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Where's the beef?

Date 29/10/2008

Patrick L Young

Even a blind man on a galloping horse could probably discern from a distance that there’s a lot of heat being generated in the investment space for exchanges right now. Moreover, as various correspondents have noted, perhaps there is a danger of a ‘bubble’ developing within the market infrastructure arena. However, bubbles are built on an excessive faith in ‘paradigm shifts’ or other buzzwords when the immediate benefits are not being provided. Thus dotcom companies or tulip-related enterprises dazzled the broad investor communities in different centuries without actually producing that essential benefit to society: tangible results.

In the exchange space, one can immediately notice a very different environment as the markets themselves are predominantly already profitable in their operations. The key issue is just how profitably they can operate and indeed how they can expand. On this front, the outlook appears remarkably propitious.

To identify and examine all the potential ‘growth drivers’ of exchanges in detail could take up a hefty tome in its own right. However, there are a number which can be described relatively briefly. In so doing, I feel there is a good argument to suggest that, while valuations may be a bit giddy at the 60 times earnings or higher applied to some marketplaces, exchanges are likely to produce significant returns for the foreseeable future and profitability ought to continue to grow, even if some markets remain as cyclical as, well, markets traditionally are. Moreover, with growth rates of 40% per annum not unknown in some markets, earnings multiples are wont to collapse every time exchanges report their results.

So, in no particular order, I believe there are 10 key areas driving growth in exchanges and markets platforms, all of which have considerable potential for enhancing revenues and profits:

  • Enhanced IT processes
  • Growing emerging market economies
  • The death of the floor
  • Generic growth in futures, options and ‘simple derivatives’
  • Generic growth in structured products and more complex derivatives
  • New products in all forms of derivatives
  • OTC trading
  • Clearing services
  • Small capital equity markets
  • Special purpose vehicles/fund exchanges/ETFs etc.

One key issue which binds together all the growth drivers is the fact that the exchange industry has expanded considerably – almost exponentially – in the past two decades. Skills sets which previously were prized as being rare are in fact remarkably broadly distributed. The absolute best new product developers may be capable of a convention in a telephone box (presuming any telephone boxes still exist in a mobile telecom/wifi/VOIP world). However, at least several hundred people are capable of developing new products for exchanges. Likewise, in IT, the number of people who developed electronic IT systems in say 1987 was limited to a few clutches of folk in a bare handful of countries. Nowadays, there are more people developing exchange IT applications in India than worked in exchange IT world-wide a couple of decades ago.

This relative preponderance of knowledge has also helped push down costs. That in itself is a massive growth driver in the exchange market. The fact that electronic exchanges themselves can be more easily created than at any time in history means that the exchange marketplace will, by its very nature, expand. Even if at the very top level we see continued consolidation, the overall number of exchanges is likely to grow in the future as the barriers to entry continue to reduce.

However, that is leading us into a discussion about new exchanges which is a parallel but separate discussion to this one. In terms of the key growth drivers that are fuelling the existing exchanges (whether recent left field entries or incumbent legacy markets), I will proceed to discuss the list outlined above.

Enhanced IT processes

Moore’s law was first predicated by the Intel founder Gordon Moore in 1965 and the theory that computing power can double roughly every 24 months, is still going strong 4 decades later. That has big implications for the exchange business.

As IT keeps getting cheaper and the bang for the buck expands exponentially, the exchange and IT are essentially inseparable. The mantra ‘Exchanges are IT and IT is Exchanges’ is indeed somewhat apposite.

Of course this raises some intriguing issues. For one thing, the cost of entry to the exchange game in IT terms has collapsed. True, it still costs into seven figures to buy systems from major vendors such as OMX. However, those wishing to establish an exchange and have the same facets, if not quite the same distribution, functionality or speed, as the likes of Nasdaq or Deutsche Börse, can do so for very modest six figure sum. True, this may again be more of an argument for a new markets than a growth driver for existing exchanges. However, within existing exchanges that are looking for new segments and products (see below), systems have never been cheaper, more dynamic or faster to implement. IT is a heady cocktail that can drive exchange growth in every facet. The current reckoning is that Moore’s Law looks likely to continue to hold for at least another decade, and exchanges will grow with it.

