances increased by 39%, to $17.54 billion, and average customer fully secured margin borrowings increased 67%, to $8.14 billion, for the quarter ended September 30, 2011, as compared to $12.65 billion and $4.88 billion, respectively, for the quarter ended September 30, 2010. Net fees earned from securities borrowed and loaned transactions increased $8.5 million for the quarter ended September 30, 2011 as compared to the year–ago quarter. In this quarter we introduced to customers our Stock Yield Enhancement Program, which provides an opportunity for customers with fully-paid stock to allow IB to lend it out. In exchange for lending out their stock, our customers receive 50% of the stock loan fees. IB places cash collateral securing the loans in the customers’ accounts.
The average Fed Funds effective rate decreased 11 basis points to .08% for the quarter ended September 30, 2011 as compared to the quarter ended September 30, 2010.
For market making, net interest income increased $5.1 million from the corresponding period last year to $6.4 million. As a result of the way we have integrated our market making and securities lending systems, our trading income and our net interest income are interchangeable and depend on the mix of market making positions in our portfolio. When implied interest rates in the equity and equity options and futures markets exceed the actual interest rates available to us, our market making systems tend to buy stock and sell it forward, which produces higher trading gains and lower net interest income. When these rates are inverted, our market making systems tend to sell stock and buy it forward, which produces lower trading gains and higher net interest income. Average securities borrowed decreased by 21%, to $3.45 billion and average securities loaned increased by 17%, to $1.74 billion, for the quarter ended September 30, 2011, which together produced a decrease in fees earned of $0.8 million, as compared to the year-ago period.
Other Income. Other income, for the quarter ended September 30, 2011, decreased $3.2 million, or 23%, to $10.7 million, as compared to the quarter ended September 30, 2010. The changes were due to mark-to-market losses on non-trading securities offset by higher revenue from market data fees, minimum activity fees and certain currency hedging activity.
Non-Interest Expenses
Non-interest expenses, for the quarter ended September 30, 2011, increased by $30.6 million, or 22%, to $167.8 million from $137.2 million, during the quarter ended September 30, 2010. The increase was primarily due to higher execution and clearing expenses and higher employee compensation and benefits expenses. As a percentage of total net revenues, non-interest expenses decreased to 44% for the quarter ended September 30, 2011 from 46% during the corresponding period in 2010.
Execution and Clearing. Execution and clearing expenses for the quarter ended September 30, 2011, increased $20.2 million, or 33%, to $82.1 million, as compared to the quarter ended September 30, 2010. The increase resulted from a 32% increase in futures contract volume and a 56% increase in options contract volume traded during the quarter ended September 30, 2011.
Employee Compensation and Benefits. Employee compensation and benefits expenses, for the quarter ended September 30, 2011, increased by $6.6 million, or 13%, to $56.2 million, as compared to the quarter ended September 30, 2010. The average number of employees decreased slightly to 850 for the quarter ended September 30, 2011, as compared to 853 for the corresponding period in 2010. As we continue to grow, our focus on automation has allowed us to maintain a relatively small staff. As a percentage of total net revenues, employee compensation and benefits expenses were 15% and 17%, for the quarters ended September 30, 2011 and 2010, respectively.
General and Administrative. General and administrative expenses, for the quarter ended September 30, 2011, increased $4.1 million, or 38% to $14.8 million, as compared to the quarter ended September 30, 2010. The increase in general and administrative expenses was primarily due to higher advertising expenditures and an increase in bad debt reserves.
Nine Months Ended September 30, 2011 Compared to the Nine Months Ended September 30, 2010
Net Revenues
Total net revenues for the nine months ended September 30, 2011 increased $314.6 million or 43%, to $1,050.4 million from $735.8 million during the nine months ended September 30, 2010. Trading volume is an important driver of revenues and costs for both our market making and electronic brokerage segments. During 2011, options and futures contracts and stock shares volume executed by our subsidiaries increased by 14%, 9% and 1%, respectively. Market making options and futures contract volumes increased 10% and 1%, respectively, brokerage options and futures contract volumes increased 21% and 11%, respectively, while market making stock share volume decreased 39% and brokerage stock share volume increased 13%. Increased customer cash and margin balances contributed to an increase of $62.4 million in net interest income in our brokerage segment. In our market making segment, wider bid/offer spreads in options, an increase in the ratio of actual to implied volatility and a reversal in translation losses contributed to an increase of $197.3 million in trading gains.
Trading Gains. Overall trading gains for the nine months ended September 30, 2011, increased $187.8 million, or 57%, to $514.7 million from $326.9 million for the nine months ended September 30, 2010. As market makers, we provide liquidity by buying from sellers and selling to buyers. During the nine months ended September 30, 2011, our market making operations executed 48.5 million trades, a decrease of 16% as compared to the number of trades executed in the nine months ended September 30, 2010. Options contracts increased 10%, futures contracts increased 1% while stock shares decreased by 39% for the nine months ended September 30, 2011 as compared to 2010. Bid/offer spreads on U.S. exchange-traded options, as reported by the NASDAQ OMX PHLX market, on average, were approximately 38% wider during the first three quarters of 2011 than during the corresponding period in 2010.
As part of managing our overall exposure to foreign currency fluctuations, we maintain a portion of our capital in a basket of currencies we call the GLOBAL. Currency translation effects as a result of holding our equity in GLOBALs had an estimated positive impact on our trading gains of $122.0 million for the nine months ended September 30, 2011 as compared to the year-ago period. A discussion of our approach to managing foreign currency exposure is contained in Part I, Item 3 of this Quarterly Report on Form 10-Q entitled “Quantitative and Qualitative Disclosures about Market Risk.”
Included in trading gains are net dividends, net bond trading interest and currency translation gains and losses from market making activities.
Dividend income and expense arise from holding market making positions over dates on which dividends are paid to shareholders of record. When a stock pays a dividend, its market price is generally adjusted downward to reflect the value paid to the shareholders of record, which will not be received by those who purchase stock after the ex-dividend date. ��Hence, the apparent gains and losses due to these price changes, reflecting the value of dividends paid to shareholders, must be taken together with the dividends paid and received, respectively, to accurately reflect the results of our market making operations.
Commissions and Execution Fees. Commissions and execution fees for the nine months ended September 30, 2011 increased $56.9 million, or 20%, to $346.3 million, as compared to the nine months ended September 30, 2010. The increase was driven by higher overall trade volume from our customers. Volume in options and futures contracts and stock shares increased by 21%, 11%, and 13%, respectively, for the nine months ended September 30, 2011 from the corresponding period in 2010. Total DARTs for cleared and execution-only customers for the nine months ended September 30, 2011 increased 17% to approximately 443,000, as compared to
approximately 380,000 during the nine months ended September 30, 2010. DARTs for cleared customers, i.e., customers for whom we execute trades as well as clear and carry positions, increased 19% to approximately 408,000, for the nine months ended September 30, 2011, as compared to approximately 344,000 for the nine months ended September 30, 2010. The number of customer accounts grew by 22% to approximately 184,000 at September 30, 2011, as compared to approximately 151,000 at September 30, 2010. Average commission per DART for cleared customers, for the nine months ended September 30, 2011, increased by 1% to $4.33, as compared to $4.28 for the nine months ended September 30, 2010.
Interest Income and Interest Expense. Net interest income (interest income less interest expense) for the nine months ended September 30, 2011 increased $75.2 million, or 106%, to $146.3 million, as compared to the nine months ended September 30, 2010. Net interest income was derived primarily from the electronic brokerage segment during the nine months ended September 30, 2011. Net interest earned by electronic brokerage increased $62.4 million, or 93%, to $129.2 million, as compared to the nine months ended September 30, 2010. Average customer cash balances increased by 46%, to $17.31 billion, and average customer fully secured margin borrowings increased 95%, to $8.57 billion, for the nine months ended September 30, 2011, as compared to $11.86 billion and $4.40 billion, respectively, for the nine months ended September 30, 2010. Net fees earned by electronic brokerage from borrowing and loaning securities increased $21.2 million for the nine months ended September 30, 2011 as compared to same period last year.
