Exchanges, and more broadly “market infrastructures”, are the critical plumbing of the capital markets. Driven by the growth of capital markets, the importance of these infrastructures has been increasing. Their evolution has been remarkable and has generated very strong returns for savvy investors.
The FTSE Mondo Visione index, the oldest, best-known index of exchange valuation, illustrates this phenomenon vividly. During 2001-2007, an investor in exchanges would have multiplied his money by 10X (~47% per annum). During 2009 -2019, by almost 6X (~18% per annum). During the long 2001 -2020 period by around 15% per annum, vs 10.5% per annum for the FTSE All-World Index. Quite a track record.
During the last 20-25 years, exchanges and market infrastructures have experienced many changes: transition to electronic trading, demutualization, privatization and sustained merger and acquisition activity. We believe they are aiming to serve the global investment process as oligopolistic, global fully integrated utilities. In many ways, they are at the peak of their game, achieving extraordinary valuations.
Will this continue? We anticipate they will be encountering formidable new challenges and competitors.
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Let us start with a definition: market Infrastructures are the institutions, systems or services which support various essential steps in the overall investment process. They include trading, clearing and settlement institutions and market data and analytics services
- Stock and Derivatives Exchanges: e.g. CME, ICE, NASDAQ, CBOE, Deutsche Boerse, LSE, Euronext, B3 (Brazil), TMX (Canada), HKEX, ASX
- Interdealer Brokers: e.g. TP ICAP, BGC Partners, Viel-Tradition
- Clearinghouses: e.g. DTCC, LCH, OCC
- Central Securities Depositories, Registrars, Transfer Agents, OTC Trade Repository Services: e.g. DTCC
- Custodian Banks: e.g. State Street, BONY Mellon, Northern Trust
- Market Data Services: e.g. Bloomberg, Refinitiv, IHS Markit
- Analytics: Index providers, rating agencies e.g. S&P, Moody’s, Fitch
Traditionally these were (and still are, mostly) distinct infrastructural activities or businesses involved in various steps of the investment process.
As businesses, they share several favorable intrinsic economic characteristics
Steadily growing revenues.
Generally, market infrastructures process transactions – e.g. purchases and sales of securities or derivative contracts and charge for their services with a mix of trading / transaction fees and/or access fees. Trading fees are tiny percentages of the volumes transacted, but since the volumes are enormous, the revenues add up. Exchanges/market infrastructures also generate valuable data, which they sell via subscription. All these items represent variable revenues, and benefit from the steadily increasing volumes of transactions in capital markets.
Mostly fixed or semi-fixed cost structure
A market infrastructure consists primarily of computers. The staff required to operate an exchange, or a clearinghouse or any market infrastructure is usually small. As a result, the operating costs of a market infrastructure are mostly fixed or semi-fixed.
Attractive profit margins
Increasing business volumes, variable/increasing revenues, mostly fixed costs, and market power are obviously a recipe for attractive profit margins.
“Natural” monopolies or oligopolies
Market infrastructures also tend to exhibit a high degree of market concentration.
- This is often the result of network effects or “network externalities”. For example, in trading, “liquidity begets the liquidity”. Traders seeking to buy or sell an asset will naturally gravitate to venues where there already are other active traders, for the same assets. In other words, they seek existing “liquidity” and contribute to it. Liquidity for any given type of asset – stocks, bonds, derivatives – thus tends to concentrate.
- In clearing and settlement, traders’ back offices must interact to exchange securities, cash payments and margin payments. With existing technology, the most efficient way to do this is to organize around a central hub – such as a clearinghouse or a central securities depository - and connect to the hub. The hub thus becomes a natural monopoly.
- In market data services and analytics, we also note a tendency towards concentration. Traders prefer to subscribe to a small, manageable number of “screens”. As a result, we end up with an oligopoly of firms – e.g. Bloomberg, Reuters/Refinitiv, S&P
Outstanding economic performance
Typical ranges of profit margins (net income as % of revenues) obtained by various market infrastructures are high and so are their valuations. (See table below)
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Typical Profit Margins |
Typical P/E Ratios |
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EXCHANGES (e.g. CME, ICE, NASDAQ, Deutsche Borse, LSE, Euronext, Brazil B3, Canada TMX, CBOE, MarketAxess ) |
25% - 45% |
17x-70x (avg 29x) |
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INTERDEALER BROKERS (e.g. TP ICAP, BGC Partners, Tradition Viel) |
7-15% |
7x-34x (avg 22x) |
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MARKET DATA SERVICES (e.g. Bloomberg, Refinitiv, IHS Markit) |
25-45% |
31x-45x (avg. 36x) |
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ANALYTICS, INDEXES, RATINGS (e.g. S&P, Moody’s, Fitch) |
35%-50% |
30x-33x
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Demutualization-Privatization -M&A
Historically, most exchanges and clearing and settlement institutions were organized as member-owned utilities. The members were usually brokerage firms, the “sell-side” and banks. Members controlled and kept for themselves exclusive access to the service – trading, clearing and settlement. Their objective was to keep the costs of services as low as possible. In fact, many exchanges and clearing and settlement institutions were technically non-profits: profits were only used to enhance facilities and to pay “fee rebates” to the members.
