Finance & Banking
In some ways, securities exchanges might seem like remnants of the past. After all, neoclassical architecture and marbled columns don’t exactly conjure images of split-second trades whizzing around modern-day global markets. But while those historic representations live on in movies and cable finance shows, they fail to depict current reality. In truth, securities exchanges are highly automated and well positioned for today’s electronic age. This digital evolution is just one of many factors that I believe will propel the growth of exchange companies and make them compelling from an investment perspective.
Financial exchanges have undergone a notable transformation in the past two decades. Among other changes, they’ve switched from nonprofit entities to public companies and bulked up through a wave of mergers. These shifts have been spurred partially by the need to retool for the electronic era. Though computers have been woven into the securities markets for decades, the combination of technological advances and falling costs caused digital trading to surge dramatically in the late 1990s.
That was initially seen as a threat to traditional exchanges, but ended up as an unexpected blessing. For the first time, these century-old venues were able to harvest enormous amounts of trading information that could be repackaged and sold to the investment firms that do business on the exchanges. Such data mining has become popular across many industries, and investment firms are particularly eager to sift through trading patterns that could yield an edge in the market. In effect, the monetization of data has amounted to a profitable new business for the exchange industry.
Securities exchanges have other advantages. They tend to have impressive profit margins, formidable barriers to entry and moderate cost structures. I expect all these factors to drive reliable revenue and earnings growth in coming years.
A securities exchange is essentially a meeting place where traders converge to buy and sell stocks, bonds, commodities or other financial instruments. Some traders want to hedge their risks — for example, a farmer seeking to lock in wheat prices before the harvest or a company trying to shield itself from gyrating interest rates — while others want to speculate. Exchanges make money in several ways, including through fees collected on each transaction.
In general, the most successful exchanges offer unique products that they control exclusively, such as futures contracts or exchange-traded funds tied to a popular stock index. An exchange with a hammerlock on a popular product has a huge competitive advantage. Traders naturally want to be in whichever market has the greatest number of other traders because that increases the odds of being able to buy or sell quickly and at favorable prices. In other words, the very fact that an exchange is popular is likely to make it more popular. Think of it as a networking event where attendees cram into a jam-packed meeting room instead of a half-filled one because they want to interact with as many people as possible.
Historically, exchanges benefited as the rising tide of economic growth led to increased trading activity. Not surprisingly, the industry does particularly well when market volatility spikes because trading volume — and hence, revenue — balloons. Exchanges benefit regardless of whether the market itself rises or falls.
Of course, trading activity goes through periodic lulls when market-moving news subsides and there is less urgency to buy and sell. That dynamic has been present in the stock market in the past year. The revenue from data products has helped to counterbalance the inherent vicissitudes in trading activity. Data services are attractive because they are typically subscription-based, with multiyear contracts and annual price increases. Trading firms use data for a variety of purposes. One of the most basic is the need to gauge whether they are getting the most favorable prices on their trades — in other words, selling for the highest price possible and buying for the lowest price.
Demand for data has also been fed by government regulations. Given their importance to the economy and financial markets, securities exchanges are heavily regulated. But surprisingly, regulation has helped the industry by creating new needs for data. For example, a rule taking effect next year will require mutual funds to give the government detailed information on certain types of risks. As a result, the investment firms’ legal departments will have to analyze data closely to ensure compliance with the rule.
The explosion of data is helping to boost revenue and profit margins at exchange companies. In fact, the industry enjoys some of the highest margins among large U.S. companies. Exchanges also generate strong cash flow, which provides leeway to raise dividends, buy back shares and acquire competitors or data analysis firms.
Aside from intermittent trading lulls, the industry faces some risks, including the chance of unfavorable government mandates in the future. There’s also the danger of trading outages caused by technological glitches. Although the effect would likely be short-lived, that could do financial or public relations damage.
Still, I believe the outlook is bright for securities exchanges. The demand for analytics and customized trading products is only likely to grow in the future. That should result in steady revenue growth and further margin expansion.
The above article originally appeared in the Summer 2017 issue of Quarterly Insights magazine.