Momentum

The case for investing in exchanges

I am already up 3% so far this year. The market seems to have taken a new victory lap around Trump’s inauguration. My natural inclination is to be careful when everybody goes max bullish. "Buy when there's blood in the streets, not when you hear the sound of trumpets."

However, we find ourselves in a peculiar situation. The current bull market shows no signs of slowing down, and as I have mentioned several times, the momentum is so strong that we have no choice but to participate. The market can go much higher. “It is a bull market, you know”!

I plan to add to Nasdaq Inc. next week. The stock has broken out from a consolidation pattern just below $80 to a new all-time high, and there is no resistance to the upside.

In this post, we'll compare and contrast some of the major exchanges - NASDAQ (NDAQ), Intercontinental Exchange (ICE), CME Group (CME), and Euronext (ENX). Even though I have decided to play the space through NDAQ, I assume all of them will work in the coming year. Stock selection is sometimes about spitzengefühle.

Transactions as an important revenue stream

Unsurprisingly, exchanges make money when you trade. Their core business model revolves around creating liquid, efficient markets that attract diverse participants. By continuously expanding tradable financial instruments—from stocks and bonds to derivatives and cryptocurrencies—exchanges increase trading volumes and attract more market participants. This strategy allows them to monetize not just trading fees, but also market data, indices, and technological infrastructure. The more diverse and active their marketplace, the more value they create for traders and issuers.

As we shall see below, exchanges are increasingly morphing into tech companies offering various data services, such as market surveillance, trade monitoring systems, analytics, and more. These services are contributing to recurring revenues decoupled from the transaction-based fees accruing from the core business. CME is the exception to this trend. Unlike its peers, CME is still mostly a transactional business.

The Chicago Mercantile Exchange is rooted in the Mid-Western commodity trade of agricultural goods, energy, and metals. Today, CME offers derivative products in almost everything from interest rates and equities to currencies and commodities. Normally, low trading volumes in one asset class are offset by strength in others. However, the recent normalization of interest rates has been particularly beneficial, as interest rate futures constitute a crucial part of CME’s business. The company's performance has markedly improved following the end of zero interest rate policies, which had previously created significant challenges. In 2024, CME achieved a record annual average daily volume of contracts in interest rate futures.

CME is more exposed to market forces than its peers, but this doesn’t mean that transactions aren’t important to the whole group. The recent strong collective performance is partly attributed to investor anticipation of a resurgence in initial public offerings (IPOs) after a prolonged lull. On the plus side, CME pays a considerably higher dividend than its peers. This substantial yield provides investors with a steady income stream, particularly valuable during market downturns. The dividend seems well covered.

Monetizing information infrastructure

Exchanges are increasingly becoming data marketplaces, monetizing various datasets beyond real-time market data, including historical tick data, reference data, and trend analysis. This shift is driven by market participants' demand for new data types to power sophisticated analytics and comply with regulations.

Charging fees for data access is an easy monetizing strategy. Exchanges charge fees for access to real-time and delayed market data feeds, including pre-trade quotes and post-trade information. Today, exchanges offer APIs for accessing market data, allowing clients to integrate data directly into their systems. All exchanges have moved much of their data access services to the cloud. Cloud-based solutions demonstrate how exchanges are adapting to changing market needs, leveraging cloud technology to provide more flexible, scalable, and accessible data services to their clients.

Exchanges are increasingly monetizing the demand for regulatory compliance through advanced surveillance products. This trend is driven by heightened regulatory scrutiny and the need for market participants to effectively monitor trading activities to prevent market abuse.

Financial institutions are subject to a multitude of regulations aimed at preventing market abuse, such as insider trading and market manipulation. There has been a marked increase in regulatory scrutiny of trading activities. Effective compliance programs help institutions identify, assess, and mitigate risks associated with market conduct. Surveillance products enable firms to conduct thorough market abuse risk assessments, which are crucial for maintaining market integrity and protecting against potential financial crimes.

The surveillance system market is projected to grow by a compound annual growth rate (CAGR) of around 13%. This growth is driven by the rising complexity of regulations and the necessity for advanced technological solutions that can adapt to changing legal landscapes.

Recurring revenues

As of the third quarter of 2024, NDAQ's Annualized Recurring Revenue (ARR) is reported to be $2.74 billion, reflecting a 31% year-over-year increase.

Roughly half of ICE’s revenue is recurring, reducing reliance on exchange fees, which is a positive, given the competition facing its equity trading business.

In the latest report, ENX reported revenue growth of 10%, citing non-volume related activities share as 58 % of total revenues.

As earlier stated, data services mean less for CME. However, market data services are also showing good growth in its P&L statement.

A short comparison between the recurring revenue machines

There are three facets I like with NDAQ. I like the strong growth in ARR and the geographical footprint of Scandinavia, the Arabian Peninsula, and the US. I also like the innovative focus of the company. For instance, how the integration of AI capabilities into its market surveillance technology enhances the efficiency of investigations related to market manipulation and insider trading. This innovation reportedly reduces investigation times by approximately 33% while improving outcomes.

There is also much to like with ICE. The company has done a good job of diversifying its revenue stream in the last few years. Through a series of acquisitions, ICE has carved out an impressive position in mortgage technology and fixed-income data. This position stands to pay off even more if and when Americans start to buy real estate again, and the demand for mortgages goes up. Anyway, the bottom line is that ICE has become increasingly less reliant on transactional revenue as it expands its data and service offerings organically and through acquisitions.

ENX is continental Europe’s competitor to the financial centers of London and New York, and it does a dam good job. ENX is now the owner of the CAC40, AEX, BEL 20, ISEQ 20, OBX, and PSI 20 indexes. With the recent acquisition of Borsa Italiana, ENX has also taken control of CC&G, the Italian multi-asset clearing house, as well as Monte Titoli, the Italian central securities depository. It is expected that by changing its clearing counterparty from France to Italy, ENX will strengthen its competitive position further. Alas, ENX is a European company that exhibits strong revenue growth, and that counts for something in this day and age.

Conclusion

As earlier mentioned, all of these stocks are likely to work well in the near future. Stock selection in this space comes down to personal tastes. Both ICE and NDAQ have their distinct competitive advantages with a long runway for future growth. CME exhibits nearly 20% annual revenue growth and pays out a sturdy dividend. European investors might be drawn to ENX since it is something as unusual as a European tech company with strong top-line growth.

Thus, I have no clear recommendations. I think investors have some leeway here.

Disclaimer: Important Information for Retail Investors

The information in this blog is for educational purposes only, not financial advice. Investing in stocks carries risks; past performance doesn't guarantee future results. Conduct thorough research and seek advice from financial professionals before investing.

The author is a retail investor, not a licensed advisor. Content accuracy isn't guaranteed due to changing market conditions. All investments have risks, including the potential loss of principal. Assess risk tolerance and goals before investing; diversification is key to managing risk.

The author may have positions in the mentioned stocks, which can change without notice. Readers should do their due diligence and consult professionals before acting on blog information.

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