The European securities markets are in the midst of profound cyclical and structural change. While much of the focus has been on the impact to asset managers and their brokers, this article seeks to unpick the implications for exchanges, clearing houses and central securities depositories (CSDs).
Falling cash markets have focussed attention on cost cutting and new product and service development while mergers are broadening the scope of the businesses and demanding even greater diligence in managing change and growth. In the face of this unparalleled degree of change, a dozen and a half exchanges around the world have demutualised and a dozen are now floated, most recently of which are the first North American exchanges (Toronto and CME).
This article seeks to provide insights into the quoted and unquoted exchange and post trade industry. We argue that the ultimate success of individual exchanges will be driven by diversification and innovation beyond their core service provision.
Industry revenues grew in 2002
Global stock exchanges, clearing houses and central securities depositories (together 'exchanges' in this article) enjoyed combined revenues of ~EUR11.2bn in 2002, which we estimate rose ~1.5% from 2001. Total industry profits were ~EUR2bn in 2002, up by ~19% from 2001 (which included substantial M&A related improvement such as at Euronext).
European exchanges account for almost 50% of global revenues. We estimate European exchanges had combined revenues of some ~EUR5.2bn in 2002 (up 2.5% on 2001) vs ~EUR4.5bn in North America and ~EUR1.5bn in Rest of World. Total European profit margins (for quoted and demutualised players but excluding mutuals) were ~26%, somewhat higher than that for the global quoted and demutualised exchanges (~22%), largely as they are at an earlier stage of demutualisation. Around the globe the 10 quoted players had on average a ~28% operating margin, down slightly from 2001.
To put this into context, in 2002 European exchanges only accounted for 9% of investor wallet in capital markets. Of this wallet, ~42% is derived from cash equities and ~19% from equity derivatives. Investor 'spend' on capital markets in terms of commissions and spread amounts to ~EUR40bn in Europe, of which the sell-side (including IDBs) captures ~EUR29.5bn, exchanges and CSDs ~EUR3.5bn, custodians ~EUR4.5bn and data/systems providers ~EUR2.5bn.
Europe's quoted players outperformed the industry average. Europe's three largest quoted exchanges (Deutsche Börse, Euronext and LSE) grew combined revenues by ~2% in 2002 to ~EUR2.8bn and grew operating profits 30% to ~EUR760 million (excluding Euronext, which was undergoing profound M&A-related changes in 2002, profit growth was ~9% on flat revenues). Once again, the large quoted exchanges outperformed most other European capital market players, albeit in part driven by M&A.
Exchanges: toll roads on capital markets volumes
Exchanges are geared investments on capital market volumes. That said, they are less geared to market value than brokers since trading earnings are in part driven by the number of trades rather than purely their value - much like a toll road.
Relative to the sell-side, exchange margins have been robust. The ratio of sell-side revenue to exchange revenue capture has fallen in European cash equities from 4.3 to 2 between 2000 and 2002 owing in part to the sell-side's ad valorem revenue model (average trading volumes fell ~13% in 2002); due to margin erosion from the shift to automated trading strategies (programme trading now accounts for ~15% of long only volumes); and to a greater proportion of trading being facilitated on-exchange. Meanwhile in equity derivatives the story is somewhat different, driven by strong OTC/structured product growth.
By contrast, European capital market players were harder hit by falling markets and issuance, with market-related revenues down ~21% between 2001 and 2002. Within this ECM suffered the most with revenues down by more than one-third, European cash markets revenues were down by 30% (vs. 24% in the US, the difference largely being greater margin erosion and ad valorem pricing model), whilst derivatives and financings were down 10% and 8%, respectively. Gearing in the model meant profits more than halved in 2002.
Trading fees represent some ~55% of European stock and derivative exchange revenues (or 30% of total 'industry' earnings). The European and Asian exchanges with their 'under one roof' business model, often with for-profit clearing and settlement, are more diversified than the US exchanges where ~70% of trading exchange revenues (or ~42% of 'industry' revenues) are trading fees. See Table 1.