The average Fed Funds effective rate decreased 6 basis points to 0.11% for the nine months ended September 30, 2011 as compared to the nine months ended September 30, 2010.
For market making, net interest income increased $10.1 million from the corresponding period last year to $13.9 million. As a result of the way we have integrated our market making and securities lending systems, our trading income and our net interest income are interchangeable and depend on the mix of market making positions in our portfolio. When implied interest rates in the equity and equity options and futures markets exceed the actual interest rates available to us, our market making systems tend to buy stock and sell it forward, which produces higher trading gains and lower net interest income. When these rates are inverted, our market making systems tend to sell stock and buy it forward, which produces lower trading gains and higher net interest income. Average securities borrowed decreased by 7%, to $4.84 billion and average securities loaned increased by 66%, to $2.33 billion, for the nine months ended September 30, 2011, which together, produced a decrease in net fees of $3.6 million as compared to the year-ago period.
Other Income. Other income, for the nine months ended September 30, 2011, decreased $5.3 million, or 11%, to $43.1 million, as compared to the nine months ended September 30, 2010. The primary components of Other Income are market data revenue collected from customers, order flow fees paid by U.S. options exchanges and minimum activity fees from inactive customers.
Non-Interest Expenses
Non-interest expenses, for the nine months ended September 30, 2011, increased by $24.6 million, or 6%, to $461.5 million from $436.9 million, during the nine months ended September 30, 2010. The increase was primarily due to higher execution and clearing expenses, and higher employee compensation and benefits expenses. As a percentage of total net revenues, non-interest expenses decreased to 44% for the nine months ended September 30, 2011 from 59% during the corresponding period in 2010.
Execution and Clearing. Execution and clearing expenses, for the nine months ended September 30, 2011, increased $7.3 million, or 4%, to $214.4 million, as compared to the nine months ended September 30, 2010, as a result of higher trading volume in all product classes. This was partially offset by an increase in executions at venues that pay participants to provide liquidity. As a market maker under the make-or-take pricing model we are paid for providing liquidity instead of being charged payment-for-order flow fees.
Employee Compensation and Benefits. Employee compensation and benefits expenses, for the nine months ended September 30, 2011, increased by $11.6 million, or 8%, to $161.2 million, as compared to the nine months ended September 30, 2010. This increase reflects the 3% growth in the average number of employees to 854 for the nine months ended September 30, 2011, as compared to 830 for the corresponding period in 2010. As we continue to grow, our focus on automation has allowed us to maintain a relatively small staff. The continued recognition of costs associated with of our stock incentive plan also increased employee compensation and benefits expense. As a percentage of total net revenues, employee compensation and benefits expenses were 15% and 20%, for the nine months ended September 30, 2011 and 2010, respectively.
General and Administrative. General and administrative expenses, for the nine months ended September 30, 2011, increased $5.7 million, or 16% to $40.8 million, as compared to the nine months ended September 30, 2010. The increase in general and administrative expenses was due to higher advertising expenditures, bad debt reserves and an increase in trading permit fees.
Business Segments
The following table sets forth the net revenues and non-interest expenses and income before income taxes of our business segments:
| | | Three Months | | | Nine Months | |
| | | Ended September 30, | | | Ended September 30, | |
| | | 2011 | | | 2010 | | | 2011 | | | 2010 | |
| | | (in millions) |
| | | | | | | | | | | | | |
| Electronic Brokerage | Net revenues | $191.7 | | | $129.3 | | | $525.1 | | | $401.1 | |
| | Non-interest expenses | 86.2 | | | 65.9 | | | 240.5 | | | 201.0 | |
| | | | | | | | | | | | | |
| | Income before income taxes | $105.5 | | | $63.4 | | | $284.6 | | | $200.1 | |
| | | | | | | | | | | | | |
| | Pre-tax profit margin | 55 | % | | 49 | % | | 54 | % | | 50 | % |
| | | | | | | | | | | | | |
| Market Making | Net revenues | $204.3 | | | $170.7 | | | $532.4 | | | $335.2 | |
| | Non-interest expenses | 75.8 | | | 66.8 | | | 210.0 | | | 221.9 | |
| | | | | | | | | | | | | |
| | Income before income taxes | $128.5 | | | $103.9 | | | $322.4 | | | $113.3 | |
| | | | | | | | | | | | | |
| | Pre-tax profit margin | 63 | % | | 61 | % | | 61 | % | | 34 | % |
| | | | | | | | | | | | | |
| Corporate* | Net revenues | ($10.4 | ) | | ($0.9 | ) | | ($7.1 | ) | | ($0.5 | ) |
| | Non-interest expenses | 5.8 | | | 4.5 | | | 11.0 | | | 14.0 | |
| | | | | | | | | | | | | |
| | Income before income taxes | ($16.2 | ) | | ($5.4 | ) | | ($18.1 | ) | | ($14.5 | ) |
| | | | | | | | | | | | | |
| Total | Net revenues | $385.6 | | | $299.1 | | | $1,050.4 | | | $735.8 | |
| | Non-interest expenses | 167.8 | | | 137.2 | | | 461.5 | | | 436.9 | |
| | | | | | | | | | | | | |
| | Income before income taxes | $217.8 | | | $161.9 | | | $588.9 | | | $298.9 | |
| | | | | | | | | | | | | |
| | Pre-tax profit margin | 56 | % | | 54 | % | | 56 | % | | 41 | % |
* Corporate includes corporate related activities as well as inter-segment eliminations.
The following sections discuss results of our operations by business segment, excluding a discussion of corporate income and expense. In the following tables, revenues and expenses directly associated with each segment are included in determining income before income taxes. Due to the integrated nature of the business segments, estimates and judgments have been made in allocating certain revenue and expense items. Transactions between segments generally result from one subsidiary facilitating the business of another subsidiary through the use of its existing trading memberships and clearing arrangements. In such cases, certain revenue and expense items are eliminated in order to accurately reflect the external business conducted in each segment. Rates on transactions between segments are designed to approximate full costs. In addition to execution and clearing expenses, which are the main cost driver for both the market making segment and the electronic brokerage segment, each segment’s operating expenses include (i) employee compensation and benefits expenses that are incurred directly in support of the businesses, (ii) general and administrative expenses, which include directly incurred expenses for property leases, professional fees, travel and entertainment, communications and information services, equipment, and (iii) indirect support costs (including compensation and other related operating expenses) for administrative services provided by IBG LLC. Such administrative services include, but are not limited to, computer software development and support, accounting, tax, legal and facilities management.
