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Nov. 12, 2019, 8:42 a.m. EST

10-Q: INTERACTIVE BROKERS GROUP, INC.

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(EDGAR Online via COMTEX) -- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes in Item 1, included elsewhere in this report. In addition to historical information, the following discussion also contains forward-looking statements that include risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under the heading "Risk Factors" in our Annual Report on Form 10-K filed with the Securities Exchange Commission ("SEC") on February 28, 2019 and elsewhere in this report.

Introduction

Interactive Brokers Group, Inc. (the "Company" or "IBG, Inc.") is a holding company whose primary asset is its ownership of approximately 18.5% of the membership interests of IBG LLC. The remaining approximately 81.5% of IBG LLC membership interests are held by IBG Holdings LLC ("Holdings"), a holding company that is owned directly and indirectly by our founder, Chairman and Chief Executive Officer, Mr. Thomas Peterffy and his affiliates, management and other employees of IBG LLC, and certain other members. The table below shows the amount of IBG LLC membership interests held by IBG, Inc. and Holdings as of September 30, 2019.

IBG, Inc. Holdings Total Ownership % 18.5% 81.5% 100.0% Membership interests 76,748,855 338,670,642 415,419,497

We are an automated global electronic broker and market maker (although, we have substantially exited our options market making business - see Note 2 - Discontinued Operations and Costs Associated with Exit or Disposal Activities to the condensed consolidated financial statements elsewhere in this report). We custody and service accounts for hedge and mutual funds, registered investment advisers, proprietary trading groups, introducing brokers and individual investors. We specialize in routing orders and executing and processing trades in securities, futures and foreign exchange instruments on more than 125 electronic exchanges and market centers around the world. Since our inception in 1977, we have focused on developing proprietary software to automate broker-dealer functions. The proliferation of electronic exchanges over nearly the last three decades has provided us with the opportunity to integrate our software with an increasing number of exchanges and market centers into one automatically functioning, computerized platform that requires minimal human intervention.

When we use the terms "we," "us," and "our," we mean IBG, Inc. and its subsidiaries for the periods presented.

Business Segments

We report our results in two operating business segments, electronic brokerage and market making (being discontinued). These segments are analyzed separately as these are the two principal business activities from which we derive our revenues and to which we allocate resources.

Electronic Brokerage. We conduct our electronic brokerage business through certain Interactive Brokers ("IB") subsidiaries. As an electronic broker, we execute, clear and settle trades globally for both institutional and individual customers. Capitalizing on our proprietary technology, 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, primarily exchange-listed products, including stocks, bonds, options, futures, forex and mutual funds traded on more than 125 exchanges and market centers in 33 countries and in 24 currencies seamlessly around the world. The emerging complexity of multiple market centers has provided us with the opportunity of building and continuously adapting our order routing software to secure excellent execution prices.

Our customer base is diverse with respect to geography and segments. Currently, approximately 69% of our customers reside outside the U.S. in over 200 countries and territories, and over 50% of new customers come from outside the U.S. Approximately 65% of our customers' equity is in institutional accounts such as hedge funds, financial advisors, proprietary trading desks and introducing brokers. Specialized products and services that we have developed are successfully attracting these accounts. For example, we offer prime brokerage services, including capital introduction and securities lending to hedge funds; our model portfolio technology and automated share allocation and rebalancing tools are particularly attractive to financial advisors; and our trading platform and low pricing attract introducing brokers.

We provide a host of analytical and business tools such as Investors' MarketplaceSM, the first electronic meeting place that brings together individual investors, financial advisors, money managers, fund managers, research analysts, technology providers, business developers and administrators, allowing them to interact to form connections and conduct business. EmployeeTrackSM is widely used by compliance officers of financial institutions to streamline the process of tracking their employees' brokerage activities. The

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Probability Lab(R) allows our customers to analyze option strategies under various market assumptions. Risk NavigatorSM is a real-time market risk management platform that allows our customers to measure risk exposure across multiple asset classes around the globe. Portfolio BuilderSM allows our customers to set up an investment strategy based on research and rankings from top research providers and fundamental data. Interactive AdvisorsSM recruits registered financial advisors, vets them, analyzes their investment track records, groups them by their risk profile, and allows retail investors to assign their accounts to be traded by one or more advisors. In addition, our Greenwich ComplianceSM affiliate offers direct expert registration and start-up compliance services, as well as answers to basic day-to-day compliance questions for experienced investors and traders looking to start their own investment advisor firms. Greenwich ComplianceSM professionals have regulatory and industry experience, and they can help investment advisors trading on the IB platform meet their registration and compliance needs.

