Motley Fool Interview with Interactive Brokers\' CEO Thomas Peterffy

Tom Gardner: Another great opportunity to hear from a business leader. Somebody who's founded a business that has been a Motley Fool recommendation — a successful Motley Fool recommendation. Alex Scherer, who's on both my team and the Stock Advisor team recommended Interactive Brokers in 2009, right in the darkest hours of the financial markets, and selected what he believed was a great company with great long-term opportunity. Great technology.

Two points of full disclosure. The Motley Fool has a partnership with Interactive Brokers. The sister company, Motley Fool Wealth Management, is using the Interactive Brokers platform for offering Separately Managed Accounts.

The second full disclosure I just found out this morning while doing a little extra reading on your life. I found a quote from a man named Tom Russo, who at the time had a law firm representing you in some work that you were doing in trying to get technology to the American Stock Exchange floor and maybe some other work. He also is the co-manager with my uncle and cousin of Gardner, Russo, Gardner Investments in Lancaster, Pennsylvania, so we have that connection going back.

Thomas, why don't you start with your personal story? Most people in the room I'm going to assume don't know how you came from Budapest to the U.S. and the narrative of how you found your way into this business.

Thomas Peterffy: I grew up in socialist Hungary that was under Russian occupation. When I was 21 years old I was able to come to the United States. I did not speak English. I had to get a job and the only job that I could do was computer programming. I was able to read the manuals and the vocabulary was only about 100 words, so it was a lot easier to learn than English.

I worked for a highway designing firm as a computer programmer. I was the only one because they bought a computer. In those days companies bought this new thing called computers, but nobody knew how to program them. I volunteered to program it, so that's how I started out.

Eventually I got a job from a little consulting firm that was building computer programs for Wall Street brokers. The kind of programs we had to build were basically statistical tables where you'd sort stocks by P/E ratio, and book value to price, et cetera. So I started to learn about Wall Street.

From there I moved to a commodity trading firm (a gold and silver trader by the name of Mocatta) and my job was to figure out how to price options. That was a very, very interesting job because in those days people were trading options by the seat of their pants because nobody understood the mathematics. And after a very long period of ruminating and running simulations on my computer, I eventually came up with a model that is very similar to what today is known as the Black-Scholes formula. Given the fact that I was the only one at the time who had that formula I saved my money. I bought a seat at the American Stock Exchange and I became a market maker.

Tom Gardner: What year was that?

Thomas Peterffy: That was in 1977. So I had my formula. I had my computer printout of the fair prices for options corresponding to various stock prices and expirations. My fair price would mean a price such as if you randomly buy and sell hundreds of thousands of times you will break even. That's the fair price.

So I did that and I started to hire people to work for me. I would give them the formula and I would make deals where I would put up the capital. They would get 30% of the profits and I would keep the rest. What happened was the people that made money I gave 30%. The people that lost money I took the whole thing and at the end I didn't make any money. That didn't work well.

I decided the best thing for me would be to computerize the process. I started to put down computer screens on the floors that would continuously state these fair prices. Bids that were slightly under the fair price offers. Slightly over the fair price. And I told my people to buy as much as they can underbid and sell as much as they can on the offer and the time of difference in between was our profits. That worked well.

By the time we got to 1990, Europeans began to realize that exchanges should be driven by computers. They put up some computerized exchanges and we became members. We just plugged in our system and it was all automated. In America it was difficult because there were the specialists and the people who worked on the floors.

They all had their vested interest in keeping the system the way it was because in the chaos, they threw them on the floors and they always had a little edge for themselves. They didn't want to automate in America. Then in the year 2000, the first American options exchange, the International Securities Exchange, came alive and with that automation started in America.

Around 1993, I began to realize that there would be other people in this business and I would not be able to compete because they would hold onto the order flow, so I decided to branch into the brokerage business while keeping the option market-making business.

