Interactive Brokers

The Professional’s Gateway to the World’s Markets

 

Interactive Brokers is an automated global electronic market maker and broker specializing in routing orders and executing and processing trades in securities, futures and foreign exchange instruments on more than 80 electronic exchanges and trading venues around the world. As a market maker, we provide liquidity at these marketplaces and, as a broker, we provide professional traders and investors with direct access to stocks, options, futures, forex, bonds and mutual funds from a single IB Universal AccountSM. Employing proprietary software on a global communications network, Interactive Brokers Group continuously integrates its software with a growing number of exchanges and trading venues into one automatically functioning, computerized platform that requires minimal human intervention.

 

What Makes Us the Broker of Choice for Professional Traders?

Globality

 

Direct access to stocks, options, futures, forex, bonds and mutual funds on over 80 market destinations, in 17 countries from a single screen.

 

 

Trade assets denominated in multiple currencies from a single account.

 
Best Trade Execution

 

IB SmartRoutingSM searches for the best price available at the time of order, and unlike other routers, dynamically routes and re-routes all or parts of the order to achieve the best aggregate executed price.

 

 

According to The Transaction Auditing Group (TAG), a third-party independent provider of audit services, Interactive Brokers’ execution price for Stocks and Options is significantly better than the industry* as a whole.

 

Ultra Low Commissions and Competitive Financing

 

In 2008, Interactive Brokers was ranked once again by Barron’s as the lowest cost broker.

   

 

Competitive interest rates charged on debit balances.

   
 Risk Management & Control

 

Our real-time margin system continuously enforces limits for each account, and automatically liquidating positions if any individual account violates its limits at any time.

 

 

IB Risk NavigatorSM is our a real-time market risk management platform that unifies exposure across multiple asset classes around the globe.

 

Superior Trading Technology

 

Market-maker designed Trader Workstation (TWS) optimizes trading speed with a single multi-product spreadsheet interface offering real-time streaming quotes and quick click order entry.

  

 

Simple, direct connection to our trading system.

 

 

Customized order entry modules designed to meet specific trading needs.

 

Flexible and Customizable Reporting 

 

Flexible download files available in text or XML format.

 

 

Customizable Activity Statements in PDF or HTML format.

   

 

Daily Margin Reports detail requirements by underlying.

IB vs Industry* Results

US Options 60 cents per contract better

US Stocks 42 cents per 100 shares better

 

Source: The Transaction Auditing Group Inc. (TAG) a third party provider of transaction audit services

 

*Industry as a whole from July – December 2008. For stocks, the analysis included all market orders of 100 shares or more, up to 10,000 shares.

  The analysis for options included all market orders with orders sizes of 1 to 50 contracts.

 


 

Year Ended December 31,

 

2006

2007 

2008

(in millions)

Revenues:  
          Trading gains $805 $888

$1,304

          Commissions and execution fees

174 261 360
          Net interest income 188 227 105
          Other income 86 93 81
                 Total net revenues 1,253 1,469 1,850
    
Non-interest expenses:    
          Variable-execution and clearing 313 336 323
          Fixed expenses 178 201 277
                 Total non-interest expenses 491 537 600
    
Income before income taxes $762 $932 $1,250
                          
Profit margin (% of net revenue) 61%    63%    68%


OPERATING HIGHLIGHTS

 

(in thousands)

 

 Customer Accounts

77 95 111

Total customer DARTs*

196 265 357
Average firm wide trades by U.S. trading day 518

752

944

                                                                              * Daily Average Revenue trades (DARTs) are based on customer orders.


Dear Fellow Shareholders,

 

2008 will be remembered as a historic turning point in the global economy. Several decades of unprecedented economic growth, fueled by equally unprecedented expansion of credit and leverage have come to an abrupt end.

 

The impact of these events on the global capital markets and our Company is transformational. Unlike the main stream, we do not believe that after a difficult recession the economy will recover and things will be back to “normal”, just the way they used to be. We believe that a new and fundamentally different economy will emerge in which the emphasis will shift from credit and consumption to savings, conservation and value.

 

We did not foresee how and when the inevitable reckoning would unfold but we did know that eventually it would come. Accordingly, we were very cautious about tightly controlling the position risk and credit risk we would take on and that we would allow our customers to take on.

 

In spite of our cautious stance, aided by high market volumes, 2008 turned out to be another record year for our business. We were able to post double-digit growth in revenues, profits and trading volumes. We closed the year with shareholders’ equity of $4.4 billion.

 

We attribute our success to our unwavering focus on automation, our discipline for cost management and our aversion to transacting products we don’t fully understand for the sake of quick profits. Unlike the many financial institutions that have either failed or leaned on the federal government for support, we have avoided opaque financial instruments that carry questionable risk, such as mortgage derivatives and credit default swaps.

 

While the unfortunate events of the past year have shaken the confidence of many investors, I believe they have also served to highlight firms with effective risk management that will prevail through these difficult times. Looking forward, we expect that activity in the capital markets will diminish substantially. There will be movement towards horizontal integration and vertical differentiation, probably on a global basis and specifically in the financial industry. There will be more emphasis on technology to reduce cost and to increase operational efficiency.

 

With our strong capital position, highly liquid balance sheet, and low fixed cost structure stemming from our relentless pursuit of automation, we are on a uniquely solid footing to take advantage of these trends.

 

We are growing our brokerage business with persistent technological innovation, strong brand recognition and an extensive suite of product offerings. We continue to expand our global footprint by entering new markets that offer healthy exchange volumes and growing our positions in markets in which we are already established. This strategy has served us well and I am confident that we will emerge from this crisis in an even stronger competitive position.

 

 

 

Thomas Peterffy

Chairman and Chief Executive Officer

 




UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


    

FORM 10-K

    

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the year ended December 31, 2008

     


 

Commission File Number: 001-33440

 

INTERACTIVE BROKERS GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware

 

30-0390693

(State or other jurisdiction

 

(I.R.S. Employer

of incorporation or organization)

 

Identification No.)

One Pickwick Plaza

Greenwich, Connecticut 06830

(Address of principal executive office)

 

(203) 618-5800

(Registrant’s telephone number, including area code)

   

Securities registered pursuant to Section 12(b) of the Act:

 

 

Title of each class

 

 

 

Name of the each exchange on which registered

Common Stock, par value $.01 per share

 

The NASDAQ Stock Market LLC

 

 

(NASDAQ Global Select Market)

   Securities registered pursuant to Section 12(g) of the Act: None

   

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the securities act.   Yes  o  

No  x.

   

 

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or 15(d) of the act.   Yes  o  

No  x.

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x      No  o.

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x

Accelerated filer  o

Non-accelerated filer  o

Smaller reporting company  o

 

 

(Do not check if smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  o  

No  x.

 

The aggregate market value of the voting and non-voting common equity stock held by non-affiliates of the registrant was approximately $1,304,600,000 computed by reference to the $32.13 closing sale price of the common stock on the NASDAQ Global Select Market, on June 30, 2008, the last business day of the registrant’s most recently completed second fiscal quarter.

    

           As of March 2, 2009, there were 40,536,615 shares of the issuer’s Class A common stock, par value $0.01 per share, outstanding and 100 shares of the issuer’s Class B common stock, par value $0.01 per share, outstanding


ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2008

 

Table of Contents

 

Cautionary Note Regarding Forward Looking Statements

1

 

 

 

PART I

 

 

 

 

 

ITEM 1.

Business

2

 

 

 

ITEM 1A.

Risk Factors

14

 

 

 

ITEM 1B.

Unresolved Staff Comments

22

 

 

 

ITEM 2.

Properties

23

 

 

 

ITEM 3.

Legal Proceedings and Regulatory Matters

24

 

 

 

ITEM 4.

Submission of Matters to a Vote of Security Holders

24

 

 

 

PART II

 

 

 

 

 

ITEM 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

25

 

 

 

ITEM 6.

Selected Financial Data

27

 

 

 

ITEM 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

31

 

 

 

ITEM 7A.

Quantitative and Qualitative Disclosures about Market Risk

53

 

 

 

ITEM 8.

Financial Statements and Supplementary Data

55

 

 

 

ITEM 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

88

 

 

 

ITEM 9A.

Controls and Procedures

88

 

 

 

ITEM 9B.

Other Information

90

 

 

 

PART III

 

 

 

 

 

ITEM 10.

Directors, Executive Officers and Corporate Governance

91

 

 

 

ITEM 11.

Executive Compensation

91

 

 

 

ITEM 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

91

 

 

 

ITEM 13.

Transactions with Related Persons, Promoters and Certain Control Persons

91

 

 

 

ITEM 14.

Principal Accountant Fees and Services

91

 

 

 

PART IV

 

 

 

 

 

ITEM 15.

Exhibits and Financial Statement Schedules

92

 

 

 

ITEMS 15 (a)(1) and 15 (a)(2)

Index to Financial Statements and Financial Statement Schedule

93

 

 

 

SIGNATURES

 

 

 

 

 


 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

We have included or incorporated by reference in this Annual Report on Form 10-K, and from time to time our management may make statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts, but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and outside our control. These statements include statements other than historical information or statements of current condition and may relate to our future plans and objectives and results, among other things, and may also include our belief regarding the effect of various legal proceedings, as set forth under “Legal Proceedings” in Part I, Item 3 of this Annual Report on Form 10-K, as well as statements about the objectives and effectiveness of our liquidity policies, statements about trends in or growth opportunities for our businesses, in Part II, Item 7 of this Annual Report on Form 10-K. By identifying these statements for you in this manner, we are alerting you to the possibility that our actual results may differ, possibly materially, from the anticipated results indicated in these forward-looking statements. Important factors that could cause actual results to differ from those in the forward-looking statements include, among others, those discussed below and under “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this Annual Report on Form 10-K.

 

Factors that could cause actual results to differ materially from any future results, expressed or implied, in these forward-looking statements include, but are not limited to, the following:

 

 

general economic conditions in the markets where we operate;

 

 

increased industry competition and downward pressures on bid/offer spreads and electronic brokerage commissions;

 

 

risks inherent to the electronic market making and brokerage businesses;

 

 

failure to protect or enforce our intellectual property rights in our proprietary technology;

 

 

our ability to keep up with rapid technological change;

 

 

system failures and disruptions;

 

 

non-performance of third-party vendors;

 

 

conflicts of interest and other risks due to our ownership and holding company structure;

 

 

the loss of key executives and failure to recruit and retain qualified personnel;

 

 

the risks associated with the expansion of our business;

 

 

our possible inability to integrate any businesses we acquire;

 

 

competitive pressures;

 

 

compliance with laws and regulations, including those relating to the securities industry; and

 

 

other factors discussed under “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K or elsewhere in this Annual Report on Form 10-K.

 

We undertake no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this Annual Report on Form 10-K.

 

1

 

PART I

 

ITEM 1.

BUSINESS

 

Overview

 

Interactive Brokers Group, Inc. (“IBG, Inc.” or the “Company”) is an automated global electronic market maker and broker specializing in routing orders and executing and processing trades in securities, futures and foreign exchange instruments on more than 80 electronic exchanges and trading venues around the world. In the U.S., our business is conducted from our headquarters in Greenwich, Connecticut as well as from Chicago, Illinois and Lake Forest, California. Abroad, we conduct business through offices located in Canada, England, Switzerland, Hong Kong, India, Australia and Japan. At December 31, 2008 we had 750 employees worldwide.

 

On May 3, 2007, IBG, Inc. priced its initial public offering (the “IPO”) of shares of common stock. In connection with the IPO, IBG, Inc. purchased 10.0% of the membership interests in IBG LLC, became the sole managing member of IBG LLC, the current holding company for our businesses, and began to consolidate IBG LLC’s financial results into its financial statements. We are currently a holding company and our primary assets are our ownership of approximately 10% of the membership interests of IBG LLC. When we use the terms “we,” “us,” and “our,” we mean IBG LLC and its subsidiaries for periods prior to the IPO, and IBG, Inc. and its subsidiaries (including IBG LLC) for periods from and after the IPO. Unless otherwise indicated, the term “common stock” refers to the Class A common stock of IBG, Inc.

 

We are a successor to the market making business founded by our Chairman and Chief Executive Officer, Thomas Peterffy, on the floor of the American Stock Exchange in 1977. Since our inception in 1977, we have focused on developing proprietary software to automate broker-dealer functions. During that time, we have been a pioneer in developing and applying technology as a financial intermediary to increase liquidity and transparency in the capital markets in which we operate. The advent of electronic exchanges in the last 18 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. Three decades of developing our automated market making platform and our automation of many middle and back office functions has allowed us to become one of the lowest cost providers of broker-dealer services and increase significantly the volume of trades we handle.

 

Our activities are divided into two principal business segments: (1) market making and (2) electronic brokerage:

 

 

As a market maker, we provide continuous bid and offer quotations on approximately 577,000 securities and futures products listed on electronic exchanges around the world. Our quotes are driven by proprietary mathematical models that assimilate market data and reevaluate our outstanding quotes each second. Unlike firms that trade over-the-counter (“OTC”) derivative products, it is our business to create liquidity and transparency on electronic exchanges.

 

 

As a direct market access broker, we serve the customers of both traditional brokers and prime brokers. We provide our customers with an advanced order management, trade execution and portfolio management platform at a very low cost. Our customers can simultaneously access different financial markets worldwide and trade across multiple asset classes (stocks, options, futures, foreign exchange (“forex”), bonds and mutual funds) denominated in 13 different currencies, on one screen, from a single account based in any major currency. Our large bank and broker-dealer customers may “white label” our trading interface (i.e., make our trading interface available to their customers without referencing our name), or can select from among our modular functionalities, such as order routing, trade reporting or clearing on specific products or exchanges where they may not have up-to-date technology, in order to offer their customers a complete global range of services and products.

 

                Our electronic market making and brokerage businesses are complementary. Both benefit from our combined scale and volume, as well as from our proprietary technology. Our brokerage customers benefit from the technology and market structure expertise developed in our market making business. The expense of developing and maintaining our unique technology, clearing, settlement, banking and regulatory structure required by any specific exchange or market center is shared by both of our businesses. This, in turn, enables us to provide lower transaction costs to our customers than our competitors, whether they use our services as a market maker, broker or both. In addition, we believe we gain a competitive advantage by applying the software features we have developed for a specific product or market to newly-introduced products and markets over others who may have less automated facilities in one or both of our businesses or who operate only in a subset of the exchanges and market centers on which we operate. Our trading system contains unique architectural aspects that, together with our massive trading volume in markets worldwide, impose a significant barrier to entry for firms wishing to compete in our specific businesses and permit us to compete favorably against our competitors.

 

Our Internet address is www.interactivebrokers.com and the investor relations section of our web site is located at www.interactivebrokers.com/ir. We make available free of charge, on or through the investor relations section of our web site, this Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission (“SEC”). Also posted on our web site are our Bylaws, our Amended and Restated Certificate of Incorporation, charters for the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee of our board of directors, our Accounting Matters Complaint Policy, our Whistle Blower Hotline, our Corporate Governance Guidelines and our Code of Business Conduct and Ethics governing our directors, officers and employees. Within the time periods required by SEC and the NASDAQ Stock Market (“NASDAQ”), we will post on our web site any amendment to the Code of Business Conduct and Ethics and any waiver applicable to any executive officer, director or senior

 

2

 

financial officer. In addition, our web site includes information concerning purchases and sales of our equity securities by our executive officers and directors, as well as disclosure relating to certain non-GAAP financial measures (as defined in Regulation G) promulgated under the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that we may make public orally, telephonically, by webcast, by broadcast or by similar means from time to time.

 

Our Investor Relations Department can be contacted at Interactive Brokers Group, Inc., 8 Greenwich Office Park, Greenwich, Connecticut 06831, Attn: Investor Relations, telephone: 203-618-4070, e-mail: investor-relations@interactivebrokers.com.

 

Segment Operating Results

 

   

Year Ended December 31,

   

2008

 

2007

 

2006

 
    (in millions)
Market Making   Net revenues   $  1,343.5 $  1,031.2 $  954.7
  Non-interest expenses   315.9 311.4 291.9
    
  Income before income taxes   $  1,027.6 $  719.8 $  662.8
    
  Pre-tax profit margin   76% 70% 69%
    
Electronic Brokerage   Net revenues   $  505.8 $  425.2 $  298.4
  Non-interest expenses   281.8 227.3 199.8
    
  Income before income taxes   $  224.0 $197.9 $98.6
    
  Pre-tax profit margin   44% 47% 33%
       
Corporate   Net revenues   $  0.8 $  11.8 $  (0.7 )
  Non-interest expenses   2.7 (2.1 ) (0.9 )
    
  Income before income taxes   $  (1.9 ) $  13.9 $  0.2
    
Total   Net revenues   $  1,850.1 $  1,468.2 $  1,252.4
  Non-interest expenses   600.4 536.6 490.8
    
          Income before income taxes
  and minority interest   $  1,249.7 $  931.6 $  761.6

 

Financial information concerning our business segments for each of 2008, 2007 and 2006 is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the consolidated financial statements and the notes thereto, which are in Part II, Items 7 and 8 of this Annual Report on Form 10-K.

 

Market Making—Timber Hill

 

Market making represented 73% of 2008 net revenues. We conduct our market making business through our Timber Hill (“TH”) subsidiaries. As one of the largest market makers on many of the world’s leading electronic exchanges, we provide liquidity by offering competitively tight bid/offer spreads over a broad base of approximately 577,000 tradable, exchange-listed products, including equity derivative products, equity index derivative products, equity securities and futures. 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. Historically, our profits have been principally a function of transaction volume on electronic exchanges rather than volatility or the direction of price movements.

 

Our strategy is to calculate quotes at which supply and demand for a particular security are likely to be in balance a few seconds ahead of the market and execute small trades at tiny but favorable differentials. 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. As a matter of practice, we will generally not take portfolio positions in either the broad market or the financial instruments of specific issuers in anticipation that prices will either rise or fall. Our entire portfolio is evaluated each second and continuously rebalanced throughout the trading day, thus 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. Our quotes are based on our proprietary model rather than customer order flow, and we believe that this approach provides us with a competitive advantage.

 

3

 

We are a market leader in exchange-traded equity options and equity-index options and futures. Together with our electronic brokerage customers, in 2008 we accounted for approximately 13.7% of exchange-listed equity options traded worldwide and approximately 15.2% of exchange-listed equity options volume traded on those markets in which we actively trade, according to data compiled by the Futures Industry Association (“FIA”) and data received from exchanges worldwide. Our ability to make markets in such a large number of exchanges and market centers simultaneously around the world is one of our core strengths and has contributed to the large volumes in our market making business. We engage in market making operations in North and South America, Europe and in the Asia/Pacific regions as described below.

 

North and South American Market Making Activities. Our U.S. market making activities are conducted through Timber Hill LLC (“TH LLC”), a SEC-registered securities broker-dealer that conducts market making in equity derivative products, equity index derivative products and equity securities. Since its inception in 1982, TH LLC has grown to become one of the largest of the listed options market makers in the United States. As of December 31, 2008, TH LLC held specialist, primary market maker or lead market maker designations in options on approximately 1,200 underlying securities listed in the United States. TH LLC is a member at NYSE Alternext, NYSE AMEX Options, Boston Options Exchange, Chicago Board Options Exchange, Chicago Mercantile Exchange, Chicago Board of Trade, International Securities Exchange, NYSE/ARCA, OneChicago and NASDAQ OMX PHLX. We also conduct market making activities in Canada through our Canadian subsidiary, Timber Hill Canada Company (“THC”) and at MEXDER and BMV in Mexico and at BOVESPA in Brazil through TH LLC.

 

International Market Making Activities. Our international market making subsidiaries, primarily Timber Hill Europe AG, conduct operations in 23 countries, comprising the major securities markets in these regions.

 

We began our market making operations in Europe in 1990. In Germany and Switzerland, we have been among the largest equity options market makers in terms of volume on Eurex, one of the world’s largest futures and options exchanges, which is jointly operated by Deutsche Börse AG and SWX Swiss Exchange. We have also been active in trading German stocks and warrants as a member of the XETRA, the German electronic stock trading system, and the Frankfurt and Stuttgart stock exchanges; and in Swiss stocks and warrants as a member of the SWX Swiss Exchange and SWX Europe Limited, a cross-border trading platform for pan-European companies. Our other European operations are conducted on the London Stock Exchange; the Irish Stock Exchange; the Copenhagen Stock Exchange; the Helsinki Stock Exchange; the Euronext exchanges in Amsterdam, Paris, Brussels, Lisbon and London; NASDAQ OMX Sweden, the Swedish and Norwegian options market; the Swedish Stock Exchange; the MEFF and Bolsa de Valencia in Spain; the IDEM and Borsa Italiana in Milan; and the ÖTOB in Vienna.

 

Since 1995, we have conducted market making operations in Hong Kong. Our Hong Kong subsidiary, Timber Hill Securities Hong Kong Ltd (“THSHK”), is a member of the cash and derivatives markets of the Hong Kong Exchanges. Since 1997, we have conducted operations in Australia. Our Australian subsidiary, Timber Hill Australia Pty Ltd (“THA”), is a member of the Australian Stock Exchange, and routes orders for its trading on the Sydney Futures Exchange through its affiliate, Interactive Brokers LLC. We commenced trading in Japan during the first half of 2002, Korea and Singapore during 2004 and Taiwan in 2007. In 2008 we began our market making operation in India through our subsidiary, Interactive Brokers (India) Private Limited (“IBI”), which is a member of the National Stock Exchange of India.

 

All of the above trading activities take place on exchanges and all securities and commodities that we trade are cleared by exchange owned or authorized clearing houses.

 

Electronic Brokerage—Interactive Brokers

 

Electronic brokerage represented 27% of 2008 net revenues. 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.

 

Since launching this business in 1993, we have grown to approximately 111,000 institutional and individual brokerage customers. We provide our customers with what we believe to be one of the most effective and efficient electronic brokerage platforms in the industry. The following are key highlights of our electronic brokerage business:

 

 

Low Costs - We provide our customers with among the lowest transaction costs in two ways. First, our customers benefit from our advanced routing of orders designed to achieve the best available price. Second, we offer among the lowest execution, commission and financing costs in the industry.

 

 

Risk Control - Throughout the trading day, we calculate margin requirements for each of our customers on a real-time basis across all product classes (stocks, options, futures, bonds and forex) and across all currencies. Our customers are alerted to approaching margin violations and if a customer’s equity falls below what is required to support that customer’s margin, we automatically liquidate positions on a real-time basis to bring the customer’s account into margin compliance. This is done to protect IB, as well as the customer, from excessive losses.