We have expanded the range of financial services we offer our customers through our Integrated Investment Management program, where customers can perform many different types of transactions from a single account. Our Interactive Brokers Debit Mastercard allows customers to spend and borrow directly against their account and to make purchases and ATM withdrawals anywhere Debit Mastercard(R)1 is accepted around the world. Our Insured Bank Deposit Sweep Program provides customers with up to $2,500,000 of Federal Deposit Insurance Corporation ("FDIC") insurance on their eligible cash balances in addition to the existing $250,000 Securities Investor Protection Corporation ("SIPC") coverage, for a maximum coverage of $2,750,000. Bill Pay allows customers to make electronic or check payments in the U.S. It can be configured for one-time or recurring payments and permits customers to schedule future payments. In addition, our customers can now have their paychecks or other recurring payments directly deposited into their brokerage account.

We recently launched our "BET, LEARN, WIN" promotion, a Simulated Sports Betting Exchange that operates as a simulated peer-to-peer market where participants can buy, sell and trade simulated bets on real sporting events. As part of the launch, we are offering the first 2.2 million participants who open a Simulated Betting account $1,000 in virtual currency for trading these contracts. Winnings in Simulated Sports Betting accounts may be converted, by eligible participants, into up to $1,000 of commission credits, on a one-time basis, to be used in an Interactive Brokers brokerage account. This promotion is intended to teach participants about the probabilistic nature of markets, trading and investing and to introduce new customers to the Interactive Brokers platform. The promotion ends on December 31, 2020 or when all awards are distributed, whichever occurs first.

IBKR LiteSM is a new offering that provides unlimited commission-free trades on U.S. exchange-listed stocks and ETFs to certain U.S. customers. IBKR LiteSM was designed to meet the needs of investors who are seeking a simple, commission-free way to trade U.S. exchange-listed stocks and ETFs and do not wish to consider our efforts to obtain greater price improvement through our IB SmartRoutingSM system. The new offering complements Interactive Brokers' existing service, which has been rebranded IBKR ProSM. New and existing customers now have the ability to select between these two levels of service.

?Market Making. As previously announced, we transferred our U.S. options market making operations to Two Sigma Securities, LLC effective September 29, 2017 and also exited the majority of our options market making activities outside the U.S. by December 31, 2017. We intend to continue conducting certain proprietary trading activities in stocks and related instruments to facilitate our electronic brokerage customers' trading in products such as ETFs, ADRs, CFDs and other financial instruments, as well as exchange-traded market making activities in a few select markets outside of the U.S. However, we do not expect the facilitation activity to be of sufficient size as to require reporting as a separate segment after we discontinue our options market making activities.

As a market maker, in the few select markets in which we operate, we provide liquidity by offering competitively tight bid/offer spreads over a broad base of 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 many times per second and continuously rebalanced throughout the trading day, thus minimizing the risk of our portfolio at all times.

The operating business segments are supported by our corporate segment which provides centralized services and executes our currency diversification strategy.

Business Environment

During the third quarter of 2019, U.S. market volatility, as measured by the average Chicago Board Options Exchange Volatility Index ("VIX(R)"), rose 23% over the low volatility seen in the quarter ended September 30, 2018. As has been the case in recent quarters, the index fluctuated over the course of the quarter, reflecting greater geopolitical and economic uncertainty and generating higher trading activity. In contrast, during the prior year quarter, the VIX exhibited a narrower range. Among our customer base,

1 Debit Mastercard is a trademark registered to Mastercard International Incorporated Corporation, Delaware, 2000 Purchase Street, Purchase, New York 10577-2405.

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volatility is strongly correlated with customer trading activity across product types. With positive customer account and asset growth, we would expect our customers' trading activity to outpace general market volume measures. In periods with widely rising and falling volatility, as occurred in the current quarter, trading activity may not achieve the rate of growth in our accounts and client assets.