Starting around the 1990s, many exchanges and clearing-settlement institutions have demutualized and privatized transforming themselves into normal for-profit, shareholder-owned firms. Once privatized, and listed, exchanges and clearinghouses, gained “acquisition currency” and were in a position to acquire each other and consolidate the industry: there has been sustained exchange consolidation since the mid-late 1990s. Exchanges have thus led the way in the evolution of market infrastructures.
Technology-driven “coalescence”
“Coalescence: the joining or merging of elements to form one mass or whole” (Oxford)
Information technology, in general, is driving the coalescence of many functions. Think of your iPhone: in one small convenient device, you have a phone, a Rolodex, videoconferencing, a camera, a TV, a calculator, a calendar, social media, various health monitoring apps and so on…Why? Because it is technologically possible, because it offers the convenience of one-stop service.
We see similar technology-driven coalescence phenomenon in many business processes, in particular in capital markets infrastructures. Capital markets businesses used to be distinct, separate functions – broker-dealers, exchanges, inter-dealer brokers, clearing houses, depositories, custodians e.g. – Each of these businesses processed certain steps of investment-related transactions and passed information to other businesses, usually in batch form, for further processing. With the transition to electronic trading, this has changed.
Technology now enables seamless, real time integration of these functionalities along several dimensions. The integration may be along the “straight-through processing” (STP) chain (pre- trade, at trade time, post-trade, asset administration), across asset classes - equities, fixed income, FX - across instruments e.g. cash markets, forwards and futures, options, repo and securities lending and of course across geographies. The diagram below, drawn from the investor viewpoint, illustrates these integration opportunities. The integration helps the end-user by providing one-stop efficient service for complex, arbitrage-based trading strategies, e.g. index arbitrage among baskets of stocks and stock index futures conducted on the same exchange, capital structure arbitrage involving stocks, stock options and credit default swaps conducted in the same venue.
For a player in the capital markets infrastructure ecosystem, there are opportunities to expand along all these dimensions. The diagram illustrates the opportunities for an exchange to move into “adjacent” businesses, along the STP chain: at-trade (interdealer brokers, post-trade (clearing and settlement) and pre-trade (data and analytics),); to expand into various asset classes, or various instruments.
And of course, geographical expansion, be it in-country, in a region e.g. Europe, or globally, is always appealing.
| AMERICAS | EUROPE/MIDDLE EAST /AFRICA | ASIA-PACIFIC |
The key point of the above diagram, which is drawn from the investor perspective, is that, due to technology, exchanges and market infrastructures are driven to “coalescing” and consolidating, in multiple dimensions: along the STP chain, across asset classes and instruments, across geographies.
They are thus headed to become integrated investment utilities.
Following privatization, exchanges and market infrastructure are driven by shareholder value creation. They are increasingly in competition with their former owners and members – the sell-side. The sell-side in fact has been considerably weakened in the last 20-30 years and was also driven to radical consolidation.
The ultimate beneficiary of the above trends is the buy-side, especially large institutional investors. As the infrastructures become more efficient, the investors will invest globally, faster, cheaper, better.
Exchange Consolidation
Historically, exchanges have led the way. Thanks to their privatizations, they gained the currency to make acquisitions and several waves of consolidations followed.
Initially, beginning around the early and mid-1990s, we saw a wave of in-country consolidations, especially in countries where there were multiple exchanges, like Germany, France, Canada, Brazil.
Subsequently, we saw various initiatives at regional consolidation, primarily in Europe: the creation of Euronext, the LSE – Deutsche Borse on-again off again merger attempts, LSE- Borsa Italia , Euronext-Ireland, Swiss SIX – Spanish BME, Euronext-Borsa Italia ; in other geographies, we noted the creation of loose coalitions, e.g. ASEAN Link of Southeast Asian exchanges and MILA , coalition of Latin exchanges.