Electronic Brokerage
The following table sets forth the results of our electronic brokerage operations for the indicated periods:
| | | | Three Months | | Nine Months |
| | | | Ended September 30, | | Ended September 30, |
| | | | 2011 | | 2010 | | 2011 | | 2010 |
| | | | (in millions) |
| | | | | | | | | | |
| Revenues: | | | | | | | |
| | Commissions and execution fees | $130.6 | | $90.2 | | $346.3 | | $289.4 |
| | Interest income | 56.3 | | 30.4 | | 160.4 | | 80.2 |
| | Other income | 15.7 | | 14.2 | | 49.6 | | 44.9 |
| | | | | | | | | | |
| | | Total revenues | 202.6 | | 134.8 | | 556.3 | | 414.5 |
| | | | | | | | | | |
| | Interest expense | 10.9 | | 5.5 | | 31.2 | | 13.4 |
| | | | | | | | | | |
| | | Total net revenues | 191.7 | | 129.3 | | 525.1 | | 401.1 |
| | | | | | | | | | |
| Non-interest expenses: | | | | | | | |
| | Execution and clearing | 43.4 | | 31.1 | | 115.2 | | 95.0 |
| | Employee compensation and benefits | 14.5 | | 13.7 | | 45.9 | | 41.8 |
| | Occupancy, depreciation and amortization | 3.2 | | 3.4 | | 9.4 | | 10.2 |
| | Communications | 3.8 | | 2.7 | | 9.2 | | 7.7 |
| | General and administrative | 21.3 | | 15.0 | | 60.8 | | 46.3 |
| | | | | | | | | | |
| | | Total non-interest expenses | 86.2 | | 65.9 | | 240.5 | | 201.0 |
| | | | | | | | | | |
| Income before income taxes | $105.5 | | $63.4 | | $284.6 | | $200.1 |
Three Months Ended September 30, 2011 Compared to the Three Months Ended September 30, 2010
Electronic brokerage total net revenues for the quarter ended September 30, 2011 increased $62.4 million, or 48%, to $191.7 million, from $129.3 million during the quarter ended September 30, 2010, primarily due to increases in commissions and execution fees and net interest income. Commission and execution fees increased $40.4 million, or 45%, and net interest income increased $20.5 million, or 82%, for the quarter ended September 30, 2011 as compared to the corresponding period in 2010. The increase in net interest income was attributable to an increase of $4.89 billion in average customer cash balances and an increase of $3.26 billion in average fully secured margin borrowings as well as an increase of $8.5 million on net fees earned from securities borrowed and loaned transactions. During the same time period, the Fed Funds effective rate decreased 11 basis points or 56%. The increase in commission and execution fees is directly attributable to increased customer trading volume. Volume in options and futures contracts and stock shares increased by 49%, 36% and 17%, respectively, for the quarter ended September 30, 2011 from the corresponding period in 2010. Total DARTs from cleared and execution-only customers for the quarter ended September 30, 2011 increased 39% to approximately 495,000, as compared to approximately 355,000 during the quarter ended September 30, 2010. DARTs from cleared customers for the quarter ended September 30, 2011 increased 43% to approximately 457,000, as compared to approximately 320,000 during the quarter ended September 30, 2010. Total customer equity grew by 23% to $23.3 billion at September 30, 2011, from $18.9 billion at September 30, 2010. The number of customer accounts grew 22% from September 30, 2010 to approximately 184,000 at September 30, 2011.
Electronic brokerage non-interest expenses for the quarter ended September 30, 2011 increased $20.3 million, or 31%, as compared to the quarter ended September 30, 2010. Within non-interest expenses, execution and clearing expenses increased by $12.3 million, driven by an increase in customer trading volume. Employee compensation and benefits expenses increased by $0.8 million, or 6% during the quarter ended September 30, 2011 as compared to 2010. General and administrative expenses increased $6.3 million as administrative and consulting fees increased $3.4 million during the quarter ended September 30, 2011 as compared to 2010. As a percentage of total net revenues, non-interest expenses decreased to 45% from 51% for the quarter ended September 30, 2011 as compared to 2010.
Nine Months Ended September 30, 2011 Compared to the Nine Months Ended September 30, 2010
Electronic brokerage total net revenues for the nine months ended September 30, 2011 increased $124.0 million, or 31%, to $525.1 million, from $401.1 million during the nine months ended September 30, 2010, primarily due to an increase in net interest income and higher commission and execution fees. Net interest income increased $62.4 million, or 93%, for the nine months ended September 30, 2011 as compared to the corresponding period in 2010. The increase in net interest income was attributable to an increase of $5.45 billion in average customer cash balances and an increase of $4.17 billion in average fully secured margin borrowings as well as a $21.2 million increase in net fees earned from securities borrowed and loaned transactions. Net interest income increased despite a
decrease in the average Fed Funds effective rate of approximately 6 basis points to 0.11% for the nine months ended September 30, 2011 as compared to 0.17% for the nine months ended September 30, 2010. Commission and execution fees increased $56.9 million, or 20%, for the nine months ended September 30, 2011 as compared to the corresponding period in 2010. The increase in commission and execution fees is directly attributable to increased customer trading volume. Volume in options and futures contracts and stock shares increased by 21%, 11% and 13% respectively for the nine months ended September 30, 2011 from the corresponding period in 2010. Total DARTs from cleared and execution-only customers for the nine months ended September 30, 2011 increased 17% to approximately 443,000, as compared to approximately 380,000 during the nine months ended September 30, 2010. DARTs from cleared customers for the nine months ended September 30, 2011 increased 19% to approximately 408,000, as compared to approximately 344,000 during the nine months ended September 30, 2010. Total customer equity grew by 23% to $23.3 billion at September 30, 2011, from $18.9 billion at September 30, 2010. The number of customer accounts grew 22% from September 30, 2010 to approximately 184,000 at September 30, 2011.
Electronic brokerage non-interest expenses for the nine months ended September 30, 2011 increased $39.5 million, or 20%, as compared to the nine months ended September 30, 2010. Within non-interest expenses, execution and clearing expenses increased by $20.2 million, driven by higher futures fees. Employee compensation and benefits expenses increased by $4.1 million, or 10% during the nine months ended September 30, 2011 as compared to 2010. General and administrative expenses increased $14.5 million as administrative and consulting fees increased $10.4 million during the nine months ended September 30, 2011 as compared to 2010. As a percentage of total net revenues, non-interest expenses decreased to 46% from 50% for the nine months ended September 30, 2011 as compared to 2010.
Market Making
The following table sets forth the results of our market making operations for the indicated periods:
| | Three Months | | Nine Months |
| | | | Ended September 30, | | Ended September 30, |
| | | | 2011 | | 2010 | | 2011 | | 2010 |
| | | | (in millions) |
| Revenues: | | | | | | | | |
| | Trading gains | $198.1 | | | $162.9 | | $518.4 | | $321.1 |
| | Interest income | 18.7 | | | 13.0 | | 49.3 | | 42.8 |
| | Other income | (0.2 | ) | | 6.5 | | 0.1 | | 10.3 |
| | | | | | | | | | | |
| | | Total revenues | 216.6 | | | 182.4 | | 567.8 | | 374.2 |
| | | | | | | | | | | |
| | Interest expense | 12.3 | | | 11.7 | | 35.4 | | 39.0 |
| | | | | | | | | | | |
| | | Total net revenues | 204.3 | | | 170.7 | | 532.4 | | 335.2 |
| | | | | | | | | | | |
| Non-interest expenses: | | | | | | | | |
| | Execution and clearing | 39.0 | | | 30.6 | | 100.2 | | 112.2 |
| | Employee compensation and benefits | 15.7 | | | 17.9 | | 47.2 | | 54.8 |
| | Occupancy, depreciation and amortization | 1.8 | | | 2.6 | | 6.9 | | 7.6 |
| | Communications | 2.2 | | | 3.0 | | 7.5 | | 9.7 |
| | General and administrative | 17.1 | | | 12.7 | | 48.2 | | 37.6 |
| | | | | | | | | | | |
| | | Total non-interest expenses | 75.8 | | | 66.8 | | 210.0 | | 221.9 |
| | | | | | | | | | | |
| Income before income taxes | $128.5 | | | $103.9 | | $322.4 | | $113.3 |
| | | | | | | | | | | |
Three Months Ended September 30, 2011 Compared to the Three Months Ended September 30, 2010
Market making total net revenues for the quarter ended September 30, 2011 increased $33.6 million, or 20%, to $204.3 million, from $170.7 million during the quarter ended September 30, 2010. Trading gains for the quarter ended September 30, 2011 increased $35.2 million, or 22%. Trading gains were positively impacted by a 26% increase in average volatility, as measured by the VIX, which increased to 30.6, for the three months ended September 30, 2011 as compared to the year-ago quarter; as well as a 48% increase in the ratio of actual to implied volatility to 111% for the three months ended September 30, 2011 as compared to the same period last year. Bid/offer spreads on U.S. exchange-traded options, as reported by the NASDAQ OMX PHLX market, were approximately 68% wider in the third quarter of 2011 than in the corresponding period in 2010. Market making options and futures contracts volume increased 60% and 14%, respectively, and stock share volume decreased 11% in the quarter ended September 30, 2011 as compared to the corresponding period in 2010. We continued to selectively pare down trading in less profitable products. Trading gains also include translation gains and losses.
