In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.
Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily. One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.
Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.
The Financial Times is reporting how individual retail investment in U.S. equities has fallen to record lows (see article). This recent data highlights not only the nervousness of retail investors, but also illustrates the growing importance of institutional investors. By the end of 2006, retail investors owned 34 percent of all shares and 24 percent of the stock of the top 1,000 companies. These record low numbers are in contrast to when retail investors owned 94 percent of all stocks in 1950 and 63 percent in 1980. As comparison, institutions owned 76 percent of the shares in the biggest 1,000 companies in 2006, up from 61 percent in 2000.
Of course, one way to have the overall level of retail invest be down is for the large and rich retail investors to bail out of the market. A recent HSBC report (see Yahoo article) finds that the world's wealthiest people are moving their money out of stocks and bonds and into cash. As mentioned by Peter Braunwalder, chief executive of HSBC Private Bank:
"The first half of 2008 has seen a notable change in client expectations and investment choices. Faced with inflation worries, volatile asset prices and sudden changes in exchange rates, a majority of investors have reduced their transaction volumes in equities, bonds, and structured products."Apparently, such movement into cash is greatest for clients from Asia, where their tolerance for derivatives and structure vehicles has decreased significantly as counterparty risks and volatility has increased. Given recent moves by the Fed and other central banks to increase liquidity in the wake of the credit crisis, some worry how this liquidity will eventually be removed from the market, and worry that interest rates will rise as a result.
Apparently, even large sovereign wealth funds may also be having second thoughts, or are at least re-evaluating how they deploy their ever increasing capital. An article from Asian Investor discusses how sovereign wealth funds, with their own mixed investment results allocating capital to struggling financial institutions, may now be looking for broad diversification, which will ultimately increase the amount of passive investments they make.
None of this really seems to be good news for the banks or the exchanges. As evidence of further weakening, derivative trades on the exchanges fell 13% in the second quarter (see Bloomberg article). This weakening comes as more exchanges enter the fray, causing the London Stock Exchange to cut fees as it deals with new competitors (see Financial Times article). The IPO market has also suffered recently (see Wall Street Journal article, Financial Times article). Only 25 companies priced their stock IPOs somewhere in the world in August, the lowest number of deals since Dealogic began tracking them in 1995.
Maybe even more troublesome than the reduced number of IPOs is the increased numbers of delistings that are also putting pressure on the exchanges. Year-to-date more companies have been delisted from the Nasdaq Stock Market than a year ago (see Financial Week article). To a lesser extent, NYSE listing are also up as companies fail to meet minimum listing requirements. So far, more Nasdaq-listed companies have been delisted for non-compliance this year than in the previous two years. As of August 7, 54 stocks were delisted. As comparison, only 48 total companies were delisted last year, with 52 delistings in 2006. For the NYSE, 11 companies were delisted as of July 1 of this year. This compares to 21 last year and 14 in 2006.
Along with a lower number of IPOs, the lower number of listings are affecting the profitability of the exchanges which derive up to 15% of their overall revenue from listing fees. While there have been more delistings on the Nasdaq, in part since smaller companies are more vulnerable during difficult times, companies pay much less to be on the Nasdaq (around $27,500 a year), so the loss of listing fees is not as severe. On the other hand, the NYSE will lose around $878,000 in annual revenue from IndyBank and Bear Stearns alone. When looking at the stock performance, the NYSE Euronext (NYX) stock has suffered over the last year and is right around its 52 week low near $40 per share. The CME Group (CME) has bounced slightly from 52 week lows near $300 a share to move near $340 a share, but is still struggling. On the other hand, the Nasdaq OMX Group (NDAQ) has recover to $32 a share after bottoming out around $24 a share in early July. The exchanges certainly have more issues to worry about than just delistings, and their stocks reflect this, but the continued fallout of the credit crisis is certainly continuing to find its way into more areas than the obvious players.
A few years ago it seemed that all we heard about from stock market pundits were the exchanges and how they were literally printing presses for money. They were the gate keepers at the toll booths of trading, taking a small cut every time a trade matched. As trading volume increased, and platforms became more efficient, the ability to generate steady and growing profits seem limitless. And then of course, the market sold off, trading patterns and hot products changed, and the stock prices of the exchanges corrected.
As the charts of the Nasdaq OMX (NDAQ) and NYSE Euronext (NYX) show (Source: StockCharts.com), it has been a difficult two months for the stocks of the exchanges. The drop in prices has been severe enough that many of the stock pickers that seemed to continuously pump the exchanges, even through the current downturn, have recently found themselves throwing up their hands and admitting defeat.
