With the recent news about the Federal Reserve and Congress taking action to maintain the U.S.'s financial plumbing, it's easy to forget that exchanges are among the most important financial infrastructure out there. Between the massive sell-off in the equity markets and some of the issues in the commodities markets, those exchanges are being put to the test. If you had to buy one for your portfolio, which one would you choose?
Nasdaq: Half the U.S. stock exchange duopoly
Nasdaq (NASDAQ:NDAQ) is one side of the U.S. stock market duopoly. Intercontinental Exchange, which owns the New York Stock Exchange, is the other. Nasdaq earns revenue through fees and clearing charges, and it licenses its data to trade platforms and news services. Nasdaq also operates a couple of other ancillary businesses.
In the U.S., Nasdaq operates three cash equity exchanges and six electronic options exchanges. In Europe, it operates the stock exchanges in Sweden, Denmark, and Finland. The company also has exchanges in Iceland and the Baltic states. Nasdaq's main business is cash equities trading, which is basically day-to-day stock trading. Market services (trading and clearing) constituted 36% of revenue in 2019, followed by information services (data) at 31%, and corporate services (capital markets and consulting) at 20%.
CME Group: A derivatives giant
The CME Group (NASDAQ:CME) is the premier derivatives exchange in the world, covering the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, and the Commodities Exchange. While Nasdaq trades completely electronically, CME still operates open-outcry pit trading. CME trades futures and options contracts in equity indexes, currencies, interest rates, and commodities. Last year, it traded an average of 19.2 million contracts per day, with interest rate derivatives accounting for over half the volume. The main interest rate products are Eurodollar and Treasury contracts.
Both stocks have fallen since the big sell-off in the stock market. Here is a quick rundown of the key metrics. Nasdaq has the lower multiples and the better dividend yield, but its net revenue growth (gross revenues less rebates) is flat compared with CME Group, which is experiencing double-digit revenue growth. CME also has a much higher profit margin: 44%, versus 18% for Nasdaq, which is driven by Nasdaq's lower-margin ancillary offerings.
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This summer, a new competitor for stock trading will emerge: the Members Exchange (MEMX), a joint venture by several large banks and securities firms including Goldman Sachs, JPMorgan Chase, Virtu Finacial, and Citadel Securities. Essentially it is planning on doing to stock trading what Charles Schwab did to the brokerage business: offer a stripped-down but cheaper version of trading that will satisfy the needs of most people. This will have a material effect on Nasdaq's market share and trading revenue; Citadel and Virtu alone account for a big chunk of U.S. trading volume. The data portion of Nasdaq's offerings could see pressure as well.
Technology is replacing more and more humans in the stock trading business, and with Virtu taking over much of the market-making function, Goldman and JPMorgan Chase could start replacing even more humans to drive down costs. ("Alexa, buy 250,000 shares of XYZ Corp, work 10% of the volume with a $50 top.") Most professional traders simply manually input orders into an execution algorithmic trading system to begin with, so it really isn't that big a leap.
Nasdaq is cheaper for a reason
Nasdaq has always been a kind of second fiddle in the stock-trading business. It was the scrappy upstart versus the venerable New York Stock Exchange, but it suffered a black eye in the Crash of 1987 because the market makers stopped answering their phones. It lost the bidding war for Oslo Bors (Oslo's stock exchange), it lost its hostile bid for the London Stock Exchange, and it won the Stockholm OMX more or less as a consolation prize.
It faces a competitive threat that CME does not. Nasdaq was only able to manage flat net revenue growth in 2019 to begin with, and will be looking at a market-share loss. CME has none of these headaches. While CME is more expensive on a P/E basis, it has a deeper competitive moat and is the better long-term bet.