As part of managing our overall exposure to foreign currency fluctuations, we maintain a portion of our capital in a basket of currencies we call the GLOBAL. Currency translation effects as a result of holding our equity in GLOBALs had an estimated negative impact on our trading gains of $66.5 million for the three months ended September 30, 2011 as compared to the year-ago period. A discussion of our approach to managing foreign currency exposure is contained in Part I, Item 3 of this Quarterly Report on Form 10-Q entitled “Quantitative and Qualitative Disclosures about Market Risk.”
Net interest income for the quarter ended September 30, 2011 increased by $5.1 million to $6.4 million. As described above, our trading gains and our net interest income are interchangeable and depend on the mix of market making positions in our portfolio and on relative interest rates in the stock and options markets. In the quarter ended September 30, 2011, these factors, together with securities lending activity, produced more interest income than in the third quarter of 2010.
Market making non-interest expenses for the quarter ended September 30, 2011 increased $9.0 million, or 13%, as compared to the quarter ended September 30, 2010. The increase primarily resulted from an $8.4 million increase in execution and clearing fees and a $4.4 million increase in general and administrative fees during the quarter ended September 30, 2011 as compared to 2010. The increase in execution and clearing fees is primarily due to an increase in options and futures volume. The increase in general and administrative fees was largely a result of a $5.1 million increase in administrative and consulting fees during the quarter ended September 30, 2011 as compared to the corresponding period in 2010. Employee compensation expenses decreased 12% as a result of a 13% reduction in headcount compared to the year-ago quarter. As a percentage of total net revenues, market making non-interest expenses decreased to 37% from 39% for the quarters ended September 30, 2011 and 2010, respectively.
Nine Months Ended September 30, 2011 Compared to the Nine Months Ended September 30, 2010
Market making total net revenues for the nine months ended September 30, 2011 increased $197.2 million, or 59%, to $532.4 million, from $335.2 million during the nine months ended September 30, 2010. Trading gains for the nine months ended September 30, 2011 increased $197.3 million, or 61%, primarily due to a reversal in translation losses and wider bid/offer spreads on exchange-traded options as compared to the year-ago period. Market making options and futures contract volumes increased 10% and 1% respectively, while stock share volume decreased 39% during the nine months ended September 30, 2011 as compared to the corresponding period in 2010. In 2010, and during the first nine months of 2011, we selectively pared down trading in less profitable products. Bid/offer spreads on U.S. exchange-traded options, as reported by the NASDAQ OMX PHLX market, on average, were approximately 38% wider during the first three quarters of 2011 than during the corresponding period in 2010.
As part of managing our overall exposure to foreign currency fluctuations, we maintain a portion of our capital in a basket of currencies we call the GLOBAL. Currency translation effects as a result of holding our equity in GLOBALs had an estimated positive impact on our trading gains of $122.0 million for the nine months ended September 30, 2011 as compared to the year-ago period. A discussion of our approach to managing foreign currency exposure is contained in Part I, Item 3 of this Quarterly Report on Form 10-Q entitled “Quantitative and Qualitative Disclosures about Market Risk.”
Net interest income for the nine months ended September 30, 2011 increased by $10.1 million to $13.9 million. As described above, our trading gains and our net interest income are interchangeable and depend on the mix of market making positions in our portfolio and on relative interest rates in the stock and options markets. In the nine months ended September 30, 2011, these factors, together with securities lending activity, produced more interest income than in the first nine months of 2010.
Market making non-interest expenses for the nine months ended September 30, 2011 decreased $11.9 million, or 5%, as compared to the nine months ended September 30, 2010. The decrease primarily resulted from a $12.0 million decrease in execution and clearing fees and a $7.6 million decrease in employee compensation and benefits expenses, partially offset by a $10.6 million increase in general and administrative fees during the nine months ended September 30, 2011 as compared to 2010. The decrease in execution and clearing fees was driven by a greater proportion of our U.S. options volume executed on exchanges with make-or-take pricing, where we are paid for providing liquidity. In addition, ETF issuer fees, a component of execution and clearing fees, decreased $2.4 million. Employee compensation expenses decreased as a result of a refinement in methods that we use to attribute certain expenses to the electronic brokerage and market making segments as if they were stand-alone businesses and from an 8% decrease in average staff count during the first nine months of 2011 compared to the same period last year. The increase in general and administrative fees was largely a result of an $11.1 million increase in administrative and consulting fees during the nine months ended September 30, 2011 as compared to the corresponding period in 2010. As a percentage of total net revenues, market making non-interest expenses decreased to 39% from 66% for the nine months ended September 30, 2011 and 2010, respectively.
Liquidity and Capital Resources
We maintain a highly liquid balance sheet. The majority of our assets consist of exchange-listed marketable securities, which are marked-to-market daily, cash and securities segregated for customers, and collateralized receivables arising from customer-related and proprietary securities transactions. Collateralized receivables consist primarily of securities borrowed, and, to a lesser extent, customer margin loans, receivables from clearing houses for settlement of securities transactions and securities purchased under agreements to resell. At September 30, 2011, total assets were $33.2 billion of which approximately $32.7 billion, or 98.7%, were considered liquid and consisted predominantly of marketable securities, customers’ cash and collateralized receivables.
We undertake daily monitoring of liquidity needs and available collateral levels to help ensure that we maintain an appropriate liquidity cushion, in the form of unpledged collateral at all times. Our ability to quickly reduce funding needs by balance sheet contraction without adversely affecting our core businesses and to pledge additional collateral in support of secured borrowings is continuously evaluated to ascertain the adequacy of our capital base.
We actively manage our excess liquidity and we maintain significant borrowing facilities through the securities lending markets and with banks. In response to changes in the credit market environment that began during late 2008, we continue to maintain sufficient levels of cash on hand to provide us with a buffer should we need immediately available funds for any reason.
For purposes of providing additional liquidity and further increasing our regulatory capital reserves, we issue senior notes and we maintain a committed senior secured revolving credit facility from a syndicate of banks (see “Principal Indebtedness” below). As of September 30, 2011, borrowings under these facilities totaled $125.9 million, which represented 3% of our total capitalization. Based on our current level of operations, we believe our cash flows from operations, available cash and available borrowings under our senior secured revolving credit facility will be adequate to meet our future liquidity needs for more than the next twelve months.
Historically, our consolidated equity has consisted primarily of accumulated retained earnings, which to date have been sufficient to fund our operations and growth. Our consolidated equity decreased $0.48 billion or 10% to $4.63 billion at September 30, 2011 from $5.11 billion at September 30, 2010 as a result of the approximately $1 billion special dividend that IBG LLC paid in December 2010 and regular distributions, partially offset by twelve months of earnings. In April 2011 we announced a regular $0.10 per share quarterly cash dividend, the first of which was paid in June 2011.
Cash Flows
The following table sets forth our cash flows from operating activities, investing activities and financing activities for the periods indicated:
| | Nine Months Ended September 30, |
| | 2011 | | 2010 |
| | (in millions) |
| Cash provided by operating activities | $ 674.4 | | | $ 773.3 | |
| Cash used in investing activities | (105.9 | ) | | (14.5 | ) |
| Cash used in financing activities | (340.4 | ) | | (309.2 | ) |
| Effect of exchange rate changes on cash and cash equivalents | (26.6 | ) | | 35.6 | |
| Increase in cash and cash equivalents | $ 201.5 | | | $ 485.2 | |
Our cash flows from operating activities are largely a reflection of the size and composition of trading positions held by our market making subsidiaries and of the changes in customer cash and margin debit balances in our electronic brokerage business. Our cash flows from investing activities are primarily related to capitalized internal software development, purchases and sales of memberships at exchanges where we trade and strategic investments in exchanges where such investments will enable us to offer better execution alternatives to our current and prospective customers, or create new opportunities for ourselves as market makers or where we can influence exchanges to provide competing products at better prices using sophisticated technology. Our cash flows from financing activities are comprised of short-term borrowings, long-term borrowings and capital transactions. Short-term borrowings from banks are part of our daily cash management in support of operating activities. Other borrowings provide us with flexible sources of excess liquidity and regulatory capital. These borrowings include senior notes issued in private placements to certain qualified customers of IB LLC and a committed two-year $100.0 million senior secured revolving credit facility, from a syndicate of banks. This facility was entered into in May 2010 and replaced a one-year $100.0 million facility that expired at the same time.
