Interactive Brokers Strategy: Turning Technology into a Competitive Advantage
by Mary Ann Burns
Thomas Peterffy is a patient man. He tied his fortunes to technology back in 1972 when traders thought telephones were high-tech, and he waited for the markets to go electronic. Thirty-four years later some exchanges still haven’t completed the migration to the screen, but his commitment to technology has paid off in a multi-billion dollar enterprise known as Interactive Brokers Group.
Today, Peterffy is chairman of the holding company, IBG, and oversees its U.S. subsidiaries Interactive Brokers LLC and Timber Hill, as well as their sister companies in London, Hong Kong, Australia, and Canada.
IBG says it is responsible for 20% of the options executed in the U.S. and 17% executed worldwide on the markets it trades. On busy days, IBG executes over two million equity options contracts.
Timber Hill is the market making and proprietary trading arm of the firm, established in 1982. Interactive Brokers was established in 1993 to make TH’s electronic execution services and global network available to customers. IB targets active traders, advisors, institutions and other brokers who trade on average 650 times per year.
In the U.S. futures markets, IBG, combined with Timber Hill, held $209 million in customer seg funds at year-end 2005, up 122% from a year ago. Although the combined figure would put Interactive Brokers comfortably in the top 40 FCMs according to seg funds, Peterffy says this doesn’t truly represent the size of the customer assets they hold. “We sweep available customer funds into the securities segment of our customers’ accounts for their benefit,” he says. “Accordingly, our seg funds are a very small part of our [total] customer funds.”
Peterffy says IBG’s astonishing growth can be attributed to cutting-edge technology, low commission rates, and the ability to offer clients one account statement for all assets they trade. The growth has been mostly organic with no major acquisitions contributing to the bottom line, although it hasn’t been for lack of trying. IBG lost a bid for Spear Leeds to Goldman Sachs a few years ago, and more recently it lost out to Man Financial in the auction to buy Refco’s futures unit.
Ironically, the marketing effort that accompanied the Refco bid was very successful. In the weeks following the announcement of accounting irregularities at Refco Capital markets, IBG ran full page ads in the Wall Street Journal, Financial Times, New York Times and Chicago Tribune promoting its electronic access, low commissions and best execution and inviting Refco customers to switch to IBG. IBG won’t divulge how much business transferred from Refco, but customer seg funds had an uptick in October after Refco’s accounting irregularities were announced. “Certainly Refco did not hurt us in being able to bring this electronic message to the press,” says Steve Sanders, vice president, business development.
Cutting Edge Technology
Peterffy’s unwavering commitment to technology has set IB apart from other firms for most of its history. Peterffy introduced the first handheld electronic device for option valuation on the floor of the Amex in 1983. He then went to work on a communication network that connected his firm to exchanges around the world. He was able to connect the order routing capability with the handheld valuation system to create the first algorithmic trading system in 1985. In 1986, the firm’s traders generated 430% return on equity using the new trading system.
His fortunes grew as electronic exchanges came online. In 1990, Timber Hill became a member of its first all-electronic market, Deutsche Terminborse. In the first year, it became one of the leading market makers, handling more than 10% of the volume.
IBG introduced “smart order routing” in 1999. IBG’s system is particularly wellsuited for the equity options market where brokers are bound by best execution rules. It breaks large orders into pieces and finds the best price for each piece. It also breaks spreads apart and may execute one leg of the spread at one exchange and the other leg at another exchange—wherever it can find the best price.
Sanders attributes IBG’s continued success with technology to two key factors: inhouse technology development and the low turnover of staff. “Our technology people have been here for 20 years,” explains Sanders. “They’re not moving around. It’s easy for us to change things. We were originally on Sun platforms, but Sun became very expensive. Linux was a much cheaper alternative, so over time we moved from the Sun platform to Linux. We will never be hostage to old technology. If we find a better opportunity to deliver our products at a cheaper price, we’re going to go for it. You can’t do that when you outsource. When you have people moving around, you just don’t have that expertise.”
In addition to its proprietary order routing system, IBG offers two interfaces into its system. One is a proprietary application program interface and one is a FIX API. A number of third-party vendors write to its APIs.
While IBG remains firmly committed to electronic trading, it is making one concession —it will shortly provide electronic access to floor-based trading on four U.S. exchanges: the Chicago Board of Trade, Chicago Mercantile Exchange, the New York Board of Trade and the New York Mercantile Exchange. “We’ve gotten demand for it so we’re putting it in,” says Sanders. “We will route customer orders to the floor. The customer is still going to look at it through the screen and get their fill electronically.”
Cost-Efficient
Automating order entry and trade reporting has helped IBG keep fees low. While most brokerage firms’ biggest expense is compensation, IBG says its biggest expense is exchange fees. Just 500 employees staff offices in Greenwich, CT, Chicago, Montreal, London, Hong Kong, Sydney, and Zug, Switzerland.
Sanders says another reason IBG is able to keep fees low is because it builds and maintains its own technology from front to back. “What we designed for the Timber Hill side, we moved to the IB side, so there’s not a huge investment in technology that has to be made.”
IBG bills itself as the cheapest place to trade on the street. It offers two pricing schemes for futures and futures options: bundled (fixed rate per contract traded) and unbundled (based on monthly cumulative trade volume).
“We attract customers who tend to make a profit and understand that low commissions, speed, the availability of conditional orders or easily programmable interfaces are key to trading profitability,” says Peterffy.
Universal Account
Another strong selling point is IBG’s “universal” account. Because of the bifurcated regulatory scheme and bankruptcy protections in the U.S., the ability to deliver one statement to clients has eluded many firms. IBG customers trade stocks, equity options, futures, exchange-traded funds, forex and bonds in different currencies around the world from a single screen and all transactions are reported in a single account. “We can do it because underneath the hood, we maintain separate accounts: One on the securities side and one on the commodities side,” explains Sanders. “Physically, the money is in two separate accounts, but what the customer sees is one account.”
Vision for the Future
Peterffy’s vision for the future is not very different from the vision upon which he started his first firm in 1977. He believed then that exchanges would evolve to become a large computer connected to many small computers. “This is basically what happened,” he says. “Our customers have direct access to over 50 exchanges from the same account on the same screen. When exchanges are talking about consolidating so that all products would be available on the same exchange, they are attempting to offer a solution to a problem that has been solved some years ago. They should focus on developing innovative products instead of offering what is already available elsewhere.”
He gave members of the International Options Markets Association in April a rare glimpse of his vision for how markets will evolve in the coming years. He believes that exchanges are nodes in a digital network, “the platform on which global economic planning and resource allocation will take place” to which access is equal and the number of participants is unlimited.
In order to facilitate the global flow of risk capital, he urged the exchanges to make the process cheaper, more secure and more convenient and to apply the process to more products. The first order of business is to make sure the process is entirely automated. “If your exchange is not yet electronic, you are not yet in the network,” he said.
Second he says is to eliminate barriers to entry. Make sure access to exchanges is global and not constrained by rules that prohibit remote clearing, participation by foreign brokerages, or cross-border electronic transmission of orders.
Third is to attract market makers, brokers and customers with markets that are protected by “a firm but smart regulatory environment.”
Finally, he emphasized that exchanges must add new products—more foreign exchange interest rate products, credit default swaps, corporate debt derivatives, economic indicator and index derivatives, insurance products, various forms of energy, chemicals, transportation and housing derivatives.
Peterffy’s view of the global network is exactly what Peterffy has positioned IBG to take advantage of. It has worked remarkably well for the last 30 years and he expects it to continue for at least the next 30 years. |