 

 

IB Universal AccountSM - From a single point of entry in one IB Universal AccountSM our customers are able to trade

 

4

 

products denominated in 13 different currencies, across multiple classes of tradable, exchange-listed products, including stocks, bonds, options, futures and forex, traded on more than 80 exchanges and market centers and in 17 countries around the world seamlessly.

 

 

IB SmartRoutingSM - Our customers benefit from our advanced routing. IB SmartRoutingSM retains control of the customer’s order, continuously searches for the best available price and, unlike most other routers, dynamically routes and re-routes all or parts of a customer’s order to achieve optimal execution and among the lowest execution and commission costs in the industry.

 

 

Flexible and Customizable System - Our platform is designed to provide an efficient customer experience, beginning with a highly automated account opening process and ending with a fast trade execution, with real-time position monitoring. Our sophisticated interface provides interactive real-time views of account balances, positions, profits or losses, buying power and “what if” scenarios to enable our customers to more easily make informed investment decisions and trade efficiently. Our system is configured to remember the user’s preferences and is specifically designed for multi-screen systems. When away from their main workstations, customers are able to access their accounts through our IB WebTraderSM or MobileTrader interfaces.

 

 

Interactive AnalyticsSM and IB Options AnalyticsSM - We offer our customers state-of-the-art tools, which include a customizable trading platform, advanced analytic tools and sophisticated order types such as guaranteed combination trades. IB also provides real-time option analytics, an arbitrage meter (a tool that illustrates the extent of the premium (or discount) of the lead month futures price above (or below) its fair future value with respect to the index price) and various combinations of charts and other analytical tools.

 

 

IB Risk NavigatorSM - We offer free to all customers, our real-time market risk management platform that unifies exposure across multiple asset classes around the globe. The system is capable of identifying overexposure to risk by starting at the portfolio level and drilling down into successively greater detail within multiple report views. Report data is updated every ten seconds or upon changes to portfolio composition. Predefined reports allow the summarization of a portfolio from different risk perspectives, and allow views of Exposure, Value at Risk (“VaR”), Delta, Gamma, Vega and Theta and profit and loss and position quantity measures for the different portfolio views. The system also offers the customer the ability to modify positions through “what-if” scenarios that show hypothetical changes to the risk summary.

 

 

White Labeling - Our large bank and broker-dealer customers may “white label” our trading interface or can select from among our modular functionalities, such as order routing, trade reporting or clearing, on specific products or exchanges where they may not have up-to-date technology, in order to offer to their customers a complete global range of services and products.

 

IB provides its customers with high-speed trade execution at low commission rates, in large part because it utilizes the backbone technology developed for Timber Hill’s market making operations. As a result of our advanced electronic brokerage platform, IB attracts sophisticated and active investors. No single customer represents more than 1.9% of our commissions and execution fees.

 

Technology

 

Our proprietary technology is the key to our success. We built our business on the belief that a fully computerized market making system that could integrate pricing and risk exposure information quickly and continuously would enable us to make markets profitably in many different financial instruments simultaneously. We believe that integrating our system with electronic exchanges and market centers results in transparency, liquidity and efficiencies of scale. Together with the IB SmartRoutingSM system and our low commissions, this reduces overall transaction costs to our customers and, in turn, increases our transaction volume and profits. Over the past 31 years, we have developed an integrated trading system and communications network and have positioned our company as an efficient conduit for the global flow of risk capital across asset and product classes on electronic exchanges around the world, permitting us to have one of the lowest cost structures in the industry. We believe that developing, maintaining and continuing to enhance our proprietary technology provides us and our customers with the competitive advantage of being able to adapt quickly to the changing environment of our industry and to take advantage of opportunities presented by new exchanges, products or regulatory changes before our competitors.

 

The quotes that we provide as market makers are driven by proprietary mathematical models that assimilate market data and reevaluate our outstanding quotes each second. Because our technology infrastructure enables us to process large volumes of pricing and risk exposure information rapidly, we are able to make markets profitably in securities with relatively low spreads between bid and offer prices. As market makers, we must ensure that our interfaces connect effectively and efficiently with each exchange and market center where we make markets and that they are in complete conformity with all the applicable rules of each local venue. Utilizing up-to-date computer and telecommunications systems, we transmit continually updated pricing information directly to exchange computer devices and receive trade and quote information for immediate processing by our systems. As a result, we are able to maintain more effective control over our exposure to price and volatility movements on a real-time basis than many of our competitors. This is important, not only because our system must process, clear and settle several hundred thousand market maker trades per day with a minimal number of errors, but also because the system monitors and manages the risk on the entire portfolio, which generally consists of more than ten

 

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million open contracts distributed among more than 100,000 different products. Using our system, which we believe affords an optimal interplay of decentralized trading activity and centralized risk management, we quote markets in approximately 577,000 securities and futures products traded around the world.

 

In our electronic brokerage business, our proprietary technology infrastructure enables us to provide our customers with the ability to effect trades at among the lowest execution and commission costs in the industry. Additionally, our customers benefit from real-time systems optimization for our market making business. Customer trades are both automatically captured and reported in real time in our system. Our customers trade on more than 80 exchanges and market centers in 17 countries around the world. All of these exchanges are partially or fully electronic, meaning that a customer can buy or sell a product traded on that exchange via an electronic link from his or her computer terminal through our system to the exchange. We offer our products and services through a global communications network that is designed to provide secure, reliable and timely access to the most current market information. We provide our customers with a variety of means to connect to our brokerage systems, including dedicated point-to-point data lines, virtual private networks and the Internet.

 

Specifically, our customers receive worldwide direct-access connectivity through our Trader Workstation (our real-time Java-based trading platform), our proprietary Application Program Interface (“API”), and/or industry standard Financial Information Exchange (“FIX”) connectivity. Customers who want a professional quality trading application with a sophisticated user interface utilize our Trader Workstation. Customers interested in developing program trading applications in MS-Excel, Java, Visual Basic or C++ utilize our API. Large institutions with FIX infrastructure prefer to use our FIX solution for seamless integration of their existing order gathering and reporting applications.

 

While many brokerages, including online brokerages, rely on manual procedures to execute many day-to-day functions, IB employs proprietary technology to automate, or otherwise facilitate, many of the following functions:

 

 

account opening process;

 

 

order routing and best execution;

 

 

seamless trading across all types of securities and currencies around the world from one account;

 

 

order types and analytical tools offered to customers;

 

 

delivery of customer information, such as confirmations, customizable real-time account statements and audit trails;

 

 

customer service; and

 

 

risk management through automated real-time credit management of all new orders and margin monitoring.

 

Research and Development

 

One of our core strengths is our expertise in the rapid development and deployment of automated technology for the financial markets. Our core software technology is developed internally, and we do not generally rely on outside vendors for software development or maintenance. To achieve optimal performance from our systems, we are continuously rewriting and upgrading our software. Use of the best available technology not only improves our performance but also helps us attract and retain talented developers. Our software development costs are low because the employees who oversee the development of the software are the same employees who design the application and evaluate its performance. This also enables us to add features and further refine our software rapidly.

 

Our internally-developed, fully integrated trading and risk management systems are unique and transact across all product classes on more than 80 markets and 17 currencies around the world. These systems have the flexibility to assimilate new exchanges and new product classes without compromising transaction speed or fault tolerance. Fault tolerance, or the ability to maintain system performance despite exchange malfunctions or hardware failures, is crucial to successful market making and ensuring best executions for brokerage customers. Our systems are designed to detect exchange malfunctions and quickly take corrective actions by re-routing pending orders.

 

Our company is technology-focused, and our management team is hands-on and technology-savvy. Most members of the management team write detailed program specifications for new applications. The development queue is prioritized and highly disciplined. Progress on programming initiatives is generally tracked on a weekly basis by a steering committee consisting of senior executives. This enables us to prioritize key initiatives and achieve rapid results. All new business starts as a software development project. We generally do not engage in any business that we cannot automate and incorporate into our platform prior to entering into the business.

 

The rapid software development and deployment cycle is achieved by our ability to leverage a highly integrated, object oriented development environment. The software code is modular, with each object providing a specific function and being reusable in multiple applications. New software releases are tracked and tested with proprietary automated testing tools. We are not hindered by disparate

 

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and often limiting legacy systems assembled through acquisitions. Virtually all of our software has been developed and maintained with a unified purpose.

 

For over 30 years, we have built and continuously refined our automated and integrated, real-time systems for world-wide trading, risk management, clearing and cash management, among others. We have also assembled a proprietary connectivity network between us and exchanges around the world. Efficiency and speed in performing prescribed functions are always crucial requirements for our systems. As a result, our trading systems are able to assimilate market data, recalculate and distribute streaming quotes for tradable products in all product classes each second.

 

Risk Management Activities

 

The core of our risk management philosophy is the utilization of our fully integrated computer systems to perform critical, risk-management activities on a real-time basis. In our market making business, our real-time integrated risk management system seeks to ensure that overall IBG positions are continuously hedged at all times, curtailing risk. In our electronic brokerage business, integrated risk management seeks to ensure that each customer’s positions are continuously credit checked and brought into compliance if equity falls short of margin requirements, curtailing bad debt losses.

 

Market Making

 

We employ certain hedging and risk management techniques to protect us from a severe market dislocation. Our risk management policies are developed and implemented by our Chairman and our steering committee, which is comprised of senior executives of our various companies. Our strategy is to calculate quotes a few seconds ahead of the market and execute small trades at a tiny but favorable differential as a result. This is made possible by our proprietary pricing model, which evaluates and monitors the risks inherent in our portfolio, assimilates market data and reevaluates the outstanding quotes in our portfolio each second. Our model automatically rebalances our positions throughout each trading day to manage risk exposures both on our options and futures positions and the underlying securities, and will price the increased risk that a position would add to the overall portfolio into the bid and offer prices we post. Under risk management policies implemented and monitored primarily through our computer systems, reports to management, including risk profiles, profit and loss analysis and trading performance, are prepared on a real-time basis as well as daily and periodical bases. Although our market making is completely automated, the trading process and our risk are monitored by a team of individuals who, in real time, observe multiple dimensional representations of various risk parameters of our consolidated positions. Our assets and liabilities are marked-to-market daily for financial reporting purposes and re-valued continuously throughout the trading day for risk management and asset/liability management purposes.

 

Since 1990 we have rapidly expanded our market presence and the number of financial instruments in which we make markets. This diversification acts as a passive form of portfolio risk management.

 

We trade primarily the options on stocks (and individual stocks) where the underlying equity market capitalization is greater than $1 billion. Throughout the trading day we produce online, real-time profit and loss, risk evaluation, activity and other management reports. Our software assembles from external sources a balance sheet and income statements for our accounting department to reconcile the trading system results.

 

The adaptability of our portfolio risk management system and trading methods have allowed us to expand not only the number of financial instruments traded but also across markets.

 

Electronic Brokerage

 

IB calculates margin requirements for each of its customers on a real-time basis across all product classes (stocks, options, futures, bonds and forex) and across all currencies. Recognizing that IB’s customers are experienced investors, we expect our customers to manage their positions proactively and we provide tools to facilitate our customers’ position management. However, if a customer’s equity falls below what is required to support that customer’s margin, IB will automatically liquidate positions on a real-time basis to bring the customer’s account into margin compliance. This is done to protect IB, as well as the customer, from excessive losses and further contributes to our low-cost structure. The entire credit management process is completely automated, and IB does not employ a margin department.

 

As a safeguard, all liquidations are displayed on custom built liquidation monitoring screens that are part of the toolset our technical staff uses to monitor performance of our systems at all times the markets around the world are open. In the event our systems absorb erroneous market data from exchanges, which prompts liquidations, risk specialists on our technical staff have the capability to halt liquidations that meet specific criteria. The liquidation halt function is highly restricted.

 

IB’s customer interface includes color coding on the account screen and pop-up warning messages to notify customers that they are approaching their margin limits. This feature allows customers to take action, such as entering margin reducing trades, to avoid having IB liquidate their positions. These tools and real-time margining allow IB’s customers to understand their trading risk at any moment of the day and help IB maintain low commissions, by not having to price in the cost of credit losses.

 

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Operational Controls

 

We have automated the full cycle of controls surrounding the market making and brokerage business. Key automated controls include the following:

 

 

Our technical operations section continuously monitors our network and the proper functioning of each of our nodes (exchanges, ISPs, leased customer lines and our own data centers) around the world.

 

 

Our real-time credit manager software provides pre- and post-execution controls by:

 

 

testing every customer order to ensure that the customer’s account holds enough equity to support the execution of the order, rejecting the order if equity is insufficient or directing the order to an execution destination without delay if equity is sufficient; and

 

 

continuously updating a customer account’s equity and margin requirements and, if the account’s equity falls below its minimum margin requirements, automatically issuing liquidating orders in a smart sequence designed to minimize the impact on account equity.

 

 

Our market making system continuously evaluates approximately 577,000 securities and futures products in which we provide bid and offer quotes and changes its bids and offers in such a way as to maintain an overall hedge and a low-risk profile. The speed of communicating with exchanges and market centers is maximized through continuous software and network engineering innovation, thereby allowing the firm to achieve real-time controls over market exposure.

 

 

Our clearing system captures trades in real-time and performs automated reconciliation of trades and positions, corporate action processing, customer account transfer, options exercise, securities lending and inventory management, allowing the firm to effectively manage operational risk.

 

 

Our accounting system operates with automated data feeds from clearing and banking systems, allowing the firm to produce financial statements for all parts of our business every day by mid-day on the day following trade date.

 

 

Software developed to interface with the accounting and market making systems performs daily profit and loss reconciliations, which provide tight financial controls over market making functions.

 

Transaction Processing

 

Our transaction processing is automated over the full life cycle of a trade. Our market making software generates and disseminates to exchanges and market centers continuous bid and offer quotes on approximately 577,000 tradable, exchange listed products. Our fully automated smart router system searches for the best possible combination of prices available at the time a customer order is placed and immediately seeks to execute that order electronically or send it where the order has the highest possibility of execution at the best price.

 

At the moment a trade is executed, our systems capture and deliver this information back to the source, either the market making system or via the brokerage system to the customer, in most cases within a fraction of a second. Simultaneously, the trade record is written into our clearing system, where it flows through a chain of control accounts that allow us to reconcile trades, positions and money until the final settlement occurs. Our integrated software tracks other important activities, such as dividends, corporate actions, options exercises, securities lending, margining, risk management and funds receipt and disbursement.

 

IB SmartRoutingSM

 

IB SmartRoutingSM searches for the best destination price in view of the displayed prices, sizes and accumulated statistical information about the behavior of market centers at the time an order is placed, and IB SmartRoutingSM immediately seeks to execute that order electronically. Unlike other smart routers, IB SmartRouting SM never relinquishes control of the order, and constantly searches for the best price. It continuously evaluates fast-changing market conditions and dynamically re-routes all or parts of the order seeking to achieve optimal execution. IB SmartRouting SM represents each leg of a spread order independently and enters each leg at the best possible venue. IB SmartRouting AutorecoverySM re-routes a customer’s U.S. options order in the case of an exchange malfunction, with IB undertaking the risk of double executions. In addition, IB SmartRoutingSM checks each new order to see if it could be executed against any of its pending orders. As the system gains more users, this feature becomes more important for customers in a world of multiple exchanges and penny price orders because it increases the possibility of best executions for our customers ahead of customers of other brokers.

 

As a result of this feature, our customers have a greater chance of executing limit orders and can do so sooner than those who use other routers.

 

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Clearing and Margining

 

Our activities in the United States are almost entirely self-cleared. We are a full clearing member of The Options Clearing Corporation (“OCC”), the Chicago Mercantile Exchange Clearing House (“CMECH”), The Clearing Corporation and The Depository Trust and Clearing Corporation.

 

Due to our large positions in broad based index products, we benefit from the cross margin system maintained by these clearing houses. For example, if we hold a position in an OCC-cleared product and have an offsetting position in a CMECH cleared product, the cross margin computation takes both positions into account, thereby reducing the overall margin requirement. The reduced margin benefit proves especially useful during times of market stress, such as on days with large price movements when intra-day margin calls may be reduced or eliminated by the cross margin calculation.

 

In addition, we are self-cleared in Canada, the United Kingdom, Switzerland, France, Ireland, Germany, Belgium, Austria, the Netherlands, Norway, Sweden, Denmark, Finland, Hong Kong and India.

 

Customers

 

We established our electronic brokerage subsidiary, IB, in 1993 to enhance the use of our global network of trading interfaces, exchange and clearinghouse memberships and regulatory registrations assembled over the prior 16 years to serve our market making business. We realized that electronic access to market centers worldwide through our network could easily be utilized by the very same floor traders and trading desk professionals who, in the coming years, would be displaced by the conversion of exchanges from open outcry to electronic systems.

 

We currently service approximately 111,000 cleared customer accounts. Our customers reside in approximately 150 countries around the world.

 

The target IB customer is one that requires the latest in trading technology, derivatives expertise, and worldwide access and expects low overall transaction costs. IB’s customers are mainly comprised of “self-service” individuals, former floor traders, trading desk professionals, electronic retail brokers, financial advisors who are comfortable with technology, banks that require global access and hedge funds.

 

Our customers fall into three groups based on services provided: cleared customers, trade execution customers and wholesale customers. With the advent of portfolio margining, we have been able to persuade more of our trade execution hedge fund customers to utilize our cleared business solution, which benefits the hedge funds in terms of cost savings. Many prime brokers once offered increased leverage over Regulation T credit limitations and NYSE margin requirements through offshore entities and joint back office arrangements. In the past year, we observed competition diminish. Through portfolio margining, IB is able to offer similar leverage with lower margin requirements that reflect the reduced risk of a hedged portfolio.

 

 

Cleared Customers: We provide trade execution and clearing services to our cleared customers who are generally attracted to our low commissions, low financing rates, high interest paid and best price execution. From small market making groups and individual market makers, our cleared customer base has expanded over the years to include institutional and individual traders and investors, financial advisors and introducing brokers.

 

 

Trade Execution Customers: We offer trade execution for customers who choose to clear with another prime broker or a custodian bank; these customers are able to take advantage of our low commissions for trade execution as well as our best price execution.

 

 

Wholesale Customers: Our wholesale customers, which include some of the largest banks and retail electronic brokers, are generally self-clearing. These customers count on us for our superior options and option/stock combination trade routing and execution and our ability to assist them in satisfying their regulatory requirements to provide best execution to their customers.

 

Our non-cleared customers include large online brokers and increasing numbers of the proprietary and customer trading units of U.S., Canadian and European commercial banks. These customers are attracted by the IB SmartRouting SM technology as well as our direct access to stock, options, futures, forex and bond markets worldwide.

 

Our customers receive worldwide direct access connectivity in one of three ways: the Trader Workstation (our real-time Java-based trading platform), our proprietary API, and/or industry standard FIX connectivity.

 

Employees and Culture

 

We take pride in our technology-focused company culture and embrace it as one of our fundamental strengths. We remain committed to improving our technology, and we try to minimize corporate hierarchy to facilitate efficient communication among employees. We have assembled what we believe is a highly talented group of employees. As we grow, we expect to continue to provide significant rewards for our employees who provide significant value to us and the world’s financial markets.

 

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As of December 31, 2008, we had 750 employees, all of whom were employed on a full-time basis. None of our employees are covered by collective bargaining agreements. We believe that our relations with our employees are good.

 

Competition

 

Market making

 

Market makers range from sole proprietors with very limited resources, of which there are still a few hundred left, to a few highly sophisticated groups which have substantial financial and other resources, including programmers and other research and development personnel. Along with the ongoing conversion of exchanges from floor-based, open outcry arenas to electronic matching systems, Timber Hill’s competitors have changed from many individuals or groups of traders to large, integrated broker-dealers. Today, Timber Hill’s major competitors are large broker-dealers, such as Goldman Sachs, Citigroup, UBS, Morgan Stanley and Merrill Lynch (now a part of Bank of America), and niche players such as Citadel, LaBranche, Group One Trading, Wolverine Trading and Peak6. The credit market turmoil and large losses experienced by some of these firms in late 2008 have diminished their effectiveness as strong competitors. Many of our competitors in market making are larger than we are and have more captive order flow, although this is less true with respect to our narrow focus on options, futures and ETFs listed on electronic exchanges. In order to compete successfully, we believe that we must have more sophisticated, versatile and robust software than our competitors. This is our primary focus, as contrasted with many of our competitors. With respect to these competitors, Timber Hill maintains the advantage of having had much longer experience with the development and usage of its proprietary electronic brokerage and market making systems. Market conditions that are difficult for other market participants often present Timber Hill with the opportunities inherent in diminished competition. Our advantage is our expertise and decades of single-minded focus on developing our technology. This enables us to have a unique platform specializing strictly in electronic market making and brokerage.

 

Electronic brokerage

 

                The market for electronic brokerage services is rapidly evolving and highly competitive. IB believes that it neither fits within the definition of a traditional broker nor a prime broker. IB’s primary competitors include offerings targeted to professional traders by large retail online brokers (such as E*TRADE’s Power E*TRADE Pro business and Charles Schwab & Co., Inc.’s CyberTrader business) and the prime brokerage and electronic brokerage arms of major investment banks and brokers (such as Goldman Sachs’ RediPlus business and Morgan Stanley’s Passport business). We also encounter competition to a lesser extent from full commission brokerage firms including Merrill Lynch, Smith Barney, as well as other financial institutions, some of which provide online brokerage services. The electronic brokerage businesses of many of our competitors are relatively insignificant in the totality of their firms’ business. IB provides access to a global range of products from a single IB Universal AccountSM and professional level executions and pricing, which positions it in competition with niche direct-access providers and prime brokers. In addition, IB provides sophisticated order types and analytical tools that give a competitive edge to its customers.

 

Regulation

 

Our securities and derivatives businesses are extensively regulated by U.S. federal and state regulators, foreign regulatory agencies, and numerous exchanges and self-regulatory organizations of which our subsidiaries are members. In the current era of heightened regulation of financial institutions, we expect to incur increasing compliance costs, along with the industry as a whole.

 

Overview

 

As registered U.S. broker-dealers, Interactive Brokers LLC (“IB LLC”) and TH LLC are subject to the rules and regulations of the Exchange Act, and as members of various exchanges, we are also subject to such exchanges’ rules and requirements. Additionally, as registered futures commission merchants, IB LLC and TH LLC are subject to the Commodity Exchange Act and rules promulgated by the Commodity Futures Trading Commission (“CFTC”) and the various commodity exchanges of which they are members. Finally, we are subject to the requirements of various self-regulatory organizations such as the Financial Industry Regulatory Authority (“FINRA”) and the National Futures Association (“NFA”). Our foreign affiliates are similarly regulated under the laws and institutional framework of the countries in which they operate.