Of course there is an intriguing issue here and while IT costs are falling and processing power increasing, exchanges find themselves under pressure to pass on their cost savings. So in some ways this may appear to be a zero sum game. However, the processing capacity increases have the effect of expanding the core capacity of the marketplace. In other words, while per transaction costs may continue to fall, exchanges with upgraded systems achieve an additional knock-on benefit whereby their overall platform cost is falling, thus making new products cheaper to launch at the margin and indeed allowing such products to achieve profitability more rapidly. This has been clear in the fact that exchanges’ overall profits have been growing rapidly in recent years, while overall costs per transaction have generally been on a steep downward curve.

Of course, the low cost of IT benefits new entrants, but a new player has to take on the established brand and liquidity of the incumbent exchange. Overall, in a world where the other growth factors favour both generic and new product growth, the benefits of technology remain enormous for all exchanges. The fact that so many brokers escaped their ‘near death experience’ during the first dotcom bubble to reinvent themselves as providers of wafer thin margin services with new value additive facilities elsewhere has helped – and will continue to help – the strongest and most nimbly managed exchanges to continue their significant growth in recent years.

Growing emerging market economies

Exchanges such as MCX in India or the JSE in South Africa are just two examples of markets which have helped commerce to expand almost frictionlessly where before there were considerable barriers in commodity markets. More of that in relation to deregulation below. Meanwhile, the speed with which equity culture has spread throughout the world’s emerging markets has surprised even the most hardened of Marxist reactionaries. Regardless of religion, political culture or geography, the equity marketplace (and with it bond markets, or Sukuk or other forms of financial product) is exploding.

Yet emerging markets are not just about localised marketplaces. The London Stock Exchange has enjoyed considerable success with an index of Russian equities, for instance. Moreover, while the world may be increasingly inter-linked for commercial purposes, different asset cycles are likely to remain in different markets. While many global equity markets have some form of correlation to the United States of America or China, equity markets in many developing nations have relatively little propensity to follow the global titan economies as they are still preoccupied with their own domestic economic prospects.

The death of the floor

It seems ridiculous to those who witnessed the European modernist movement led by DTB (now EUREX) in the 1990s that electronic trading would become the only game in town. Globally, the exchange industry took note and those who could, took action. Nowadays, there are still garrisons holding out against the inevitability of electronic trading. Some are in the most bizarre places – the Deutsche Börse, majority shareholder in EUREX, retains a floor in Frankfurt for instance.

However, it is in the USA where the floors still occupy far too much of this industry’s resources. In the best totalitarian traditions, management have tried to justify their outmoded floors through new trading jargon and robust PR, but the fact remains that floors have had their day. There’s no point calling something ‘Open Auction’ to justify its outmoded nature. The greatest ‘Open Outcry’ of the modern exchange industry is that anybody even listens to the facile arguments of floor trading apologists. The sooner the floor system is dead and buried, the faster the industry can grow and the better exchanges can service all stakeholders.

For starters, the NYSE’s Specialist system will not survive much longer. Moreover, investor impatience is likely to push the existing floors within ‘hybrid’ exchanges into closure in the near future. The simple economics of IT mean that a new wave of technology will target the soft underbelly of exchanges which have failed to motivate their floor traders to abandon their asphyxiating self-interest. It is a bizarre paradox of markets that, in the case of floors, the majority are thwarted from benefiting from marketplaces due to the workings of a minority.

In the world of exchanges, a clear digital dividend of above average growth has been experienced by every exchange which has closed its floor and turned electronic. The explosive expansion of LIFFE and the CME electronic suite of products bear testimony to the incredible growth that can be experienced when the innate bottle necks of floor trading are abandoned. Likewise, there are no products in the commoditised exchange repertoire that cannot be traded electronically. Arguments that professional traders prefer the ‘feel and smell’ of the floor is a specious one whether applied to oil futures or equity options.

True, there is arguably a bare exception concerning ring dealing at the likes of LME, but here the product uses the same space throughout the day and also creates a ‘fix’ price which provides a core marketing function for the exchange – the bulk of trading is increasingly electronic anyway.

The death knell of the floor was tolled many years ago. If exchanges want to perpetuate their growth then those with floors need to close them as soon as possible, not merely to reduce the burgeoning cost burden of the pits but also to permit exchanges, their clients and investors to benefit from the digital dividend of increased growth.

Generic growth in futures, options and ‘simple derivatives’

There are a fair few people in the exchange industry who still haven’t caught the biggest trend of our generation, but for those who have missed the fact that this is a derivatives’ world, the outlook is bleak. For one thing, the growth of exchange products in futures and options is simply not about to abate. Indeed, it might even accelerate. Floor closure has always helped derivatives markets in the past and in the near term, the prospects for existing products in futures and options look bright. Even a massive product area such as US equity options enjoyed phenomenal growth in 2007, during what was a reasonable but hardly stellar year for equity price inflation in the USA.

