Stock Exchanges | Beautiful Business Models

Stock exchanges are beautiful business models with very strong two-sided economics. In fact, you could say that they are multi-sided economics. Exchanges serve companies in need of efficiently racing capital through Initial Public Offerings, as well as serving sellers and buyers of risk capital by making the secondary market for those assets more efficient.

Demutualization

Exchanges benefit from network effects. In fact, many of the oldest securities exchanges started with brokers-dealers forming mutual organisations or co-operatives. The broker-dealers would earn seats on the exchanges and derive rights to profits through the business relationships they brought to the exchange.

A demutualization is simply put, the act of turning a mutual company or a co-op into a private company. The demutualization of the Stockholm Stock Exchange in 1993, marked the beginning of a wave of privatization of national stock exchanges. Many of these stock became public companies, with their shares being publicly traded.

Consolidation

The privatisation of securities exchanges subsequently led to consolidation within the industry as bigger exchanges started acquiring smaller ones. The most aggressive consolidators were Nasdaq and Intercontinental Exchange (ICE). In 2013, ICE acquired the world’s biggest stock exchange, the New York Stock Exchange.

It is worth noting that the consolidation of the industry was to some extent driven by the advent of the internet and the digitalization of trading. At a larger scale, exchanges are able to more efficiently develop the platform technology needed to operate the exchanges.

Functions of Stock Exchanges

Centralization is a defining characteristic of a securities exchange. An exchange centralizes all trades of a given security under a single platform. This gives participants full transparency into the order book and transactions.

Platforms, where trading is not unified, are known as Alternative Trading Systems. These platforms can facilitate a trade between two parties, but these actors will not have full visibility into the liquidity of the market. Trading through alternative trading systems is known as the Over-the-Counter market or dark pools.

Furthermore, exchanges are self-regulatory institutions. They are tasked with upholding certain regulatory and governance standards within the exchange participants. As such, licenses to form and operate exchanges are not handed out freely by governments and the process of optaining a license is a costly endeavour. Therefore, these licenses are scarce and valuable assets.

Profitable Business Models

Due to the characteristics listed above, Securities Exchanges tend to be extremely profitable operations. It is not uncommon to see these firms that operate exchanges deliver EBIT margins (Earnings Before Interest and Taxes as a percentage of Revenues) as has 60%.

Screen Shot 2018-07-14 at 01.02.55
Source: Burgundy Asset Mangement

In recent years, many securities exchanges have come under scrutiny on how they generate their revenues. Many exchanges have started to sell privileged access to trading, by offering high-speed connections.

This has lead to what is known as High-Frequency Trading, where sophisticated brokers with high-speed access to the marketplace are able to front-run other participants for transactions. This obviously creates inequality amongst market participants and it remains to be seen if regulatory authorities will step in and how that would affect the profitability of these exchanges.

Nonetheless, we believe that licenses to operate centralized and regulated exchanges will continue to be highly valuable assets in the future.

Nasdaq Acquires Oslo Børs

According to a press release published on January 30 by Nasdaq AB, it seems that the company is outmanoeuvring its competitor Euronext, in acquiring the Norwegian stock exchange, Oslo Børs. Two weeks earlier, Euronext had submitted a tender offer for all equity of the exchange’s parent company, Oslo Børs VPS Holding ASA.

Oslo Bors 2018
From Oslo Bors 4Q2018 financial statements.

Oslo Børs operates with the high EBIT-margins that one would expect from a national stock exchange. With an EBIT margin of 44%, it resembles that of Nasdaq current operations.

The acquisition of Oslo Børs will also mark Nasdaq Inc’s completion of acquiring the national stock exchanges in all the Nordic Countries, having already OMX exchanges, which include Denmark, Sweden, Finland and the Icelandic Stock Exchange.

Oslo Bors Nasdaq Acquisition
Oslo Bors Nasdaq Acquisition

Store of Value

The transaction multiples of Oslo Børs illustrate the scarcity value of a national exchange license. With very limited growth, the exchange commands a transaction multiple of almost 19 times earnings.

We expect to see other further consolidation of exchanges at similar multiples in the future.

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The Fundamental Finance Playbook is a publication dedicated to the Fundamental Research of Stocks and Security Analysis. We publish thoughts and opinions on individual publicly traded stocks as well as our thinking on methodologies for finance and investing practices in general.

All publications on the Fundament Finance Playbook are provided for informational and entertainment purposes only and do not constitute a recommendation to any particular security, a portfolio of securities, or an investing strategy. All views expressed are our own and we receive no compensation from any of the stocks we write about. 

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