That's when we started Interactive Brokers. The idea always was that we'll automate everything that a broker has to do and that will enable us to do our work extremely inexpensively so that we can share the benefits with our clients. That is still the idea today.

Tom Gardner: Just one more step back in history. Paint the picture — a story or two — about the resistance you got to bring computers onto the American Stock Exchange floor. The entrenched interests trying to block you for the reasons that you described. Are there any pictures or little narrative moments that you remember that stand out as the challenges that face a disruptor with technology?

Thomas Peterffy: The biggest problem we got was from the Chicago Board Options Exchange. There came a time when we designed these laptops that looked like an iPad, but not so cool. It looked rough, but it basically did the same thing. I gave them to my employees to take down to the floor. This was automated and it gave them the prices on which to deal. And I spent a lot of money — a great deal of money — developing these. When we went onto the Chicago floor with these laptops, the floor committee disallowed the use of the laptops. I asked why and they said because it's a hazard.

[Laughter]

Thomas Peterffy: So I knew how to deal with that. I appealed and the appeals committee rejected my appeal. They said it is a hazard. It was a terrible situation because I spent so much money developing this thing that I was beginning to run into debt.

They had an S&P 500 options contract that died because nobody wanted to trade it. They had OEX and S&P 500. Everybody traded OEX, [but nobody traded] S&P 500 options. They delisted it.

So I went back to the Exchange and I said, "Look. [I want] you to allow me to put up big screens on the floor where I can show my people bids and offers for each of the options on the S&P 500 series. Will you allow me to do this? I will guarantee I stay here for a year so if somebody buys something they can be sure that they can get out because I will be there for a year."

They ultimately agreed. I put up the screens and nothing much happened. People didn't come. Didn't trade. Then suddenly somebody came and he bought 50 contracts. That was something that showed up in the newspaper. And then the next day he came back and he bought another 50 contracts. And that went on.

And then more people came, but this man kept coming back buying, buying, and buying. It came to the point where he had 2,000 contracts. I said, "There's got to be something wrong here." We discovered that the S&P 500 options expired into a futures contract that matured a month after expiration and they were both about a dollar difference, so we lost $2 million. We immediately corrected the problem. We paid the $2 million, but that made the S&P 500 contract the biggest options contract there is. That's how automation finally got accepted on the floor.

Tom Gardner: How transparent do you think the markets are now, from both the standpoint of the completion of a transaction, but also the fee that somebody is paying? How much understanding do you think is out there among investors (particularly individual investors) about what they're actually paying for the transactions they're making?

Thomas Peterffy: Well, I think very few people understand what goes on. That includes myself.

[Laughter]

Thomas Peterffy: No, I'm kidding.

[Laughter]

Thomas Peterffy: The truth is that most brokers sell the order flow that they get from their customers. The folks that buy the order flow execute it against themselves. It's called internalization. When they have a seller, they buy it from the seller and the seller is the customer of the broker.

So they make that bid and offer differential and whenever possible, they lower the bid and raise the offer because the national market system requires people to execute each order within the national bid and offer, but only to the extent that the size of the national bid and offer is equal or greater than the size of the order. So when the national bid is, say, for 500 shares and somebody sends in an order to sell 700 shares, then you get 500 shares at the good price and 200 other shares at a worse price.

That's where basically the money comes from, but also there's an issue about hidden orders. There are many dark pools and there are many order types, even at exchanges, which do not get displayed. So if you have a broker — well, I think we're the only one of those brokers — that has a system that continuously searches and probes for these types of hidden bids and offers, then you can get a better execution. That doesn't happen very much.

Tom Gardner: How many people in the room are shareholders of Interactive Brokers?

Thomas Peterffy: Thank you.

Tom Gardner: And how many of you are using the Interactive Brokers platform in some way?

Thomas Peterffy: Oh! That's quite a lot of people! I'm impressed!

Tom Gardner: Here's an observation I have of your work, Thomas. You tell me if you agree or disagree. You've brought transparency, efficiency, technical sophistication, and lower costs. But in that focus on technology, you haven't necessarily created convenience for a consumer who's never used the system. It's a different system.