 

U.S. broker-dealers and futures commission merchants are subject to laws, rules and regulations that cover all aspects of the securities and derivatives business, including:

 

 

sales methods;

 

 

trade practices;

 

 

use and safekeeping of customers’ funds and securities;

 

 

capital structure;

 

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record-keeping;

 

 

financing of customers’ purchases; and

 

 

conduct of directors, officers and employees.

 

In addition, the businesses that we may conduct are limited by our agreements with and our oversight by FINRA. Participation in new business lines, including trading of new products or participation on new exchanges or in new countries often requires governmental and/or exchange approvals, which may take significant time and resources. As a result, we may be prevented from entering new businesses that may be profitable in a timely manner, or at all.

 

As certain of our subsidiaries are members of FINRA, we are subject to certain regulations regarding changes in control of our ownership. FINRA Rule 1017 generally provides that FINRA approval must be obtained in connection with any transaction resulting in a change in control of a member firm. The FINRA defines control as ownership of 25% or more of the firm’s equity by a single entity or person and would include a change in control of a parent company. As a result of these regulations, our future efforts to sell shares or raise additional capital may be delayed or prohibited by FINRA.

 

Net Capital Rule

 

The SEC, FINRA, CFTC and various other regulatory agencies within the United States have stringent rules and regulations with respect to the maintenance of specific levels of net capital by regulated entities. Generally, a broker-dealer’s capital is net worth plus qualified subordinated debt less deductions for certain types of assets. The Net Capital Rule requires that at least a minimum part of a broker-dealer’s assets be maintained in a relatively liquid form.

 

If these net capital rules are changed or expanded, or if there is an unusually large charge against our net capital, our operations that require the intensive use of capital would be limited. A large operating loss or charge against our net capital could adversely affect our ability to expand or even maintain these current levels of business, which could have a material adverse effect on our business and financial condition.

 

The SEC and FINRA impose rules that require notification when net capital falls below certain predefined criteria. These rules also dictate the ratio of debt-to-equity in the regulatory capital composition of a broker-dealer, and constrain the ability of a broker-dealer to expand its business under certain circumstances. If a firm fails to maintain the required net capital, it may be subject to suspension or revocation of registration by the applicable regulatory agency, and suspension or expulsion by these regulators could ultimately lead to the firm’s liquidation. Additionally, the Net Capital Rule and certain FINRA rules impose requirements that may have the effect of prohibiting a broker-dealer from distributing or withdrawing capital and requiring prior notice to and approval from the SEC and FINRA for certain capital withdrawals.

 

Supervision and Compliance

 

Our Compliance Department supports and seeks to ensure proper operations of our market making and electronic brokerage businesses. The philosophy of the Compliance Department, and our company as a whole, is to build automated systems to try to eliminate manual steps and errors in the compliance process and then to augment these systems with human staff who apply their judgment where needed. We have built automated systems to handle wide-ranging compliance issues such as trade and audit trail reporting, financial operations reporting, enforcement of short sale rules, enforcement of margin rules and pattern day trading restrictions, review of employee correspondence, archival of required records, execution quality and order routing reports, approval and documentation of new customer accounts, and anti-money laundering and anti-fraud surveillance. In light of our automated operations and our automated compliance systems, we have a smaller and more efficient Compliance Department than many traditional securities firms. Nonetheless, we have increased the staffing in our Compliance Department over the past several years to meet the increased regulatory burdens faced by all industry participants.

 

IB and TH each has a Chief Compliance Officer who reports to its General Counsel and its internal audit and compliance committee. These Chief Compliance Officers, plus certain other senior staff members, are FINRA-registered principals with supervisory responsibility over the various aspects of our businesses. Staff members in the Compliance Department or in other departments of the firm are also registered with FINRA, NFA or other regulatory organizations.

 

Patriot Act and Increased Anti-Money Laundering (“AML”) and “Know Your Customer” Obligations

 

Registered broker-dealers traditionally have been subject to a variety of rules that require that they “know their customers” and monitor their customers’ transactions for suspicious financial activities. With the passage of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”), broker-dealers are now subject to even more stringent requirements. Likewise, the SEC, CFTC, foreign regulators, and the various exchanges and SROs, of which IB companies are members, have passed numerous new AML and customer due diligence rules. Significant criminal and civil

 

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penalties can be imposed for violations of the Patriot Act, and significant fines and regulatory penalties for violations of other governmental and SRO AML rules.

 

As required by the Patriot Act and other new rules, we have established comprehensive anti-money laundering and customer identification procedures, designated an AML compliance officer, trained our employees and conducted independent audits of our program. Our anti-money laundering screening is conducted using a mix of automated and manual review and has been structured to comply with recent regulations. We collect required information through our new account opening process and then screen accounts with databases for the purposes of identity verification and for review of negative information and appearance on the Office of Foreign Assets and Control, Specially Designated Nationals and Blocked Persons lists. Additionally, we have developed methods for risk control and continue to add upon specialized processes, queries and automated reports designed to identify money laundering, fraud and other suspicious activities.

 

Business Continuity Planning

 

Federal regulators and industry self-regulatory organizations have passed a series of rules in the past several years requiring regulated firms to maintain business continuity plans that describe what actions firms would take in the event of a disaster (such as a fire, natural disaster or terrorist incident) that might significantly disrupt operations. IB has developed business continuity plans that describe steps that the firm and its employees would take in the event of various scenarios. The firm has built a backup site for certain of its operations at its Chicago facilities that would be utilized in the event of a significant outage at the firm’s Greenwich headquarters. In addition, the firm has strengthened the infrastructure at its Greenwich headquarters and has built redundancy of certain systems so that certain operations can be handled from multiple offices.

 

Foreign Regulation

 

Our international subsidiaries are subject to extensive regulation in the various jurisdictions where they have operations. The most significant of our international subsidiaries are: Timber Hill Europe AG (“THE”), registered to do business in Switzerland as a securities dealer; THSHK, registered to do business in Hong Kong as a securities dealer; THA, registered to do business in Australia as a securities dealer and futures broker; Interactive Brokers (U.K.) Limited (“IBUK”), registered to do business in the U.K. as a broker; Interactive Brokers Canada Inc. (“IBC”) and THC, registered to do business in Canada as an investment dealer and securities dealer, respectively.

 

As with those U.S. subsidiaries subject to FINRA rules, the ability of our regulated U.K. subsidiary, IBUK, to pay dividends or make capital distributions may be impaired due to applicable capital requirements. IBUK is subject to “consolidated” regulation, in addition to being subject to regulation on a legal entity basis. Consolidated regulation impacts the regulated entity and its parent holding companies in the United Kingdom, including the regulated entity’s ability to pay dividends or distribute capital.

 

IBUK is also subject to regulations regarding changes in control similar to those described above under “Overview.” Under Financial Services Authority (“FSA”) rules, regulated entities must obtain prior approval for any transaction resulting in a change in control of a regulated entity. Under applicable FSA rules, control is broadly defined as a 10% interest in the regulated entity or its parent or otherwise exercising significant influence over the management of the regulated entity. As a result of these regulations, our future efforts to sell shares or raise additional capital may be delayed or prohibited by the FSA.

 

In Hong Kong, the Securities and Futures Commission (“SFC”) regulates our subsidiary, THSHK, as a securities dealer. The compliance requirements of the SFC include, among other things, net capital requirements and stockholders’ equity requirements. The SFC regulates the activities of the officers, directors, employees and other persons affiliated with THSHK and requires the registration of such persons.

 

In Canada, both THC and IBC are subject to the Investment Dealers Association of Canada (“IDA”) risk adjusted capital requirement. In Switzerland, THE is subject to the Swiss National Bank eligible equity requirement. In Australia, THA is subject to the Australian Stock Exchange liquid capital requirement.

 

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Executive Officers of Interactive Brokers Group

 

The following table sets forth the names, ages and positions of our current directors and executive officers.

 

Name

Age

Position

Thomas Peterffy 64  Chairman of the Board of Directors, Chief Executive Officer and President
Earl H. Nemser 61  Vice Chairman and Director
Paul J. Brody 48  Chief Financial Officer, Treasurer, Secretary and Director
Thomas A. Frank 53  Executive Vice President and Chief Information Officer
Milan Galik 42  Senior Vice President, Software Development and Director
Lawrence E. Harris 52  Director
Hans R. Stoll 69  Director
Ivers W. Riley 76  Director

 

Thomas Peterffy. Mr. Peterffy emigrated from Hungary to the United States in 1965. After working for 10 years as a computer programmer, he became a member of the American Stock Exchange in 1977. As an individual floor trader, he founded the firm which became our company. As Chief Executive Officer and President, Mr. Peterffy is active in our day-to-day management.

 

Earl H. Nemser. Mr. Nemser has been our Vice Chairman since 1988 and also serves as a director and/or officer for various subsidiaries of IBG LLC. Mr. Nemser has served as Special Counsel to the law firm Dechert LLP since January 2005. Prior to such time Mr. Nemser served as Partner at the law firms of Swidler Berlin Shereff Friedman, LLP from 1995 to December 2004 and Cadwalader, Wickersham & Taft LLP prior to 1995. Mr. Nemser received a Bachelor of Arts degree in economics from New York University in 1967 and a Juris Doctor, magna cum laude, from Boston University School of Law in 1970.

 

Paul J. Brody. Mr. Brody joined us in 1987 and has served as Chief Financial Officer since December 2003. Mr. Brody serves as a director and/or officer for various subsidiaries of IBG LLC. Mr. Brody also serves as a director of the Options Clearing Corporation, of which Timber Hill LLC and IB LLC are members. Mr. Brody received a Bachelor of Arts degree in economics from Cornell University in 1982.

 

Thomas A. Frank. Dr. Frank joined us in 1985 and has served since July 1999 as Executive Vice President and Chief Information Officer of Interactive Brokers LLC. In addition, Dr. Frank has served as Vice President of Timber Hill LLC since December 1990. Dr. Frank received a Ph.D. in physics from the Massachusetts Institute of Technology in 1985.

 

Milan Galik. Mr. Galik joined us in 1990 as a software developer and has served since October 2003 as Senior Vice President, Software Development of IBG LLC. In addition, Mr. Galik has served as Vice President of Timber Hill LLC since April 1998. Mr. Galik received a Master of Science degree in electrical engineering from the Technical University of Budapest in 1990.

 

Lawrence E. Harris. Dr. Harris has been a director since July 2007. He is a professor of Finance and Business Economics at the University of Southern California, where he holds the Fred V. Keenan Chair in Finance at the Marshall School of Business. Dr. Harris also serves as a director of the Clipper Fund and as the research coordinator of the Institute for Quantitative Research in Finance. Dr. Harris formerly served as Chief Economist of the U.S. Securities and Exchange Commission. Dr. Harris received his Ph.D. in Economics from the University of Chicago, where he examined price-volume relations in securities markets. He is an expert in the economics of securities market microstructure and the uses of transactions data in financial research. He has written extensively about trading rules, transaction costs, index markets, and market regulation. Dr. Harris is also the author of the widely respected textbook “Trading and Exchanges: Market Microstructure for Practitioners.”

 

Hans R. Stoll. Dr. Stoll has been a director since April 2008. Dr. Stoll has been The Anne Marie and Thomas B. Walker, Jr., Professor of Finance and Director of the Financial Markets Research Center at the Owen Graduate School of Management, Vanderbilt University since 1980. Dr. Stoll has published several books and more than 60 articles on numerous securities and finance related subjects. His book, ‘‘Futures and Options’’ with Robert Whaley, appeared in 1992. Dr. Stoll served as a member of the board of directors of the Options Clearing Corporation from 2005 to 2008. Dr. Stoll received his A.B. degree from Swarthmore College in 1961 and his M.B.A. and Ph.D. degrees from the Graduate School of Business of the University of Chicago in 1963 and 1966, respectively.

 

Ivers W. Riley. Mr. Riley has been a director since April 2008. He served as chairman of the International Securities Exchange, the first fully electronic U.S. options exchange, until 2006. From 1994 to 1997, and again from 1999 to 2000, he was chief executive of the Hong Kong Futures Exchange and chairman of the HKFE Clearing Corporation. Mr. Riley was Senior Executive Vice President in charge of all derivatives activity at the American Stock Exchange from 1986 to 1993. While at Amex, he was the driving force in the development of SPDRs, a popular exchange-traded fund based on the S&P 500 index. Mr. Riley received his Bachelor of Science degree in finance from The University of California, Los Angeles in 1955 and completed an advanced management program at Harvard University in 1986.

 

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ITEM 1A. RISK FACTORS

 

We face a variety of risks that are substantial and inherent in our businesses, including market, liquidity, credit, operational, legal and regulatory. In addition to the risks identified elsewhere in this Annual Report on Form 10-K, the following risk factors apply to our business results of operations and financial condition:

 

Risks Related to Our Company Structure

 

Control by Thomas Peterffy of a majority of the combined voting power of our common stock may give rise to conflicts of interests and could discourage a change of control that other stockholders may favor, which could negatively affect our stock price, and adversely affect stockholders in other ways.

 

Thomas Peterffy, our founder, Chairman and Chief Executive Officer, and his affiliates beneficially own approximately 85% of the economic interests and all of the voting interests in IBG Holdings LLC, which owns all of our Class B common stock, representing approximately 89.6% of the combined voting power of all classes of our voting stock. As a result, Mr. Peterffy has the ability to elect all of the members of our board of directors and thereby to control our management and affairs, including determinations with respect to acquisitions, dispositions, material expansions or contractions of our business, entry into new lines of business, borrowings, issuances of common stock or other securities, and the declaration and payment of dividends on our common stock. In addition, Mr. Peterffy is able to determine the outcome of all matters requiring stockholder approval and will be able to cause or prevent a change of control of our company or a change in the composition of our board of directors and could preclude any unsolicited acquisition of our company. The concentration of ownership could discourage potential takeover attempts that other stockholders may favor and could deprive stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company and this may adversely affect the market price of our common stock.

 

Moreover, because of Mr. Peterffy’s substantial ownership, we are eligible to be and are, treated as a “controlled company” for purposes of the NASDAQ Marketplace Rules. As a result, we are not be required by NASDAQ to have a majority of independent directors or to maintain Compensation and Nominating and Corporate Governance Committees composed entirely of independent directors to continue to list the shares of our common stock on The NASDAQ Global Select Market (“NASDAQ GS”). Our Compensation Committee is comprised of Messrs. Thomas Peterffy (Chairman of the Compensation Committee) and Earl H. Nemser (our Vice Chairman). Mr. Peterffy’s membership on the Compensation Committee may give rise to conflicts of interests in that Mr. Peterffy is able to influence all matters relating to executive compensation, including his own compensation.

 

We are dependent on IBG LLC to distribute cash to us in amounts sufficient to pay our tax liabilities and other expenses.

 

We are a holding company and our primary assets are our approximately 10.4% equity interest in IBG LLC and our controlling interest and related rights as the sole managing member of IBG LLC and, as such, we operate and control all of the business and affairs of IBG LLC and are able to consolidate IBG LLC’s financial results into our financial statements. We have no independent means of generating revenues. IBG LLC is treated as a partnership for U.S. federal income tax purposes and, as such, is not subject to U.S. federal income tax. Instead, its taxable income is allocated on a pro rata basis to IBG Holdings LLC and us. Accordingly, we incur income taxes on our proportionate share of the net taxable income of IBG LLC, and also incur expenses related to our operations. We intend to cause IBG LLC to distribute cash to its members in amounts at least equal to that necessary to cover their tax liabilities, if any, with respect to the earnings of IBG LLC. To the extent we need funds to pay such taxes, or for any other purpose, and IBG LLC is unable to provide such funds, it could have a material adverse effect on our business, financial condition or results of operations.

 

We are required to pay IBG Holdings LLC for the benefit relating to additional tax depreciation or amortization deductions we claim as a result of the tax basis step-up our subsidiaries received in connection with our IPO.

 

In connection with our IPO, we purchased interests in IBG LLC from IBG Holdings LLC for cash. In addition, IBG LLC membership interests held by IBG Holdings LLC may be sold in the future to us and financed by our issuances of shares of our common stock. The initial purchase did, and the subsequent purchases may, result in increases in the tax basis of the tangible and intangible assets of IBG LLC and its subsidiaries that otherwise would not have been available. Such increase will be approximately equal to the amount by which our stock price at the time of the purchase exceeds the income tax basis of the assets of IBG LLC underlying the IBG LLC interests acquired by us. These increases in tax basis will result in increased deductions in computing our taxable income and resulting tax savings for us generally over the 15 year period which commenced with the initial purchase. We have agreed to pay 85% of these tax savings, if any, to IBG Holdings LLC as they are realized as additional consideration for the IBG LLC interests that we acquire.

 

As a result of the IPO, the increase in the tax basis attributable to our interest in IBG LLC is $0.95 billion. The tax savings that we would actually realize as a result of this increase in tax basis likely would be significantly less than this amount multiplied by our effective tax rate due to a number of factors, including the allocation of a portion of the increase in tax basis to foreign or non-depreciable fixed assets, the impact of the increase in the tax basis on our ability to use foreign tax credits and the rules relating to the amortization of intangible assets, for example. Based on current facts and assumptions, including that subsequent purchases of IBG LLC interests will occur in fully taxable transactions, the potential tax basis increase resulting from the initial and future purchases of the IBG LLC interests held by IBG Holdings LLC could be as much as $9.45 billion. The tax receivable agreement requires 85% of such tax savings, if any, to be paid to IBG Holdings LLC, with the balance to be retained by us. The actual increase in tax basis

 

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depends, among other factors, upon the price of shares of our common stock at the time of the purchase and the extent to which such purchases are taxable and, as a result, could differ materially from this amount. Our ability to achieve benefits from any such increase, and the amount of the payments to be made under the tax receivable agreement, depends upon a number of factors, as discussed above, including the timing and amount of our future income.

 

If either immediately before or immediately after any purchase or the related issuance of our stock, the IBG Holdings LLC members own or are deemed to own, in the aggregate, more than 20% of our outstanding stock, then all or part of any increase in the tax basis of goodwill may not be amortizable and, thus, our ability to realize the annual tax savings that otherwise would have resulted if such tax basis were amortizable may be significantly reduced. Although the IBG Holdings LLC members are prohibited under the exchange agreement from purchasing shares of Class A common stock, grants of our stock to employees and directors who are also members or related to members of IBG Holdings LLC and the application of certain tax attribution rules, such as among family members and partners in a partnership, could result in IBG Holdings LLC members being deemed for tax purposes to own shares of Class A common stock.

 

If the IRS successfully challenges the tax basis increase, under certain circumstances, we could be required to make payments to IBG Holdings LLC under the tax receivable agreement in excess of our cash tax savings.

 

Our senior secured revolving credit facility and our senior notes impose certain restrictions. A failure to comply with these restrictions could lead to an event of default, resulting in an acceleration of indebtedness, which may affect our ability to finance future operations or capital needs, or to engage in other business activities.

 

As of December 31, 2008, our total indebtedness (consisting of the aggregate amounts outstanding under senior notes, senior secured revolving credit facility and short-term borrowings) was approximately $651.2 million. On May 19, 2006, IBG LLC entered into a $300.0 million three-year senior secured revolving credit facility with JPMorgan Chase Bank, N.A. as administrative agent, Harris N.A. as syndication agent, and Citibank, N.A. and HSBC Bank USA National Association as co-syndication agents. In addition, subject to restrictions in our senior secured revolving credit facility and our senior notes, we may incur additional first-priority secured borrowings under the senior secured revolving credit facility.

 

The operating and financial restrictions and covenants in our debt agreements, including the senior secured revolving credit facility and our senior notes, may adversely affect our ability to finance future operations or capital needs or to engage in other business activities. Our senior secured revolving credit facility requires us to maintain specified financial ratios and tests, including interest coverage and total leverage ratios and maximum capital expenditures, which may require that we take action to reduce debt or to act in a manner contrary to our business objectives. In addition, the senior secured revolving credit facility and the senior notes restrict our ability to, among other things:

 

 

incur additional indebtedness;

 

 

dispose of assets;

 

 

guarantee debt obligations;

 

 

repay indebtedness or amend debt instruments;

 

 

pay dividends;

 

 

create liens on assets;

 

 

make investments;

 

 

make acquisitions;

 

 

engage in mergers or consolidations; or

 

 

engage in certain transactions with subsidiaries and affiliates and otherwise restrict corporate activities.

 

A more detailed discussion of the restrictions contained in our senior secured revolving credit facility can be found in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K. A failure to comply with the restrictions contained in the senior secured revolving credit facility could lead to an event of default, which could result in an acceleration of our indebtedness. Such an acceleration would constitute an event of default under our senior notes. A failure to comply with the restrictions in our senior notes could result in an event of default under our senior notes. Our future operating results may not be sufficient to enable compliance with the covenants in the senior secured revolving credit facility, our senior notes or other indebtedness or to remedy any such default. In addition, in the event of an acceleration, we may not have or be able to obtain sufficient funds to refinance our indebtedness or make any accelerated payments, including those under the senior notes. In addition, we may not be able to obtain new financing. Even if we were able to obtain new financing, we would not be able to guarantee that the new

 

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financing would be on commercially reasonable terms or terms that would be acceptable to us. If we default on our indebtedness, our business financial condition and results of operation could be materially and adversely affected.

 

Future sales of our common stock in the public market could lower our stock price, and any additional capital raised by us through the sale of equity or convertible securities may dilute your ownership in us.

 

The members of IBG Holdings LLC have the right to cause the redemption of their IBG Holdings LLC membership interests over time in connection with offerings of shares of our common stock. We intend to sell additional shares of common stock in subsequent public offerings on a regular basis, including annual offerings of our common stock to finance future purchases of IBG LLC membership interests which, in turn, will finance corresponding redemptions of IBG Holdings LLC membership interests. These annual offerings and related transactions are anticipated to occur on or about each of the first eight years following the IPO and, depending on the timing of redemptions, possibly extend into the future in accordance with an exchange agreement among us, IBG LLC, IBG Holdings LLC and the historical members of IBG LLC. The size and occurence of these offerings may be affected by market conditions. We may also issue additional shares of common stock or convertible debt securities to finance future acquisitions or business combinations. We currently have approximately 40.6 million outstanding shares of common stock. Assuming no anti dilution adjustments based on combinations or divisions of our common stock, the annual offerings referred to above could result in the issuance by us of up to an additional approximately 357.6 million shares of common stock. It is possible, however, that such shares could be issued in one or a few large transactions.

 

We cannot predict the size of future issuances of our common stock or the effect, if any, that future issuances and sales of shares of our common stock may have on the market price of our common stock. Sales of substantial amounts of our common stock (including shares issued in connection with an acquisition), or the perception that such sales could occur, may cause the market price of our common stock to decline.