Nine Months Ended September 30, 2011: Our cash and cash equivalents increased by $201.5 million to $1,555.7 million for the nine months ended September 30, 2011. We raised $674.4 million from net cash in operating activities. We used net cash of $446.3 million in our investing and financing activities primarily due to a decrease in short-term borrowings, the repayment of borrowings under our senior secured revolving credit facility and dividends paid to IBG Holdings LLC and to common stockholders.
Nine Months Ended September 30, 2010: Our cash and cash equivalents increased by $485.2 million to $1,291.7 million for the nine months ended September 30, 2010. We raised $773.3 million in net cash in operating activities. We used net cash of $323.7 million in our investing and financing activities primarily due to an increase in short-term borrowings and dividends paid to and redemption of member interests from IBG Holdings LLC.
Regulatory Capital Requirements
Our principal operating subsidiaries are subject to separate regulation and capital requirements in the United States and other jurisdictions. Timber Hill LLC and Interactive Brokers LLC are registered U.S. broker-dealers and futures commission merchants, and their primary regulators include the SEC, the Commodity Futures Trading Commission, the Chicago Board Options Exchange, the Chicago Mercantile Exchange, the Financial Industry Regulatory Authority and the National Futures Association. Timber Hill Europe AG is registered to do business in Switzerland as a securities dealer and is regulated by the Swiss Financial Market Supervisory Authority. Interactive Brokers (U.K.) Limited is subject to regulation by the U.K. Financial Services Authority. Our various other operating subsidiaries are similarly regulated. See Note 13 to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for further information regarding our regulatory capital requirements.
At September 30, 2011, aggregate excess regulatory capital for all of the Operating Companies was $2.33 billion.
Principal Indebtedness
IBG LLC is the borrower under a $100.0 million senior secured revolving credit facility, which had no balance outstanding as of September 30, 2011, and is the issuer of senior notes, of which $125.9 million were outstanding as of September 30, 2011.
Senior Secured Revolving Credit Facility
On May 18, 2010, IBG LLC entered into a $100 million two-year senior secured revolving credit facility with a syndicate of banks. IBG LLC is the sole borrower under this credit facility, which is required to be guaranteed by IBG LLC’s domestic non-regulated subsidiaries (currently there are no such entities). The facility’s interest rate is indexed to the LIBOR rate for the relevant term, at the borrower’s option, and is secured by a first priority interest in all of the capital stock of each entity owned directly by IBG LLC (subject to customary limitations with respect to foreign subsidiaries). The facility may be used to finance working capital needs and general corporate purposes. The financial covenants contained in this credit facility are as follows:
| | · | minimum consolidated shareholders’ equity, as defined, of $3.6 billion, with quarterly increases equal to 25% of positive consolidated income; |
· maximum total debt to capitalization ratio of 30%;
· minimum liquidity ratio of 1.0 to 1.0; and
· maximum total debt to net regulatory capital ratio of 35%.
At maturity, subject to meeting certain terms of the facility, IBG LLC will have an option to convert the facility to a one-year term loan. As of September 30, 2011, no borrowings were outstanding under this credit facility and IBG LLC was in compliance with all of the covenants. This credit facility replaced a $100 million senior secured revolving credit facility that expired on May 19, 2010.
Senior Notes
IBG LLC periodically issues senior notes in private placements to certain qualified customers of IB LLC. IBG LLC uses the proceeds from sales of the senior notes to provide capital to IBG LLC’s broker-dealer subsidiaries in the form of subordinated loans and for other general purposes. In June of 2011 we reduced the interest rate on new notes to 3% per annum. The outstanding senior notes have a 5% and 3% per annum interest rate, and either a 15-month or an 18-month maturity. IBG LLC may, solely at its option, redeem the senior notes at any time on or after a specified date in the third month or the sixth month, respectively, after the date on which the senior notes are issued and sold, at a redemption price equal to 100% of the principal amount of the senior notes to be redeemed plus accrued interest.
Total senior notes outstanding at September 30, 2011 of $125.9 million, with $40.1 million being 5% notes and $85.8 million being 3% notes. Senior notes outstanding at December 31, 2010 were $194.6 million with $46.9 being 7% notes and $147.7 million being 5% notes. During the period from January 1 through September 30, 2011, total senior notes issued were $340.3 million, and senior notes redeemed totaled $409.0 million. The lower rates offered on our newer senior notes may have contributed to the reduction in senior notes issued for the nine months ended September 30, 2011, which decreased by $131.3 million as compared to the a same period last year.
The senior notes are secured, as is the senior secured revolving credit facility, by a first priority interest in all of the capital stock of each entity owned directly by IBG LLC (subject to customary limitations with respect to foreign subsidiaries). The senior notes contain covenants that may limit IBG LLC’s ability to:
| | · | incur, or permit its subsidiaries to incur, additional indebtedness; |
| | · | create, or permit its subsidiaries to create, liens on any capital stock or equity interests of its subsidiaries; |
| | · | declare and pay dividends or make other equity distributions; and |
| | · | consolidate, merge or sell all or substantially all of its assets. |
Capital Expenditures
Our capital expenditures are comprised of compensation costs of our software engineering staff for development of software for internal use and expenditures for computer, networking and communications hardware. These expenditure items are reported as property and equipment. Capital expenditures for property and equipment were approximately $9.7 million and $14.5 million for the nine month periods ending September 30, 2011 and 2010, respectively. We anticipate that our gross capital expenditures will be level with the first nine months of the year, including costs related to the expansion of our data center and backup facilities. We expect our future capital expenditures to rise as we continue our focus on technology infrastructure initiatives to further enhance our competitive position. We anticipate that we will fund capital expenditures with cash from operations and cash on hand. In response to changing economic conditions, we believe we have the flexibility to modify our capital expenditures by adjusting them (either upward or downward) to match our actual performance. If we pursue any strategic acquisitions, we may incur additional capital expenditures.
Seasonality
Our businesses are subject to seasonal fluctuations, reflecting varying numbers of market participants at times during the year and varying numbers of trading days from quarter-to-quarter, including declines in trading activity due to holidays. Typical seasonal trends may be superseded by market or world events, which can have a significant impact on prices and trading volume.
Inflation
Although we cannot accurately anticipate the effect of inflation on our operations, we believe that inflation has not had for the three most recent years, and is not likely in the foreseeable future to have, a material impact on our results of operations.
Strategic Investments and Acquisitions
We periodically engage in evaluations of potential strategic investments and acquisitions. The Company holds strategic investments in electronic trading exchanges including: Boston Options Exchange, LLC; OneChicago LLC and CBOE Stock Exchange, LLC. The company has also made investments in Quadriserv Inc., an electronic securities lending platform provider and Factor Advisors, LLC, an Exchange Traded Funds (“ETF”) issuer.
We intend to continue making acquisitions on an opportunistic basis, generally only when the acquisition candidate will, in our opinion, enable us to acquire either technology or customers faster than we could develop them on our own. At September 30, 2011, there were no definitive agreements with respect to any material acquisition.
Certain Information Concerning Off-Balance-Sheet Arrangements
IBG, Inc. may be exposed to a risk of loss not reflected in the unaudited condensed consolidated financial statements for futures products, which represent obligations of the Company to settle at contracted prices, which may require repurchase or sale in the market at prevailing prices. Accordingly, these transactions result in off-balance sheet risk as IBG, Inc.’s cost to liquidate such futures contracts may exceed the amounts reported in our unaudited condensed consolidated statements of financial condition.
