Why Does the Stock Business Stink?

With all the exchange merger mania, it pays to think about their different lines of business.  Why does an exchange like the $NDAQ have such a low PE, and an exchange like the $ICE have a significantly higher PE?  

Their PE ratios tell you a lot about their business, and their regulator. Stock exchange and option exchange valuations suffer because they are regulated by the SEC.  The SEC allows all sorts of anti-competitive practices to go on.  These regulations allow for most of the stock trading to be done off the exchange.

Orders are rarely filled on the floors, or even in the computer networks of the exchanges.  Instead, they are funneled to a dark pool, or internalized onto a bank or fund trading desk.  For example, according to Michael Moore at  Bloomberg, Goldman Sachs is closing a prop trading desk.

“The group reported results as part of Goldman Sachs’s fixed-income trading division, the person said. That division generated revenue of $13.7 billion in 2010, 35 percent of the firm’s total.”

They were not trading against other traders competitively at the $NYX or $NDAQ.

The $CBOE has a more profitable business. But their profits can be tied directly to the excellent proprietary contracts they have created. Because they either own the contract through an agreement with another organization, or they own the intellectual property on them, they are able to earn an acceptable margin from them. In generic listed options, $CBOE isn’t any different than any other options exchange. Options traders from $CBOE tell me that their electronic technology for trading is far superior to anything else on the street, so that gives them an edge. But, internalization and payment for order flow allow everyone to compromise that advantage. If the SEC were to end these two nefarious practices, $CBOE would be worth appreciably more than it currently trades for. Currently, their PE is pumped up simply because they are a takeover target, nothing else.

An exchange like $ICE is regulated by the CFTC. The CFTC is trying to emulate the SEC, which is a bad sign. They have one of the worst commissioners ever in Bart Chilton. He said in effect that there was too much speculation in the market place and it made it tough for hedgers to get their trades on. Imagine that, more volume equals less liquidity in his world! Even with the backwardness, the CFTC has been a pretty good regulator over the years. It has ferreted out fraud, and policed the industry. They also haven’t pushed fungibility, until now. No fungibility in clearing gives exchanges a strong profit motive to be more efficient and innovative. The lack of fungibility improves futures exchange profitability. Hence, futures is a growing business, with very high levels of competition. Exchanges here garner a higher PE.

If the SEC were to change the way it regulates the market, that would improve shareholder value significantly. It also would make the market flatter, more competitive, more liquid, and better for everyone. But, it shouldn’t surprise anyone that the government is creating competitive imbalances that affect the broader marketplace. They do it in corn, oil, home loans, education and virtually everything they touch.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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