The European exchanges' portfolios of business provide a degree of natural hedging and avenues for growth. Derivatives growth has offset weakness in cash over the last two years. Moreover, settlement and custody capabilities have performed strongly as well as opened opportunities for niche services adjacent to the core vanilla offerings, while the largest European exchanges have sought to commercialise their IT technology to other exchanges.
| Table 1: Sources of revenue at major exchanges | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| EUROPEAN | NORTH AMERICAN | ASIAN | |||||||||
| DBAG | Euronext | LSE | OM Group | CME | NYSE | Nasdaq | TSX | Australia | HK | Singapore | |
| Cash listing | 1% | 4% | 16% | 7% | 0% | 39% | 22% | 32% | 19% | 18% | 0% |
| Cash trading | 14% | 22% | 39% | 10% | 0% | 35% | 49% | 34% | 21% | 18% | 32% |
| Derivatives, trading (and clearing) (1) | 23% | 34% | 0% | 12% | 59% | 0% | 0% | 0% | 19% | 5% | 21% |
| Clearing, settlement | 43% | 20% | 0% | 0% | 20% | 0% | 0% | 0% | 23% | 10% | 40% |
| Information products | 8% | 11% | 40% | 4% | 11% | 16% | 25% | 25% | 13% | 16% | 7% |
| Systems | 11% | 6% | 0% | 62% | 0% | 0% | 0% | 0% | 0% | 0% | 0% |
| Other | 0% | 3% | 5% | 5% | 10% | 10% | 4% | 9% | 5% | 33% | 0% |
Note: 2002 for Euronext, ASX, OM, NYSE, LSE and Deutsche Boerse. 2H02 for Singapore and Hong Kong. 3Q02 for Nasdaq, TSX Group and CME. For Euronext we have excluded minorities (i.e. 73% of GL Trade and 20% of Clearnet). DBAG pro forma as if 100% Clearstream owned for 12 months. (1) Clearing of derivatives is booked under 'Derivatives' at DBAG, CME and OM.
Source: Company data, Morgan Stanley Research, Mercer Oliver Wyman
Three structural trends are offsetting cyclical weakness of cash markets
Three structural trends - the growth in the velocity of cash trading, the growth in derivative trading strategies and a greater proportion of trading being channelled through clearing houses (both cash and derivatives) - have helped offset the cyclical weakness of earnings from cash markets-related activities.
The current bear market is unusual in that cash trading velocity has increased - driven largely by the accelerated reduction in 'all-in' trading costs, and in part by high market volatility. Brokerage costs have fallen 10-15% p.a. in the past two years, more than double the average in the previous five years, through greater automation of trading, introduction of CCP functionality and shifts to lower revenue margin trading strategies, such as programme trading and static arb. Moreover, the new trading strategies are slicing and dicing orders and generating more trades. Take the UK in 2002, which was the most extreme: while the FTSE fell ~25%, the value of trading only fell 4% and the number of trades grew 16%. LSE equity trading revenues were up 8%.
Whilst hangovers can be enduring, we expect equity trading volumes to continue to grow modestly. Whilst we are experiencing severe headwinds to equity returns, our base case posits an improvement. In our base case, we anticipate a run rate net equity asset appreciation (assuming 50% of dividends are reinvested) at ~6.5% per annum (from March 2003) plus new listings of ~1.5% per annum, giving overall market cap growth of ~8% per annum, in conjunction with an increase in trading velocity of ~2.3% per annum, driven largely by greater application of quantitative trading strategies.
Whilst relatively bullish given current market conditions, this increase in traded value is considerably lower than the 1990-1999 run rate of ~27.5% per annum. Accounting for margin erosion would suggest revenue for brokers and exchanges would increase at a slower rate than traded value. That said, there are risks to this base case: heavy headwinds could continue in the equity markets, stalling many new issues, and a collapse in volatility could put our velocity forecast at risk.