 

Certain provisions in our amended and restated certificate of incorporation may prevent efforts by our stockholders to change our direction or management.

 

Provisions contained in our amended and restated certificate of incorporation could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders. For example, our amended and restated certificate of incorporation authorizes our board of directors to determine the rights, preferences, privileges and restrictions of unissued series of preferred stock, without any vote or action by our stockholders. We could issue a series of preferred stock that could impede the completion of a merger, tender offer or other takeover attempt. These provisions may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including through transactions, and, in particular, unsolicited transactions, that some or all of our stockholders might consider to be desirable. As a result, efforts by our stockholders to change our direction or management may be unsuccessful.

 

Risks Related to Our Business

 

Our business may be harmed by global events beyond our control, including overall slowdowns in securities trading.

 

Like other brokerage and financial services firms, our business and profitability are directly affected by elements that are beyond our control, such as economic and political conditions, broad trends in business and finance, changes in volume of securities and futures transactions, changes in the markets in which such transactions occur and changes in how such transactions are processed. A weakness in equity markets, such as a slowdown causing reduction in trading volume in U.S. or foreign securities and derivatives, has historically resulted in reduced transaction revenues and would have a material adverse effect on our business, financial condition and results of operations.

 

Because our revenues and profitability depend on trading volume, they are prone to significant fluctuations and are difficult to predict.

 

Our revenues are dependent on the level of trading activity on securities and derivatives exchanges in the United States and abroad. In the past, our revenues and operating results have varied significantly from period to period due primarily to the willingness of competitors to trade more aggressively by decreasing their bid/offer spreads and thereby assuming more risk in order to acquire market share, to movements and trends in the underlying markets, and to fluctuations in trading levels. As a result, period to period comparisons of our revenues and operating results may not be meaningful, and future revenues and profitability may be subject to significant fluctuations or declines.

 

Our reliance on our computer software could cause us great financial harm in the event of any disruption or corruption of our computer software. We may experience technology failures while developing our software.

 

We rely on our computer software to receive and properly process internal and external data. Any disruption for any reason in the proper functioning or any corruption of our software or erroneous or corrupted data may cause us to make erroneous trades or suspend

 

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our services and could cause us great financial harm. In order to maintain our competitive advantage, our software is under continuous development. As we identify and enhance our software, there is risk that software failures may occur and result in service interruptions and have other unintended consequences.

 

Our business could be harmed by a systemic market event.

 

Some market participants could be overleveraged. In case of sudden, large price movements, such market participants may not be able to meet their obligations to brokers who, in turn, may not be able to meet their obligations to their counterparties. As a result, the financial system or a portion thereof could collapse, and the impact of such an event could be catastrophic to our business.

 

We may incur material trading losses from our market making activities.

 

A substantial portion of our revenues and operating profits is derived from our trading as principal in our role as a market maker and specialist. We may incur trading losses relating to these activities since each primarily involves the purchase or sale of securities for our own account. In any period, we may incur trading losses in a significant number of securities for a variety of reasons including:

 

 

price changes in securities;

 

 

lack of liquidity in securities in which we have positions; and

 

 

the required performance of our market making and specialist obligations.

 

These risks may limit or restrict our ability to either resell securities we purchased or to repurchase securities we sold. In addition, we may experience difficulty borrowing securities to make delivery to purchasers to whom we sold short, or lenders from whom we have borrowed. From time to time, we have large position concentrations in securities of a single issuer or issuers engaged in a specific industry or traded in a particular market. Such a concentration could result in higher trading losses than would occur if our positions and activities were less concentrated.

 

                In our role as a market maker, we attempt to derive a profit from the difference between the prices at which we buy and sell, or sell and buy, securities. However, competitive forces often require us to match the quotes other market makers display and to hold varying amounts of securities in inventory. By having to maintain inventory positions, we are subjected to a high degree of risk. We cannot assure you that we will be able to manage such risk successfully or that we will not experience significant losses from such activities, which could have a material adverse effect on our business, financial condition and operating results.

 

Reduced spreads in securities pricing, levels of trading activity and trading through market makers and/or specialists could harm our business.

 

Computer-generated buy/sell programs and other technological advances and regulatory changes in the marketplace may continue to tighten spreads on securities transactions. Tighter spreads and increased competition could make the execution of trades and market making activities less profitable. In addition, new and enhanced alternative trading systems such as ECNs have emerged as an alternative for individual and institutional investors, as well as broker-dealers, to avoid directing their trades through market makers, and could result in reduced revenues derived from our market making business.

 

We may incur losses in our market making activities in the event of failures of our proprietary pricing model.

 

The success of our market making business is substantially dependent on the accuracy of our proprietary pricing mathematical model, which continuously evaluates and monitors the risks inherent in our portfolio, assimilates market data and reevaluates our outstanding quotes each second. Our model is designed to automatically rebalance our positions throughout the trading day to manage risk exposures on our positions in options, futures and the underlying securities. In the event of a flaw in our pricing model and /or a failure in the related software, our pricing model may lead to unexpected and/or unprofitable trades, which may result in material trading losses.

 

The valuation of the financial instruments we hold may result in large and occasionally anomalous swings in the value of our positions and in our earnings in any period.

 

The market prices of our long and short positions are reflected on our books at closing prices which are typically the last trade price before the official close of the primary exchange on which each such security trades. Given that we manage a globally integrated portfolio, we may have large and substantially offsetting positions in securities that trade on different exchanges that close at different times of the trading day. As a result, there may be large and occasionally 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.

 

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We are exposed to losses due to lack of perfect information.

 

As market makers, we provide liquidity by buying from sellers and selling to buyers. Quite often, we trade with others who have different information than we do, and as a result, we may accumulate unfavorable positions preceding large price movements in companies. Should the frequency or magnitude of these events increase, our losses will likely increase correspondingly.

 

Rules governing specialists and designated market makers may require us to make unprofitable trades or prevent us from making profitable trades.

 

Specialists and designated market makers are granted certain rights and have certain obligations to “make a market” in a particular security. They agree to specific obligations to maintain a fair and orderly market. In acting as a specialist or designated market maker, we are subjected to a high degree of risk by having to support an orderly market. In this role, we may at times be required to make trades that adversely affect our profitability. In addition, we may at times be unable to trade for our own account in circumstances in which it may be to our advantage to trade, and we may be obligated to act as a principal when buyers or sellers outnumber each other. In those instances, we may take a position counter to the market, buying or selling securities to support an orderly market. Additionally, the rules of the markets which govern our activities as a specialist or designated market maker are subject to change. If these rules are made more stringent, our trading revenues and profits as specialist or designated market maker could be adversely affected.

 

We are subject to potential losses as a result of our clearing and execution activities.

 

As a clearing member firm providing financing services to certain of our brokerage customers, we are ultimately responsible for their financial performance in connection with various stock, options and futures transactions. Our clearing operations require a commitment of our capital and, despite safeguards implemented by our software, involve risks of losses due to the potential failure of our customers to perform their obligations under these transactions. If our customers default on their obligations, we remain financially liable for such obligations, and although these obligations are collateralized, we are subject to market risk in the liquidation of customer collateral to satisfy those obligations. There can be no assurance that our risk management procedures will be adequate. Any liability arising from clearing operations could have a material adverse effect on our business, financial condition and/or operating results.

 

As a clearing member firm of securities and commodities clearing houses in the United States and abroad, we are also exposed to clearing member credit risk. Securities and commodities clearing houses require member firms to deposit cash and/or government securities to a clearing fund. If a clearing member defaults in its obligations to the clearing house in an amount larger than its own margin and clearing fund deposits, the shortfall is absorbed pro rata from the deposits of the other clearing members. Many clearing houses of which we are members also have the authority to assess their members for additional funds if the clearing fund is depleted. A large clearing member default could result in a substantial cost to us if we are required to pay such assessments.

 

We may not pay dividends on our common stock at any time in the foreseeable future.

 

As a holding company for our interest in IBG LLC, we will be dependent upon the ability of IBG LLC to generate earnings and cash flows and distribute them to us so that we may pay any dividends to our stockholders. To the extent (if any) that we have excess cash, any decision to declare and pay dividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our results of operations, financial conditions, cash requirement, contractual restrictions and other factors that our board of directors may deem relevant. We have made no determination as to whether to pay dividends on our common stock at any time in the foreseeable future.

 

Regulatory and legal uncertainties could harm our business.

 

The securities and derivatives businesses are heavily regulated. Firms in financial service industries have been subject to an increasingly regulated environment over recent years, and penalties and fines sought by regulatory authorities have increased accordingly. This regulatory and enforcement environment has created uncertainty with respect to various types of transactions that historically had been entered into by financial services firms and that were generally believed to be permissible and appropriate. Our broker-dealer subsidiaries are subject to regulations in the United States and abroad covering all aspects of their business. Regulatory bodies include, in the United States, the SEC, FINRA, the Board of Governors of the Federal Reserve System, the Chicago Board Options Exchange, the Chicago Mercantile Exchange, the Commodity Futures Trading Commission, and the National Futures Association; in Switzerland, the Federal Banking Commission; in the United Kingdom, the Financial Services Authority; in Hong Kong, the Securities and Futures Commission; in Australia, the Australian Securities and Investment Commission; in India, the Securities and Exchange Board of India; and in Canada, the Investment Dealers Association of Canada and various Canadian securities commissions. Our mode of operation and profitability may be directly affected by additional legislation changes in rules promulgated by various domestic and foreign government agencies and self-regulatory organizations that oversee our businesses, and changes in the interpretation or enforcement of existing laws and rules. Noncompliance with applicable laws or regulations could result in sanctions being levied against us, including fines and censures, suspension or expulsion from a certain jurisdiction or market or the revocation or limitation of licenses. Noncompliance with

 

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applicable laws or regulations could adversely affect our reputation, prospects, revenues and earnings. In addition, changes in current laws or regulations or in governmental policies could adversely affect our operations, revenues and earnings.

 

Domestic and foreign stock exchanges, other self-regulatory organizations and state and foreign securities commissions can censure, fine, issue cease-and-desist orders, suspend or expel a broker-dealer or any of its officers or employees. Our ability to comply with all applicable laws and rules is largely dependent on our internal system to ensure compliance, as well as our ability to attract and retain qualified compliance personnel. We could be subject to disciplinary or other actions in the future due to claimed noncompliance, which could have a material adverse effect on our business, financial condition and results of operations. To continue to operate and to expand our services internationally, we may have to comply with the regulatory controls of each country in which we conduct, or intend to conduct business, the requirements of which may not be clearly defined. The varying compliance requirements of these different regulatory jurisdictions, which are often unclear, may limit our ability to continue existing international operations and further expand internationally.

 

Our future efforts to sell shares or raise additional capital may be delayed or prohibited by regulations.

 

As certain of our subsidiaries are members of FINRA, we are subject to certain regulations regarding changes in control of our ownership. FINRA Rule 1017 generally provides that FINRA approval must be obtained in connection with any transaction resulting in a change in control of a member firm. FINRA defines control as ownership of 25% or more of the firm’s equity by a single entity or person and would include a change in control of a parent company. Interactive Brokers (U.K.) Limited is subject to similar change in control regulations promulgated by the FSA in the United Kingdom. As a result of these regulations, our future efforts to sell shares or raise additional capital may be delayed or prohibited. We may be subject to similar restrictions in other jurisdictions in which we operate.

 

We depend on our proprietary technology, and our future results may be impacted if we cannot maintain technological superiority in our industry.

 

Our success in the past has largely been attributable to our sophisticated proprietary technology that has taken many years to develop. We have benefited from the fact that the type of proprietary technology equivalent to that which we employ has not been widely available to our competitors. If our technology becomes more widely available to our current or future competitors for any reason, our operating results may be adversely affected. Additionally, adoption or development of similar or more advanced technologies by our competitors may require that we devote substantial resources to the development of more advanced technology to remain competitive. The markets in which we compete are characterized by rapidly changing technology, evolving industry standards and changing trading systems, practices and techniques. Although we have been at the forefront of many of these developments in the past, we may not be able to keep up with these rapid changes in the future, develop new technology, realize a return on amounts invested in developing new technologies or remain competitive in the future.

 

The loss of our key employees would materially adversely affect our business.

 

Our key executives have substantial experience and have made significant contributions to our business, and our continued success is dependent upon the retention of our key management executives, as well as the services provided by our staff of trading system, technology and programming specialists and a number of other key managerial, marketing, planning, financial, technical and operations personnel. The loss of such key personnel could have a material adverse effect on our business. Growth in our business is dependent, to a large degree, on our ability to retain and attract such employees.

 

We are exposed to risks associated with our international operations.

 

During 2008, approximately 44% of our net revenues were generated outside the United States. We are exposed to risks and uncertainties inherent in doing business in international markets, particularly in the heavily regulated brokerage industry. Such risks and uncertainties include political, economic and financial instability; unexpected changes in regulatory requirements, tariffs and other trade barriers; exchange rate fluctuations; applicable currency controls; and difficulties in staffing, including reliance on newly hired local experts, and managing foreign operations. These risks could cause a material adverse effect on our business, financial condition or results of operations.

 

We do not have fully redundant systems. System failures could harm our business.

 

If our systems fail to perform, we could experience unanticipated disruptions in operations, slower response times or decreased customer service and customer satisfaction. Our ability to facilitate transactions successfully and provide high quality customer service also depends on the efficient and uninterrupted operation of our computer and communications hardware and software systems. Our service has experienced periodic system interruptions, which we believe will continue to occur from time to time. Our systems and operations also are vulnerable to damage or interruption from human error, natural disasters, power loss, telecommunication failures, break-ins, sabotage, computer viruses, intentional acts of vandalism and similar events. While we currently maintain redundant servers to provide limited service during system disruptions, we do not have fully redundant systems, and our formal disaster recovery plan does not include restoration of all services. For example, we have backup facilities at our disaster recovery site that enable us, in the case of

 

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complete failure of our main North America data center, to recover and complete all pending transactions, provide customers with access to their accounts to deposit or withdraw money, transfer positions to other brokers and manage their risk by continuing trading through the use of marketable orders. These backup services are currently limited to U.S. markets. We do not currently have separate backup facilities dedicated to our non-U.S. operations. It is our intention to provide for and progressively deploy backup facilities for our global facilities over time. In addition, we do not carry business interruption insurance to compensate for losses that could occur to the extent not required. Any system failure that causes an interruption in our service or decreases the responsiveness of our service could impair our reputation, damage our brand name and materially adversely affect our business, financial condition and results of operations.

 

Failure of third-party systems on which we rely could adversely affect our business.

 

We rely on certain third-party computer systems or third-party service providers, including clearing systems, exchange systems, Internet service, communications facilities and other facilities. Any interruption in these third-party services, or deterioration in their performance, could be disruptive to our business. If our arrangement with any third party is terminated, we may not be able to find an alternative source of systems support on a timely basis or on commercially reasonable terms. This could have a material adverse effect on our business, financial condition and results of operations.

 

We face competition in our market making activities.

 

In our market making activities, we compete with other firms who act as market makers based on our ability to provide liquidity at competitive prices and to attract order flow. Market makers range from sole proprietors with very limited resources, of which there are still a few hundred left, to a few highly sophisticated groups which have substantially greater financial and other resources, including research and development personnel, than we do. These larger and better capitalized competitors may be better able to respond to changes in the market making industry, to compete for skilled professionals, to finance acquisitions, to fund internal growth and to compete for market share generally. We may not be able to compete effectively against these firms, particularly those with greater financial resources, and our failure to do so could materially and adversely affect our business, financial condition and results of operations. As in the past, we may in the future face enhanced competition, resulting in narrowing bid/offer spreads in the marketplace that may adversely impact our financial performance. This is especially likely if others can acquire systems that enable them to predict markets or process trades more efficiently than we can.

 

Our direct market access clearing and non-clearing brokerage operations face intense competition.

 

With respect to our direct market access brokerage business, the market for electronic and interactive bidding, offering and trading services in connection with equities, options and futures is relatively new, rapidly evolving and intensely competitive. We expect competition to continue and intensify in the future. Our current and potential future competition principally comes from five categories of competitors:

 

 

prime brokers who, in an effort to satisfy the demands of their customers for hands-on electronic trading facilities, universal access to markets, smart routing, better trading tools, lower commissions and financing rates, have embarked upon building such facilities and product enhancements;

 

 

direct market access and online options and futures firms;

 

 

direct market access and online equity brokers;

 

 

software development firms and vendors who create global trading networks and analytical tools and make them available to brokers; and

 

 

traditional brokers.

 

In addition, we compete with financial institutions, mutual fund sponsors and other organizations, many of which provide online, direct market access or other investing services. A number of brokers provide our technology and execution services to their customers, and these brokers will become our competitors if they develop their own technology. Some of our competitors in this area have greater name recognition, longer operating histories and significantly greater financial, technical, marketing and other resources than we have and offer a wider range of services and financial products than we do. Some of our competitors may also have an ability to charge lower commissions. We cannot assure you that we will be able to compete effectively or efficiently with current or future competitors. These increasing levels of competition in the online trading industry could significantly harm this aspect of our business.

 

We are subject to risks relating to litigation and potential securities laws liability.

 

We are exposed to substantial risks of liability under federal and state securities laws, other federal and state laws and court decisions, as well as rules and regulations promulgated by the SEC, the CFTC, the Federal Reserve, state securities regulators, the self-regulatory organizations and foreign regulatory agencies. We are also subject to the risk of litigation and claims that may be without merit. We could incur significant legal expenses in defending ourselves against and resolving lawsuits or claims. An adverse resolution of any future lawsuits or claims against us could result in a negative perception of our company and cause the market price of our

 

20

 

common stock to decline or otherwise have an adverse effect on our business, financial condition and/or operating results. See Part I, Item 3, “Legal Proceedings and Regulatory Matters.”

 

Any future acquisitions may result in significant transaction expenses, integration and consolidation risks and risks associated with entering new markets, and we may be unable to profitably operate our consolidated company.

 

Although our growth strategy has not focused historically on acquisitions, we may in the future engage in evaluations of potential acquisitions and new businesses. We may not have the financial resources necessary to consummate any acquisitions in the future or the ability to obtain the necessary funds on satisfactory terms. Any future acquisitions may result in significant transaction expenses and risks associated with entering new markets in addition to integration and consolidation risks. Because acquisitions historically have not been a core part of our growth strategy, we have no material experience in successfully utilizing acquisitions. We may not have sufficient management, financial and other resources to integrate any such future acquisitions or to successfully operate new businesses and we may be unable to profitably operate our expanded company.

 

Internet-related issues may reduce or slow the growth in the use of our services in the future.

 

Critical issues concerning the commercial use of the Internet, such as ease of access, security, privacy, reliability, cost, and quality of service, remain unresolved and may adversely impact the growth of Internet use. If Internet usage continues to increase rapidly, the Internet infrastructure may not be able to support the demands placed on it by this growth, and its performance and reliability may decline. The recent growth in Internet traffic has caused frequent periods of decreased performance, outages and delays. Although our larger institutional customers use leased data lines to communicate with us, our ability to increase the speed with which we provide services to consumers and to increase the scope and quality of such services is limited by and dependent upon the speed and reliability of our customers’ access to the Internet, which is beyond our control. If periods of decreased performance, outages or delays on the Internet occur frequently or other critical issues concerning the Internet are not resolved, overall Internet usage or usage of our web based products could increase more slowly or decline, which would cause our business, results of operations and financial condition to be materially and adversely affected.

 

Our computer infrastructure may be vulnerable to security breaches. Any such problems could jeopardize confidential information transmitted over the Internet, cause interruptions in our operations or cause us to have liability to third persons.

 

Our computer infrastructure is potentially vulnerable to physical or electronic computer break-ins, viruses and similar disruptive problems and security breaches. Any such problems or security breaches could cause us to have liability to one or more third parties, including our customers, and disrupt our operations. A party able to circumvent our security measures could misappropriate proprietary information or customer information, jeopardize the confidential nature of information transmitted over the Internet or cause interruptions in our operations. Concerns over the security of Internet transactions and the privacy of users could also inhibit the growth of the Internet or the electronic brokerage industry in general, particularly as a means of conducting commercial transactions. To the extent that our activities involve the storage and transmission of proprietary information such as personal financial information, security breaches could expose us to a risk of financial loss, litigation and other liabilities. Our estimated annual losses from reimbursements to customers whose accounts have been negatively affected by unauthorized access have historically been less than $500,000 annually, but instances of unauthorized access of customer accounts have been increasing recently on an industry-wide basis. Our current insurance program may protect us against some, but not all, of such losses. Any of these events, particularly if they (individually or in the aggregate) result in a loss of confidence in our company or electronic brokerage firms in general, could have a material adverse effect on our business, results of operations and financial condition.

 

We may not be able to protect our intellectual property rights or may be prevented from using intellectual property necessary for our business.

 

We rely primarily on trade secret, contract, copyright, patent and trademark laws to protect our proprietary technology. It is possible that third parties may copy or otherwise obtain and use our proprietary technology without authorization or otherwise infringe on our rights. We may also face claims of infringement that could interfere with our ability to use technology that is material to our business operations.

 

In the future, we may have to rely on litigation to enforce our intellectual property rights, protect our trade secrets, determine the validity and scope of the proprietary rights of others or defend against claims of infringement or invalidity. Any such litigation, whether successful or unsuccessful, could result in substantial costs and the diversion of resources and the attention of management, any of which could negatively affect our business.

 

Our future success will depend on our response to the demand for new services, products and technologies.

 

The demand for market making services, particularly services that rely on electronic communications gateways, is characterized by:

 

21

 

 

rapid technological change;

 

 

changing customer demands;

 

 

the need to enhance existing services and products or introduce new services and products; and

 

 

evolving industry standards.

 

New services, products and technologies may render our existing services, products and technologies less competitive. Our future success will depend, in part, on our ability to respond to the demand for new services, products and technologies on a timely and cost-effective basis and to adapt to technological advancements and changing standards to address the increasingly sophisticated requirements and varied needs of our customers and prospective customers. We cannot assure you that we will be successful in developing, introducing or marketing new services, products and technologies. In addition, we may experience difficulties that could delay or prevent the successful development, introduction or marketing of these services and products, and our new service and product enhancements may not achieve market acceptance. Any failure on our part to anticipate or respond adequately to technological advancements, customer requirements or changing industry standards, or any significant delays in the development, introduction or availability of new services, products or enhancements could have a material adverse effect on our business, financial condition and operating results.

 

The expansion of our market making activities into forex-based products entails significant risk, and unforeseen events in such business could have an adverse effect on our business, financial condition and results of operation.

 

Over the past several years we entered into market making for forex-based products. This includes the trading of cash in foreign currencies with banks and exchange-listed futures, options on futures, options on cash deposits and currency-based ETFs. All of the risks that pertain to our market making activities in equity-based products also apply to our forex-based market making. In addition, we have comparatively less experience in the forex markets and even though we are expanding this activity very slowly, any kind of unexpected event can occur that can result in great financial loss.