Critical Accounting Policies
Valuation of Financial Instruments
Due to the nature of our operations, substantially all of our financial instrument assets, comprised of securities owned, securities purchased under agreements to resell, securities borrowed and receivables from brokers, dealers and clearing organizations are carried at fair value based on published market prices and are marked to market daily, or are assets which are short-term in nature (such as U.S. government treasury bills or spot foreign exchange) and are reflected at amounts approximating fair value. Similarly, all of our financial instrument liabilities that arise from securities sold but not yet purchased, securities sold under agreements to repurchase, securities loaned and payables to brokers, dealers and clearing organizations are short-term in nature and are reported at quoted market prices or at amounts approximating fair value. Our long and short positions are valued at either the last consolidated trade price or the last consolidated bid/offer mid-point (where applicable) at the close of regular trading hours, in their respective markets. Given that we manage a globally integrated market making portfolio, we have large and substantially offsetting positions in securities and commodities that trade on different exchanges that close at different times of the trading day. As a result, there may be large and anomalous swings in the value of our positions daily and, accordingly, in our earnings in any period. This is especially true on the last business day of each calendar quarter, although such swings tend to come back into equilibrium on the first business day of the succeeding calendar quarter.
Contingencies
Our policy is to estimate and accrue for potential losses that may arise out of litigation and regulatory proceedings, to the extent that such losses are probable and can be estimated, in accordance with ASC 450, Contingencies. Potential losses that might arise out of tax audits, to the extent that such losses are “more likely than not,” would be estimated and accrued in accordance with ASC 740-10. Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability accrued with respect to litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses based on, among other factors, the progress of each case, our experience with and industry experience with similar cases and the opinions and views of internal and external legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, or where cases or proceedings are in the early stages, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred.
We have been from time to time subject to certain pending and legal actions which arise out of the normal course of business. Litigation is inherently unpredictable, particularly in proceedings where claimants seek substantial or indeterminate damages, or which are in their early stages. We cannot predict with certainty the actual loss or range of loss related to such legal proceedings, the manner in which they will be resolved, the timing of final resolution or the ultimate settlement. Consequently, we cannot estimate losses or ranges of losses related to such legal matters, even in instances where it is reasonably possible that a future loss will be incurred. As of September 30, 2011, we, along with certain of our subsidiaries, have been named parties to legal actions, which we and/or such subsidiaries intend to defend vigorously. Although the results of legal actions cannot be predicted with certainty, it is the opinion of management that the resolution of these actions is not expected to have a material adverse effect, if any, on our business or financial condition, but may have a material impact on the results of operations for a given period. As of September 30, 2011 and December 31, 2010, reserves provided for potential losses related to litigation matters were not material.
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts and disclosures in the unaudited condensed consolidated financial statements and accompanying notes. Estimates, by their nature, are based on judgment and available information. Therefore, actual results could differ materially from those estimates. Such estimates include the estimated value of investments accounted for under the equity method of accounting, the estimated useful lives of property and equipment, including capitalized internally developed software, the allowance for doubtful accounts, compensation accruals, tax liabilities and estimated contingency reserves.
Recent Accounting Pronouncements
Subsequent to the adoption of the ASC, the FASB will issue Accounting Standards Updates (“ASU’s”) as the means to add to or delete from, or otherwise amend the ASC. In 2011, prior to the issuance of the Company’s unaudited condensed consolidated financial statements, ASU’s 2011-01 through ASU 2011-09 were issued. Following is a summary of recently issued ASU’s that may affect the Company’s condensed consolidated financial statements:
| | Affects | |
| ASU 2010-13 | Compensation - Stock Compensation (Topic 718) - Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades | Fiscal years, and interim periods within those fiscal years, beginning after December 15, 2010. Early application is permitted. |
| | | |
| ASU 2011-01 | Receivables (Topic 310) - Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 | Effective on issuance. |
| | | |
| ASU 2011-02 | Receivables (Topic 310) - A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring | First interim or annual period beginning after June 15, 2011, to be applied retrospectively to the beginning of the annual period of adoption. Early adoption is permitted. |
| | | |
| ASU 2011-03 | Transfers and Servicing (Topic 860) - Reconsideration of Effective Control for Repurchase Agreements | Fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. Early application is not permitted. |
| | | |
| ASU 2011-04 | Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS | To be applied prospectively for interim and annual periods beginning after December 15, 2011. Early adoption is not permitted for public entities. |
| | | |
| ASU 2011-05 | Comprehensive Income (Topic 220) - Presentation of Comprehensive Income | To be applied retrospectively, with reporting to commence in fiscal years beginning after December 15, 2011. Early adoption is permitted. |
| | | |
| ASU 2011-08 | Intangibles - Goodwill and Other (Topic 350) - Testing Goodwill for Impairment | Effective for fiscal years beginning after December 15, 2011. Early adoption is permitted. |
Adoption of those ASU’s that became effective during 2011, prior to the issuance of the Company’s unaudited condensed consolidated financial statements, did not have a material effect on those financial statements. Other than ASU 2011-05, which the Company adopted early, as permitted, for the quarter ended June 30, 2011, management is assessing the potential impact on the Company’s financial statements of adopting ASU’s that will become effective in the future.
ASC/IFRS Convergence
In February 2010, the SEC issued “Commission Statement in Support of Convergence and Global Accounting Standards”, a formal statement updating the status of its November 2008 “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers” (“IFRS Roadmap”). The statement supported convergence of accounting standards and the development of a single set of global accounting standards. As directed in this statement, the SEC staff issued “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers” (the “Work Plan”) in May 2010, and issued a follow-up Staff Paper, subtitled “Exploring a Possible Method of Incorporation” in May 2011. The Work Plan outlines the steps to be taken to provide the SEC with information to be able to conclude whether IFRS should be adopted for U.S. registrants and the Staff Paper discusses alternative approaches (“Convergence” and “Endorsement”) to adoption that could be applied. Within the Staff Paper, the SEC Staff has issued a Request for Comment on these alternatives. The Comment period ended July 31, 2011 and the SEC Staff have not issued further reporting to date.
Neither the February statement, the Work Plan nor the Staff Paper define a certain date for adoption of IFRS. A decision on whether the SEC will mandate adoption of IFRS, in full or in part, may be made in 2011. If a decision to adopt IFRS is made at that point in time, initial adoption for U.S. registrants would be approximately December 31, 2015 or 2016, with a transition date of either January 1, 2013 or 2014 for the initial three year retrospective comparative reporting period. Management continues to assess the potential impact of adopting IFRS on the Company’s unaudited condensed consolidated financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various market risks. Our exposures to market risks arise from assumptions built into our pricing models, equity price risk, foreign currency exchange rate fluctuations related to our international operations, changes in interest rates which impact our variable-rate debt obligations, and risks relating to the extension of margin credit to our customers.
Pricing Model Exposure
Our strategy as a market maker is to calculate quotes a few seconds ahead of the market and execute small trades at tiny but favorable differentials as a result. This is made possible by our proprietary pricing model, which continuously evaluates and monitors the risks inherent in our portfolio, assimilates market data and reevaluates the outstanding quotes in our entire portfolio each second. Certain aspects of the model rely on historical prices of securities. If the behavior of price movements of individual securities diverges substantially from what their historical behavior would predict, we might incur trading losses. We attempt to limit such risks by diversifying our portfolio across many different options, futures and underlying securities and avoiding concentrations of positions based on the same underlying security. Historically, our losses from these events have been immaterial in comparison to our annual trading profits.
Foreign Currency Exposure
As a result of our international market making activities and accumulated earnings in our foreign subsidiaries, our income and net worth is exposed to fluctuations in foreign exchange rates. Our European operations and some of our Asian operations are conducted by our Swiss subsidiary, THE. THE is regulated by the Swiss Financial Market Supervisory Authority as a securities dealer and its financial statements are presented in Swiss francs. Accordingly, THE is exposed to certain foreign exchange risks as described below:
| | · | THE buys and sells futures contracts and securities denominated in various currencies and carries bank balances and borrows and lends such currencies in its regular course of business. At the end of each accounting period THE’s assets and liabilities are translated into Swiss francs for presentation in its financial statements. The resulting gains or losses are reported as translation gain or loss in THE’s income statement. When we prepare our consolidated financial statements, THE’s Swiss franc balances are translated into U.S. dollars for U.S. GAAP purposes. THE’s translation gains or losses appear as such on IBG, Inc.’s income statement, included in trading gains. |
| | · | THE’s net worth is carried on THE’s books in Swiss francs in accordance with Swiss accounting standards. At the end of each accounting period, THE’s net worth is translated at the then prevailing exchange rate into U.S. dollars and the resulting gain or loss is reported in our consolidated statement of financial condition as “other comprehensive income,” which is now reported as a component of comprehensive income in our statement of comprehensive income, in accordance with U.S. GAAP. |
Historically, we have taken the approach of not hedging the above exposures, based on the notion that the cost of constantly hedging over the years would amount to more than the random impact of rate changes on our non-U.S. dollar balances. For instance, an increase in the value of the Swiss franc would be unfavorable to the earnings of THE but would be counterbalanced to some extent by the fact that the yearly translation gain or loss into U.S. dollars is likely to move in the opposite direction.