Derivative volumes are rising strongly, driven by greater sophistication in risk management, new products on-exchange and modest cannibalisation of the cash markets. In Europe exchange traded contracts grew 18% over 1998-2002 (vs 14% in the US), and continue to have early momentum in 2003. Today the global exchange traded derivatives market (trading and clearing fees) generates ~EUR2.6bn in revenues (of which in Europe, equity derivatives represented ~EUR425m, non-equity derivatives ~EUR520m and cash equity ~EUR1.3bn) - only modestly smaller than the global cash markets (~EUR3.2bn). Whilst some of the growth in derivatives is cyclical, and therefore may decline, the underlying secular trend to greater risk management, in our view, is dominant. We estimate less than half of the volumes on Europe's major derivative exchanges are explained by changes in volatility, and the majority of growth of capital market products on-exchange are driven by structural shifts.
Capital efficiency, risk management and new services are shifting an increasing proportion of cash and derivative business on-clearing house and thereby on-exchange. Today, over two-thirds of blue chip stocks are traded on-exchange in Europe and less than one-third off, with the derivatives market being roughly the mirror image:
- Whilst there is a catch-up opportunity for cash markets that are introducing central counterparty (CCP) functionality (e.g. Germany, Spain, Italy, Nordic) or those with less history of electronic order books (e.g. US), cash equity markets appear to be approaching a maximum threshold of order book capture. The level of this cap is likely to vary from ~70% to 90% of market volume, driven by the nature of regulatory, market and investor characteristics (e.g. in France with relatively low institutional participation and concentration rules we believe that there is little scope to increase beyond the current ~85% capture rate, whilst the UK with less than half of the value of trading going through the order book potentially has further upside).
- In derivatives, on the other hand, there still appears to be significant headroom for growth. Over the last 18 months, trading of derivatives on-exchange grew faster than OTC for the first time in a decade. We believe this trend will continue, as mounting concerns over counterparty creditworthiness and capital efficiency encourage investors to trade (or, more accurately, clear) on-exchange and take advantage of centralised clearing. As shown in Table 2, globally three-quarters of interest rate derivatives and one-half of equity products are traded off-exchange. Whilst some of this will remain off-exchange, we expect an increasing proportion of vanilla flow products to shift on-clearing house.
| Table 2: Value of derivatives trading by location (USDtr) | |||||||
|---|---|---|---|---|---|---|---|
| OTC | Exchange Traded Futures | Exchange Traded Options | Total | ||||
| as % | as % | as % | |||||
| FX | 16.9 | 99.3% | 0.1 | 0.6% | 0.02 | 0.1% | 17.02 |
| Interest rate | 67.5 | 75.8% | 9.1 | 10.2% | 12.5 | 14.0% | 89.1 |
| Equity-linked | 1.9 | 51.4% | 0.3 | 8.1% | 1.5 | 40.5% | 3.7 |
| Other | 13.5 | 100.0% | 0 | 0.0% | 0 | 0.0% | 13.5 |
| Total | 99.8 | 80.9% | 9.5 | 7.7% | 14 | 11.4% | 123.32 |
Note: OTC at June 2001, on-exchange at December 2001, Notional value, NB this is global not just European statistics.
Source: BIS quarterly
Centralised clearing could receive an additional boost as Basel II regulation bites. Central counterparty mechanisms can be instrumental in reducing systemic risk (both operational and counterparty): regulators should actively incentivise maximum leverage of these central mechanisms in the fine-tuning of risk management frameworks. Overall we believe clearing fees will be a welcome source of new revenues, although they will begin to cannibalise settlement earnings.
Threats to the exchange franchises
Whilst exchanges will increasingly seek to compete with each other, particularly for new products/services, we believe the real challenge to exchanges' franchises comes from brokers, post-trade players and the risk of regulatory or technology discontinuities.
