‘Under The Hood’ At Interactive Brokers

While in the past, where brokers weren’t reporting client profitability based on asset class, we are now seeing more detailed reports being filed. As a result, we have been able to paint a clearer picture of Interactive Broker’s Forex trading results. In our most recent report of US broker profitability, Interactive’s clients were the most profitable, at a clip of 42%.

Forex Magnates met up with one of the people responsible for creating Interactive’s forex trading division in 2004, Jonathan Chait, COO & Director of Client Operations. We wanted to gain a better understanding of the broker’s forex operation and why its clients were more profitable compared to traders at its peers.

What are the origins of IB’s Forex Business?

An important part of our business as a multi-national, multi asset broker, and what we do best, is to offer clients the ability to trade what they want, where they want, with an account denominated in the currency they want. This led us to create our Universal Account, with a variety of choices of currencies in which to denominate and fund the account. The advantage was that clients wouldn’t need to be charged the hefty fees by their local commercial bank (as much as a few percentage points) when they converted their native currency to fund a foreign account.

Having creating the ability to hold funds in various denominations, we then received demand from traders acting internationally and creating profit/loss in other currencies, to hedge the currency exposure, or to facilitate the repatriation of monies to their preferred base currency. A classic early example was ADR arbitrage wherein a trader could, for example, buy shares of British Petroleum on the US market in USD and sell it in pounds in the UK. (FM Note: ADR arbitrage occurs when a stock is listed on multiple global exchanges and in different currencies. When one of the stocks becomes pricier than at another exchanges, traders will buy the cheaper stock and short the one that is more expensive). Creating a forex offering provided the opportunity to “close the currency risk gap” to make this trades. With demand for a forex platform, we started an automated order matching engine in 2004, with cooperation and liquidity from Bear Stearns.

Just out of curiosity, back then, what was considered to be tight spreads?

At the time, our platform was showing steady spreads of between 2 to 3 pips for the EURUSD, and it was considered a solid spread for non-professionals at that time.

What then happened is that we found to our surprise that traders wanted to trade forex as its own asset class. We then went out and, based on our extensive experience with exchange listed products, created an STP platform with multi bank liquidity that was based on an exchange (or ECN) -like central order book, where all market participants could see the live order book to transact transparently with other clients or liquidity providers.

So, Interactive basically saw what the demand was, and then reacted and created the product?

Yes, the demand for forex trading initially came from the client. But what we saw was there wasn’t much transparency in the retail space. Therefore, we said “we like transparency, so let’s do it and build an STP trading platform for forex traders.”

The result is an order book driven model. Our banks bring liquidity to the platform, but lots of transactions are also customer-to-customer, so clients can trade even inside the bank quotes.

I noticed that you only allow 40-1 leverage, do clients complain about this?

We did hear some complaints, but when you trade with 100 to 1, that is a remarkable amount of leverage, and the chances of getting blown out by even a small adverse price move are high. We looked at volatility, and crossed check against currency futures and decided what would be acceptable leverage.
We want our customers to be profitable: with an ECN model we don’t want to have to liquidate clients because they were over-leveraged for the market conditions.

Why do you believe your clients are more profitable, is it something that Interactive Brokers does, or is it due to the types of clients you attract?

It’s both. We have an educated client base. Our platform isn’t the most intuitive to use since it has the complexity needed to service six different asset classes on 100 exchanges in 19 countries. Because of the learning curve to use the platform, having a more educated customer is a great starting point.

Also, lower leverage and tight spreads lead to higher likelihood of success. The spreads are actually tighter than you see on the screen. Our internal order book tracks orders to the 0.1 pip for most pairs but we show quotes rounded out to 0.5 pip increments. We do this because we found that clients are most interested in getting a fill at a price they can see (0.1 price changes are so fast, most people cannot even see them on the screen), rather than perhaps miss the trade because the price moves 0.1 pips. But when the actual order book price is better than the client’s order price, the client gets 100% of the improved execution price so they can experience substantial price improvement on their trading activity.

What drives our trading technology is our smart router. It was created for the stock and options markets, and we applied it to forex. The routing engine can determine the best place to get the fill based on a variety of metrics. If multiple banks show the same price, our algos determine the best place to send the order to maximize the client’s likelihood of getting the trade he wants. Unlike many forex FCMs, IB doesn’t take the opposite position against the clients’ orders so our interests to get a fill are are aligned with the clients’ interest. For this we earn our execution and clearing commission.

Last question, what are your views on Mobile trading?

Interactive Brokers does offer a well regarded mobile trading platform app for iPhone, iPad, and Android platforms. However, mobile isn’t a big part of our business [yet]. Most of our customers are active traders, so the limited display area of a mobile application isn’t as convenient or efficient for this active trading. Nevertheless, our mobile services do allow clients to track their real-time portfolio and manage orders / execute trades when needed.