We hedge our currency exposure throughout the day on a continuous basis. In connection with the development of our currency hedging strategy, we have determined to base our net worth in GLOBALs. Through September 30, 2011, we defined a GLOBAL as consisting of 55 U.S. cents, 24 Euro cents, 10 Japanese yen, 3 British pence, 4 Canadian cents and 3 Australian cents. With the growth of our international operations, we determined to include other currencies in our definition of the GLOBAL. As our forex market making systems continue to develop, and as more exchanges trade more forex-based products electronically, we expect more trading volume to flow through this system and, accordingly, we expect to be able to manage the risks in forex in the same low cost manner as we currently manage the risks of our market making in equity-based products.
On October 3, 2011 we announced that going forward the composition of the GLOBAL will be expanded from 6 to 16 currencies. The company currently transacts business and is required to manage balances in each of these 16 currencies. The table below displays the component changes in detail. U.S. dollar ("USD") amounts are calculated using September 30, 2011 exchange rates. | GLOBAL | | | | | NEW | CHANGE |
| | 9/30/2011 | GLOBAL | GLOBAL in | % of | GLOBAL | GLOBAL in | % of | % of |
| Currency | FX Rates | Composition | USD Equiv. | Comp. | Composition | USD Equiv. | Comp. | Comp. |
| USD | 1.0000 | 0.55 | 0.550 | 49.3% | 0.41 | 0.410 | 36.8% | -12.5% |
| EUR | 1.3400 | 0.24 | 0.322 | 28.8% | 0.17 | 0.228 | 20.4% | -8.4% |
| GBP | 1.5594 | 0.03 | 0.047 | 4.2% | 0.03 | 0.047 | 4.2% | 0.0% |
| JPY | 0.0130 | 10.00 | 0.130 | 11.6% | 10.00 | 0.130 | 11.6% | 0.0% |
| AUD | 0.9674 | 0.03 | 0.029 | 2.6% | 0.03 | 0.029 | 2.6% | 0.0% |
| CAD | 0.9545 | 0.04 | 0.038 | 3.4% | 0.04 | 0.038 | 3.4% | 0.0% |
| CHF | 1.1034 | | | | 0.03 | 0.033 | 3.0% | 3.0% |
| HKD | 0.1284 | | | | 0.26 | 0.033 | 3.0% | 3.0% |
| SEK | 0.1457 | | | | 0.09 | 0.013 | 1.2% | 1.2% |
| MXN | 0.0721 | | | | 0.30 | 0.022 | 1.9% | 1.9% |
| DKK | 0.1801 | | | | 0.04 | 0.007 | 0.6% | 0.6% |
| NOK | 0.1704 | | | | 0.06 | 0.010 | 0.9% | 0.9% |
| KRW | 0.0008 | | | | 28.00 | 0.024 | 2.1% | 2.1% |
| BRL | 0.5317 | | | | 0.08 | 0.043 | 3.8% | 3.8% |
| INR | 0.0204 | | | | 2.00 | 0.041 | 3.7% | 3.7% |
| SGD | 0.7646 | | | | 0.01 | 0.008 | 0.7% | 0.7% |
| Total GLOBALS, as measured in USD | $ 1.115 | 100.0% | | $ 1.115 | 100.0% | 0.0% |
We actively manage our global currency exposure by maintaining our equity in GLOBALs. As a result, we consider ourselves a global enterprise based in a diversified basket of currencies rather than a U.S. dollar based company. At September 30, 2011 approximately half of our equity was denominated in currencies other than U.S. Dollars. The strengthening of the U.S. dollar relative to other key currencies during this quarter had a negative effect on our market making earnings, which are reported in U.S. dollars.
Interest Rate Risk
Under our senior secured revolving credit facility, we have the ability to choose borrowing tenors from overnight to twelve months, which permits us to minimize the risk of interest rate fluctuations. We have no borrowings outstanding under this facility as of September 30, 2011.
We pay our electronic brokerage customers interest based on benchmark overnight interest rates in various currencies. In a higher interest rate environment, exhibiting a positive yield curve, we typically invest a portion of these funds in U.S. government treasury securities with maturities of up to three months. Under these circumstances, if interest rates were to increase rapidly and substantially, in increments that were not reflected in the yields on these treasury securities, our net interest income from customer deposits would decrease. Based upon investments outstanding at September 30, 2011, we had minimal exposure of this nature.
We also face the potential for reduced net interest income from customer deposits due to interest rate spread compression in a low rate environment. Due to a currently low rate environment, a decrease of the U.S. benchmark interest rates to zero, or roughly 0.08%, would reduce our net interest income by approximately $1.3 million on an annualized basis.
We also face substantial interest rate risk due to positions carried in our market making business to the extent that long or short stock positions may have been established for future or forward dates on options or futures contracts and the value of such positions are impacted by interest rates. We hedge such risks by entering into interest rate futures contracts. To the extent that these futures positions do not perfectly hedge this interest rate risk, our trading gains may be adversely affected. The amount of such risk cannot be quantified.
Dividend Risk
We face dividend risk in our market making business as we derive significant revenues and incur significant expenses in the form of dividend income and expense, respectively, from our substantial inventory of equity securities, and must make significant payments in lieu of dividends on short positions in securities in our portfolio. Projected future dividends are an important component of pricing equity options and other derivatives, and incorrect projections may lead to trading losses. The amount of these risks cannot be quantified.
Margin Credit
We extend margin credit to our customers, which is subject to various regulatory requirements. Margin credit is collateralized by cash and securities in the customers’ accounts. The risks associated with margin credit increase during periods of fast market movements or in cases where collateral is concentrated and market movements occur. During such times, customers who utilize margin
credit and who have collateralized their obligations with securities may find that the securities have a rapidly depreciating value and may not be sufficient to cover their obligations in the event of a liquidation. We are also exposed to credit risk when our customers execute transactions, such as short sales of options and equities that can expose them to risk beyond their invested capital.
We expect this kind of exposure to increase with growth in our overall business. Because we indemnify and hold harmless our clearing firms from certain liabilities or claims, the use of margin credit and short sales may expose us to significant off-balance-sheet risk in the event that collateral requirements are not sufficient to fully cover losses that customers may incur and those customers fail to satisfy their obligations. As of September 30, 2011, we had $6.82 billion in margin credit extended to our customers. The amount of risk to which we are exposed from the margin credit we extend to our customers and from short sale transactions by our customers is unlimited and not quantifiable as the risk is dependent upon analysis of a potential significant and undeterminable rise or fall in stock prices. Our account level margin credit requirements meet or exceed those required by Regulation T of the Board of Governors of the Federal Reserve or the SEC portfolio margining regulations, as appropriate. As a matter of practice, we enforce real-time margin compliance monitoring and liquidate customers’ positions if their equity falls below required margin requirements.
We have a comprehensive policy implemented in accordance with regulatory standards to assess and monitor the suitability of investors to engage in various trading activities. To mitigate our risk, we also continuously monitor customer accounts to detect excessive concentration, large orders or positions, patterns of day trading and other activities that indicate increased risk to us.