In every product segment, in every market throughout the world, volumes have tended to be on a one way streak for the past decade. With increases in network technology, distribution is reaching more and more potential users. End user interest in exchange traded derivatives is exploding as they seek to justify their fee structure. Such end users may not be looking at becoming all singing and dancing multi-directional highly leveraged beasts like the most agile hedge funds. However, even a modicum of interest among more traditional fund managers to interpolate a little or manage their potential pay-off/risk profiles, for instance, would be a huge fillip to the existing derivatives universe.

The explosion in all forms of financial products dates back to the original financial derivatives revolution which in many ways has parallels with the current era. In the early 1970s, the collapse of the Bretton Woods agreement proved the initial deregulatory catalyst. Then the Nixon government’s massive deregulation of stock commissions killed off oligopolistic cartels. With a lack of foresight that remains fairly common in the industry, the brokers, banks et al fought the legislation (that ultimately grew the financial industry by more than any other single act in history) tooth and nail. Fortunately for all of us, they failed.

Similar attempts to permit the brokerage industry to actually practice capitalism as opposed to a sort of perverse redistribution through frictional costs were notably successful in the UK, amongst other nations. In all cases, faced with a collapse in commission rates, the exchange industry started looking for alternative products from which it could extract higher margins for broking and trading. Thus the financial derivatives bandwagon gained a great many passengers and the world of risk transfer was revolutionised, thanks to the insights of visionaries such as Professor Richard Sandor. The generic growth of those self-same simple futures and options products will remain a massive factor over the next few years. Aided and abetted, of course, by Moore’s law and the power of networks.

Generic growth in structured products and more complex derivatives

I’ll gloss over the unfortunate branding incident that left the latest Deutsche Börse/SwX joint venture named ‘Scoach’, which in US street slang means ‘to steal with extreme stealth’. The fact is that, regardless of name, the demand for structured equity products is almost insatiable. In the USA the exchange traded structured products market remains very modest compared to Europe. In fact, even the European market is quite modest, in terms of geographic distribution. The Germans and the Swiss have led the field in many respects and the number of issues has seen stellar momentum in recent years. Italy is pretty impressive, but thereafter the field tails off relatively rapidly (but not for long). With everybody looking for a little twist to their portfolio, the prospects for structured products are enormous.

New products in all forms of derivatives

Roll up, roll up, ladies and gentlemen, this is the golden age of product development. Thanks to that bounteous supply of cheap IT, a product for just about every possible stakeholder beckons.

Governments that are no longer able to subsidise from the pork barrel are increasingly seeing the benefits of the exchange marketplace. The abolition of the South African Maize Board’s, reducing transaction costs per tonne of maize from 50 rand to 10 cents, is a salutory tale to chill the heart of any bureaucrat. Nevertheless, we still have no global trading benchmark for rice, one of the most critical staple foods in the world. In an era where simply paying pensions is becoming tricky for cash strapped governments, subsidy regimes will continue to crumble, undermined by the low cost, low friction exchange alternative. Not directly subsidised as such but nonetheless in the early stages of its own, er, liquidity revolution, water will soon be on the fast track to massive trading volumes.

Although deregulation is a key factor behind many developments in the commodity marketplace, exchanges might ironically benefit from some increase in regulatory pressure, as the ongoing fall-out from the credit derivatives debacle may ultimately involve moves to push OTC trading onto more transparent exchange platforms. True, that will involve a degree of deft balancing by the regulators to avoid causing further issues of evaporating confidence, but the likelihood is that more OTC business will move onto exchanges – of which more shortly.

Remember, the growth of ‘new exchange products’ isn’t just about new-fangled instruments never touched by risk transfer intervention. In reality, it never was: most ‘new products’ have been previously traded OTC somewhere, even if only within a tiny adults-only circle of institutions. The product groups such as emissions and weather previously touched upon in the Capital Market Revolution! books are still in their infancy.

Moreover, the flexibility and low cost base of electronic marketplaces, make the digital DNA of markets, the microtrade, much more cost effective, permiting greater diversity of product than ever before. Smart deployment of spreading algorithms encourages the growth of granular derivatives, allowing market users to have access to hedging benchmarks closer to their own needs. After all, what was more absurd than an oil market where the benchmarks were a pair of light sweet crudes, West Texas Intermediate and Brent Crude, which barely correlated with the more acidic or heavier crudes that much of the planet actually extracts? In a digital marketplace, the prospect for filling in such products grows exponentially.

