We met the management of over a dozen global exchanges and e-brokers at a recent conference in New York. Global exchanges and e-brokers have benefitted from secular, regulatory and cyclical tailwinds over the past decade, which has resulted in robust earnings growth and driven strong stock outperformance. The Hamilton Capital Global Financials Yield ETF (HFY) which is outperforming its benchmark by 270 bps since inception and has a superior 4.65% yield1, has ~7% exposure to exchanges and brokers, while the Hamilton Capital U.S. Mid-Cap Financials ETF (HFMU.U), has a ~6% exposure to brokers and exchanges. The Hamilton Capital Global Banks ETF (HBG), which is 21.7% ahead of its benchmark2, invests in global banks, and therefore, has zero exposure to these sub-sectors.
Below are our key takeaways:
E-brokers: Consolidation and digitization drive transition to a full-service advisory model
Starting out as discount brokers in the 1970s and 1980s, the large e-brokers are now well on their way to becoming full-service investment advisory businesses. This is evidenced by the e-brokers’ growing market share in U.S client investment assets (20% in 2015 versus 15% in 2008; Source: KBW/ATKearney Study/Aite Group). The group’s revenue stream is also more diversified and less dependent on transactional revenues than in the past (24% of revenues in 2016 vs. 34% in 2010).
We expect continued strategic M&A and investment in digitization as e-brokers consolidate investable client assets (particularly retirement assets) and adapt to changing digital-first preference of its clientele.
Exchanges: Scale driven consolidation has resulted in market share gains …
Over the past decade, consolidation in the exchanges sector has resulted in the large, global exchanges becoming dominant players in trading across most major asset classes (equity, credit, currency and commodities among others). The exchanges have also come to own lucrative market data and analytics platforms (between 10-40% of revenues) and added clearing and post-trade services as a means of diversifying revenue streams and reducing dependency on trading related revenues.
The CEOs at several global exchanges were particularly optimistic about their market data and analytics businesses due to the segment’s high margins and growing data demand from the traditional asset managers. The data demand from asset managers is driven by a renewed focus on operating efficiency amid secular fee pressure and changing customer preferences (digitization and pending generational wealth transfer).
…and regulatory reforms continue to drive trading volumes into exchange platforms
Global exchanges are also expected to benefit from recent regulatory and market reforms particularly the Markets in Financial Instruments Directive or MIFID II reforms in Europe. MIFID II legislation was rolled out across Europe on the 3rd January 2018. The legislation aims to improve financial market transparency by moving trades to regulated trading venues (i.e. exchanges), unbundling of research and trading costs to remove conflict of interest and placing a cap on equity dark pools. While the SEC has granted exemption to the U.S. asset managers from MIFID II requirements, management teams expect the regulation to have its intended effect of pushing more trading volumes away from OTC trading and dark pools into exchange platforms globally.
Regulatory backdrop favorable for both exchanges and e-brokers: SEC Chairperson Jay Clayton was a keynote speaker at the conference. He spoke of the agency’s focus on improving market transparency and efficiency, particularly in U.S. small and mid-cap stocks. He also highlighted a focus on reducing advice conflict through fiduciary requirements for investment advisers. Generally, we thought that regulatory impetus on greater exchange based liquidity and fiduciary requirements favor the listed exchanges and brokers.
Exchanges and e-brokers are low capital intensity businesses and have low deposit betas: Exchanges and e-brokers are low capital intensity businesses and thus face less restrictive regulatory capital requirements than peers among banks and insurers. On the funding side, according to the CEO of a large e-broker, customers think of deposits with his firm as “dry powder” unlike banks where deposit betas (i.e. deposit sensitivity to interest rates) and thus costs tends to rise in periods of rising interest rates.
Competing fin-tech business models are at a nascent stage and focus on niche market opportunities: Competitive threats from fin-tech businesses are growing particularly in the fast growing areas of low-cost online advisory and high-regulatory risk cryptocurrency trading. However, the U.S. and Europe based fin-tech business models remain at a nascent stage and are competing against well-capitalized, dominant incumbents with spend budgets several times larger than the new entrants.
According to one global exchange CEO, the fin-tech threat was more significant in Asia as the large Chinese tech behemoths are now leveraging their dominant market share in the lucrative payments business to building a full-service advisory and trading platform.
1 KBW Nasdaq Financial Sector Dividend Yield Index (KDXTR) translated to CAD, as at May 31, 2018.
2 KBW Global Banks Index (GBKXN) translated to CAD. Performance is annualized since inception on January 22, 2016, as at May 31, 2018
Note: Comments, charts and opinions offered in this commentary are produced by Hamilton Capital and are for information purposes only. They should not be considered as advice to purchase or to sell mentioned securities. Any information offered is believed to be accurate, but is not guaranteed.