Then we saw global consolidation: NASDAQ-OM, NYSE-Euronext , HKX-LME, ICE-LIFFE
Exchange consolidation follows a simple but powerful intrinsic logic:
- a more powerful exchange acquires a smaller one, paying with stock (preferably) or cash
- it seeks some economies of scale, typically by migrating to a common technology platform, and other cost reductions
- as these economies are achieved, the valuation of the new combined exchange increases, which provides currency for a subsequent acquisition
- repeat!!!!
Clearly in-country consolidations are most compelling and have delivered strong economic results.
Regional consolidation is more complex since each “national” market fears losing its autonomy to the regional leader(s). Remember the many attempts to merge LSE with Deutsche Boerse.
Global consolidation is even more challenging since the economic synergies across very different geographies and time zones may be tenuous and difficult to achieve.
As the chart above illustrates, there was a tremendous wave of consolidation, in-country, regional and global from 2000 to 2007-2008, when it stopped due to the great financial crisis. It is interesting to note that there was a break of about 2-3 years following the crisis and then several failed attempts at further geographic consolidation (e.g. London – Canada, Singapore- Australia). The M&A waves track the valuation of exchanges (see FTSE Mondo Visione index).
The geographic consolidation process has restarted in recent years, with a few exchanges that had remained alone e.g. Swiss SIX – Spanish BME, Euronext – Irish Stock Exchange and may continue in areas which are still fragmented, notably in Asia and Africa.
Today’s “equilibrium situation” seems to be a combination of
- a few global exchanges (CME, NASDAQ OM, ICE e.g.),
- some regional exchanges (e.g. Euronext),
- remaining national exchanges usually in smaller countries (e.g. Israel)
- a few loose coalitions of exchanges (e.g. MILA -Mercado Integrado Latinoamericano or ASEAN Link)
- a large number of new “startup” exchanges (especially in jurisdictions such as the US with Reg NMS)
The nature of the consolidation process has also been changing.
We note several trends:
- Initiatives by exchanges to become “technology businesses”
- Initiatives by exchanges to penetrate new asset classes
- Initiatives by exchanges to penetrate the “pre-trade” market data and analytics business (and for market data companies to enter new areas)
Technology businesses
Since information technology is key to operations, any exchange or market infrastructure must have a “core competence” in IT. Whenever a merger of exchanges occurs, one of the typical key steps is to move the target’s IT to the acquiror’s IT platform, thus eliminating significant costs. This creates IT development and implementation skills.
Several major exchanges, e.g. NASDAQ OM, LSE, Euronext have built on their IT skill foundation and set up standalone technology businesses. They offer turnkey or customized solutions to other exchanges and clearing and settlement institutions.
New asset classes
The basic mechanisms of capital markets – trading, clearing and settlement, market data – can be applied to many new asset classes.
Among financial asset classes, this could include the equity and debt of private companies. Several exchanges are already experimenting in this area. Some are considering consumer credit assets, such as credit card receivables securitizations.
Other asset classes include commodities (which have sometimes preceded financial assets), electric energy, petroleum and natural gas, carbon credits and digital assets such as cryptocurrencies. Many exchanges already handle all of these.
A few exchanges are bolder and going further.
Brazil, for instance, is one of the leading countries for exchange-related Innovation. Brazil’s futures exchange has for many years launched debt instruments related to agricultural financing. CETIP, a unit of the Brazilian B3 exchange-clearinghouse-depository has pioneered central registration of vehicle liens (related to automobile finance) and appraisal / registration of real estate properties ( in support of mortgage finance). These are very large asset classes, and they offer promising new frontiers for market infrastructures
The market for intellectual property – patents, copyrights, trademarks, and related licenses - is also very intriguing. Such intangible assets could also be registered centrally. A market infrastructure could monitor and manage their utilization and royalties and offer a central venue for trading them.
The Data/Analytics “New Frontier”
We have long advocated that exchanges should be active in the data and analytics space. Many exchanges are reluctant, fearing members or regulators would react negatively. However, it is very logical for exchanges to expand into the pre-trade space of market data, indexes, benchmarks, and analytics.
In recent years, several leading exchanges have in fact started to focus on the pre-trade, data/analytics business.
London Stock Exchange (LSE), which had historically missed out on many development opportunities (in-country consolidation with LIFFE in 2000, several cross-border mergers - with Deutsche Boerse several times and with Toronto in 2011) and faced Brexit, has been forced to be bold.
LSE started in the data business with FTSE, its joint venture with the Financial Times (FT), established 1995; it bought out the FT for GBP 450 million in 2011; it acquired the Frank Russell company (indexes and passive management) in 2014 for USD 2.7 billion and subsequently divested the asset management portion. The result is FTSE Russell a global player in indexes and benchmarks.