Internalisation of order flow is a threat to exchanges' dominance, but if they retain a highly competitive offering, the impact should be limited. Some 10-15% of industry volumes could be at risk from being internally crossed and changes in market regulation, albeit with significant capital, technology and retail flow requirements. Despite modest signs of rejuvenation in sell-side technology development budgets, our view remains that the threat to exchanges is finite, given the complexity of any such technology initiatives and uncertainty of returns, not to mention regulatory positioning and best execution mechanisms/parameters. Indeed, so long as exchanges reward brokers with the benefits of scale economies through lower pricing/greater value across the activity chain, the risk ought to be contained. As margin erosion in equity brokerage is likely to continue as a greater proportion of trading is facilitated electronically, how the pie is divided will be a hotly debated issue, we believe.
Pan-European or alternative exchanges and clearers has, so far, failed to provide a more compelling offering for brokers, as virt-x, Nasdaq, DTCC and Jiway found to their cost. The stickiness of liquidity and economies of scale (largely passed on to investors via lower trading costs) provide a head start to incumbents. We believe that we would need to see a major change in exchange functionality or pricing to make the economic case to switch. Rather we expect exchanges, particularly derivative ones, will compete ferociously for new products and services as in the contest between Eurex and LIFFE-Euronext.
We expect the overlap of post-trade players with custody and CSD offerings will be brought to the fore as global custodians push upstream on the back of a value-added service offering and local agent banks are likely to continue to be squeezed. The ability of exchanges to compete head on in the more value-added services is, in our view, relatively limited and we anticipate some retrenchment towards core competence.
Market structure and regulation debates, we believe, are likely to be addressed pragmatically, anchored on the broad public policy goals of cheaper all-in trading costs, a more tightly integrated pan-European equity marketplace, systemic risk management and investor (particularly retail) protection. In particular, we think the highly charged horizontal vs. vertical debate about the ideal structure of trading, clearing and settlement will burn itself out, as market participants and regulators will look for pragmatic, as opposed to ideological, ways to facilitate cheaper trading costs in Europe. Giovannini II appears a good example of this, in our view. We believe vertical structures will tend to become more horizontal and 'interoperable' over time - much like the Leaning Tower of Pisa. Moreover, it is arguable that the introduction of clearing in many markets by vertical exchange operators (e.g. Germany, Italy and Spain) over time could actually aid greater cross-border activity, as CCPs become the standard in Europe and reduce capital at risk for counterparties. So far, national regulators feel at ease with the tensions inherent in organisations that have both a public role as a quasi-utility and are for-profit, and we believe that in order to sustain this trust exchanges will need to continue to deliver lower all-in trading costs across the activity chain. That said, one should never underestimate the unpredictable nature of lawmaking in Brussels or nationally.
Earnings growth likely to be slower in the medium term
In our base case we expect European industry revenue growth from core activities (excluding M&A) to slow to ~4-6% per annum in the next 3 years (vs. 20% 1998-2001), with profitability growth at ~7-9% as the knock-on effects from structural change among key market participants take shape. Albeit, deciding if 2003 is a normalised base year to take these projections from is highly debatable. Moreover, different assumptions for market returns and volatility will impact our forecasts, and any single exchange could differ from the industry average.
We expect based case growth of ~4% in the value of cash trading, including effects of Jan and Feb 2003, driven by net market appreciation (after reinvestment of 50% of dividends) (~6.5% p.a.), issuance (~1.5% p.a.) and continued growth in trading velocity driven by lower trading costs. Assuming 0% market appreciation has the effect of reducing the overall base case growth rate to ~1.5%; assuming 10% increases the growth rate to ~5%.
In this new world, we believe the derivatives market will be the primary engine of growth (driven by new activity as well as cannibalisation of OTC volumes), accounting for 50% of the total revenue increase.
