Are Exchanges Overheated?

Exchanges are this year's hottest financial-services story. The Dow Jones Global Exchange index is up 77%. NYSE Group (NYSE: NYX  ) is merging with Euronext. Nasdaq (Nasdaq: NDAQ  ) is bidding for the LondonStock Exchange -- the latter's fifth suitor in two years. And the public markets embraced Nymex Holdings (NYSE: NMX  ) by doubling its stock on the first day of trading earlier this month. With the Chicago Mercantile Exchange (NYSE: CME  ) trading at a higher price-to-sales ratio than Google, it's a good time to think about risks to exchange valuations.

More technologists than traders
In a recent article in the Financial Times, Glenn Hutchins, whose private equity firm, Silver Lake Partners, owns an 8% share in Nasdaq, commented, "[Exchanges] are technology businesses, an insight that most of the people running them don't even get." A little harsh, but it's a lesson investors should learn.

Technology is a big driver of current exchange valuations. Traditional exchanges, including the NYSE and New York Mercantile Exchange (Nymex), were built around trading arranged by humans, working from a physical floor. Applying high-speed, algorithm-based trading technologies creates a large opportunity for automation. For example, fully automated trading at the NYSE threatens the livelihood of roughly 2,500 specialists, floor brokers, and clerks.

To exploit this opportunity, NYSE is rolling out the Hybrid system. Similarly, trading of many of Nymex's trading contracts is migrating from the open-outcry pits to Globex, an electronic trading system licensed from the Chicago Mercantile Exchange (CME). The drawback is that these large automation benefits are one-time effects -- once the specialists and their pits go, so does the potential cost savings.

In addition, technology is driving the merger fever in exchanges. Originally, the motive was defensive. By acquiring Archipelago, NYSE removed a major threat. The same argument can be made for Nasdaq's acquisition of Instinet's INET system. Over time, technology has muscled up. It's the main catalyst for the NYSE Euronext merger; out of forecast annual savings of $275 million, $250 million comes from technology. For the CME and Chicago Board of Trade (NYSE: BOT  ) merger, half of the potential annual cost savings of $125 million will come from technology.

Battle of the trading machines
Technology has more lasting effects in its ability to speed up trading execution and support greater trading volumes, with little increase in marginal cost.

As hyperactive traders demand faster and faster trading, developing faster technology is now an arms race. Nasdaq investor presentations state that their trading systems have one-millisecond response times for orders, executions, and cancels. And the chief executive of the LSE recently boasted that the latest version of its trading system will cut dealing times to 10 milliseconds. Meanwhile, the NYSE's new Hybrid system brings average transaction times down from nine seconds to 300 milliseconds.

The new trading technologies are even more important in enabling substantial increases in trading volumes at minimal marginal costs. For example, at the NYSE, trading volume is low relative to the market capitalization of the companies that trade on the exchange. Its trading volume-to-market capitalization ratio is 1; the European exchanges have a ratio of 1.5, and Nasdaq has a vigorous 2.5.

The big question: How much of the forecast increase in future trading volumes is already built into current stock prices? Pricing is already trending downward under pressure from customers and competitors.

Don't provoke the customers
Securities exchanges are, in theory, low-margin, high-volume utility businesses. However, CME and Nymex have operating margins greater than 60%, and though it's still turning around, NYSE has a margin of close to 30%. Margin envy has set in, provoking exchanges' investment-bank customers to action.

First, investment banks have formed pools of "dark liquidity," internal trading platforms that anonymously match buy and sell orders. Examples include Morgan Stanley's MS Pool and Goldman's Sigma X.

Second, the investment banks have made protective investments in regional exchanges. Investment banks own the majority of the Philadelphia Exchange, and the Boston Stock Exchange has an alliance with Citigroup, CSFB (NYSE: CS  ) , and Lehman (NYSE: LEH  ) .

Third, in Europe, the investment banks have taken the extra step with "Project Turquoise," a mild-mannered code name for a plan to build a new trading platform to compete with the established exchanges in Europe.

Finally, the investment banks are investing in start-up companies to compete with the exchanges. A good example is BATS Trading, a new alternative trading system. It's currently handling 100 million shares a day, with a target of one billion shares a day by the end of 2008. At a reported cost of less than $2 million, the system is cheap to use and build. Lehman Brothers, Morgan Stanley, and Credit Suisse all have stakes in the company.

Powered by Paris
There are many components involved in evaluating the value of an exchange, including liquidity, type and breadth of instruments traded, and operating performance. (For a framework, see this article.)

In an era of battling trading machines, the quality of the trading technology is critical. But investors may be surprised to learn how interlinked the trading technology is at the various exchanges. The story starts and ends in Paris.

It begins with an electronic market system called NSC, originally developed by Euronext Paris. In Chicago, CME has a long-term license on NSC, a key component of its vaunted CME Globex electronic trading platform. In turn, CME earns services revenue from CBOT and NYMEX by processing their trades using CME Globex. Back in Paris, NYSE is planning to merge with Euronext. As a result, three major U.S. exchanges will be NYSE customers, running off a system originally developed in France.

Equally tight relationships exist in the profitable but oft-forgotten clearing business. CME and NYMEX jointly built a system called "Clearing 21," which they, in turn, have licensed back to Euronext.

In summary, investors in the exchange sector face Google-like valuation multiples driven by one-off technology improvements and trading volume increases that may not materialize. In addition, investors face the risk of paying premium prices for trading technologies that are often based on a common French ancestor. Investors should tread carefully around these trading machines until prices fall to more reasonable levels.

Further Foolishness in milliseconds:

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Fool contributorJohn Finneranwrites and advises on increasing the financial value of technology. He is ranked 355 out of 14,330 in CAPS, and does not own any of the shares mentioned. The Fool's disclosure policy is remarkably quick.


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