U.S. overnight interest rates fell this quarter as the Federal Reserve cut interest rates twice. Despite the forward yield curve turning flat to inverted during the quarter, we earned more net interest income on interest-sensitive assets as previous-period investments in U.S. Treasury securities with higher rates matured with a lag time to overnight rate cuts.

Equity market indices around the globe were predominantly up in the current quarter, with the S&P 500 index rising 2% year over year, though decreases occurred in some European and Asian markets. Amid a positive equity market environment, customer account growth remained robust, with total customer accounts increasing 16% from the prior year quarter to 666 thousand. Customer equity increased 10% to $156.6 billion as healthy inflows from customers continued, aided by generally rising securities markets, which positively impacted the value of customers' holdings. Institutional customers, such as hedge funds, mutual funds, introducing brokers, proprietary trading groups and financial advisors, are a growing piece of our business, and comprised approximately 50% of total accounts as of September 30, 2019, versus 51% in the prior year quarter. We continue to attract large customers that seek our superior technology and execution capabilities, high interest rates on cash balances, and low costs, as well as our securities finance services, including margin lending and short sale support.

The following is a summary of the key profit drivers that affect our business and how they compared to the prior year quarter:

Volatility. Average U.S. market volatility, as measured by the VIX, increased 23% versus the prior year quarter. Higher volatility improves our electronic brokerage performance because it generally corresponds to higher trading volumes; and, likewise, lower volatility generally corresponds to lower trading volumes.

Global trading volumes. According to industry data, average daily volumes in U.S. exchange-listed equity-based options rose by 8%, in U.S. futures by 30%, and in U.S. listed cash equities by 20%. As noted above, the third quarter of 2019 showed higher trading activity with higher volatility, compared to the prior year quarter, affecting industry and Company volumes. It is important to note that while U.S. options, futures and cash equities volumes represent most of our volumes and are readily comparable measures, they reflect only a portion of the global volumes that generate our commission revenues. See tables on pages 46-47 of this Quarterly Report on Form 10-Q for additional details regarding our trade volumes, contract and share volumes, and brokerage statistics.

Interest rates. The U.S. Federal Reserve cut the target federal funds rate by 25 basis points twice this quarter, after a series of four 25 basis point hikes in 2018. Rates in other currencies were generally down this quarter versus the prior year quarter. Our interest rates on customer cash balances and margin loans are based on fixed spreads to benchmark rates. Hence, in a falling rate environment, net interest income is typically reduced for interest-sensitive assets, though increases can be generated from rising customer balances and opportunities to invest longer-term when the yield curve is positive.

In light of a flattening, and at times inverted, yield curve, we continued to shorten the duration of our U.S. government securities portfolio. The majority of our segregated cash is invested in U.S. government securities and related instruments, so the increases in rates during 2018, partially offset by the decreases this quarter, increased the interest rate we earned on these balances this quarter, versus the prior year quarter. Our margin balances declined this quarter due, in part, to a market environment in which certain investors chose to take on less risk, versus the prior year quarter. Though the four increases in rates during 2018, partially offset by the two rate decreases this quarter, increased the yield we earned on our U.S. dollar customer margin loans, actual margin loan interest declined slightly as a result of lower balances. Because the interest we pay on customer cash is tied to benchmark rates, falling rates lower the interest we pay on our customer cash balances.

Electronic brokerage net interest income grew 20% in the current quarter, compared to the prior year quarter. Over that time period, average customer credit balances rose 11% due, in part, to an inflow of new accounts, while average customer margin loan balances decreased 11%, primarily due to a market environment in which certain investors chose to take on less risk. U.S. benchmark interest rates were higher in the current quarter versus the prior year quarter, leading to higher rates paid on customer credit balances and higher rates earned on customer margin loans and on segregated cash and securities.

Because we pay among the highest rates in the brokerage industry on qualified customer cash balances, and charge among the lowest rates on margin loans, we attract customers who seek to maximize their yields and minimize their costs. We believe our high yields on qualified cash balances and low rates on margin borrowings are important factors that attract customers to our platform.