In a world where a benchmark is always keenly sought, the business of indexing will see greater and greater growth, with existing indices being challenged by the birth of new products. Many will be granular products built around sectors of existing indices, while other new and interesting index products will doubtless be created to permit greater opportunities across borders as well as within them.

In the marketplace for Islamic finance, the prospects likewise remain immense.

Then there are those quasi-taboo areas of product development which can only be promoted in the United States of America while risking a lifetime in an orange jumpsuit; but that won’t stop the sports exchange business further cementing its position as a centrepiece of the global gambling and speculation industry.

On another front, the offspring of the sports exchange, the oxymoronically titled ‘prediction market’, is set to run and run, as the public finds an entertaining way to profit and speculate on all manner of political and related events.

OTC trading

As schemes such as the A/B/C initiative from LIFFE have demonstrated, there is palpable demand for some OTC products to be traded via, or cleared under, the auspices of existing exchanges and clearing houses. As older OTC products become increasingly commoditised, the likelihood of their moving onto exchanges increases. As their marginal return to specialists within investment banks decreases, so they seek new opportunities in higher margin markets. Thus there is an ongoing growth in exchange product, a highly virtuous circle for exchanges – unless of course the major OTC players of IDBs can manage to keep the commoditised flow within platforms of their own design and preclude the legacy exchanges from entering the business.

Clearing services

Essentially, the growth in cleared product is being driven from the OTC business as mentioned above. Regulators are also keen to push products onto exchanges. While a Basel III is hardly in the offing yet, expect regulators to keep up pressure for more clearing of certain existing OTC products. Indeed, given that arguably the fastest growing products of all are forex and contracts for difference (CFDs) – neither broadly exchange traded – there is huge scope for clearing of margined foreign exchange alone.

Small capital equity markets

They may have been largely disparaged by some leading US figures in recent times – but the European-led small capital markets (championed by LSE’s Alternative Investment Market or AIM) has become a new hot trend in the industry. In the USA, this trend has been modified (largely due to regulatory considerations) to be an ‘adults only’ marketplace under rule 144a, with participation from professional institutions only. Intriguingly, the self-same folks who sought to disparage the AIM marketplace are at the forefront of launching 144a initiatives. However one looks at it, smaller capital exchanges are in vogue and that can only enhance volumes and listing fees at cash exchanges. The opportunities are once again enormous.

Special Purpose Vehicles/fund exchanges/ETFs etc.

An interesting method for exchanges to escape from the perilous ‘road kill’ categorisation (originally proposed in New Capital Market Revolution) has been pioneered by the Irish Stock Exchange, amongst others. The ISE leveraged the Dublin International Financial Services Centre’s advantageous tax structure to create a market where it was cheap to list special purpose vehicles and fund entities. The result has been little short of miraculous. Dublin provides listing at relatively minuscule fees and as a result has a vast quantity of listings. On the other hand, trading revenue is not considerable – but if the world’s funds, insurers et al can pay the bills with listing fees, who cares?

Similar exchanges specialising in funds and suchlike include the Channel Islands SX and Luxembourg in Europe. In South-East Asia, the Labuan International Financial Exchange subsidiary of Bursa Malaysia is amongst those markets seeking to list many Islamic financial products such as Sukuk. Wherever in the world one looks, existing and new exchanges are creating specialised areas for the listing of all manner of SPVs, funds and of course that relatively established fund product, the genuine ‘people’s derivative’, Exchange Traded Funds (ETFs).

Short of using that perfect investing tool, 20:20 hindsight, nobody can tell when a market has peaked. However, when it comes to exchanges, there are very clear factors at work which are driving profitability throughout the industry. True, threats remain. The post-CDO world of banks is a worry and a major credit crisis could always dry up demand. Equally, exchanges are in a period of unprecedented attack from upstart competitors. However, at the end of the twentieth century, exchanges faced total oblivion. Their survival instincts proved remarkable and in the current era, the fact is that exchanges have progressed considerably in their ability to deal with outside threats and evaluate new opportunities. The growth drivers for exchanges are stacking up and the outlook ought to be very favourable for the world of traded products.

Patrick L Young (Patrick@derivativesvision.com) is chairman of a Balkan investment boutique and author of the Capital Market Revolution! books. A columnist in Mondo Visione’s Trading Places newsletter, Patrick Young advises governments, investors and exchanges on their strategy and growth.