The shock of the Swiss National Bank’s decision to abandon the 1.20 floor for EUR/CHF has spilled over to electronic brokers and market makers. Currency brokerage firm FXCM has seen more than three quarters of value disappear after announcing that negative equity balances owed to FXCM were approximately $250M. FXCM’s two day panic caused the company to breach regulatory capital requirements, needing a $300M rescue fund from Leucadia National. Given the US dollar’s recent appreciation and the client debt implications from the Swiss decision, brokers will be ill-equipped to manage risk exposure. Interactive Brokers (IBKR) is the imminent target with fourth quarter earnings on January 20.
How Interactive Brokers Escaped the Crisis… For Now
IB manages currency risk exposure using hedging strategies based on a defined basket of 16 currencies referred to as “GLOBAL”. This strategy minimizes the fluctuations of the company’s net worth, expressed in GLOBALs, as currency risk is diversified in alignment with the included currencies. Roughly 60% of IB’s basket of currencies is allocated to the USD & Euro. The franc (CHF) makes up 3% of the GLOBAL Composition (below).
Interactive Brokers (“IB”) announced that their customers suffered losses in aggregate of $120M due to the sudden move of the franc. This equates to less than 2.5% of Interactive Brokers’ net worth due to GLOBALs minute exposure to Swiss francs. As a result, IBKR stock was down 7% in early Friday morning trading, but recovered the majority of losses closing 0.6% in the red.
According to Deutsche Bank, there are CHF 280bn worth of euro-denominated foreign deposits held in Swiss banks, significantly more than deposits in francs (200B). That is nearly 56B of euro-denominated value depreciated in Swiss banks. As a result of the Euro’s current slide and the spike of the franc, expected volatility in the currency market is expected to continue, at least in the short term. Brokers with risk management systems not ready for these swings will experience the hazards of leverage.
Interactive Brokers’ Q4 Earnings Could Trigger Bearish Momentum
IB’s upcoming fourth quarter earnings may not be as promising as Wall St expects. Currently, IBKR is trading at a trailing P/E of 38X whereas peers are seeing valuation multiples of nearly half with a 21X P/E ratio. IB’s lofty premium suggests optimistic investor sentiment. Though Interactive Brokers is expected to grow due to international expansion, there are troubling signs.
Earnings Affected by USD Appreciation
The company reports financial results in US dollars, so the change in the value of the GLOBAL basket, expressed in USD, affects earnings. During the third quarter, the appreciation of the USD against all other major global currencies created an unusually large currency translation loss of $211M, of which $133M were recorded as reduced trading gains. The US dollar’s appreciation continued throughout the tail end of 2014 (below).
Using the third quarter results as indicators, IB Q4 earnings are expected to be negatively affected, once again, by the rise of the dollar. International operations are translated back to USD, meaning the dollar’s appreciated value converts foreign currencies at a lower rate. Similar to the prior quarter, a currency translation loss in the approximation of $200M is reasonable to assume.
Declining FOREX Volume
Interactive Brokers has announced that foreign exchange volume has declined, on a year over year basis, for the last two quarters. Though currently immaterial as overall trade volumes are up, this trend will become more concerning if it continues in Q4 and into 2015. Commissions and executions fees make up large portion (~45%) of total revenues. Therefore, having declining volume in foreign exchange trades will directly affect one of Interactive Brokers’ essential revenue streams.
With IBKR price trading at 5 year highs, many insiders have taken the opportunity to cash out (below).
Since late December 2014, CFO Paul Jonathan Brody sold more than $650,000 worth of stock. The volume of insider sales in the last 3 months could be a troubling figure that indicates of a weak end to 2014.
The dust has yet to settle on the commotion caused by the Swiss National Bank’s currency cap decision. Volatility in the currency market is expected to continue as the European Central Bank could launch a bond-buying program as soon as its January 22 meeting. Even the brokers that initially avoided the Swiss crisis are not off the hook yet. A combination of a high risk environment and the troubling company specific signs discussed above, make Interactive Brokers’ stock a compelling short opportunity.