Our credit exposure is to a great extent mitigated by our policy of automatically evaluating each account throughout the trading day and closing out positions automatically for accounts that are found to be under-margined. While this methodology is effective in most situations, it may not be effective in situations where no liquid market exists for the relevant securities or commodities or where, for any reason, automatic liquidation for certain accounts has been disabled.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures.
Our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this quarterly report, our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) are effective, in all material respects, to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
In addition, no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) occurred during the period covered by this report quarter that has materially affected, or is likely to materially affect, our internal control over financial reporting.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS [TO BE UPDATED]
Except as stated below, there have been no material changes to the legal proceedings disclosed under Part 1, Item 3 of our Annual Report on Form 10-K filed with the SEC on February 28, 2011. During our normal course of business, the Company’s regulated operating companies are in discussions with regulators about matters raised during regulatory examinations or otherwise subject to their inquiry. These matters could result in censures, fines or other sanctions. Management believes the outcome of any resulting actions will not be material to the Company’s financial condition, results of operations or cash flows. However, the Company is unable to predict the outcome of these matters.
On February 3, 2010, Trading Technologies International, Inc. ("Trading Technologies") filed a complaint in the United States District Court for the Northern District of Illinois, Eastern Division, against Interactive Brokers Group, Inc., IBG LLC, IBG Holdings LLC, and Interactive Brokers LLC. Thereafter, Trading Technologies dismissed Interactive Brokers Group, Inc. and IBG Holdings LLC from the case, leaving only IBG LLC and Interactive Brokers LLC as defendants ("Defendants"). The operative complaint, as amended, alleges that the Defendants have infringed and continue to infringe twelve U.S. patents held by Trading Technologies. Trading Technologies is seeking, among other things, unspecified damages and injunctive relief. The case is in the pleadings stage. While it is too early to predict the outcome of the matter, we believe we have meritorious defenses to the allegations made in the complaint and intend to defend ourselves vigorously against them. However, litigation is inherently uncertain and there can be no guarantee that the Company will prevail or that the litigation can be settled on favorable terms.
The Company believes, based on current knowledge and after consultation with counsel, that the outcome of the pending matters will not have a material adverse effect on the consolidated financial condition of the Company. Legal reserves have been established in accordance with ASC 450, Contingencies. The ultimate resolution may differ from the amounts reserved.
There have been no material changes to the risk factors disclosed in under Part 1, Item 1A of our Annual Report on From 10-K filed with the SEC on February 28, 2011.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Immediately prior to and immediately following the consummation of the IPO, IBG, Inc., IBG Holdings LLC, IBG LLC and the members of IBG LLC consummated a series of transactions collectively referred to herein as the “Recapitalization.” In connection with the Recapitalization, IBG, Inc., IBG Holdings LLC and the historical members of IBG LLC entered into an exchange agreement, dated as of May 3, 2007 (the “Exchange Agreement”), pursuant to which the historical members of IBG LLC received membership interests in IBG Holdings LLC in exchange for their membership interests in IBG LLC. Additionally, IBG, Inc. became the sole managing member of IBG LLC.
The Exchange Agreement also provides for future redemptions of member interests and for the purchase of member interests in IBG LLC by IBG, Inc. from IBG Holdings LLC, which is expected to result in IBG, Inc. acquiring the remaining member interests in IBG LLC that it does not own. On an annual basis, holders of IBG Holdings LLC member interests will be able to request redemption of such member interests over an eight (8) year period following the IPO; 12.5% annually for seven (7) years and 2.5% in the eighth year. The primary manner in which redemptions are expected to be funded is from the proceeds from sales of additional shares of Common Stock. Three hundred sixty (360) million shares of authorized Common Stock were reserved for such future sales.
On an annual basis, each holder of a membership interest may request that the liquefiable portion of that holder’s interest be redeemed by IBG Holdings LLC. We expect IBG Holdings LLC to use the net proceeds it receives from such sales to redeem an identical number of IBG Holdings LLC membership interests from the requesting holders.
With the consent of IBG Holdings LLC and the Company (on its own behalf and acting as the sole managing member of IBG LLC), IBG LLC agreed in June 2011 to redeem certain membership interests from IBG Holdings LLC through the sale of Common Stock and the distribution of the proceeds of such sale to the beneficial owners of such membership interests.
On August 4, 2011, the Company issued 1,983,624 shares of Class A Common stock to IBG Holdings LLC, for sale for the benefit of, certain of its members in exchange for membership interests in IBG LLC equal in number to such number of shares of Common Stock issued by the Company. As a consequence of this transaction, IBG, Inc.’s interest in IBG LLC increased to approximately 11.5%, with IBG Holdings LLC owning the remaining 88.5%. The redemptions also resulted in an increase in the IBG Holdings LLC interest held by Thomas Peterffy and his affiliates from approximately 85.8% to approximately 86.3%. The redemptions were completed during August, 2011.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 5. OTHER INFORMATION
None
| Exhibit | | |
| Number | | Description |
| | | |
| 10.1 | | Amended and Restated Operating Agreement of IBG LLC (filed as Exhibit 10.1 to the Quarterly Report on |
| | | Form 10-Q for the Quarterly Period Ended March 31, 2007 filed by the Company on June 15, 2007).** |
| | | |
| 10.2 | | Form of Limited Liability Company Operating Agreement of IBG Holdings LLC (filed as Exhibit 10.5 to |
| | | Amendment No. 1 to the Registration Statement on Form S-1 filed by the Company on February 12, 2007).** |
| | | |
| 10.3 | | Exchange Agreement by and among Interactive Brokers Group, Inc., IBG Holdings LLC, IBG LLC and the |
| | | Members of IBG LLC (filed as Exhibit 10.3 to the Quarterly Report on Form 10-Q for the Quarterly Period |
| | | Ended September 30, 2009 filed by the Company on November 11, 2009).** |
| | | |
| 10.4 | | Tax Receivable Agreement by and between Interactive Brokers Group, Inc. and IBG Holdings LLC (filed as |
| | | Exhibit 10.3 to the Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2007 filed by the |
| | | Company on June 15, 2007).** |
| | | |
| 10.5 | | Interactive Brokers Group, Inc. 2007 Stock Incentive Plan (filed as Exhibit 10.8 to Amendment No. 2 to the |
| | | Registration Statement on Form S-1 filed by the Company on April 4, 2007).**+ |
| | | |
| 10.6 | | Interactive Brokers Group, Inc. 2007 ROI Unit Stock Plan. (filed as Exhibit 10.9 to Amendment No. 2 to the |
| | | Registration Statement on Form S-1 filed by the Company on April 4, 2007).**+ |
| | | |
| 31.1 | | Certification of Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 31.2 | | Certification of Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.1 | | Certification of Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.2 | | Certification of Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 101.INS | | XBRL Instance Document* |
| | | |
| 101.SCH | | XBRL Extension Schema* |
| | | |
| 101.CAL | | XBRL Extension Calculation Linkbase* |
| | | |
| 101.DEF | | XBRL Extension Definition Linkbase* |
| | | |
| 101.LAB | | XBRL Extension Label Linkbase* |
| | | |
| 101.PRE | | XBRL Extension Presentation Linkbase* |
| | | |
| | | |
| ** | | Previously filed; incorporated herein by reference. |
| | | |
| + | | These exhibits relate to management contracts or compensatory plans or arrangements. |
| | | |
| * | | Attached as Exhibit 101 to this Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, are the following materials formatted in XBRL (Extensible Business Reporting Language) (i) the Condensed Consolidated Statements of Financial Condition, (ii) the Condensed Consolidated Statements of Comprehensive Income, (iii) the Condensed Consolidated Statements of Cash Flows, (iv) the Condensed Consolidated Statement of Changes in Stockholders' Equity and (v) Notes to Condensed Consolidated Financial Statements tagged in detail levels 1-4. |
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | INTERACTIVE BROKERS GROUP, INC. |
| | | |
| | | /s/ Paul J. Brody |
| | | Name: Paul J. Brody |
| | | Title: Chief Financial Officer, Treasurer and Secretary |
| | | (Signing both in his capacity as a duly authorized officer and as principal financial officer of the registrant) |
| | | |
| Date: November 8, 2011 | | |