Clearing, settlement and depository volumes should grow with cash and derivatives growth, but we predict continued strong price pressure from the large institutions, particularly on the custody side. We expect this will reduce margins considerably (2% per annum in clearing & settlement, and 4% per annum for custodial services). The net result is likely to be that clearing, settlement and depository revenues will grow at ~3% per annum until 2005.
We expect additional revenue growth of ~4% in listing fees, 3% per annum in data services, and 5% per annum in systems. All of these line items are highly sensitive to differing macroeconomic outlooks.
Returns will be driven by efficiency, scale, and gearing
In this environment, delivering operational efficiency, scale and gearing will be key to better returns.
Exchanges are highly operationally geared businesses with some ~70% of costs fixed in the near term. Despite this, the diversification of the European businesses, lower gearing to value of trades and growing operational efficiency post-flotation have meant that quoted global stock exchanges have enjoyed strong and relatively stable operating margins.
Europe's largest exchanges have spent heavily on systems to build up state-of-the-art scaleable order book trading platforms. We believe that ongoing spend will be focused on maintenance and fine-tuning rather than fundamental systems overhaul in the near term, reducing the relative run rate. However, the increasing importance of risk management functionality and domestic and cross border straight through processing will drive spend on clearing and settlement in Europe (we estimate it at 50% of total IT spend) above historical levels.
The net result of the base case revenue and expense scenarios is an improvement in profit margin in Europe from 26% in 2002 to ~29% in the core existing businesses for for-profit entities, assuming no step change margin compression. Exchanges with strong derivatives platforms, robust track records in IT delivery and central counterparty hybrid trading models are well positioned to outperform relative to the market average, in our view.
However, demutualisation, M&A and cyclical markets have all made managing an exchange more challenging, and management teams will have to keep a firm hand on the tiller and bring about further significant change in management practices. Specifically, we believe exchanges will need to develop an improved understanding of customer needs and economic drivers whilst ensuring the flexibility to respond appropriately.
M&A and technology alliances
M&A and technology alliances could deliver significant value creation, albeit demonstrating delivery on early forays will be critical.
The semi-fixed cost nature of exchange platforms means M&A could be an attractive strategy, releasing ~10% of combined costs in a merger, of which two-thirds are related to technology budgets. That said, regulatory hurdles, support of broker clientele and infrastructure change-over, make the path difficult to navigate. Alternatively, it is also likely that many exchanges, wishing to retain their independence, will choose modular technology and/or increasingly share development spend in new areas, which could also foster technology savings and greater co-operation between international exchanges. Moreover, we believe the downturn in the market could well speed up the process of European exchange consolidation/co-operation, although regulatory and legal constraints will continue to slow progress.
Growth through adjacencies
Whilst there is an industrial logic to consolidation, it is fraught with integration risk and we believe greater potential may be inherent in tapping adjacent asset classes and services for additional growth - much like the global custodians have done over the last 10 years. This note highlights three major adjacencies to the existing business models:
- Exchanges could offer modular infrastructure solutions to the sell-side, leveraging existing technological/processing know-how. Assuming a modest ~5-7% cost substitution for the sell-side, this could amount to a EUR15-20bn value business opportunity.
- Exchanges could extend their intermediation and counterparty risk-mitigation model into non-equities asset classes (mainly fixed income, FX/MM and derivatives), amounting to, we estimate, a EUR4-6bn value business for a diverse and fragmented set of incumbent players.
- While mindful of potential conflict with the sell-side, they could also offer non-transaction-related services directly to the buy-side, predominantly in the areas of decision support (research and data analytics) and middle- and back-office infrastructure and service provision - amounting to a EUR20-30bn value business for incumbent players, on our estimates.
This expansion strategy would be predicated on selective acquisitions, as organic barriers to entry in most instances may be significant. In our view, the comparative advantage of exchanges relative to 'generic' outsourcers is their embedded cost advantage and inherent market neutrality and centrality.