So how do you balance those tensions? The major technological breakthroughs that have been part of your life since the first computer manual you read many decades ago — do you see Interactive Brokers pursuing more sophisticated investors or more general consumer investors? Do you have plans to move in that direction? How do you think about the complexity of onboarding and the whole customer relation side of the business?

Thomas Peterffy: Well, given that the market is very complex and our strategy is to give our customers an advantage over the customers of other brokers, we cannot do that with just a simple system, so unfortunately the system has to be complex. The only way we can do that is to provide a facility just like your Apple iPhone. People who only use it to make phone calls and send texts don't know about all the other things that it can do. Our system is, in a way, similar. Everybody goes as far — digging into the system — as they can.

You can't imagine all the things that this system can do. It provides you with research. It provides you with option models. It's just endless, all the facilities that we have. And very few people use each one, and they aren't the same people. People find the things that they like — that's what they use — and they don't go much further.

As to onboarding — that's been a hassle forever. On the one hand we have the regulators, and the regulators tell us that we have to know our customer rules. We have to know many things about our customers to make sure that they will not do [certain] trades, [because] even though we don't give any recommendations, we are liable. We have to make sure that they do not do trades that they are not fit for. I don't really know how to judge that. It's "big daddy government," so I have to do whatever they tell me to do otherwise I'll go to jail.

So it's a problem. We are continuously working on it. Just yesterday we released a new system where if somebody applies for an account, and they put in their name and email address, we immediately push to them the entire system. They don't have to put in any money. They can see the system. They can use it. And if they later want to put in money, the account goes live. Otherwise it's just a dummy account.

This way people can try it. They can find out if they like it or not. If they like it, they can fund the account. If they don't like it, goodbye. The prices are delayed for 15 minutes, so it doesn't cost anything. It's free. You can use it as long as you want. You can get your kids or grandchildren to start trading. It's all just paper — but it's a real system. It's the same system that we use for people who have many, many millions of dollars on the platform. The only difference is that the trades are not real.

Tom Gardner: Do you see a battle in any way in the financial services industry, overall, between technical sophistication, complexity, transparency ... and truly transparent low costs, convenience, simplicity, relationships, and a lot of hidden high costs?

Thomas Peterffy: I think that customers are fragmented. Many people go for simplicity and high cost and other people will go for complexity and low cost. If you're a real professional (your survival depends upon your investment skills), then you will go through the trouble of learning everything there is to know so that you can maximize your returns.

Tom Gardner: What is the culture of Interactive Brokers like relative to the culture at other discount brokers? More programmers than traders? Probably more programmers than marketers.

Thomas Peterffy: Most brokers are basically salesmen. We do not have salesmen. Everybody's a computer programmer. I always preferred computer programmers because I knew how to talk to them. I never knew how to talk to salesmen because I never believed them.

[Laughter]

Thomas Peterffy: It's a very different culture. We're into building the platform and we're not very good at sales. But over the years it appears that many people have come over to our side, so we now do more trades than any other broker. We like to go into situations where we have a self-reinforcing loop because we now do more trades than any other broker. We do 650,000 trades a day.

Tom Gardner: And what percentage of the options market, globally, is on the Interactive Brokers platform?

Thomas Peterffy: I would think it's around 8%. So the question is why does Interactive Brokers do more trades than any other broker? The answer is because it's the least expensive broker. Why is Interactive Brokers the least expensive broker? Because it does more trades than any other broker.

[Laughter]

Thomas Peterffy: And the more trades we do, the better execution we can give because each time we attempt to execute an order, we get a fresh statistical sample of the venue we have tried. The idea about best executions is that we have about 30 venues and we continuously have to have a statistical picture of what the orders are at each venue so that we can send the order to the best one at that moment.

Tom Gardner: That's all the time we have with Thomas Peterffy of Interactive Brokers. Thanks very much for coming.