Nymex IPO: not another bubble

What a week for publicly listed financial markets. On Tuesday and Wednesday, November 14 &15, European exchanges, which had been outperforming the broader market for months, fell substantially: Euronext by 8.9%; Deutsche Börse by 6.25%, and LSE, by 5.7%. The immediate catalyst for the fall was the announcement by seven international banks that they plan to set up a competitor to the European exchanges (see our blog dated November 17 below). Many analysts interpreted as the end of exchanges’ bull ride.

And then, on Friday, Nymex went public in a most spectacular IPO of 2006. On the first day of trading it gained 125%, the biggest daily increase in an IPO since 2000. Its market capitalisation stands at $11.59. Some analysts, Jim Kramer for instance, consider this price excessive, compared say to NYSE, which has a market cap of 14 billion. It also has a (much) slower growth, lower operating margin and more precarious competitive position. A better comparison is with Intercontinental Exchange (ICE), which owns the only competitor to Nymex, International Petroleum Exchange (IPE). However, Nymex has a market share of over 60% market share in energy futures, its revenue are double that of ICE. And its market cap is slightly under 200% of ICE’s market cap ($5.9 billion). So, in relative terms, compared to its peers, and in light of its growth prospects, NMX is not overpriced. However, as many observers noted, the IPO process was completely botched, crowding out retail investors and forcing selling shareholders to leave substantial money on the table. Underwriters, who represented a cream of Wall Street did not cover themselves with glory.

In this week issue of Barron’s, Andrew Bary asserts that exchange stocks are the new Internet stocks. I think the argument is overdone for the following reasons:

• All listed exchanges have good track records and are profitable. Moreover, many of them generate substantial cash

• The exchange play is a consolidation play and there is no reason to believe that the consolidation will not continue. Indeed it barely started. And so far, announced deals (CME-CBOT, NYSE – Euronext) make both strategic and financial sense

• The relative ranking of valuation is rational, with derivatives valued more highly than cash markets and bigger markets worth more than smaller markets. The discrepancy between multiples of US and EU exchanges (a weighted P/E for the former is over 40 and for the later is 25) is less justified (and based on broader historical precedents, which may not apply in this case) but it creates arbitrage opportunities.

MGM trading platform project

Emergence of financial exchanges as a major player in financial services has been a major if not always expected aspects of financial sector evolution of the last twenty years. Since the late 1990s, it became quite clear that their relationships with their erstwhile shareholders in particular global investment and commercial banks were getting more complex and many of banks saw exchanges as potential competitors. In a paper written in July 2003 for the European Federation of the Stock Exchanges and published by the European Capital Markets Institute, I wrote:

“While their [exchanges] official communication stress the competition among exchanges (Euronext vs. LSE vs. DBAG), it is becoming more evident every day that the economic dynamics create a growing rivalry between exchanges and their major users, banks and securities brokers and dealers.”

Since then, all major US exchanges went public, reaching higher relative and absolute valuations than their European counterparts, while the latter continue to (far) perform their national indices and the rest of the financial sector.

So the announcement by seven global investment banks (Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS, often referred to as MGM), made on November 14 that they are going to set up a common trading platform, which will openly compete with the exchange, is not really surprising. The only question is: Why it took them so long?

And the answer: because they know how difficult and risky the trading platform project is likely to be. Its chances of success have to be rated below par. If they were raising public funds for this project, the risk factors section in the prospectus: would have longer than the usual and contain at the minimum the following:

• Speed of implementation (time to market): The project will not go live before at least a year (and this estimate is may be overly optimistic). In the meantime, its competitors, whether existing exchanges or other ECNs , will have plenty of time to adjust their technology and their offering

• Project scope: the project is presented as direct competitor to existing exchanges (equities and equities derivatives) rather a platform for trading new instruments or new combinations of instruments, where the competition is likely to less intense

• Choice of technology supplier: In order to reduce time to market, the project could choose an existing system, including ones, which are sold by exchanges. This however would reduce the competitive edge of the project. On the other, the choice of an innovative technology will require higher costs and entail higher risks.

• Open or proprietary access standards: Will the platform use open access standards, making it easy to join but also easy to leave or closed access standards, which would be proprietary and make exit from the system more difficult

• Willingness of non-consortium banks to use the system: will other banks, which have not been invited to join the project, be willing to use the platform to provide liquidity in not an obvious challenge and odds of its success are not necessarily very good.

• Attitude of other sources of liquidity and order flow: How would other sources of liquidity, both institutional and retail, asset managers, hedge funds or online brokers, react to the new platform? Will they see as an useful alternative to existing platforms or an attempt by large players to preserve their power

• Competitive response of exchanges: Existing exchanges, whether cash or derivatives, are unlikely to remain passive. They have a wide range of potential responses. The most obvious one is to adjust their tariffs. They can also accelerate the deployment of new trading platforms and accompanying facilities. But their response can be more disruptive. Several exchanges are considering opening direct access to trading, via Internet, to final investors. This would reduce the order flow of major intermediaries.

• Regulatory uncertainty: The new platform would operate under the regulatory regime of Multilateral Trading Facilities, which offer less stringent legal requirements than the full-fledged exchanges. MTFs were seen a way for exchanges to deploy more flexible solutions. Will regulatory authorities in the UK and in Brussels accept the proposed legal framework for the platform or will they query it, in response to probable intense lobbying of exchanges and their allies.

• Co-operative curse: Co-operative projects are notoriously difficult to implement (not only in banking but also in telecommunication, software or e-commerce) as the overall project speed implementation needs to be adapted to the slower and less nimble participants. Furthermore, participants are often reluctant to put their best people and most advanced technology at the disposal of the project.

• Internal strategy conflicts: Project participant banks are very large institutions, which use a variety of trading platforms in order to serve the diversified demand both from their clients but also from various internal departments. Their top management has been historically reticent to reduce this variety and prefer to tolerate internal conflicts, particularly in a fast moving and uncertain environment. Therefore, the extent of use of the platform by the founding members cannot be guaranteed and in any case, the platform is unlikely to capture the dominant share of the order flow.

In addition to those risk factors, one needs to consider the past experience, which further reinforces scepticism concerning the chances of success of the project. While ECNs have been quite successful in the United States, with Archipelago becoming a merger partner of NYSE, and Brut and Inet acquired by NASDAQ. In Europe, alternative equity trading attempts have been unsuccessful in taking market share from the existing exchanges.

One can also consider the example of what is arguably the most successful co-operative trading project, EBS, which was founded by very much the same group of banks as the proposed trading platform, and which quickly became the market leader in spot foreign exchange trading:

• It took three years to design and implement the EBS trading platform
• Participating banks were by far the dominant players in interbank foreign exchange trading
• There was only one other established player in FX trading, Reuters
• FX is a largely unregulated market
• In 2006, EBS was sold to ICAP, the dominant interdealer market broker for a consideration of $854 million.

In view of all these elements, of which the founding members are as aware as any outside analyst, one should wonder about the rationale for the project. The timing of its announcement suggests that it is intended primarily as a signal to the exchanges, another, but certainly not final, move in a complex co-opetition game between exchanges and their erstwhile shareholders.