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Currency fluctuations. As a global electronic broker and market maker trading on exchanges around the world in multiple currencies, we are exposed to foreign currency risk. We actively manage this exposure by keeping our net worth in proportion to a defined basket of 14 currencies we call the "GLOBAL" to diversify our risk and to align our hedging strategy with the currencies that we use in our business. Because we report our financial results in U.S. dollars, the change in the value of the GLOBAL versus the U.S. dollar affects our earnings. During the current quarter the value of the GLOBAL, as measured in U.S. dollars, decreased 0.84% compared to its value as of June 30, 2019, which had a negative impact on our comprehensive earnings for the current quarter.

A discussion of our approach for managing foreign currency exposure is contained in Part I, Item 3 of this Quarterly Report on Form 10-Q entitled "Quantitative and Qualitative Disclosures about Market Risk."

Political uncertainty - Brexit. In March 2017, following a referendum, the United Kingdom ("U.K.") invoked Article 50 of the Lisbon Treaty thereby notifying the European Union ("E.U.") of its intention to withdraw from the E.U. The resolution of the terms and conditions of the U.K.'s departure from the E.U., commonly referred to as "Brexit", has been on-going over the last two years with a current end date of January 31, 2020. The uncertainty of a favorable exit from the E.U. may increase volatility in the global financial markets over the near term and, depending on the final terms of the withdrawal agreement, may negatively impact the manner in which we conduct business in Europe. We conduct business in the E.U. through our U.K. affiliate, Interactive Brokers (U.K.) Limited ("IBUK"). We have sought to address Brexit-related risks by, among other things, applying for appropriate licenses in Europe. Depending on Brexit's final terms and timing, depending on the status of our E.U. license applications, and depending on how the E.U. and each European jurisdiction treat U.K. investment firms in the wake of a possible "no-deal" Brexit, we could be unable to fully service some E.U. customers for some period of time, although we consider this unlikely.

We continue to monitor the situation and are taking steps to assess and mitigate potential operational, legal and regulatory risks.

Financial Overview

Third Quarter Results: Diluted earnings per share were $0.45 for the quarter ended September 30, 2019 ("current quarter"), compared to diluted earnings per share of $0.51 for the quarter ended September 30, 2018 ("prior year quarter"). The calculation of diluted earnings per share is detailed in Note 4 to the condensed consolidated financial statements, elsewhere in this report.

Diluted earnings per share on comprehensive income were $0.39 for the current quarter, compared to $0.50 for the prior year quarter.

In connection with our currency diversification strategy (i.e., GLOBALs) as of September 30, 2019, approximately 29% of our equity was denominated in currencies other than the U.S. dollar. In the current quarter, our currency diversification strategy decreased our comprehensive earnings by $75 million (compared to a decrease of $27 million in the prior year quarter), as the U.S. dollar value of the GLOBAL decreased by approximately 0.84%, compared to its value as of June 30, 2019. The effects of our currency diversification strategy are reported as (1) a component of other income in the condensed consolidated statement of comprehensive income and (2) OCI in the condensed consolidated statement of financial condition and the condensed consolidated statement of comprehensive income. The full effect of the GLOBAL is captured in comprehensive income.

A discussion of our approach for managing foreign currency exposure is contained in Part I, Item 3 of this Quarterly Report on Form 10-Q entitled "Quantitative and Qualitative Disclosures about Market Risk."

Consolidated: For the current quarter, our net revenues were $466 million and income before income taxes was $281 million, compared to net revenues of $439 million and income before income taxes of $276 million in the prior year quarter. The increase in income before income taxes in the current quarter was mainly driven by a $47 million increase in net interest income, and a $20 million increase in commissions revenue; partially offset by a $40 million decrease in other income, and a $22 million increase in non-interest expenses. Our pre-tax profit margin was 60%, compared to 63% for the prior year quarter.

Electronic Brokerage: For the current quarter, income before income taxes in our electronic brokerage segment increased $39 million, or 13%, compared to the prior year quarter, driven by higher net interest income and higher commissions revenue, partially offset by lower other income and higher non-interest expenses. Net revenues increased 14%, mainly from a 20% increase in net interest income, driven by higher U.S. benchmark interest rates and higher average customer credit balances, and a 12% increase in commissions revenue, primarily driven by higher options and futures contract volumes; partially offset by a 14% decrease in other income led by a $2 million net mark-to-market loss on our U.S. government securities portfolio (compared to a $1 million net mark-to-market gain in the prior year quarter) and lower risk exposure and market data fee income. Pre-tax profit margin was 65% for the current quarter, compared to 66% for the prior year quarter. Customer accounts grew 16% and customer equity increased 10% from the prior year quarter. For the current quarter, total DARTs for cleared and execution-only customers increased 13% to 859 thousand, compared to 763 thousand for the prior year quarter.