This week Barron's has an article that is taking a different approach, laying out an argument why one exchange in particular, the Nasdaq OMX, may be a good buy. With estimates of $2.50 a share in earnings (a little on the high side from consensus estimates), a 25 multiple would value the company at $62.50 a share. Why use a 25 multiple? Both Visa and MasterCard tend to be given 25 multiples, and when you get right down to it, Nasdaq OMX is a transaction processor without credit risk, similar to Visa and Mastercard. Beyond financial estimates, another reason for considering Nasdaq OMX involves the benefits they are seeing from their recent acquisitions which have helped to diversify their businesses, as well as provide a global presence. Revenue is nicely spread out between global issues (20%), market data (19%), derivatives (17%), U.S. equities (15%), Nordic equities - OMX merger (9%), market tech (8%), and other (12%).
It really is astounding to think that only 15% of Nasdaq OMX revenues now comes from U.S. equity trading. If you believe that global markets will continue to boom due to the increased levels of global capitalism and subsequent flows of capital worldwide, then Nasdaq OMX may be well positioned to take advantage of this growth. In addition to global growth, Nasdaq OMX is also increasing their exposure to the higher margin derivative business, now at 17% of revenues, and expected to increase.
While the story is intriguing, buying Nasdaq OMX at this point in time may require a little leap of short-term faith, given that you picking a bottom in the stock after the recent correction, even though the Barron's article should provide some near-term support and buying pressure. Nonetheless, at $23.70, the stock is obviously well off its recent highs, and unlikely to hit its 2003-2005 lows under $10 per share given the current diversified revenue stream (unless the current market meltdown continues and spreads - not totally out of the question). While the stock could be poised for a rebound, and again will most likely get some type of Barron's bounce or support, it may be safer to wait for additional market clarity. This is not to say that the stock will not rally from here, it very well may (I have been burnt betting with and against the Barron's rush before), but it needs to remembered that the stock has been a "good buy" all the way down from $50. It may be worth a few points to wait for a retest of the support that was recently broken to see if stock can hold up without the Barron's bounce. While the Barron's article may provide the catalyst needed to push the stock price back through previous support (now resistance), whether or not it holds will depend on more than another trader or article discussing how the stock continues to be a good buy.
The WSJ is reporting that Hong Kong is planning a new exchange that will trade fuel oil contracts. The new exchange, to be called the Hong Kong Mercantile Exchange - HKMEx, is expected to open as early as Q1 of 2009 and will sell U.S. dollar denominated contracts for delivery of fuel oil to China. If successful, China is expected to expand into other commodities it uses, such as soybeans and iron ore. All this is in an attempt to turn Hong Kong into an Asia-Pacific financial hub. China has tried similar exchanges unsuccessfully in the past, but conditions have changed. More money and capital is now flowing into the east, in particular investment in energy, metals, and soft commodities. The exchange will also give U.S. traders another outlet for both in- and after-market hours trading. Given all the consolidation that is occurring in the industry, it will be interesting to see if the HKMEx can maintain the necessary volumes to stay afloat, and if successful, whether or not it will eventually become an acquirer, the one being acquired, or stay independent. But then again, lets not get ahead of ourselves.
The exchanges have long been considered to be printing presses for money. As volume has increased in recent years, the presses have been rolling along. Today the Wall Street Journal discusses the impact that the recent Treasury proposal (see previous post) may have on their ability to continue printing money. Paulson was apparently not happy when dealing with multiple regulatory bodies while at Goldman, so it makes sense that he would want to "streamline" things. Of course, as mentioned in a previous post, the best laid plans, especially with regard to regulation ........... well, you get the point.
Some exchanges, such as the NYSE that are involved in a number of products, could possibly see some benefit. Others, like the futures exchanges (such as the CME Group), may not, and will now have to deal with a larger regulator. The existing relationship the futures exchanges have with the CFTC will not be as strong. This may be good for the markets, but not necessarily good for a futures exchange that has enjoyed quick approval of new products. Of real concern for the futures exchanges is the impact on their clearing operations, another large profit center. Opening up the clearing operations may allow for more competition and lower prices. This is certainly not something these exchanges, or their investors, would welcome. On the other hand, the NYSE, which is involved in numerous products and is increasing its international expansion, should find working with one agency a potential benefit.
It will be interesting today to see if the CME group and NYMEX trade down on the news, and for how long. Given the amount of approval needed, any move may be short-lived. (Update Noon Central: Looks like both CME and NMX are down about 1.5-2%. Time will tell if the moves are short-lived. Paulson is already saying it will take a few years.)
Tickers: CME, NYX, NMX
