August 29, 2013

Anyone who has watched the exchange business lately can't help but notice that selling IT infrastructure, surveillance software and ultrafast data feeds is a booming business for global market operators.


The Exchange Diversification PlayThis issue of Wall Street & Technology examines the evolving exchange business in today's marketplace. As the trading business continues to shrink, exchanges are selling technology and services to bolster revenues. The traditional exchange operators are offering cloud services, monitoring technology and more. To read more, download our September 2013 digital issue now.

For years, exchanges such as Nasdaq OMX, NYSE Euronext and CME Group have been licensing their trading platforms or selling their software to other financial markets, while also helping emerging markets to structure their own regional trading hubs.

Now more than ever, they're venturing into new technology businesses that leverage their investment in IT infrastructure, data centers and cloud computing to offer things such as hosted managed services for applications, colocation services and regulatory compliance.

"All the big ones -- CME, Deutsche Börse, London, Nasdaq -- they all have the technology arm," says Herbie Skeete, managing director of Mondo Visione Ltd., a research house specializing in exchanges. For example, London Stock Exchange earns 34% of its revenues from information services, including market data and index licensing of the Financial Times Stock Exchange to companies creating ETFs. And LSE's MillenniumIT earned 6% of its revenues from selling technology to other markets, Skeete says. LSE initially acquired MillenniumIT to reduce its own internal costs because it was paying Accenture to run its technology, he adds. Clearing is another area being targeted by exchanges as a means of generating steady fees. Deutsche Börse owns Clearstream, and in May, LSE Group acquired a 58% stake in LCH.Clearnet, the international clearinghouse for interest rate swaps.

Both Nasdaq OMX, operator of the Nasdaq Stock Market, and NYSE Euronext, owner of the New York Stock Exchange and Arca, have built huge technology and infrastructure businesses, offering cloud computing, data feeds, pre-trade risk management and global connectivity to other markets and liquidity providers.

"Exchanges that were levered to transaction volumes are trying to get into stable, fee-generating businesses," observes Vikas Shah, managing director of investment banking at Rosenblatt Securities in New York.

In the past, when exchanges were member-owned entities and all the brokers traded on them -- before dark pools gained in popularity -- the exchanges captured all of the transaction fees. Now exchanges are publicly traded companies with the pressure to meet quarterly numbers and get good valuations, adds Shah. "In a volatile environment, you don't get good numbers if you are levered to the volumes in the market," he says. Instead, they are "entering businesses with steady growth and stable earnings, and that comes from technology-based services because you're charging subscription-based fees," he says. They're also getting into surveillance, risk management and market data, which produce recurring fees, he adds.

"It's really a way to diversify in many directions," explains Lars Ottersgård, senior VP and head of market technology at Nasdaq OMX in Stockholm. "If you go back a number of years ago, Nasdaq was an equity trading platform in the U.S., now it's commodities, it's options, it's fixed income, it's many things. And technology is an important thing in diversifying your portfolio and growing your revenue."

The push into technology isn't unusual and has always existed, according to Tom McCabe, COO of OneChicago, an electronic exchange focused on single-stock futures. "They've always had a big chunk of their revenue come from non-transaction revenues, whether it was listing fees or market data fees," says McCabe. "Selling their services and other items has been part of the business model for a long time. To derive revenue to support continued growth and investment in technology you need to make changes."

Fragmentation Drives Change

With the downturn in U.S. equity trading volumes and competition from 13 U.S. stock exchanges and approximately 40 dark pools, finding alternative revenue sources has become critical.

"OMX makes money by selling the software that an exchange needs. If you go to Hong Kong, they're using the OMX software, the same as they are using in Stockholm," notes Bernard Donefer, information systems professor at Baruch College.

Nasdaq has dubbed its strategy "Beyond the Match," which means beyond the matching engine, according to Richard Repetto, principal at Sandler O'Neill + Partners, who follows exchanges. "They want to make [trading fees] a small component because the volatility of trading goes up and down," says Repetto. While the exchanges are going to do everything to maximize trading revenue, beyond that they're going to start focusing on non-transaction revenues, he adds.

The move to diversify revenues into a more predicable income streams is working. On July 26, Nasdaq OMX reported 2013's second-quarter earnings: 72% of its total $451 million in net revenues came from non-transaction-related services, an increase of 10% from 2012's second quarter.

"Nasdaq, NYSE Euronext and then LSE are taking advantage of their scale and scope to develop global exchange technology sales," says Frank Piasecki, CEO of ACTIV Financial, a market data provider. "Each exchange has its own little strength in non-exchange activity," he adds, noting that Nasdaq OMX is probably the leader in selling its own exchange engine to exchanges in other markets.

Nasdaq OMX's market technology, (including its Genium INET trading platform, X-Stream trading technology and SMARTS surveillance) drives trading in more than 75 marketplaces in 50 developed and emerging countries. Recently, it sold an upgrade of its market technology to the Iraq Stock Exchange and partnered with Borsa Istanbul in Turkey to operate Nasdaq OMX's suite of market technologies for trading, clearing, market surveillance and risk management across all asset classes.

Direct technology business is around a quarter of Nasdaq OMX's overall revenue, but that doesn't include colocation and access services, which to a large extent is also technology-based, says Ottersgård.

"As an exchange you're naturally positioned to provide technology for different kinds of clients who are natural stakeholders and participants in the marketplace," says Ottersgård. Nasdaq is also looking to provide compliance and surveillance technology to other exchanges, regulators and brokers.

Earlier this year, Nasdaq acquired Thomson Reuters' investor relations, public relations, and multimedia services businesses to become a significant player in corporate solutions. "They're going to offer more services to the companies that list on the Nasdaq Stock Market," says Repetto. According to Shah, the purpose of acquiring the Thomson Reuters investor relations business is to offer corporate communications services to investors of companies that are listed on the exchange. Nasdaq also bought the index calculation business of Mergent, another lucrative business, says Shah. "That is totally intellectual capital. You create these indexes and you license it and you collect a royalty stream," every time somebody launches a product (i.e., ETFs) based on it, says Shah.

Risk management is another area that exchanges must target, which also involves technology. In 2010, Nasdaq OMX purchased FTEN, a real-time provider of pre-trade risk management services to major prime brokers and hedge funds.