 

We are subject to counterparty risk whereby defaults by parties with whom we do business can have an adverse effect on our business, financial condition and/or operating results.

 

In our electronic brokerage business, our customer margin 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 in which no liquid market exists for the relevant securities or commodities or in which, for any reason, automatic liquidation for certain accounts has been disabled. If no liquid market exists or automatic liquidation has been disabled, we are subject to risks inherent in extending credit, especially during periods of rapidly declining markets. Any loss or expense incurred due to defaults by our customers in failing to repay margin loans or to maintain adequate collateral for these loans would cause harm to our business.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

22

 

ITEM 2. PROPERTIES

 

Our headquarters are located in Greenwich, Connecticut. We lease approximately 100,000 square feet for our headquarters, which lease expires in the year 2019. We also lease facilities in 14 other locations throughout parts of the world where we conduct our operations, which are located in Chicago, IL, expiring in 2017; Lake Forest, CA, expiring in 2012; Zug, Switzerland, expiring in 2009; Hong Kong, expiring in 2009; London, expiring in 2015; Sydney, Australia, expiring in 2009; Montreal, Canada, expiring in 2009; Budapest, Hungary, expiring in 2010; St. Petersburg, Russia, expiring in 2009; Tallinn, Estonia, expiring in 2009; Mumbai, India, expiring in 2012; Tokyo, Japan, expiring in 2009; and Washington D.C., expiring in 2009, Unless otherwise indicated, all properties are used by both our market making and electronic brokerage segments. We believe our present facilities, together with our current options to extend lease terms, are adequate for our current needs.

 

The following table sets forth certain information with respect to our leased facilities:

 

Location

Space

Principal Usage

Greenwich, CT 100,338 sq. feet Headquarters and data center
Jersey City, NJ 5,876 sq. feet Office space
Chicago, IL 62,446 sq. feet Office space and data center
Lake Forest, CA 22,168 sq. feet Office space
Washington, D.C. 416 sq. feet Office space
Montreal, Canada 4,566 sq. feet Office space
London, United Kingdom 2,283 sq. feet Office space
Zug, Switzerland 19,590 sq. feet Office space and data center
Sydney, Australia 1,313 sq. feet Office space
Hong Kong 5,820 sq. feet Office space and data center
Budapest, Hungary 4,297 sq. feet Office space
St. Petersburg, Russia 2,563 sq. feet Office space
Tallinn, Estonia 3,638 sq. feet Office space
Mumbai, India 1,665 sq. feet Office space
Tokyo, Japan 140 sq. feet Office space

 

23

 

ITEM 3. LEGAL PROCEEDINGS AND REGULATORY MATTERS

 

The securities industry is highly regulated and many aspects of our business involve substantial risk of liability. In recent years, there has been an increasing incidence of litigation involving the securities brokerage industry, including class action suits that generally seek substantial damages, including in some cases punitive damages. Compliance and trading problems that are reported to federal, state and provincial securities regulators, securities exchanges or other self-regulatory organizations by dissatisfied customers are investigated by such regulatory bodies, and, if pursued by such regulatory body or such customers, may rise to the level of arbitration or disciplinary action. We are also subject to periodic regulatory audits and inspections.

 

Like other securities brokerage firms, we have been named as a defendant in lawsuits and from time to time we have been threatened with, or named as a defendant in, arbitrations and administrative proceedings. The following contains information regarding potentially material pending litigation and pending regulatory inquiries. We may in the future become involved in additional litigation or regulatory proceedings in the ordinary course of our business, including litigation or regulatory proceedings that could be material to our business.

 

Settled Litigation

 

Nayab Class Action - On January 14, 2008, we were named as a defendant in a purported shareholder class action lawsuit alleging that we violated Sections 11 and 12(a)(2) of the Securities Act by issuing a registration statement and prospectus in connection with the IPO that contained false and misleading statements or omitted material facts concerning losses suffered by us in connection with trading in options of Altana AG on the German stock market.  A lead plaintiff was appointed on March 14, 2008, and an amended complaint was served on or about March 24, 2008.  The amended complaint adds our founder and chief executive officer, Thomas Peterffy, as a defendant. This case was dismissed with prejudice by the United States District Court –Southern District of New York on November 14, 2008.

 

Pending Regulatory Inquiries

 

IB’s businesses are heavily regulated by state, federal and foreign regulatory agencies as well as numerous exchanges and self-regulatory organizations. IB’s various companies are regulated under state securities laws, U.S. and foreign securities, commodities and financial services laws and under the rules of more than 25 exchanges and SROs. In the current era of dramatically heightened regulatory scrutiny of financial institutions, IB has incurred sharply increased compliance costs, along with the industry as a whole. Increased regulation also creates increased barriers to entry, however, and IB has built human and automated infrastructure to handle increased regulatory scrutiny, which provides IB an advantage over potential newcomers to the business.

 

IB receives hundreds of regulatory inquiries each year in addition to being subject to frequent regulatory examinations. The great majority of these inquiries do not lead to fines or any further action against IB. Most often, regulators do not inform IB as to when and if an inquiry has been concluded. IB is currently the subject of regulatory inquiries regarding topics such as order audit trail reporting, trade reporting, short sales, market making obligations, anti-money laundering, business continuity planning and other topics of recent regulatory interest. There are no formal regulatory enforcement actions pending against IB’s regulated entities, except as specifically disclosed herein and IB is unaware of any specific regulatory matter that, itself, or together with similar regulatory matters, would have a material impact on IB’s financial condition. Nonetheless, in the current climate, we expect to pay significant regulatory fines on various topics on an ongoing basis, as other regulated financial services businesses do. The amount of any fines, and when and if they will be incurred, is impossible to predict given the nature of the regulatory process.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of stockholders during the fourth quarter of 2008.

 

24

 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY; RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Common Stock Information

 

The following table shows the high and low sale prices for the periods indicated for the Company’s common stock, as reported by NASDAQ.

 

Sales Price

 

High 

Low 

 2008
First Quarter $  35.47 $  25.37
Second Quarter $  34.83 $  25.90
Third Quarter $  33.96 $  19.32
  Fourth Quarter $  23.58 $  13.10
    
 2009
 January 1, 2009 - February 27, 2008  $  19.71 $  14.05

 

The closing price of our common stock on February 27, 2009, as reported by NASDAQ, was $14.05 per share.

 

Holders

 

On February 27, 2009, there were two holders of record, which does not reflect those shares held beneficially or those shares held in “street” name. Accordingly, the number of beneficial owners of our common stock exceeds this number.

 

Dividends and Other Restrictions

 

No dividends have been paid on our common stock. We have made no determination as to whether to pay any dividends on our common stock in the foreseeable future. Restrictions contained in our loan agreements limit our ability to pay dividends on our common stock. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

 

Stockholder Return Performance Graph

 

The following graph compares cumulative total stockholder return on our common stock, the S&P 500 Index and the NASDAQ Financial-100 Index from January 1, 2008 to December 31, 2008. The comparison assumes $100 was invested on January 1, 2008 in our common stock and each of the foregoing indices and assumes reinvestment of dividends before consideration of income taxes. We have paid no dividends on our common stock.

 

 

 

 

25

 


 

 

(1)

The NASDAQ Financial-100 Index includes 100 of the largest domestic and international financial securities listed on The NASDAQ Stock Market based on market capitalization. They include companies classified according to the Industry Classification Benchmark as Financials, which are included within the NASDAQ Bank, NASDAQ Insurance, and NASDAQ Other Finance Indexes.

 

 

(2)

The S&P 500 Index includes 500 large cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock markets, the New York Stock Exchange and NASDAQ.

 

The stock performance depicted in the graph above is not to be relied upon as indicative of future performance. The stock performance graph shall not be deemed to be incorporated by reference into any of our filings under the Securities Act or the Exchange Act, except to the extent that we specifically incorporate the same by reference, nor shall it be deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulations 14A or 14C or to the liabilities of Section 18 of the Exchange Act.

 

Purchases of Equity Securities by the Issuer

 

On September 26, 2008, the Company’s Board of Directors approved a share buyback program by its subsidiary IBG LLC, authorizing IBG LLC to repurchase up to 8,000,000 shares of the Registrant’s common stock. The repurchases will be funded with IBG LLC’s existing cash and will be purchased from the open market and in private transactions if the Company deems the price appropriate. The purchases may be made from time to time as market conditions warrant and subject to regulatory considerations. The timing and amounts of any purchases will be determined by the Registrant’s management. The share repurchase approval has no time limit and may be discontinued at any time.

 

A summary of the repurchase activity for the Company’s fourth quarter is as follows:

 

Total Number

Maximum

of Shares

Number of Shares that

Total Number of

Average

Purchased as Part of

May yet be Purchased

Shares

Price Paid

Publicly Announced

Under the

Period

Purchased

per Share

Plans or Programs

Plans or Programs

November 1 - November 30
     Stock Repurchase

65,800

$13.16

65,800

7,934,200

Securities Authorized for Issuance under Equity Compensation Plans

                The following table provides information about shares of common stock available for future awards under all of the Company’s equity compensation plans as of December 31, 2008. The Company has not made grants of common stock outside of its equity compensation plans:

 

Number of securities to be

Number of securities

issued upon exercise of

Weighted-average exercise

remaining available for

outstanding options,

price of outstanding options

future issuance under

warrants and rights

warrants and rights

equity compensation plans (1)

Equity compensation
plans approved by
security holders

N/A

N/A

5,113,745

    
Equity compensation
plans not approved by
security holders

N/A

N/A

--

     
Total

--

--

5,113,745

 


 

(1)

Amount represents shares available for future issuance of grants under the Company's Stock Incentive Plan. The amount excludes forfeitures and shares purchased from employees to satisfy their tax withholding obligations for vested shares, which are held as treasury stock. There are no shares available for future issuance of grants under the ROI Unit Stock Plan. All shares under this plan have already granted.

 

 

26

ITEM 6. SELECTED FINANCIAL DATA

                The following tables set forth selected historical consolidated financial and other data of IBG LLC as of and for the years ended December 31, 2004, 2005, and 2006. The historical financial and other data of IBG, Inc. is presented for the years ended, and as of, December 31, 2007 and 2008.

 

On May 3, 2007, IBG, Inc. priced its initial public offering of shares of Common Stock. In connection with the IPO, IBG, Inc. purchased 10.0% of the membership interests in IBG LLC, became the sole member for IBG LLC and began to consolidate IBG LLC’s financial results into its financial statements. The consolidated statement of income data for the periods presented reflect the consolidated operating results of IBG LLC and its subsidiaries prior to May 4, 2007 and reflect the consolidated operating results of IBG, Inc. and its subsidiaries from May 4, 2007 through December 31, 2007. This represents 100% of the earnings prior to our IPO and actual earnings attributable to IBG, Inc. following the IPO. The consolidated statement of financial condition data as of December 31, 2006 reflects the audited condensed consolidated statement of financial condition of IBG LLC and its subsidiaries, and the consolidated statements of financial condition data as of December 31, 2007 and 2008 reflect the audited consolidated statement of financial condition of IBG, Inc. and its subsidiaries.

 

For all periods presented, IBG LLC has operated in the United States as a limited liability company that was treated as a partnership for U.S. federal income tax purposes. As a result, IBG LLC has not been subject to U.S. federal income taxes on its income; and historical results of operations prior to the IPO do not include Delaware franchise tax, minority interest, and federal and certain other state income taxes. Such items are included in periods subsequent to May 3, 2007.

 

                The following selected historical consolidated financial and other data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.

 

27

 

                                                                                            Year Ended December 31,
  2008  2007  2006  2005  2004 
                                                                               

 (in millions, except share and per share data)

Consolidated Statement of Income Data:    
Revenues:  
      Trading gains $  1,304.0 $  888.1 $  805.1 $  640.4 $  423.2
      Commissions and execution fees 359.5 261.1 174.4 132.1 112.0
      Interest income 437.2 782.2 672.1 273.2 79.5
      Other income 81.4 92.0 85.2 53.4 7.0
    
         Total revenues 2,182.1 2,023.4 1,736.8 1,099.1 621.7
    
      Interest expense 332.0 555.2 484.4 170.0 57.7
    
         Total net revenues 1,850.1 1,468.2 1,252.4 929.1 564.0
    
Non-interest expenses:        
      Execution and clearing 322.7 335.7 313.3 215.0 152.5
      Employee compensation and benefits 158.0 118.8 110.1 90.2 79.1
      Occupancy, depreciation and amortization 37.7 26.5 22.7 20.4 16.4
      Communications 18.7 14.9 12.6 10.4 9.0
      General and administrative 63.3 40.7 32.1 23.8 17.0
    
         Total non-interest expenses 600.4 536.6 490.8 359.8 274.0
    
Income before income taxes and minority interest $  1,249.7 $  931.6 $  761.6 $  569.3 $  290.0

 

ACTUAL: The following actual information relating to IBG LLC and IBG, Inc. is presented in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). See Note 4 to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K.

 

Actual 

Actual 

Actual

Actual

Actual

Income tax expense 128.4 63.0   27.4 33.8 19.6
Minority interest 1,028.3 568.1   0.0 0.0 0.0
        
Net income $  93.0 $  300.5   $  734.2 $  535.5 $  270.4
        
Earnings per share
          Basic $  2.30 $  1.20  
          Diluted $  2.24 $  1.16  
        
Weighted average common shares outstanding
          Basic 40,434,273 41,153,606  
          Diluted 399,905,060 401,327,844  

 

PRO FORMA: Certain pro forma information with respect to the periods described above is presented below. Information for the years ended December 31, 2007 and 2006 is presented as if we had been a public company for the entire period. For a full reconciliation between U.S. GAAP and pro forma presentations, see Part II, Item 8 “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.

 

                                                            

Actual

 Pro Forma

Pro Forma

 
Income tax expense (3),(4) 128.4 71.2 52.3
Minority interest (5) 1,028.3 794.4 658.5
    
Net income (2)(3) $  93.0 $  66.0 $  50.6
    
Earnings per share (1)(6)
          Basic $  2.30 $  1.64 $ 1.26  
          Diluted $  2.24 $  1.59 $ 1.22  
     
Weighted average common shares outstanding
          Basic 40,434,273  40,142,474  40,142,196 
          Diluted 399,905,060  401,317,190  401,317,851 

 

28


(1)

Pro forma earnings per share calculations (i) include the restricted shares of Common Stock that have been issued or are to be issued pursuant to the 2007 ROI Unit Stock Plan and (ii) issuance of restricted shares of Common Stock pursuant to the 2007 Stock Incentive Plan, but excludes shares of Common Stock that are issuable in the future pursuant to the 2007 Stock Incentive Plan.



(2)

Adjusted for Delaware franchise taxes that would have been payable, estimated at $0.165 million for the year ended December 31, 2006. Delaware franchise is already reflected in the actual amounts for the years ended December 31, 2007 and 2008.

 

(3)

The income tax adjustments of $25.2 million and $24.9 million for the years ended December 31, 2007 and 2006, respectively, represent the sum of the current income tax expense adjustment for this period and the deferred income tax expense adjustment for this period (referenced in footnote 4 below).

 

(4)

Additional deferred income tax expense will be $25.4 million annually, resulting from the straight-line amortization of the deferred tax asset of $380.8 million arising from the acquisition of the 10.0% member interest in IBG LLC (see footnote 3 above) over 15 years.

 

(5)

Adjusted for the approximate 89.7% interest in IBG LLC that IBG Holdings LLC holds arising from the Recapitalization and the IPO, including initial share issuances pursuant to employee equity incentive plans (see footnote 1 above). The adjustments are equal to approximately 89.7% of total net income for the periods presented.

 

(6)

Basic pro forma earnings per share are calculated based on 40.1 million shares of Common Stock and 100 shares of Class B common stock being outstanding, including 0.1 million shares issued pursuant to the 2007 Stock Incentive Plan. Diluted earnings per share are calculated based on an assumed purchase by us of all remaining IBG LLC membership interests held by IBG Holdings LLC and the issuance by us of 360 million shares of Common Stock, resulting in a total of 401.3 million shares deemed outstanding as of the beginning of each period. There is no impact on earnings per share for such purchase and issuance because 100% of net income before minority interest would be available to common stockholders as IBG Holdings LLC would no longer hold a minority interest, and the full difference between the book and tax basis of IBG LLC’s assets would also be available for reducing income tax expense. Therefore, the net income utilized to calculate diluted earnings per share would be $640 million and $491 million for the years ended December 31, 2007 and 2006, respectively.

 

Diluted weighted average common shares outstanding of 401.3 million shares also includes 1.2 million shares of Common Stock to be issued pursuant to the 2007 ROI Unit Stock Plan. Shares of Common Stock to be issued in connection with the 2007 Stock Incentive Plan have been excluded from diluted weighted average common shares outstanding because such shares are non-dilutive.

 

29

 

Year Ended December 31,

2008

2007 

2006 

2005 

 

2004 

(in millions)

Cash, cash equivalents and short-term investments (1) $6,651.4 $5,789.3 $3,878.8 $2,741.9 $1,844.5
Total assets (2), (3) 28,356.6 34,542.1 32,080.5 24,292.2 15,060.4
Total liabilities, excluding redeemable members'
          interests and minority interest (3) 23,948.6 30,968.3 29,278.6 22,118.0 13,261.9
Redeemable members' interests (4) - - 2,801.9 2,174.2 1,798.5
Minority interest 3,894.2 3,165.4
Stockholders' equity 513.9 408.4


(1)

Cash, cash equivalents and short-term investments represent cash and cash equivalents, cash and securities segregated under federal and other regulations, short-term investments, U.S. and foreign government obligations and securities purchased under agreements to resell.

 

(2)

At December 31, 2008, approximately $27.87 billion, or 98.3%, of total assets were considered to be liquid and consisted primarily of marketable securities.

 

(3)

As a result of our acquisition from IBG Holdings LLC of IBG LLC membership interests, we received not only an interest in IBG LLC but also, for federal income tax purposes, a step-up to the federal income tax basis of the assets of IBG LLC underlying such additional interest.  This increased tax basis is expected to result in tax benefits as a result of increased amortization deductions. We will retain 15% of the tax benefits actually realized.  As set forth in the tax receivable agreement we entered into with IBG Holdings LLC, we will pay the remaining 85% of the realized tax benefits relating to any applicable tax year to IBG Holdings LLC. The deferred tax asset was $351.6 million and $369.7 million and the corresponding payable to IBG Holdings LLC was $313.8 million and $323.7 million at December 31, 2008 and 2007, respectively.

 

(4)

Redeemable members’ interests represent member interests in IBG LLC that are entitled to share in the consolidated profits and losses of IBG LLC. IBG LLC is a private entity owned by the members holding such member interests. As a private company, such amounts were classified historically as members’ capital. For presentation purposes, IBG LLC has applied guidance within EITF D-98 which requires securities or equity interests of a company whose redemption is outside the control of the company to be classified outside of permanent capital in the statement of financial condition. The member interests in IBG LLC can be redeemed by the members at book value at their option. Because this redemption right is deemed to be outside the control of the company, IBG LLC has reclassified all members’ capital outside of permanent capital to redeemable members’ interests in the consolidated statement of financial condition. Such reclassification was made to comply with EITF D-98 and the requirements of Regulation S-X of the Exchange Act. Redeemable members’ interests include accumulated other comprehensive income.

 

30

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with the audited consolidated financial statements and the related notes in Item 8, 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 Part I, Item 1A of this Annual Report on Form 10-K.

 

Business Overview

 

We are an automated global electronic market maker and broker specializing in routing orders and executing and processing trades in securities, futures and foreign exchange instruments on more than 80 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 18 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.

 

In connection with the IPO priced on May 3, 2007, IBG, Inc. purchased 10.0% of the membership interests in IBG LLC, became the sole managing member of IBG LLC and began to consolidate IBG LLC’s financial results into its financial statements.

 

Overview of Recapitalization Transactions and Our Organizational Structure

 

Prior to the IPO, we had historically conducted our business through a limited liability company structure. Our primary assets are our ownership of approximately 10.4% of the membership interests of IBG LLC, the current holding company for our businesses, and our controlling interest and related contractual rights as the sole managing member of IBG LLC. The remaining approximately 89.6% of IBG LLC membership interests are held by IBG Holdings LLC, a holding company that is owned by our founder, Chairman and Chief Executive Officer, Thomas Peterffy, and his affiliates, management and other employees of IBG LLC, and certain other members. The IBG LLC membership interests held by IBG Holdings LLC will be subject to purchase by us over time in connection with offerings by us of shares of our common stock.

 

Business Segments

 

The Company reports its results in two business segments, market making and electronic brokerage. These segments are analyzed separately as we derive our revenues from these two principal business activities as well as allocate resources and assess performance.

 

 

Market Making. We conduct our market making business through our TH 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 approximately 577,000 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, thus 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.

 

 

Electronic Brokerage. We conduct our electronic brokerage business through our 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 and forex, traded on more than 80 exchanges and market centers and in 17 countries around the world seamlessly.

 

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Business Environment

 

As a global market maker and broker, our operations are significantly affected by economic conditions and trends in the world’s financial markets. Our results are influenced by several unpredictable, random elements.  This has the effect of creating an irregular earnings stream from one reporting period to the next. For example, our market making profits are materially driven by volatility and trading volumes, both of which behaved erratically during the year. Foreign currency markets were also very volatile which further contributed to this unpredictable earnings pattern.

 

Throughout 2008, we witnessed a series of extreme events that originated in the prior year within the financial markets and created a negative ripple effect across all sectors and geographic regions leading to a major economic downturn. The tightening of the credit markets that began in 2007 eventually led to the failure or restructuring of several major financial institutions, and a significant increase in federal governmental intervention and historical levels of volatility. We have been relatively unaffected by these events. We do not hold any mortgage derivatives or credit default swaps, nor do we trade over the counter instruments, all of which contributed to massive losses across the financial sector. With the exception of cash foreign exchange, we trade only exchange-listed instruments, which are highly liquid and have readily determinable values and cleared through central clearing houses.

 

We have managed to avoid the negative consequences of this market crisis, and in fact, our market making operations have benefited from extreme volatility, which reached historic levels in 2008, and elevated volume of trading, both of which fuel our trading gains. For much of the year, we also saw a reduction in competition by so called “high frequency traders” that utilize computerized algorithms to employ profit-making strategies. This form of competition tends to decline during times of extreme volatility, though the phenomenon is cyclical and we are likely to see it return to higher levels as markets stabilize.

