Max Pacella
Investment Analyst
2 Jul, 2021

If you want an exercise in futility, try Googling “investing in exchanges” and try to find any commentary on buying a stock exchange, rather than just “how to buy stocks on an exchange”’.

You could of course try, “why buy stock exchanges?”, to much the same effect – but the question does deserve an answer.

As in, why would an investor specifically employ the strategy of purchasing equity in an exchange, as opposed to buying a broad market index?

To create an intrigue right at the start of this note, let me list out some of the top holdings in one of my favourite ETF’s, and we’ll reveal what the fund is towards the end:

  • Deutsche Boerse AG                     (Frankfurt stock exchange)
  • ASX LTD                                           (Sydney stock exchange)
  • Intercontinental Exchange          (New York stock exchange)
  • Singapore Exchange                     (Singapore stock exchange)
  • Japan Exchange GP                       (Tokyo stock exchange)

You may notice that something like Coinbase (COIN:NASDAQ) is not listed here, but it very well could be in time, since it plays into the same thematic.

Without further cryptic allusions, let’s look at how exchanges make money and why you’d want to own them.

Face Ripping

There exists a term in the finance world, used mostly on trading floors and broking houses, of “ripping their face off”. The phrase does not have a positive connotation.

Generally, to “rip someone’s face off” implies that you have quoted them a price drastically in your favour, charged them a large spread, or in some way disadvantaged them in markets for your own gain.

Whilst it’s a term you’d associate with a stockbroker, rather than a stock exchange, it does get you thinking about how exchanges actually make their money.

An exchange is simply a central body which provides a marketplace for trading anything, from equities, to derivatives, to cryptocurrency. The larger the exchange grows, the more opportunities for revenue; you want more people buying and selling, you want more securities offered, and you want more people to keep track of your exchange as important market.

Let’s break down how an exchange like the ASX or the NYSE generates revenue;

1. Transaction Fee

The most obvious source, an exchange will charge investors a transaction fee to either buy or sell a security within their marketplace.

This could mean charging a large fund manager like a Vanguard to buy baskets of shares en masse, charging brokerage firms as they push product to clients, or charging asset management companies like Mason Stevens to facilitate trading for their end clients.

As a point of reference, in the calendar year of 2019, the NYSE earned 43% of its net revenue from ‘clearing and trading charges’, i.e. transaction fees.

2. Listing and Exchange Fees

Exchanges also charge new companies that become public (via IPO or SPAC), a listing fee to be available on their marketplace.

Most exchanges then charge an ongoing annual fee which covers trading services and listing on that exchange, so an exchange actively wants as many securities as possible available to trade – this then feeds back into increased transaction fees, in a beautiful example of a circular revenue model.

3. Data Fees, Software and Other

Exchanges will charge external parties (Bloomberg, IRESS, FactSet, Yahoo Finance etc.) a fee to provide them with market data, be it real-time or delayed.

Any time you Google a stock to see its price, check the volume or see what has traded, whoever is showing you that information is paying an ongoing fee to the exchange.

This applies to everybody from smaller brokers or research firms (think Robinhood showing its customers the historical volatility of a stock on the NASDAQ) to large fund managers constantly streaming data into their quantitative models. Market data is like the oil of the finance world, you can do very little without it, and you can get very little of it for free.

This data is often coupled with proprietary trading software provided to institutional investors, which also attracts a product fee for the exchange.

One other point is that many stock exchanges hold collateral cash balances for their clients – this sits with a financial institutions when it is not in use and gathers interest for the exchange, leveraged to usually whatever the overnight cash rate is for the respective central bank.

You may notice that these are relatively high margin revenue streams; the marginal cost of adding another company onto the exchange, providing a data stream to another provider, is minimal.  Between 2010 and 2020, the ASX has reported EBIT margins of around 70%, a mixture of net revenue and net interest income.

When Do You Buy Exchanges?

Time to let the cat out of the bag, the mystery ETF mentioned at the start of that note was none other than Horizon Kinetics Inflation Beneficiaries (INFL:NYSE), which may give you a hint to when you’d buy an exchange.

Historically as certain market conditions are met, people buy and sell more stocks, and exchanges are direct beneficiaries.

The first is most certainly inflation – and this ties into the recent Bitcoin narrative as well – as the purchasing power of currency decreases, people try to outperform inflation and retain value in their wealth, generally through the trading of securities to make a capital gain.

The second is when you expect volatility in market. Volatility necessarily means prices are moving, if you suspect that there will be liquidity in the market, for example if you expect volatility in the S&P 500 as opposed to trading small cap stocks, then exchanges will be seeing increased trading volumes at all prices levels – more revenue, more models desperately pulling data.

Source: Bloomberg, S&P500 against VIX Index

There are several investible ideas, from INFL to the individual exchanges listed towards the start of this note. A key is to consider the size of the respective market, your geographical exposure and how that will necessarily affect the macroeconomic outlook of trading in thar market (people in the U.S trade differently to people in Japan, as an example).

The Not So Free Market

Exchanges are a topic that are often left out of broad investing conversation, excluding their possible inclusion in an index fund or two.

But given their high margin business model and direct gains from increased trading volume, exchanges may represent a compelling investment case depending on the macroeconomic environment.

Plus, you get to participate in the irony of paying a transaction fee to an exchange, to buy a part of that exchange, to benefit from people paying transaction fees to the exchange.

Say that three times fast.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.