Talk of Reform Boosts Financial Exchanges

Includes: CME, DIA, ICE, QQQ, SPY
by: Zachary Scheidt

Thursday was an important day for financial exchanges CME Group Inc. (NASDAQ:CME) and IntercontinentalExchange (NYSE:ICE). The action was hot and heavy as traders bid ICE to a new high for the year and CME shares traded to levels not seen since January. Investors were betting that regulatory reform would push more derivative volume onto their exchanges – boosting revenue and profits for years to come.

Up the street in Manhattan, the action was just as intense. After calling bank executives “fat cats” and pinning much of the blame for the financial crisis on the leaders of financial firms (that’s a discussion for another day) Obama tried to bridge the gap, asking the industry to call off lobbying campaigns to derail the financial reform bill.

The meeting appeared to be civil… no one threw shoes, shouted in anger, or spouted off to the media afterwards. But the environment was relatively tense as the president attempted to sell his plan to a group his administration has painted as villains and irresponsible citizens.

Tension was also the theme in Washington as Democrats and Republicans struggled to come to agreements on the details of the bill. With so many moving parts, and a sharp divide between lobby interests and public outcry against Wall Street, the bill will no doubt face challenges and multiple changes along the way.

Clearance of OTC Contracts

While changes will be made and the final outcome is still not a complete certainty, there will almost undoubtedly be provisions in the bill which require major financial institutions to clear a much broader portion of Over The Counter (OTC) contracts. These contracts represent derivative agreements between financial institutions and historically have been out of the view of most investors.

Causing these contracts to be cleared would help to reduce the systemic risk associated with the potential for default, but introducing a third party (ICE or CME) to “guarantee” the trades between institutions. Essentially, ICE and CME would require the institutions to put up margin for each trade and the exchange would keep that money segregated for settlement of the trade. As the OTC contract moves against one of the parties, the exchange would require additional margin to account for the increasing risk.

So the business model for CME and ICE requires strict risk control, and an accurate understanding of the terms for each of these detailed transactions. On the other hand, while the risk management is intensive, the clearance fees can be extremely lucrative which is why investors are sending the stocks significantly higher.

Critical Mass and Nimble Growth

If I had to choose between CME and ICE to invest in, I would have to side with IntercontinentalExchange. The company has about 1/3 the market cap of CME but as an 8 billion dollar company, they still have enough critical mass to compete in the industry. Remember, to guarantee the huge trades these investment bankers are engaged in, the clearance firms must have significant capital reserves.

Both companies have grown their businesses through acquisitions in the past, buying rival exchanges and purchasing the rights to design futures contracts on specific indices followed by managers. The clearance market is now primarily a duopoly with any rival firms struggling to present the critical mass necessary to garner the required confidence.

ICE has always been known for its energy markets although the company has increased its product offering tremendously in the past decade. The company has a strong reputation and has continued to grow its revenue base even throughout the financial crisis. In fact, the financial crisis may very well have benefited the firm as sharply increased trading volumes as well as the need for third party clearance actually drove business. I wouldn’t be surprised if we saw a similar environment sometime in the next 12 months…

Being a smaller firm, ICE can more easily pursue deals that would make a material impact on its bottom line. International expansion is already underway, but ICE could certainly increase its presence in Europe, Asia, and in other evolving economies. Expertise in agricultural products will also be a benefit as inflationary concerns along with a ballooning population will drive commodity trading.

Investors have to pay a bit more for ICE – which is currently trading at 21.5 times expected 2010 earnings. But the strong growth, a management team that has proven its ability and desire to complete large deals, and a political environment that drives more business to the exchange should make the premium price worthwhile.

The recent breakout will likely be just the start of a strong run for both ICE and CME. Pullbacks can likely be bought as there will no doubt be some uncertainty surrounding the finance bill. But over the next 12 to 18 months I expect to see a robust return on this investment. (Click to enlarge)

IntercontinentalExchange (<a href='' title='Intercontinental Exchange, Inc.'>ICE</a>)

Disclosure: Author has long positions in client accounts