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Market Making: For the current quarter, income before income taxes in our market making segment increased $1 million, compared to the prior year quarter, to $8 million, primarily due to higher net interest income, largely offset by lower other income, while operating costs in the remaining operations remained unchanged.

Corporate: In June 2018 we consummated a strategic investment in Up Fintech Holding Limited ("Tiger Brokers") by purchasing preferred shares that represented a 7.4% beneficial ownership interest. On March 20, 2019, Tiger Brokers priced its initial public offering ("IPO") of American Depositary Shares listed on NASDAQ Global Select market and, concurrently with the IPO, we purchased unregistered ordinary shares in Tiger Brokers through a private placement offering which transactions resulted in a beneficial ownership interest of 7.6%. For the quarter ended September 30, 2019, we have recognized a mark-to-market loss of approximately $13 million in our investment in Tiger Brokers. For the nine months ended September 30, 2019 we recognized a net mark-to-market gain of $16 million on this investment.

Nine-Month Results: Diluted earnings per share were $1.52 for the nine months ended September 30, 2019 ("current nine-month period"), compared to $1.71 for the nine months ended September 30, 2018 ("prior year nine-month period"). The calculation of diluted earnings per share is detailed in Note 4 to the condensed consolidated financial statements, elsewhere in this report.

Diluted earnings per share on comprehensive income were $1.49 for the current nine-month period, compared to $1.54 for the prior year nine-month period.

Consolidated: For the current nine-month period, our net revenues were $1,437 million and income before income taxes was $845 million, compared to net revenues of $1,411 million and income before income taxes of $887 million in the prior year nine-month period. The decrease in income before income taxes in the current nine-month period was mainly driven by a 6% decrease in commissions revenue, a 38% decrease in trading gains, a 31% decrease in other income, a 6% increase in employee compensation and benefits expense, and a $43 million increase in customer bad debt expense; partially offset by a 16% increase in net interest income and an 2% decrease in execution, clearing and distribution fees.

Electronic Brokerage: For the current nine-month period, income before income taxes in our electronic brokerage segment increased $17 million, or 2%, compared to the prior year nine-month period, driven by higher net interest income, higher other income and lower execution, clearing and distribution fees; partially offset by lower commissions revenue, higher customer bad debt expenses, higher employee compensation and benefits expenses, and higher general and administrative expenses. Net revenues increased 6%, mainly from a 17% increase in net interest income, driven by higher U.S. benchmark interest rates and higher average customer credit balances; and a 6% increase in other income led by higher net mark-to-market gains on our U.S. government securities portfolio, higher fees earned from our FDIC sweep program, and higher account activity fee income; partially offset by a 6% decrease in commissions revenue compared to the prior year nine-month period. Pre-tax profit margin was 62% for the current nine-month period, compared to 64% for the prior year nine-month period. For the current nine-month period, total DARTs for cleared and execution-only customers increased 2% to 845 thousand, compared to 832 thousand for the prior year nine-month period.

As previously disclosed, over an extended period in 2018, a small number of our brokerage customers had taken relatively large positions in a security listed on a major U.S. exchange. We extended margin loans against the security at a conservatively high collateral requirement. In December 2018, within a very short timeframe, this security lost a substantial amount of its value. The customer accounts were well margined and at December 31, 2018 they had incurred losses but had not fallen into any deficits. During the quarter ended March 31, 2019, subsequent price declines in the stock caused these accounts to fall into deficits, despite our efforts to liquidate the customers' positions. During the nine months ended September 30, 2019, we recognized a net aggregate loss of approximately $42 million. The maximum aggregate loss, which would occur if the security's price fell to zero and none of the debts were collected, would be approximately $51 million. The ultimate effect of this incident on our results will depend upon market conditions and the outcome of our debt collection efforts.

Market Making: For the current nine-month period, income before income taxes in our market making segment was $25 million unchanged from the prior year nine-month period, driven by lower trading gains, offset by higher net interest . . .

Nov 12, 2019

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