 

Our brokerage business has benefited from recent events as well. The changing landscape amongst brokers and heightened concern by investors over financial safety has provided us with a unique opportunity to grow our customer base by highlighting our stability and conservative risk profile and acquiring displaced customers of failed brokerages.

 

Option volumes continued to rise throughout the first half of 2008. However, activity began to slow down when the market crisis escalated late in the year. According to data compiled by the FIA and based on data received from exchanges worldwide, volumes in exchange-listed equity-based options increased by approximately 21% globally and 25% in the U.S. during the year ended December 31, 2008, compared to the same period in 2007. This is a continuation of a trend we have observed over the past eight years, and we believe that as the “equity culture” spreads around the world, after a brief period of interruption, this trend is likely to continue. We have also observed a rise in certain types of options activity that are driven by non-trading strategies. One such strategy results in spikes in trading volume prior to ex-dividend dates that would appear to be overstating the exchange-reported volumes, especially in the United States. Such activity does not represent trades with which other market participants, including market makers and customers, can interact. We cannot estimate the impact this activity has on overall trading volumes.

 

In 2008, the SEC continued its rollout of the penny pricing pilot program which was introduced in February 2007. Options in this program trade in minimum price increments of one cent, rather than the five and ten cent increments quoted in other options classes. Overall, the results of this program have been favorable to our business, which we believe is a reflection of our ability to compete at narrower bid/offer spreads. Penny pricing was extended to 63 options classes by the end of 2008, which accounts for over 50% of U.S. options volume.

 

According to data compiled by the FIA and based on data received from exchanges worldwide, in 2008 we accounted for approximately 13.7% of the exchange-listed equity based options (including options in ETF's and stock index products) volume traded worldwide and approximately 16.5% of exchange-listed equity based options volume traded in the U.S. This compares to approximately 14.1% of the exchange-listed equity based options volume traded worldwide and approximately 18.3% of the exchange-listed equity based options volume traded in the U.S. in 2007.

 

Financial Overview

 

Diluted earnings per share were $2.24 for year ended December 31, 2008. The calculation of diluted earnings per share is detailed in Note 4, “Initial Public Offering and Recapitalization,” to the audited consolidated financial statements, in Part II, Item 8 of this Annual Report on Form 10-K. Pro forma diluted earnings per share, calculated as if the company had been public for the duration of the period, was $1.59 for the year ended December 31, 2007. The calculation of pro forma diluted earnings per share is detailed in Part II, Item 6, “Selected Financial Data” of this Annual Report on Form 10-K.

 

For the year ended December 31, 2008, our net revenues were $1,850.1 million and income before income taxes and minority interest was $1,249.7 million, compared to net revenues of $1,468.2 million and income before income taxes of $931.6 million for 2007. Trading gains increased 47% in 2008, compared to the same period last year and commissions and execution fees increased by 38% for the same time period, while net interest income decreased 54%. Our pre-tax margin for the year ended December 31, 2008 was 68%, compared to 63% for 2007.

 

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During the year ended December 31, 2008, income before income taxes in our market making segment increased 43%, compared with the same period in 2007. A healthy increase in trading gains was driven by a productive trading environment throughout most of the year when trading volumes and volatility in the markets presented our automated trading system with more opportunities to trade. Pre-tax margin increased to 76% in 2008 compared to 70% in 2007. Our strong capital position, which allows us to maintain more than $1 billion of excess regulatory capital, together with committed standby financing facilities, allowed us to make markets continuously during the period of constrained liquidity throughout the year.

 

During the year ended December 31, 2008, income before income taxes in our electronic brokerage segment grew 13% compared to the same period in 2007, reflecting higher revenues from commissions and execution fees. Pre-tax margin decreased from 47% to 44% in the same time periods. The increase in commissions and execution fees was related to strong growth in transaction volume and customer accounts. Total Daily Average Revenue Trades (“DARTs”) for cleared and execution-only customers increased 35% to 357,000 during the year ended December 31, 2008, compared to 265,000 during the year ended December 31, 2007.

 

Market making, by its nature, does not produce predictable earnings. Our results in any given period may be materially affected by volumes in the global financial markets, the level of competition and other factors. Electronic brokerage is more predictable, but it is dependent on customer activity, growth in customer accounts and assets, interest rates and other factors. For a further discussion of the factors, that may affect our future operating results, please see the description of risk factors in Part I, Item 1A of this Annual Report on Form 10-K.

 

   The following two tables present net revenues and income before income taxes for each of our business segments for the periods indicated.

 

 

Net revenues of each of our business segments and our total net revenues are summarized below:

 
   

Year Ended December 31,

 

2008

 

2007

 

2006

 
 

(in millions)

Market making   $  1,343.5 $  1,031.2 $ 954.7
Electronic brokerage   505.8 425.2 298.4
Corporate (1)   0.8 11.8 (0.7 )
    
Total  

$  1,850.1

$ 1,468.2 $ 1,252.4
 


(1)

Corporate includes corporate related activities as well as inter-segment eliminations.

 

 

 

Income before income taxes of each of our business segments and our total income before income taxes are summarized below:

 

 

Year Ended December 31,

 

2008

 

2007

  2006  
 

(in millions)

Market making   $  1,027.6 $  719.8 $  662.8
Electronic brokerage   224.0 197.9 98.6
Corporate (1)   (1.9 ) 13.9 0.2
    
Total   $  1,249.7 $  931.6 $  761.6
 


(1)

Corporate includes corporate related activities as well as inter-segment eliminations.

 

Revenue

 

 

Trading Gains

 

           Our revenue base is comprised largely of trading gains generated in the normal course of market making. Trading revenues are, in general, proportional to the trading activity in the markets. Our revenue base is highly diversified and comprised of millions of relatively small individual trades of various financial products traded on electronic exchanges, primarily stocks, options and futures. Trading gains accounted for approximately 60%, 44% and 46% of our total revenues for the years ended December 31, 2008, 2007 and 2006, respectively. Trading gains also include translation gains and losses on cash and positions in foreign currency held primarily by our foreign market making subsidiaries as well as revenues from net dividends. Market making activities require us to hold a substantial inventory of equity securities. We derive significant revenues in the form of dividend income from these equity securities. This dividend income is largely offset by dividend expense incurred when we make significant payments in lieu of dividends on short positions in

 

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securities in our portfolio. 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 the stock after the dividend date. Hence, the apparent gains and losses due to these price changes must be taken together with the dividends paid and received, respectively, in order to accurately reflect the results of our market making operations.

 

As a result of the way we have integrated our market making and securities lending systems, our trading gains and our net interest income from the market making segment 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.

 

  Our trading gains are geographically diversified. In 2008, 2007 and 2006, we generated 53%, 41% and 25%, respectively, of our trading gains from operations conducted internationally.

 

 

Commissions and Execution Fees

 

             We earn commissions and execution fees from our cleared customers for whom we act as executing and clearing brokers and from our non-cleared customers for whom we act as an executing broker only. We have a commission structure that allows customers to choose between an all-inclusive “bundled” rate or an “unbundled” rate that has lower commissions for high volume customers. For “unbundled” commissions, we charge regulatory and exchange fees, at our cost, separately from our commissions, adding transparency to our fee structure. Commissions and execution fees accounted for 16%, 13% and 10% of our total revenues for the years ended December 31, 2008, 2007 and 2006, respectively.

 

  Our commissions and execution fees are geographically diversified. In 2008, 2007 and 2006 we generated 23%, 29% and 30%, respectively of commissions and execution fees from operations conducted internationally.

 

 

Interest Income and Interest Expense

 

           We earn interest on customer funds segregated in safekeeping accounts; on customer borrowings on margin, secured by marketable securities these customers hold with us; from our investment in government treasury securities; from borrowing securities in the general course of our market making and brokerage activities, and on bank balances. Interest income accounted for 20%, 39% and 39% of total revenues for the years ended December 31, 2008, 2007 and 2006, respectively. Interest income is partially offset by interest expense.

 

           We pay interest on cash balances customers hold with us; for cash received from lending securities in the general course of our market making and brokerage activities; and on our borrowings. Interest expense was 15%, 27% and 28% of total revenues for the years ended December 31, 2008, 2007 and 2006, respectively.

 

  We have automated and integrated our securities lending system with our trading system. As a result, we have been able to tailor our securities lending activity to produce more optimal results when taken together with trading gains (see description under “Trading Gains” above). Our net interest income accounted for approximately 6%, 15% and 15% of our total net revenues for the years ended December 31, 2008, 2007 and 2006, respectively.

 

 

Other Income

 

            Other income consists primarily of payment for order flow income, mark-to-market gains on non-traded securities (primarily investments in exchanges) and market data fee income. Our other income accounted for approximately 4%, 5% and 5% of our total revenues for each of the years ended December 31, 2008, 2007 and 2006, respectively.

 

Costs and Expenses

 

 

Execution and Clearing Expenses

 

             Our largest single expense category is execution and clearing expenses, which includes the costs of executing and clearing our market making and electronic brokerage trades, as well as other direct expenses, including payment for order flow, regulatory fees and market data fees. Execution fees are paid primarily to electronic exchanges and market centers on which we trade. Clearing fees are paid to clearing houses and clearing agents. Payments for order flow are made as part of exchange-mandated programs and to otherwise attract order volume to our system. Market data fees are fees that we must pay to third parties to receive streaming quotes and related information.

 

 

Employee Compensation and Benefits

 

                Employee compensation and benefits includes salaries, bonuses, group insurance, contributions to benefit programs and other related employee costs.

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Occupancy, Depreciation and Amortization

 

            Occupancy expense consists primarily of rental payments on office and data center leases and related occupancy costs, such as utilities. Depreciation and amortization expense results from the depreciation of fixed assets such as computing and communications hardware as well as amortization of leasehold improvements and capitalized in-house software development.

 

 

Communications

 

            Communications expense consists primarily of the cost of voice and data telecommunications lines supporting our business including connectivity to exchanges around the world.

 

 

General and Administrative

 

            Expenses in this category are primarily incurred for professional services, such as legal and audit work, and other operating expenses such as advertising and exchange membership lease expenses. As a public company since May 4, 2007, we are incurring additional costs for external services such as legal, accounting and auditing.

 

 

Income Tax Expense

 

            Historically, our business was operated through a limited liability company that was not subject to U.S. federal and certain state income taxes; our income tax expense consisted primarily of corporate subsidiary taxes, and our net income did not reflect cash distributions to IBG LLC’s members to pay their taxes related to their proportionate shares of our net income. Those distributions reduced IBG LLC’s members’ capital. After the IPO, we became subject to taxes applicable to “C” corporations. As a corporation, we are required to pay U.S. federal, state and local income taxes on our taxable income, which is proportional to the percentage of IBG LLC owned by IBG. Our subsidiaries will continue to be subject to income tax in the respective jurisdictions in which they operate.

 

Minority Interest

 

             We are the sole managing member of IBG LLC and, as such, operate and control all of the business and affairs of IBG LLC and its subsidiaries and consolidate IBG LLC’s financial results into our financial statements. We hold approximately 10.4% ownership interest in IBG LLC. IBG Holdings LLC is owned by the original members of IBG LLC and holds approximately 89.6% ownership interest in IBG LLC. We reflect IBG Holdings LLC’s ownership as a minority interest in our statement of financial condition and statement of income. Our historical results are those of IBG LLC, as our predecessor company. As a result, our net income, after excluding IBG Holdings LLC’s minority interest, represents approximately 10.4% of IBG LLC’s net income and similarly, outstanding shares of our common stock represent approximately 10.4% of the outstanding membership interests of IBG LLC.

 

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 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.

 

 

There has been increased scrutiny of equity and option market makers, hedge funds and soft dollar practices by the regulatory and legislative authorities. New legislation or modifications to existing regulations and rules could occur in the future.

 

 

There has been consolidation among market centers over the past few years, which 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.

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             See “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K 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. Historical results of operations are reported as a limited liability company until the IPO and do not include Delaware franchise tax, minority interest, and federal and certain state income taxes. Such items are included in subsequent periods. Therefore the historical results for periods prior to the IPO and subsequent thereto are not comparable. For a pro forma comparison calculated as if the Company had been a public company for the duration of each year ending December 31, 2006 and 2007 see Part I, Item 6 “Selected Financial Data,” of this Annual Report on Form 10-K.

 

The following table sets forth our consolidated results of operations for the indicated periods:

 

Year Ended December 31,

2008 

2007 

2006 

(in millions)

Revenues:    
          Trading gains $  1,304.0 $  888.1 $  805.1
          Commissions and execution fees 359.5 261.1 174.4
          Interest income 437.2 782.2 672.1
          Other income 81.4 92.0 85.2
   
                 Total revenues 2,182.1 2,023.4 1,736.8
   
          Interest expense 332.0 555.2 484.4
   
                 Total net revenues 1,850.1 1,468.2 1,252.4
   
Non-interest expenses:  
          Execution and clearing 322.7 335.7 313.3
          Employee compensation and benefits 158.0 118.8 110.1
          Occupancy, depreciation and amortization 37.7 26.5 22.7
          Communications 18.7 14.9 12.6
          General and administrative 63.3 40.7 32.1
   
                 Total non-interest expenses 600.4 536.6 490.8
   
Income before income taxes and minority interest 1,249.7 931.6 761.6
   
Income tax expense 128.4 63.0 27.4
Minority interest 1,028.3 568.1 0.0
   
Net income (1) $  93.0 $  300.5 $  734.2
 


 

(1)

For calculation of 2007 net income see Note 4 to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K. For pro forma comparison calculated as if the company had been public for the duration of each year ending December 31, 2006 and 2007 see Part I, Item 6 “Selected Financial Data,” of this Annual Report on Form 10-K.

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The following table sets forth our consolidated results of operations as a percent of our total revenues for the indicated periods:

 

Year Ended December 31,

2008 

2007 

2006 

Revenues:
          Trading gains 59.8% 43.9% 46.4%
          Commissions and execution fees 16.5% 12.9% 10.0%
          Interest income 20.0% 38.7% 38.7%
          Other income 3.7% 4.5% 4.9%
   
                 Total revenues 100.0% 100.0% 100.0%
   
          Interest expense 15.2% 27.4% 27.9%
  
                 Total net revenues 84.8% 72.6% 72.1%
  
Non-interest expenses:      
          Execution and clearing 14.8% 16.6% 18.0%
          Employee compensation and benefits 7.2% 5.9% 6.3%
          Occupancy, depreciation and amortization 1.7% 1.3% 1.3%
          Communications 0.9% 0.7% 0.8%
          General and administrative 2.9% 2.0% 1.9%
   
                 Total non-interest expenses 27.5% 26.5% 28.3%
   
Income before income taxes and minority interest 57.3% 46.0% 43.8%
   
Income tax expense 5.9% 3.1% 1.6%
Minority interest 47.1% 28.1% 0.0%
   
Net income 4.3% 14.9% 42.2%

 

Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007

Net Revenues

Total net revenues for the year ended December 31, 2008 increased $381.9 million, or 26%, to $1,850.1 million from $1,468.2 million, during the year ended December 31, 2007. Trading volume is one of the most important drivers of revenues and costs for both our market making and electronic brokerage segments. Based on data published by the FIA and options exchanges worldwide, global equity options volume 2008 increased approximately 21%, compared to 2007. For the year ended December 31, 2008, options contracts executed by our subsidiaries increased by 111.4 million, or 17%, to 784.5 million contracts from 673.1 million contracts for the year ended December 31, 2007.

Trading Gains. Trading gains for the year ended December 31, 2008 increased $415.9 million, or 47%, to $1,304.0 million from $888.1 million for the year ended December 31, 2007. As market makers, we provide liquidity by buying from sellers and selling to buyers. During 2008, our market making operations executed 101.7 million trades, an increase of 3% compared to the number of trades executed in the year ended December 31, 2007. Market making options contract volume in the year ended December 31, 2008 increased by 21% from the same period in 2007.

Included in trading gains are net dividends and currency translation gains and losses from market making activities. As stated above, 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, in order to accurately reflect the results of our market making operations. As part of managing our overall exposure to foreign currency fluctuations, we maintain a portion of our capital in foreign currencies. Translation gains of $31.6 million were recognized in the year ended December 31, 2008, on foreign currency balances held by our subsidiaries, compared to translation gains of $43.3 million for the year ended December 31, 2007. A discussion of our approach to managing foreign currency exposure is contained in Part II, Item 7A of this Annual Report on Form 10-K entitled “Quantitative and Qualitative Disclosures about Market Risk.”

Commissions and Execution Fees. Commissions and execution fees for the year ended December 31, 2008 increased $98.4 million, or 38%, to $359.5 million, as compared to the year ended December 31, 2007. This increase was primarily due to higher customer trading volume on an expanded customer base. Total DARTs for cleared and execution-only customers for the year ended December 31, 2008 increased 35% to 357,000, compared to 265,000 during the year ended December 31, 2007. DARTs for cleared

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customers, i.e., customers for whom we execute trades as well as clear and carry positions, increased 46% to approximately 316,000, for the year ended December 31, 2008, compared to approximately 217,000 for the year ended December 31, 2007.The number of customer accounts grew by 17% to approximately 111,000 at December 31, 2008, compared to approximately 95,000 at December 31, 2007. Average commission per DART for cleared customers, for the year ended December 31, 2008, decreased by $0.40, or 9%, to $4.17, as compared to $4.57 for the year ended December 31, 2007, primarily due to smaller order size which is typical in fast moving markets.

Interest Income and Interest Expense. Net interest income (interest income less interest expense) for the year ended December 31, 2008 decreased $121.8 million, or 54%, to $105.2 million, as compared to the year ended December 31, 2007. Net interest income from market making, which accounted for 36% of total net interest income, contracted to $37.5 million, a decrease of 75% from the same period last year. 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. The relative interest rates during 2008 resulted in a mix of positions that produced more trading income and less interest income. In addition, average securities borrowed decreased by 34%, to $5.72 billion and average securities loaned decreased by 53%, to $2.63 billion, for the year ended December 31, 2008, as market making positions contracted. Customer cash balances decreased by 9%, to $6.93 billion, end-of-period, and customer fully secured margin borrowings decreased 19%, to $1.55 billion, end-of-period, at December 31, 2008, as compared to $7.63 billion and $1.91 billion, end-of-period, respectively, at December 31, 2007. Lower interest rates have had a negative effect on the net interest income we earned on small customer cash balances. The average Fed Funds effective rate dropped 310 basis points to 1.92% for the year ended December 31, 2008 as compared to 5.02% for the year ended December 31, 2007. Net interest earned in electronic brokerage decreased $7.6 million, or 9%, to $76.1 million, as compared to the year ended December 31, 2007.

 

Other Income. Other income, for the year ended December 31, 2008, decreased $10.6 million, or 12%, to $81.4 million, as compared to the year ended December 31, 2007. This decrease was primarily attributable to a $13.0 million decrease in payment for order flow income received by our brokerage unit, primarily due to the options penny pricing program which was introduced in February 2007 and extended to 63 options classes in March 2008 and a $10.0 million write down in our equity investment in W.R. Hambrecht + Co. Inc. These were offset by a $7.6 million increase in rebates from market centers for liquidity provided by our U.S. market making unit and a $5.0 million increase in market data fee income.

Non-Interest Expenses

Non-interest expenses, for the year ended December 31, 2008, increased by $63.8 million, or 12%, to $600.4 million from $536.6 million, during the year ended December 31, 2007. Execution and clearing expenses made up 54% and employee compensation and benefits were 26% of non-interest expenses. As a percentage of total net revenues, non-interest expenses declined to 32% for the year ended December 31, 2008 from 37% during the same period in 2007.

Execution and Clearing.  Execution and clearing expenses, for the year ended December 31, 2008, decreased $13.0 million, or 4%, to $322.7 million, as compared to the year ended December 31, 2007. Execution and clearing expenses, outside of payment for order flow expenses, increased by $10.4 million, or 4%, to $306.3 million primarily due to increased trading volume across the markets in which the Group and its customers traded. Payments to order flow customers, a component of execution and clearing costs, for the year ended December 31, 2008, decreased by $23.4 million, or 59%, to $16.4 million, as compared to the year ended December 31, 2007. The decrease was attributable to discontinued servicing, which began at the end of the second quarter in 2007, of certain non-cleared broker-dealer customers who received payment for order flow, and had a positive impact on our operating margins in the year ended December 31, 2008.  Payment for order flow expense was partially offset by payment for order flow revenue received from U.S. options exchanges, as described above under “Net Revenues—Other Income.”

Employee Compensation and Benefits. Employee compensation and benefits expenses, for the year ended December 31, 2008, increased by $39.2 million, or 33%, to $158.0 million, as compared to the year ended December 31, 2007. This increase reflected the continued phase-in of expenses related to our employee stock incentive plan and the 24% growth in the average number of employees to 750 at December 31, 2008, as compared to 675 at December 31, 2007. 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 9% and 8%, for the years ended December 31, 2008 and 2007, respectively.

Occupancy, Depreciation and Amortization. Occupancy, depreciation and amortization expenses increased $11.2 million, or 42%, to $37.7 million for the year ended December 31, 2008 from $26.5 million for the year ended December 31, 2007 primarily due to increased expenses for additional office and data center space and additional amortization of assets related to our acquisition of Future Trade Technologies at the end of 2007. As a percentage of total net revenues, occupancy, depreciation and amortization expenses were 2% for each of the years ended December 31, 2008 and 2007.

 

Communications. Communications expenses increased $3.8 million, or 26%, to $18.7 million for the year ended December 31, 2008 from $14.9 million for the year ended December 31, 2007. This increase was driven by additional telecommunications bandwidth

 

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required to support increased trading volume at electronic exchanges and the expansion in the number of markets in which IBG LLC operates. As a percentage of total net revenues, communications expenses were 1% for each of the years ended December 31, 2008 and 2007.

 

General and Administrative. General and administrative expenses, for the year ended December 31, 2008, increased $22.6 million, or 56%, to $63.3 million, as compared to the year ended December 31, 2007, primarily attributable to an increase in bad debt expense of approximately $14.1 million related uncollectable customer losses related to corporate action processing, trading errors and software errors, in addition to increases in advertising expenditures.

 

Income Tax Expense. IBG LLC historically operated in the United States as a limited liability company that was treated as a partnership for U.S. federal income tax purposes. Accordingly, IBG LLC’s income was not subject to U.S. federal income taxes. Subsequent to the IPO in May 2007, income taxes have been provided for our proportionate share of IBG LLC’s income that is subject to federal and state income taxes. As a result, income tax expense increased $57.2 million, or 80%, to $128.4 million for the year ended December 31, 2008, as compared to $71.2 million on a pro forma basis for the year ended December 31, 2007.