In 2020, LSE announced a blockbuster $27 billion acquisition of Refinitiv, the former Thomson Reuters market data services (which has just been approved by regulators). Due to Brexit, and needing to appease EU regulators, LSE has ceded Borsa Italia to Euronext.
Also, in late 2020, S&P Global, a rating agency and market data, analytics, and index player, announced it is acquiring IHS Markit for $44 billion, a giant consolidation in the “pre-trade” space (also subject to regulatory approval).
These enormous deals underline the growing importance of the data/analytics space. Since the trading and post-trade businesses have experienced competitive fee compression, data and analytics are very attractive, notwithstanding possible conflicts of interest. Obviously, the data and analytics space is also becoming oligopolistic, which will undoubtedly attract regulatory and antitrust attention.
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To sum up, exchanges and related market infrastructures have been consolidating along a variety of dimensions – geographically, along the STP chain, across asset classes.
They are becoming giant oligopolistic players, implicitly aiming to become integrated investment process utilities supporting a “centralized architecture” of the capital markets world, which is the historical model. These strategies and the market concentration they have engendered, have delivered phenomenal profitability and shareholder value. Market infrastructures are in a golden era!!!
However, some challenges are already apparent. Regulators and the investment community are concerned with the increasing power and scope of giant exchanges/market utilities.
More important, technology is advancing and may change the game.
The establishment of central venues for trading was key in concentrating liquidity and the establishment of central clearing and settlement institutions was key for mitigating counterparty credit risk. Technological change may bring about new decentralized market models and new challenges.
Technology-driven restructuring: towards decentralized markets?
With ubiquitous fast internet, blockchain technology and artificial intelligence it is possible to envisage a decentralized market architecture, with disintermediation of central institutions such as traditional exchanges and central clearing and settlement institutions.
- A multilateral, decentralized, networked architecture rather than a centralized architecture for liquidity provision
- A decentralized, bilateral “DVP at T Zero” real-time clearing and settlement architecture, based on blockchain technology
- Asset tokenization
Multilateral liquidity networks
As a result of sell-side consolidation and Basel III regulation, market-making activities in banks have been penalized with heavy capital requirements. Liquidity has become “bifurcated”: lots of liquidity in the large caps and the already-liquid products and scarce liquidity in smaller securities, currencies, and derivatives. At the same time, there is a lot of hidden liquidity (in the trading room of a Fidelity, there are every day lots of buy and sell orders which can be crossed internally at a price compliant with Best Execution) and a lot of latent liquidity (liquidity which would be available at a price) in investor portfolios.
A multilateral liquidity network would match potential buyers and sellers and arrange quick auctions for any product at short notice. The network would enable traders to place various types of orders and to be matched with counterparties anywhere in the world.
Orders that remain unexecuted could be routed to appropriate exchanges or market-makers.
Bilateral T Zero Settlement
In a blockchain-enabled world, securities and FX trades could be settled in T Zero, on a bilateral basis, without the need for Central Counter-Party (CCP ) institutions. Settling trades with DVP in T Zero means counterparty credit risk is practically eliminated, which would reduce the capital required in CCP institutions (which is often the members’ capital). CCPs will still be needed for derivatives and margin trades.
Asset tokenization
Asset tokenization is defined as digital representation on a blockchain of any asset, ranging from stocks, bonds, derivatives, commodities, to real estate, vehicles, intellectual property, and art. Basically it means that any item of significant value gets a unique, tamper-proof “identity card”.
The combination of the above trends means that at some point in the future, investors will be able to trade and hold a great variety of assets, in a convenient, tamper-proof electronic form. Issuance of equity will be greatly facilitated for small and medium sized enterprises. Trading of all types of assets will be greatly facilitated, at negligible transaction costs. It will be possible to diversify portfolios widely, to execute a broad variety of arbitrage strategies easily and rapidly and to manage risks in a “granular” way. Market liquidity and trading volumes will continue to increase.
These developments are still in their early days. The technologies are already there, but their implementation will still require legal and regulatory evolution.
These developments promise new kinds of decentralized market structures, which represent challenges to the existing centralized market model. This means new competition for today’s market infrastructures.
During a golden era for exchanges and market infrastructures, it is difficult to imagine negative or unfavorable scenarios. It is easy to miss the time when the tide is turning…Exchange and market infrastructure management and their shareholders should prepare!!!
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The CBM Group, founded in 1992, is a New York based consulting firm specialized in capital markets. CBM has advised over 25 exchanges, interdealer brokers, clearing and settlement institutions, market data services/analytics firms and rating agencies on strategy, risk management and mergers and acquisitions.
Copyright © 2021 The CBM Group LLC
Contact:
Andre Cappon, President acappon@thecbmgroup.com
