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Publicly Traded Exchanges: How to Beat the House


Focus on CME, ICE instead of individual equities.

Stock Exchanges Too Tied to Financials

Just as easy money in the form of low interest rates propelled the record activity and earnings in investment banks, hedge funds and private-equity firms were also paying top dollar for what are now very discounted assets. These were the very same customers that drove the increase in trading volume at the exchanges -- which inflated their own stock prices and allowed them to pay large premiums to consolidate as a means of gaining market share.

While there's still room for cost-cutting and synergies, what had been an expanding pie of trading volume is no longer growing as quickly. And that was what justified the previous high price-to-earnings ratios that had been awarded to the exchanges.

This is certainly true for equity trading. The latest data for June shows that trading volume in stocks has been basically flat during the first half of 2009.

Not only is the pie not expanding, but the pieces are being sliced ever thinner: Competition from off exchange electronic platforms and ECNs like BATs take market share and drive margins lower.

Deriving Growth

Compare this to volume in options, futures, and other derivatives, which has increased nearly 35% across the board during the first 5 months of 2009. Exchange-traded options are on pace for the sixth consecutive year -- and there's more than a 30% increase in trading volume.

So, if you're looking to invest in an exchange, focus on the ones that have the greatest exposure to derivatives. This leads us back to the CME and ICE, which have seen their shares nearly double from the March lows.

A new catalyst that could drive volume growth and in turn, share price, is the move to list over-the-counter and exotic derivatives -- such as credit default swaps (CDS) -- onto the exchanges. The argument is that this will provide a more liquid market, greater transparency, and third-party clearing, which will reduce counterparty risk.

Establishing a bullish position through the purchase of call options would be a good way to play the continued growth of trading in options and other derivatives.
No positions in stocks mentioned.

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