 

Net Income. Net income for the year ended December 31, 2008 was $93.0 million. Net income excluding the adjustment for minority interest increased $260.9 million or 30% to $1,121.3 million for the year ended December 31, 2008, as compared to $860.4 million on a pro forma basis for the year ended December 31, 2007. Net income excluding the adjustment for minority interest as a percentage of net revenues was 61% and 59% for the years ended December 31, 2008 and 2007, respectively.

 

Year Ended December 31, 2007 Compared to the Year Ended December 31, 2006

 

Net Revenues

 

Total net revenues increased $215.8 million, or 17%, to $1,468.2 million for the year ended December 31, 2007 from $1,252.4 million for the year ended December 31, 2006. Trading volume is the most important driver of revenues and costs for both our market making and electronic brokerage segments. Based on data published by the FIA and options exchanges worldwide, global equity options volume increased by approximately 36.4%, as compared to 2006. For the year ended December 31, 2007, equity option contracts executed by our subsidiaries increased by 109.5 million, or 19%, to 673.1 million contracts from 563.6 million contracts for the year ended December 31, 2006.

 

Trading Gains. Trading gains increased $83.0 million, or 10%, to $888.1 million for the year ended December 31, 2007 from $805.1 million for the year ended December 31, 2006. During the year ended December 31, 2007, our market making operations executed 99.1 million trades, a 50% increase over the 66.0 million trades executed during the year ended December 31, 2006. The second half of the year was marked by high market volumes combined with high volatility, which allowed us to leverage our automated trading systems. In contrast, trading gains during the first half of the year were negatively affected by an unusual, non-recurring loss and by unexpectedly heavy options activity in advance of certain corporate announcements. The latter has a negative impact because, when we trade with others who have different information than we do, we may accumulate unfavorable positions preceding large price movements in the stocks of companies that announce corporate actions.

 

                We maintain a portion of our capital in foreign currencies. In the second half of 2007, we observed broad based gains in the value of foreign currencies measured in U.S. dollars. Translation gains of $43.3 million were recognized in the year ended December 31, 2007 on foreign currency balances held primarily by our European subsidiaries, compared to translation losses of $47.1 million, for the year ended December 31, 2006. A discussion of our approach to managing foreign currency exposure is contained in Part II, Item 7A of this Annual Report on Form 10-K entitled “Quantitative and Qualitative Disclosures about Market Risk.”

 

Commissions and Execution Fees. Commissions and execution fees increased $86.7 million, or 50%, to $261.1 million for the year ended December 31, 2007, as compared to $174.4 million for the year ended December 31, 2006. This increase was primarily due to higher customer trading volume on an expanded customer base. Total DARTs for cleared and execution-only customers increased 35%, to 265,000 during the year ended December 31, 2007, compared to 196,000 during the year ended December 31, 2006. DARTs for cleared customers, a subset that refers to those customers for whom we execute trades as well as clear and carry positions, increased 38% to 217,000, during the year ended December 31, 2007, compared to 157,000 during the year ended December 31, 2006.The number of customer accounts grew by 24% to approximately 95,000 at December 31, 2007, compared to approximately 77,000 at December 31, 2006. Average commission per DART for cleared customers increased by $0.32, or 8%, to $4.57 for the year ended December 31, 2007, as compared to $4.25 for the year ended December 31, 2006, primarily due to larger average trades from our cleared customers.

 

Interest Income and Interest Expense. Net interest income increased $39.3 million, or 21%, to $227.0 million for the year ended December 31, 2007, as compared to the year ended December 31, 2006. Growth in net interest income was primarily attributable to higher net interest from securities lending and increases in net customer cash and margin balances in addition to a higher capital base in the business. Net interest income from market making, which accounted for 65% of total net interest income, grew to $148.2 million during the year ended December 31, 2007, an increase of 15% for the year ended December 31, 2006. This was driven by the continuing integration of our market making systems with our securities lending systems, which allow us to maintain a profitable interest rate spread despite reduced positions. Average securities borrowed decreased by 18%, to $8.70 billion, and average securities

 

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loaned decreased 29%, to $5.56 billion, for the year ended December 31, 2007. These decreases reflect a reduction in stock positions held by our market making units and the increase in our equity capital, which reduced the need to finance positions through securities lending. Customer cash balances increased by 96%, to $7.63 billion, and customer fully secured margin borrowings increased 125%, to $1.91 billion, at December 31, 2007, as compared to $3.90 billion and $0.85 billion, respectively, at December 31, 2006. Customer cash balances at December 31, 2007 include approximately $0.86 billion from director and officer account balances. In the third quarter, due to credit tightening in the market, the differential between the U.S. dollar LIBOR and Fed Funds interest rates widened. On September 1, 2007 we changed our benchmark interest rate for interest on U.S. dollar customer balances from the overnight U.S. dollar LIBOR rate to the Fed Funds effective rate in order to better match rates paid to customers with rates earned on our investments of customer funds. We also shortened the target maturity on our investments of customer funds for this purpose. Net interest earned from customers’ cash balances and fully secured margin balances for the year ended December 31, 2007 increased $29.8 million, or 55%, to $83.7 million, as compared to the same period in 2006.

 

Other Income. Other income for the year ended December 31, 2007 increased $6.8 million, or 8%, to $92.0 million as compared to the year ended December 31, 2006. The increase was primarily attributable to a $3.7 million increase in rebates from market centers for liquidity provided by our U.S. market making unit. Increases in market data fee income and payment for order flow income, which grew $3.5 million and $1.5 million, respectively, also contributed to the increase. These increases were partially offset by a $3.0 million decrease in mark-to-market gains on non-trading securities, which primarily represents investments in exchanges. Payment for order flow income was partially offset by payment for order flow expense to our customers, as described below under “Non-Interest Expenses—Execution and Clearing.”

 

Non-Interest Expenses

 

Non-interest expenses increased by $45.8 million, or 9%, to $536.6 million for the year ended December 31, 2007, from $490.8 million during the year ended December 31, 2006. Execution and clearing expenses comprised 63% and employee compensation and benefits were 22% of non-interest expenses. As a percentage of total net revenues, non-interest expenses fell to 37% for the year ended December 31, 2007 from 39% for the same period in 2006.

 

Execution and Clearing.  Execution and clearing expenses increased $22.4 million, or 7%, to $335.7 million for the year ended December 31, 2007, as compared to $313.3 million in the year ended December 31, 2006, attributable to increases in trading volume. Payments for order flow, a component of execution and clearing costs decreased $14.4 million, or 27%, to $39.8 million for the year ended December 31, 2007, as compared to the year ended December 31, 2006.  The decrease was attributable to discontinued servicing, which took place at the end of the second quarter, of certain non-cleared institutional customers who received payment for order flow. This had a positive impact on our operating margins in the year ended December 31, 2007.  Payment for order flow expense was offset by payment for order flow revenue received from U.S. options exchanges, as described above under “Net Revenues—Other Income.”

 

Employee Compensation and Benefits. Employee compensation and benefits expenses increased by $8.7 million, or 8%, to $118.8 million for the year ended December 31, 2007, as compared to $110.1 million, for the year ended December 31, 2006. This increase was primarily due to a 15% growth in the number of employees to 609 at December 31, 2007 (excluding employees of FutureTrade Technologies, LLC) from 532 as of December 31, 2006, and increased employee benefits costs. Following our acquisition of FutureTrade Technologies, LLC in December 2007, our total staff count increased by 66, which had little impact on our compensation expenses for the year ended December 31, 2007. 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 8% and 9% for the years ended December 31, 2007 and 2006, respectively.

 

Occupancy, Depreciation and Amortization. Occupancy, depreciation and amortization expenses increased $3.8 million, or 17%, to $26.5 million for the year ended December 31, 2007 from $22.7 million for the year ended December 31, 2006 primarily due to increased office rent expenses for additional office space. As a percentage of total net revenues, occupancy, depreciation and amortization expenses were 2% for each of the years ended December 31, 2007 and 2006.

 

Communications. Communications expenses increased $2.3 million, or 18%, to $14.9 million for the year ended December 31, 2007 from $12.6 million for the year ended December 31, 2006. This increase was driven by additional telecommunications bandwidth required to support increased trading volume at electronic exchanges and the expansion in the number of markets in which IBG LLC operates. As a percentage of total net revenues, communications expenses were 1% for each of the years ended December 31, 2007 and 2006.

 

General and Administrative. General and administrative expenses increased $8.6 million, or 27% to $40.7 million for the year ended December 31, 2007 as compared to $32.1 million for the year ended December 31, 2006, primarily attributable to increased professional fees related to our IPO and public company status.

 

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Income Tax Expense. IBG LLC historically operated in the United States as a limited liability company that was treated as a partnership for U.S. federal income tax purposes. Accordingly, IBG LLC’s income was not subject to U.S. federal income taxes. Subsequent to the IPO, income taxes have been provided for our proportionate share of the IBG LLC’s income that is subject to federal and state income taxes. As a result, income tax expense increased $35.6 million, or 130%, to $63.0 million for the year ended December 31, 2007, as compared to $27.4 million for the year ended December 31, 2006.

 

Net Income. Net income for the year ended December 31, 2007 was $300.5 million. This represents 100% of the earnings prior to our IPO and actual earnings attributable to IBG, Inc. following the IPO. As a result of our IPO, we recognized $568.1 million in minority interest expense in 2007. Net income excluding the adjustment for minority interest increased $134.4 million or 18% to $868.6 million for the year ended December 31, 2007, as compared to $734.2 million for the year ended December 31, 2006. Net income excluding the adjustment for minority interest as a percentage of net revenues was 59% for each of the years ended December 31, 2007 and 2006.

 

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Supplemental Information

 

The following tables present historical trading volumes for our business. However, volumes are not the only 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 
2004 41,506  28,876  2,932  73,314  290 
2005 54,044  30% 34,800  21% 7,380  152% 96,224  31% 382 
2006 66,043  22% 51,238  47% 12,828  74% 130,109  35% 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 

 

CONTRACT AND SHARE VOLUMES:

(in 000’s, except %)

TOTAL

 

Options  Futures*  Stocks 

Period

(contracts)  Change  (contracts)  Change  (shares)  Change 
2004 269,715    37,748    17,487,528   
2005 409,794  52% 44,560  18% 21,925,120  25%
2006 563,623  38% 62,419  40% 34,493,410  57%
2007 673,144  19% 83,134  33% 47,324,798  37%
2008 784,497  17% 108,984  31% 55,845,428  18%

 

MARKET MAKING

 

 

Options 

Futures* 

%

Stocks 

Period

(contracts) 

Change  

(contracts) 

Change

(shares) 

Change 

2004 236,569    10,511  12,600,280   
2005 308,613  30% 11,551  10% 15,625,801  24%
2006 371,929  21% 14,818  28% 21,180,377  36%
2007 447,905  20% 14,520  -2% 24,558,314  16%
2008 541,394  21% 21,544  48% 26,008,433  6%

 

BROKERAGE TOTAL

 

Options  Futures*  Stocks 

Period 

(contracts) Change   (contracts)  Change  (shares)  Change 
2004 33,146    27,237    4,887,247   
2005 101,181  205% 33,009  21% 6,299,319  29%
2006 191,694  89% 47,601  44% 13,313,033  111%
2007 225,239  17% 68,614  44% 22,766,484  71%
2008 243,103  8% 87,440  27% 29,836,995  31%

 

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BROKERAGE CLEARED

 

Options  Futures*  Stocks  % 
Period  (contracts) Change   (contracts)  Change  (shares)  Change 
2004 16,438  24,118    4,339,462   
2005 23,456  43% 30,646  27% 5,690,308  31%
2006 32,384  38% 45,351  48% 12,492,870  120%
2007 51,586  59% 66,278  46% 20,353,584  63%
2008 77,207  50% 85,599  29% 26,334,752  29%
 


* Includes options on futures

 

BROKERAGE STATISTICS:

(in 000’s, except % and where noted)

 

4Q2008  4Q2007  % Change
Total Accounts 111  95  17%
Customer Equity (in billions) * $  8.9  $  8.8  1%
   
Cleared DARTs 340  259  31%
Total Customer DARTs 372  307  21%
   
(in $'s, except DART per account)    
   
Commission per DART $  3.86  $  4.27 
DART per Avg. Account (Annualized) 789  701 
Net Revenue per Avg. Account (Annualized) $  3,939  $  4,386 
 


* Excluding Non-Customers (i.e., officers, directors and affiliated parties)

 

Business Segments

 

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.

 

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Market Making

 

The following table sets forth the results of our market making operations for the indicated periods:

 

Year Ended December 31,

2008 

2007 

2006 

(in millions)

Revenues:  
          Trading gains $  1,277.0 $  865.9 $  807.7
          Interest income 244.6 485.4 508.2
          Other income 29.0 17.1 18.6
    
                 Total revenues 1,550.6 1,368.4 1,334.5
   
          Interest expense 207.1 337.2 379.8
    
                 Total net revenues 1,343.5 1,031.2 954.7
    
Non-interest expenses:    
          Execution and clearing 195.3 211.7 198.1
          Employee compensation and benefits 59.8 47.6 47.3
          Occupancy, depreciation and amortization 9.6 11.3 10.6
          Communications 10.5 7.7 6.6
          General and administrative 40.7 33.1 29.3
    
                 Total non-interest expenses 315.9 311.4 291.9
    
Income before income taxes 1,027.6 719.8 662.8
    
Income tax expense 101.0 43.1 24.9
    
Net income $  926.6 $  676.7 $  637.9

 

Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007

Market making total net revenues for the year ended December 31, 2008 increased $312.3 million, or 30%, to $1,343.5 million, from $1,031.2 million during the year ended December 31, 2007. Trading gains for the year ended December 31, 2008 increased $411.1 million, or 47%, primarily due to increased market volumes and high actual volatility in market prices relative to implied volatility in options prices in the first and third quarter of 2008. Market making options contract volume in the year ended December 31, 2008 increased by 21% from the same period in 2007, driven by favorable market conditions. Trading gains also include translation gains and losses. Translation losses, for the year ended December 31, 2008, were $18.9 million, as compared to translation gains of $32.0 million, for the year ended December 31, 2007. Net interest income, for the year ended December 31, 2008, decreased by $110.7 million, or 75%. As described above, our trading income and our net interest income are interchangeable and depend on the mix of market making positions in our portfolio and on the relative interest rates in the stock and options markets. In 2008 these factors produced more trading income and less interest income.

Market making non-interest expenses for the year ended December 31, 2008 increased $4.5 million, or 1%, as compared to the year ended December 31, 2007. This small change resulted from a $16.4 million decrease in execution and clearing costs offset by a $12.2 million increase in employee compensation and benefits expenses and a $7.6 million increase in general and administrative expenses. The 8% decrease in execution and clearing expenses reflects the reduction in exchange mandated payment for order flow program costs as more options are traded in pennies. In addition, greater options volume was executed on U.S. option exchanges that use the make-or-take model, where as a market maker we are paid for providing liquidity instead of paying exchange fees. As a percentage of total net revenues, market making non-interest expenses decreased to 24% from 30% for the years ended December 31, 2008 and 2007, respectively.

Market making income before income taxes increased $307.8 million, or 43%, to $1,027.6 million for the year ended December 31, 2008 from $719.8 million for the year ended December 31, 2007. As a percentage of total net revenues for the market making segment, income before income taxes were 76% and 70% for the years ended December 31, 2008 and 2006, respectively.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

 

Market making total net revenues increased $76.5 million, or 8%, to $1,031.2 million for the year ended December 31, 2007, from $954.7 million during the year ended December 31, 2006. Trading gains during the year ended December 31, 2007 increased $58.2 million, or 7% from the year ended December 31, 2006. Heavy options activity in advance of certain corporate announcements and an unusual, non-recurring loss of approximately $37 million in the second quarter marked the first half of the year. During the second half of the year, we observed a period of high volume and robust volatility, which is generally a productive environment for our

 

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market making business and tight liquidity conditions in the market, which allowed us to take advantage of our strong capital position in managing both our working capital and our regulatory capital needs. During the year ended December 31, 2007, we executed 99.1 million trades compared to 66.0 million trades, for the year ended December 31, 2006; however, market making options contracts grew by a comparatively smaller 20%, to 447.9 million contracts, from 371.9 million contracts. Translation gains and losses fluctuate with exchange rates and with changes in the composition of our trading assets and liabilities. Translation gains for the year ended December 31, 2007 were $32.0 million, as compared to translation losses of $45.5 million for the year ended December 31, 2006. A discussion of our approach to managing foreign currency exposure is contained in Part II, Item 7A of this Annual Report on Form 10-K entitled “Quantitative and Qualitative Disclosures about Market Risk.” Net interest income increased $19.8 million, or 15%, to $148.2 million for the year ended December 31, 2007, primarily attributable to increased securities lending profitability resulting from the continuing integration of our securities lending system with our trading system.

 

Market making non-interest expenses for the year ended December 31, 2007 increased $19.5 million, or 7%, to $311.4 million as compared to $291.9 million for the year ended December 31, 2006. Of this increase, $13.6 million consisted of higher execution and clearing expenses, an increase of 7%, over the year ended December 31, 2006, reflecting higher trading volume in 2007. As a percentage of total net revenues, market making non-interest expenses were 30% and 31% for the years ended December 31, 2007 and 2006, respectively.

 

Market making income before income taxes increased $57.0 million, or 8.6%, to $719.8 million for the year ended December 31, 2007 from $662.8 million for the year ended December 31, 2006. As a percentage of total net revenues for the market making segment, income before income taxes were 70% and 69% for the years ended December 31, 2007 and 2006, respectively.

 

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Electronic Brokerage

 

The following table sets forth the results of our electronic brokerage operations for the indicated periods:

 

Year Ended December 31,

2008 

2007 

2006 

(in millions)

Revenues:  
          Commissions and execution fees $  359.5 $  261.1 $  174.5
          Interest income 206.4 310.7 167.3
          Other income 70.2 80.4 70.0
    
                 Total revenues 636.1 652.2 411.8
    
          Interest expense 130.3 227.0 113.4
    
                 Total net revenues 505.8 425.2 298.4
    
Non-interest expenses:    
          Execution and clearing 129.2 125.1 115.4
          Employee compensation and benefits 47.8 36.4 28.8
          Occupancy, depreciation and amortization 16.5 7.5 5.8
          Communications 8.2 7.1 6.0
          General and administrative 80.1 51.2 43.8
    
                 Total non-interest expenses 281.8 227.3 199.8
    
Income before income taxes 224.0 197.9 98.6
   
Income tax expense 1.4 1.9 1.7
    
Net income $  222.6 $  196.0 $  96.9

 

Year ended December 31, 2008 Compared to the Year ended December 31, 2007

Electronic brokerage total net revenues for the year ended December 31, 2008 increased $80.6 million, or 19%, to $505.8 million, from $425.2 million during the year ended December 31, 2007, primarily due to higher commissions and execution fees. This increase reflects strong growth in the number of new customer accounts and significantly higher customer trading activity, which outweighed the decreases in customer cash and margin debit balances. Total DARTs from cleared and execution-only customers for the year ended December 31, 2008 increased 35% to 357,000, compared to 265,000 during the year ended December 31, 2007. DARTs from cleared customer’s for the year ended December 31, 2008 increased 46% to 316,000, compared to 217,000 during the year ended December 31, 2007. Total customer account equity grew by 1% to $8.9 billion at December 31, 2008, from $8.8 billion at December 31, 2007. The primary component of other income, payment for order flow received through programs administered by U.S. options exchanges, decreased $13 million, or 21%, and it was offset by the reductions in payment for order flow expense.

Electronic brokerage non-interest expenses for the year ended December 31, 2008 increased $54.5 million, or 24%, as compared to the year ended December 31, 2007.  Within that, execution and clearing expenses increased by $4.1 million, which was comprised of an increase of $26.1 million in trade execution and clearing expenses partially offset by a $22.0 million reduction in payment for order flow expense in the year ended December 31, 2008, as compared to the year ended December 31, 2007. Employee compensation and benefits expenses, for the year ended December 31, 2008, increased by $11.4 million, or 31%, to $47.8 million, as compared to the year ended December 31, 2007.  This increase was primarily due to a 33% growth in the average number of employees due to our acquisition of FutureTrade Technologies, LLC and continuing growth in our customer service capabilities. General and administrative expenses increased by $28.9 million, or 56%, primarily due to increased bad debt expense related to a customer loss of approximately $10.0 million, as well as increased advertising expenses. As a percentage of total net revenues, non-interest expenses increased to 56% from 53% for the year ended December 31, 2008 and 2007, respectively.

Electronic brokerage income before income taxes increased $26.1 million, or 13%, to $224.0 million for the year ended December 31, 2008 from $197.9 million for the year ended December 31, 2007. As a percentage of total net revenues for the electronic brokerage segment, income before income taxes was 44% and 47% for the years ended December 31, 2008 and 2007, respectively.

 

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Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

 

Electronic brokerage total net revenues increased $126.8 million, or 42%, to $425.2 million during the year ended December 31, 2007, from $298.4 million during the year ended December 31, 2006, primarily due to higher commissions and execution fees and net interest income, which increased $86.6 million, or 50%, and $29.8 million, or 55%, respectively. These increases reflect strong growth in the number of new customer accounts and significantly higher customer trading activity combined with increases in customer cash and margin debit balances. DARTs from cleared and execution-only customers increased 35% to 265,000, during the year ended December 31, 2007 compared to 196,000 during the year ended December 31, 2006. DARTs from cleared customers increased 38% to 217,000 during the year ended December 31, 2007, compared to 157,000 during the year ended December 31, 2006. Total customer account equity grew by 44%, to $8.80 billion at December 31, 2007 from $6.10 billion at December 31, 2006, as discussed above. The primary component of other income, which increased 15% to $80.4 million, was payment for order flow received through programs administered by U.S. options exchanges and it was largely offset by payment for order flow expense.

 

Electronic brokerage non-interest expenses increased $27.5 million, or 14%, to $227.3 million for the year ended December 31, 2007 as compared to $199.8 million for the year ended December 31, 2006.  Of this increase, $24.1 million reflected an 8% increase in execution and clearing expenses and was offset by $14.4 million reduction in payment for order flow expense.  The increase in execution and clearing costs is reflective of greater customer trading volume.  As a percentage of total net revenues, non-interest expenses decreased to 53% from 67% for the years ended December 31, 2007 and 2006, respectively, reflecting the scalability of our automated brokerage platform.

 

Electronic brokerage income before income taxes increased $99.3 million, or 101%, to $197.9 million for the year ended December 31, 2007 from $98.6 million for the year ended December 31, 2006. As a percentage of total net revenues for the electronic brokerage segment, income before income taxes was 47% and 33% for the years ended December 31, 2007 and 2006, respectively.

