Another 'Moat' Investing Example

Summary

• NFX is another example of a failed attempt to "breach the castle".
• Both CME & ICE have a massive "moat around their (energy) franchises".
• Nasdaq recognizes a mistake 4 years too late.

On November 13th, 2019, buried deep in the WSJ, was an article that merited more time and analysis. With much fanfare, in 2015, Nasdaq launched its energy futures exchange called NFX. This was supported by Nasdaq CEO Bob Greifeld and was a full attack on the dominant energy exchanges of CME Group (NASDAQ:CME) and Intercontinental Exchange (NYSE:ICE). In fact, Greifeld stated that these two exchanges were running a "monopolistic environment" for trading energy contracts and he was looking to cut trading fees by 50%.

CME dominates the trading of WTI Crude, while ICE is the defacto Brent Crude exchange. The simple logic went that traders would migrate to lower cost environments, if only other exchanges made the futures contracts available. This misses the bigger picture for traders. Yes, they don't love high fees, but trading costs are only one component they focus on. For traders, liquidity is much more important. Tight bid/ask spreads, coupled with plenty of liquidity is what draws traders to an exchange, not lowered fees.

At the time of NFX's creation, both these stocks (CME & ICE) were weak, with heightened competition and the threat of an intense competitive landscape. This was not the 1st attack on these dominant exchanges. Every few years, an international exchange or US start-up exchange attempts to steal market share, with the brilliant idea of simply cutting trading costs. Each and every time, these new entrants fail, because tradings costs are not nearly as important as liquidity / volumes.

Every time a new entrant arrives at the exchange castle (i.e. the proverbial "gate", to continue the metaphor), the incumbent exchanges see their stock prices fall. It only impacts them for a short while, but it negatively impacts sentiment and creates uncertainty. As we continuously say, "stocks hate uncertainty" and both exchanges were under pressure from a well-capitalized and publicly traded Nasdaq (NASDAQ:NDAQ) in 2015.

Let's fast forward 4 years, to 2019. During the 1st half of the year, NFX traded 4.5 million contracts. On a year-over-year basis, this was 65% lower. To put the size of those traded contracts into perspective, over the same time period, NFX traded roughly 1% the number of contracts as CME. This is well less than 1%, if ICE's Brent contracts are included.

Adena Friedman took over as CEO of Nasdaq in 2017 and has emphasized that money losing ventures are not in NDAQ's plans. She has properly focused NDAQ's attention on its recurring data and information businesses, which are more profitable, more predictable and sustainable.

Yesterday, NFX was sold to EEX Group, Deutsche Borse's energy exchange. The price it sold for was not released, but NDAQ released a statement saying that NFX has made "steady progress" and that the combined EEX and NFX would "continue its mission". We have no idea what NDAQ "invested" in NFX, but it absolutely was un-profitable and clearly took management's focus and attention away from its primary, long-term goals.

The pain suffered from NFXs launch was initially felt by shareholders in CME and ICE. Both were great opportunities for long-term investors to pick up shares at discounted prices. In fact, both stocks have materially outperformed since the launch of NFX.

When NFX gets sold, there is little mention of this failure and little positive reaction from CME and ICE. However, Nasdaq shareholders have experienced the most pain, with the costly failed experiment of NFX. This comes back to one of our core investment tenets, which is the rational allocation of capital by management teams. At least Nasdaq's CEO Friedman has recognized this costly mistake and acted decisively to cut the losses after 4 years.

In the meantime, we will wait for the next "threat" to attempt to swim across the "hungry alligator-filled moat", that both the CME and ICE possess. Good luck trying to steal volumes with lower trading prices. Time and time again, this does not work...

Disclosure: I am/we are long CME, ICE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.