 

Liquidity and Capital Resources

 

We maintain a highly liquid balance sheet. The majority of our assets consist of exchange-listed marketable securities inventories, which are marked-to-market daily, and collateralized receivables arising from customer-related and proprietary securities transactions. Collateralized receivables consist primarily of securities borrowed, receivables from clearing houses for settlement of securities transactions and, to a lesser extent, customer margin loans and securities purchased under agreements to resell. At December 31, 2008, total assets were $28.36 billion of which approximately $27.87 billion, or 98.3% were considered liquid and consisted predominantly of marketable securities and collateralized receivables.

 

Daily monitoring of liquidity needs and available collateral levels is undertaken to help ensure that an appropriate liquidity cushion, in the form of unpledged collateral, is maintained 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 or 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 during late 2008, we have substantially increased cash on hand. This provides us with a buffer should we need immediately available funds for any reason.

 

In order to provide additional liquidity and to further increase 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 December 31, 2008, borrowings under these facilities totaled $443.1 million, which represented 10% of IBG LLC’s 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. The consolidated equity of IBG LLC grew from $3.52 billion at December 31, 2007 to $4.36 billion at December 31, 2008, representing an increase of 24%.

 

Cash Flows

 

The following table sets forth our cash flows from operating activities, investing activities and financing activities for the periods indicated:

 

  Year Ended December 31,
 

2008

 

2007

 

2006

 
 

(in millions)

Cash provided by (used in) operating activities   $  2,092.3 $  (89.7 ) $  (219.3 )
Cash used in investing activities   (20.1 ) (1,214.1 ) (50.4 )
Cash (used in) provided by financing activities   (1,598.2 ) 1,127.6 504.0
Effect of exchange rate changes on cash and cash equivalents   (52.3 ) 28.7 26.7
Increase (decrease)  in cash and cash equivalents   $  421.7 $  (147.5 ) $  261.0

 

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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 the purchase of interests in IBG LLC from existing members, 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 proceeds from the issuance of common stock in connection with the IPO, 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. Long-term borrowings provide us with flexible sources of excess liquidity and regulatory capital, and they include a committed senior secured revolving credit facility from a syndicate of banks that was initiated in May 2006, and senior notes issued in private placements to certain qualified customers of IB LLC.

 

Year Ended December 31, 2008, IBG, Inc.: Our cash and cash equivalents increased by $421.7 million to $943.5 million at the end of 2008. We raised net cash of $2.07 billion in our operating and investing activities primarily from net income, including minority interest, and reducing trading positions during the year. We used $1.60 billion in net cash in financing activities primarily from the reduction of short-term borrowings, payment of dividends to and redemption of member interests from IBG Holdings LLC.

 

Year Ended December 31, 2007, IBG, Inc.: Our cash and cash equivalents decreased by $147.5 million to $521.8 million at the end of 2008. We raised $1.13 billion in net cash from financing activities primarily from the net proceeds from the issuance of our common stock. We used net cash of $1.30 billion in our operating and investing activities primarily for the purchase of approximately 10% of the outstanding members’ interest in IBG LLC and increased trading positions partially offset by increased net liabilities due to our increased customer base.

 

Year Ended December 31, 2006, IBG LLC: Our cash and cash equivalents increased by $261.0 million to $669.3 million at the end of 2007. We raised $504.0 million in net cash from financing activities primarily in short-term borrowings and our senior secured credit facility. We used net cash of $269.7 million in our operating and investing activities primarily due to increased trading assets net of trading liabilities reflecting normal changes in the makeup of market making positions and investments in OneChicago, LLC ($20.0 million), ISE Stock Exchange, LLC ($4.25 million) and CBOE Stock Exchange, LLC ($2.25 million).

 

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 Federal Banking Commission. Interactive Brokers (U.K.) Limited is subject to regulation by the U.K. Financial Services Authority and our various other operating subsidiaries are similarly regulated. See the notes to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information regarding our regulated subsidiaries.

 

At December 31, 2008, aggregate excess regulatory capital for all of the Operating Companies was $2,948,527.

Principal Indebtedness

 

IBG LLC is the borrower under a $300.0 million senior secured revolving credit facility and is the issuer of senior notes, of which $300.0 million and $143.1 million were outstanding, respectively as of December 31, 2008.

 

Senior Secured Revolving Credit Facility

 

On May 19, 2006, IBG LLC entered into a $300.0 million three-year senior secured revolving credit facility with JPMorgan Chase Bank, N.A. as administrative agent, Harris N.A., as syndication agent, and Citibank, N.A. and HSBC Bank USA National Association, as co-syndication agents. 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 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, including downstreaming funds to IBG LLC’s regulated broker-dealer subsidiaries as regulatory capital. This allows IBG LLC to take advantage of market opportunities when they arise, while maintaining substantial excess regulatory capital. The financial covenants contained in this credit facility are as follows:

 

 

minimum net worth of $1.5 billion, with quarterly increases equal to 25% of positive consolidated income;

 

 

maximum total debt to capitalization ratio of 30%;

 

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minimum liquidity ratio of 1.0 to 1.0; and

 

 

maximum total debt to net regulatory capital ratio of 35%.

 

As of December 31, 2008, IBG LLC was in compliance with all of the covenants under this credit facility. In January 2009, the Company reduced its borrowings under this facility to $-0-. This credit facility will expire in May of 2009 and the Company is considering renewing this facility. Since we maintain a highly liquid balance sheet, this will not have a material impact on our future cash needs.

 

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. The outstanding senior notes have a 7% 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.

 

IBG LLC had $143.1 million and $160.5 million of senior notes outstanding at December 31, 2008 and 2007, respectively. During the period from January 1 through December 31, 2008, total senior notes issued were $474.6 million, and senior notes redeemed totaled $492.0 million.

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 $26.0 million for each of the years ended December 31, 2008 and 2007. We anticipate that our 2009 gross capital expenditures to be at a similar level, including costs related to 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 in order 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.

 

Contractual Obligations Summary

 

Our contractual obligations principally include obligations associated with our outstanding indebtedness and interest payments as of December 31, 2008.

 

Payments Due by Year

     Total

   2009-2010

   2011-2012

   Thereafter

(in millions)

Senior notes $143.1 $143.1 $  -  $  - 
Interest payments on senior notes(1) 12.2 12.2
Senior secured credit facili 300.0 300.0
Interest payments on senior secured credit facility(1) 4.3 4.3
Operating leases 56.1 9.9 17.1 29.1
Total contractual cash obligations $  515.7 $  469.5 $  17.1 $  29.1

 


(1)

Future principal and interest payments are calculated based on the assumption that all debt is outstanding until maturity.

 
49

 

Additionally, as of December 31, 2008, we maintained standby letters of credit in the amount of $60.3 million, of which $50.9 million expire on demand and $9.4 million expire in April 2009.

 

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 has made strategic investments in electronic trading exchanges including: Boston Options Exchange, LLC, OneChicago LLC and CBOE Stock Exchange, LLC.

 

At December 31, 2008, the Company had loans to and holds warrants to purchase approximately 25.86% of W.R. Hambrecht + Co. Inc. See Note 7 to the Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.

 

On December 23, 2008, the Company sold 100% of its investment in ISE Stock Exchange, LLC for proceeds of $5.0 million, realizing a gain of $1.5 million. During 2008, the Company also sold 0.30% of its investment in CBOE Stock Exchange LLC for proceeds of $0.3 million realizing a gain of $150 thousand.

 

On November 25, 2008, the Company closed on an acquisition of Moriai Securities, Inc., a Japanese broker-dealer. This acquisition is expected to facilitate our membership applications on Japanese exchanges and clearing houses, as well as serve as a platform for customer business from Japanese traders.

 

On December 18, 2007, IB LLC closed on its acquisition of FutureTrade Technologies, LLC (“FTT”), a technology solutions provider to hedge funds and other institutional investors, and its wholly-owned subsidiary, FutureTrade Securities, LLC, which is an SEC registered broker-dealer.

 

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 December 31, 2008, 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 consolidated financial statements for futures products, which represent obligations of IBG, Inc. 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 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 market prices, as published by exchanges and clearinghouses, 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

 

50

 

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 the 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 Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for 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 FASB Interpretation (“FIN”) No. 48.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 litigation and other legal proceedings. As of December 31, 2008, 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 December 31, 2008 and 2007, reserves provided for potential losses related to litigation matters were not material.

 

Use of Estimates

 

The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States. In applying these principles, management is required to use certain assumptions and make estimates that could materially affect the reported amounts of assets, liabilities, revenues and expenses in the consolidated financial statements. We base our estimates and judgments on historical experience and other assumptions that we believe are reasonable under the circumstances. These assumptions, estimates and/or judgments, however, are often subjective and our actual results may change based on changing circumstances or changes in our analyses. If actual amounts are ultimately different from our estimates, the revisions are included in our results of operations for the period in which the actual amounts become known. These estimates are periodically reevaluated by management. We believe the following critical accounting policies could potentially produce materially different results if we were to change underlying assumptions, estimates and/or judgments.

 

Recent Accounting Pronouncements

 

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations.” SFAS No. 141(R) replaces SFAS No. 141, mandating changes in the accounting for business combinations most notably that changes in purchase price allocations, if made, are required to be applied retrospectively, whereas under SFAS No. 141, such changes were applied prospectively. SFAS No. 141(R) is effective for an entity’s fiscal year beginning after December 15, 2008, and early adoption is not permitted. The Company cannot anticipate whether adoption of SFAS No. 141(R) will have a material effect on its consolidated financial statements as such effect would be solely dependent on whether the Company enters into business combinations after December 31, 2008 and the terms of such transactions.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51.” SFAS No. 160 requires non-controlling (“minority”) interests in a reporting entity to be reported as a component of the entity’s stockholder’s equity. SFAS No. 160 is effective for an entity’s fiscal year beginning after December 15, 2008, and early adoption is not permitted. Management is assessing the potential impact on the Company’s consolidated financial statements of adopting SFAS No. 160. With the adoption of SFAS No. 160, we expect to include our minority interest as equity of the public company. Applying SFAS 160, our consolidated equity at December 31, 2008 would have been $4.4 billion.

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133.” SFAS No. 161 requires enhanced disclosures about an entity’s derivative and hedging

 

51

 

activities, and is effective for financial statements issued for fiscal years beginning after November 2008. Adoption of SFAS No. 161 is not expected to have a material effect on our consolidated financial statements.

 

On May 9, 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles." SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities in accordance with U.S. GAAP. This Statement became effective in November 2008, 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” Adoption of SFAS No. 162 did not have a material effect on IBG, Inc.’s consolidated statements of financial condition, income or cash flows.

 

In November 2008, the SEC issued its “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers” (“IFRS Roadmap”). The IFRS Roadmap would require SEC registrants to prepare their financial statements in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board in 2014. IFRS is increasingly being applied by financial statement preparers in countries outside the U.S. One of the stated purposes of the IFRS Roadmap is that adopting IFRS will provide a global set of high-quality accounting standards so that U.S. investors would have an enhanced ability to compare financial information of U.S. companies with that of non-U.S. Companies. In issuing the IFRS Roadmap, the SEC stated that, in 2011, it will determine whether to proceed with rulemaking to require the use of IFRS by U.S. registrants beginning in 2014. Management is assessing the potential impact of adopting IFRS on the Company’s consolidated financial statements.

 

52

 

ITEM 7A. 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 Federal Banking Commission 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 neither an income nor an expense item in our statement of 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.

 

In late 2005, we began to expand our market making systems to incorporate cash forex and forex options in order to hedge our currency exposure at little or no cost. In September 2006, we began hedging 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. We define GLOBAL as consisting of a basket of major currencies that currently includes U.S. dollar, euro, Japanese yen, British pound, Canadian dollar and Australian dollar. With the growth of our international operations, we foresee including 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.

 

Interest Rate Risk

 

We had $300.0 million in variable-rate debt outstanding at December 31, 2008. These debt obligations are subject to fluctuations in interest rates at the end of each borrowing term, which impact the amount of interest we must pay. If the debt were to remain at this level and variable interest rates were to increase by 1.0% per annum, the annual impact to our net income from debt obligations of this amount would be a reduction of $3.0 million. 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 pay our electronic brokerage customers interest based on benchmark overnight interest rates in various currencies. In a normal rate environment, 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 December 31, 2008, we had no exposure of this nature.

 

53

 

We also face the potential for reduced net interest income from customer deposits due to interest rate spread compression in a low rate environment. A decrease of 0.25% in benchmark interest rates below 0.50% would reduce our net interest income by approximately $17.0 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 December 31, 2008, we had $1.55 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. 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.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Index to Consolidated Financial Statements

 

 

Financial Statements Introductory Note

56

 

 

Report of Independent Registered Public Accounting Firm

57

 

 

Consolidated Statements of Financial Condition as of December 31, 2008 and 2007

58

 

 

Consolidated Statements of Income for the years ended December 31, 2008, 2007 and 2006

59

 

 

Consolidated Statements of Cash Flows for the years ended December 2008, 2007 and 2006

60

 

 

 

Consolidated Statement of Changes in Redeemable Members’ Interests and Stockholders’ Equity for the years ended     December 31, 2008, 2007 and 2006

62

 

 

Notes to Consolidated Financial Statements

63

 

 

Supplementary Data

84

 

 

Quarterly Results

84

 

 

Reconciliation between US GAAP and pro forma financials for the years ended December 31, 2007 and 2006, presented as if we had been a public company for the entire period

85

 

55

 

Financial Statements Introductory Note

Interactive Brokers Group, Inc. (“IBG, Inc.” or the “Company”) is a holding company whose primary asset is its ownership of approximately 10.4% of the membership interests of IBG LLC (the “Group”).

 

We are an automated global electronic market maker and broker specializing in routing orders and executing and processing trades in securities, futures and foreign exchange instruments on more than 80 electronic exchanges and trading venues around the world. In the U.S., our business is conducted from our headquarters in Greenwich, Connecticut as well as from Chicago, Illinois and Lake Forest, California. Abroad, we conduct business through offices located in Canada, England, Switzerland, Hong Kong, India and Australia. At December 31, 2008 we had 750 employees worldwide.

 

On May 3, 2007, IBG, Inc. priced its initial public offering (the “IPO”) of shares of its Class A common stock, par value $0.01 per share (the “Common Stock”). In connection with the IPO, IBG, Inc. purchased 10.0% of the membership interests in IBG LLC, and became the sole managing member of IBG LLC, the holding company for our businesses, and began to consolidate IBG LLC’s financial results into its financial statements. When we use the terms “we,” “us,” and “our,” we mean IBG LLC and its subsidiaries for periods prior to the IPO, and IBG, Inc. and its subsidiaries (including IBG LLC) for periods from and after the IPO. Such transactions, collectively referred to herein as the “Recapitalization,” are described in greater detail in Note 4 to the consolidated financial statements. Unless otherwise indicated, the term “common stock” refers to the Class A common stock of IBG, Inc.

The consolidated financial statements as of and for the year ended December 31, 2008 and the consolidated statement of financial condition as of December 31, 2007 reflect IBG, Inc. and its subsidiaries. The consolidated statements of income and of cash flows for the year ended December 31, 2007 presented reflect the historical results of operations of IBG, Inc., including consolidation of its investment in IBG LLC subsequent to the May 4, 2007 IPO. Prior to May 4, 2007, the consolidated financial statements included herein represent the financial statements of IBG LLC and its subsidiaries.

The consolidated financial statements do not reflect what the financial position, results of operations or cash flows of IBG, Inc. or the Group would have been had these companies been stand-alone public companies prior to May 4, 2007. Specifically, the historical financial statements of the Group do not give effect to the following matters:

 

the Recapitalization;

 

U.S. corporate federal income taxes; and

 

minority interest held by IBG Holdings LLC.

As a consequence, earnings per share information reported in the consolidated statements of income reflect only net income available for common stockholders for the period subsequent to May 3, 2007, as detailed in Note 4 to the consolidated financial statements.

 

56

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Interactive Brokers Group, Inc.

Greenwich, CT

 

We have audited the accompanying consolidated statements of financial condition of Interactive Brokers Group, Inc. and subsidiaries (the "Company") as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in redeemable members’ interests and stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2008.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Interactive Brokers Group, Inc. and subsidiaries at December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2009 expressed an unqualified opinion on the Company's internal control over financial reporting.

 

/s/ Deloitte & Touche LLP

New York, New York

February 25, 2009

 

57

 

 Interactive Brokers Group, Inc. and Subsidiaries
Consolidated Statements of Financial Condition
     December 31,
(in thousands, except share data)      

2008

    2007  
   Assets            
   Cash and cash equivalents     $ 943,497   $ 521,776  
   Cash and securities - segregated for regulatory purposes       4,992,121     5,232,557  
   Securities borrowed       5,911,881     6,862,028  
   Securities purchased under agreements to resell       715,732     35,001  
   Trading assets, at fair value:            
     Financial instruments owned       10,049,481     11,018,613  
     Financial instruments owned and pledged as collateral       1,065,180     5,838,900  
        11,114,661     16,857,513  
   Other receivables:            
      Customers, less allowance for doubtful accounts of $17,572 and $1,999 at            
         December 31, 2008 and 2007       1,621,162     1,916,076  
      Brokers, dealers and clearing organizations       2,527,981     2,484,163  
      Receivable from affiliate        641     -  
      Interest       25,185     85,478  
           4,174,969     4,485,717  
   Other assets       503,774     547,494  
    
   Total assets     $ 28,356,635   $ 34,542,086  
    
   Liabilities and stockholders’ equity            
   Liabilities:            
   Trading liabilities - financial instruments sold but not yet purchased, at fair value     $ 13,476,757   $ 14,315,853  
   Securities loaned       656,625     4,968,863  
   Short-term borrowings       208,117     1,415,725  
   Other payables:    
     Customers       6,929,617     7,630,703  
     Brokers, dealers and clearing organizations       1,614,810     1,568,620  
     Payable to affiliate       313,800     323,901  
     Accounts payable, accrued expenses and other liabilities       289,659     231,008  
     Interest       16,135     53,133  
            9,164,021     9,807,365  
   Senior notes payable       143,054     160,456  
   Senior secured credit facility       300,000     300,000  
   Minority interest       3,894,207     3,165,421  
    
   Commitments, contingencies and guarantees            
   
   Stockholders’ equity:            
     Common stock, $0.01 par value per share:            
     Class A – Authorized - 1,000,000,000, Issued - 45,336,255 and 43,270,823, Outstanding –            
         40,536,615 and 40,143,760 shares at December 31, 2008 and 2007       453     433  
     Class B – Authorized, Issued and Outstanding – 100 shares            
        at December 31, 2008 and 2007    

--

--

     Additional paid-in capital       485,837     450,667  
     Retained earnings       141,207     48,160  
     Accumulated other comprehensive income, net of income taxes of $2,271 and $2,388 at            
        December 31, 2008 and 2007       3,907     4,109  
     Treasury stock, at cost, 4,799,640 and 3,127,063 shares            
        at December 31, 2008 and 2007       (117,550 )   (94,966 )
   Total stockholders’ equity       513,854     408,403  
   Total liabilities and stockholders’ equity     $ 28,356,635   $ 34,542,086  

See accompanying notes to the consolidated financial statements.

 

58

 

   Interactive Brokers Group, Inc. and Subsidiaries
    Consolidated Statements of Income
Three Years Ended December 31, 2008
(in thousands, except for shares or per share amounts)      

2008

   

2007

   

2006

 
   Revenues:                
     Trading gains     $ 1,303,994   $ 888,065   $ 805,110  
     Commissions and execution fees       359,529     261,104     174,437  
     Interest income       437,172     782,197     672,057  
     Other income       81,407     92,009     85,238  
         Total revenues       2,182,102     2,023,375     1,736,842  
  
   Interest expense       331,968     555,213     484,433  
  
        Total net revenues       1,850,134     1,468,162     1,252,409  
  
   Non-interest expenses:                
     Execution and clearing       322,746     335,756     313,271  
     Employee compensation and benefits       158,018     118,770     110,125  
     Occupancy, depreciation and amortization       37,663     26,482     22,697  
     Communications       18,650     14,889     12,645  
     General and administrative       63,308     40,696     32,110  
         Total non-interest expenses       600,385     536,593     490,848  
  
   Income before income taxes and minority interest       1,249,749     931,569     761,561  
   
   Income tax expense       128,371     63,037     27,392  
   Minority interest subsequent to May 3, 2007       1,028,331     568,040     --  
   Net income     $ 93,047   $ 300,492   $ 734,169  
   
   Net income and earnings per share for periods subsequent to May 3, 2007 (Note 4):                
   
   Net income available for common stockholders     $ 93,047   $ 48,160      
    
   Earnings per share:                
     Basic     $ 2.30   $ 1.20      
     Diluted     $ 2.24   $ 1.16      
   
   Weighted average common shares outstanding:                
     Basic       40,434,273     40,153,606      
     Diluted       399,905,060     401,327,844      

 

See accompanying notes to the consolidated financial statements.

 

59

 
  Interactive Brokers Group, Inc. and Subsidiaries
      Consolidated Statements of Cash Flows
                                          
                                                                                                  

Year ended December 31,

(in thousands)       2008     2007     2006  
   Cash flows from operating activities:    
     Net income     $ 93,047   $ 300,492   $ 734,169  
     Adjustments to reconcile net income to net cash provided by operating activities:                
       Translation (gains) losses       (28,351 )   (44,674 )   47,130  
       Deferred income taxes       50,099     7,079     (587 )
       Depreciation and amortization       17,897     12,068     11,630  
       Minority interest        1,028,331     568,040     --  
       Employee stock plan compensation        25,921     13,264     --  
       Losses (gains) on non-trading investments, net       14,107     (630 )   337  
       Bad debt expense and other       20,287     1,781     1,481  
     Change in operating assets and liabilities:                
       Decrease (increase) in cash and securities - segregated for regulatory purposes       240,500     (2,119,496 )   (1,307,649 )
       Decrease (increase) in securities borrowed       965,207     3,852,844     (1,570,433 )
       (Increase) decrease in securities purchased under agreements to resell       (680,721 )   62,882     (93,817 )
       Decrease (increase) in trading assets       5,795,379     (1,156,606 )   (3,716,794 )
       Decrease (increase) in receivables from customers       295,559     (1,066,914 )   (410,288 )
       Decrease (increase) in other receivables       40,928     (1,652,058 )   (288,910 )
       Decrease (increase) in other assets       13,381     (3,984 )   (19,544 )
       (Decrease) increase in trading liabilities       (794,979 )   (265,269 )   2,300,181  
       (Decrease) increase in securities loaned       (4,307,016 )   (3,200,489 )   1,899,853  
       (Decrease) increase in payable to customers       (698,735 )   3,713,557     1,495,049  
       Increase in other payables       1,483     888,445     698,891  
         Net cash provided by (used in) operating activities