Flash Boys, Meet Crypto Bros
Welcome to another issue of Front Month, a newsletter covering the biggest stories in exchanges & market structure every Friday. If you have questions or feedback, please reply to this email or find me on Twitter. If you like this newsletter and want to follow the exchange industry with me, please hit the Subscribe button below & be sure to share with friends & colleagues:
News
FTX.US backs 'Flash Boys' exchange IEX as firm maps out crypto strategy: Traditional market structure firms have to start taking FTX competition seriously whether they like it or not. FTX has secured a licensed US derivatives exchange & clearinghouse through its LedgerX purchase in late 2021. It’s made its retail broker ambitions clear via plans to launch FTX US Stocks in the coming months. Now the crypto giant has made new inroads in the stock exchange space through its investment in IEX with an estimated value of over $100 million. A check of this size likely bought FTX a 10%-20% stake in the exchange, suggesting a serious partnership & interest in IEX going forward.
Why do a deal with IEX? On the surface, it seems rather odd for an emerging retail broker to buy a stake in an exchange partner considering best execution rules & potential conflicts of interest that can come from such an alliance. In crypto, exchanges support the entire order lifecycle, including front-end customer management, custody, settlement, and core matching of trades. In traditional finance, different firms support each disparate part of the order lifecycle, and these firms don’t normally intertwine. Will FTX try and own a retail broker, a derivatives exchange & a stock exchange at the same time? Would regulators even allow that?
There is a different angle that puts the strategic rationale behind this deal in more context. Here’s an excerpt from FTX’s press release announcing the partnership:
“Through this investment, the two companies will work together to establish a clear, simple, and transparent market structure for buying, selling, and trading digital asset securities”
(Source)
Digital asset securities are a relatively new concept in US market structure but one I think we’ll be talking about with ever increasing frequency this year. SBF and Brad Katsuyama have had many closed door discussions with regulators over the future of crypto regulation, and my guess is they’re becoming more convinced that many crypto assets will ultimately be regulated as securities in the US. If that happens, existing crypto exchanges will need to register with the SEC if they want to keep doing business, or these assets will need to migrate to a compliant trading venue. Enter FTX & IEX, now with a head-start in that arena. I think the deal between the two firms is a smart, long-term attempt to establish a regulatory head start in the crypto & tokenized security space, and one that I think competitors across TradFi would be wise to notice. It’s likely not a coincidence that Gary Gensler was quoted earlier this week calling for crypto exchanges to split up their market-making & custody arms to better comply with the SEC.
CME Group to Launch 11 New Cryptocurrency Reference Rates on April 25: After launching Bitcoin & Ethereum futures in 2018 and 2021, CME’s crypto strategy became harder to foresee. Would the exchange move to lower market cap cryptocurrencies to build new products? Would it expand beyond futures trading to adjacencies like a spot exchange or market data business? A recent press release gives us a likely answer.
Speaking at a London conference a few days ago, CME executives hinted at internal discussions to prepare launches of Solana & Cardano futures, among other products for smaller coins down the road. Then on April 7 we saw another important crypto futures development when CME announced the creation of 11 new crypto indices in partnership with CF Benchmarks. To launch a futures product, you need a strong, stable benchmark on which to price & settle trades. The launch of these new crypto reference rates allows CME to move one step closer to forming an altcoin futures market, further entrenching itself as the leading crypto futures exchange in the US. The announcement excites me for a number of reasons:
It helps CME defend futures market share from the likes of FTX, Coinbase & Cboe who are vying to build crypto derivatives platforms of their own. If institutions who already trade interest rates, commodities & equities on CME don’t have to use another platform to trade altcoins, it makes it much harder for challengers to take share.
While a predictable trend by now, it allows CME to offer a number of sub-products that promote retail & quant trading interest in the exchange - namely mini & micro versions of the same futures it could launch. Retail users can trade micro Solana futures if/when they become available, quant traders can arb the mini future to the main future & even more traders can arb CME futures to the numerous spot exchanges that offer trading in the altcoin. Each new CME product adds another 3-5 angles for new users to enter the exchange’s ecosystem.
I also want to point out an unlikely winner of CME’s growing crypto futures dominance - Kraken, the owner of crypto index provider CF Benchmarks since 2019. CF has been chosen as the provider for a number of CME crypto futures products, adding vital legitimacy to a firm with many competitors. If the crypto futures space continues to grow with CME as its main exchange, look for Kraken to accumulate significant market power & leverage it for valuable data revenue over time. I think of CF Benchmarks like an early crypto version of S&P Global, who’s able to extract hundreds of millions in fees from CME for providing the prices underpinning its S&P 500 futures business. Kraken may not have the most market share or be the most talked about exchange today, but it should certainly remain a critical part of crypto market structure for quite a long time.
The purpose of this newsletter is to inform & educate people about the exchange industry in all its forms. A big part of that education is equity research - properly valuing & understanding Wall Street estimates for the public exchange stocks. My latest paid post dives into this subject by building & explaining a financial model for CME Group, populating it with sell-side analyst consensus estimates & examining whether those estimates are reasonable. Premium subscribers get immediate access to this model, my thoughts on the stock, and a deep archive of past market structure research. Sign up below if interested:
Other Stories I’m Reading
LME Faces U.K. Regulatory Review Over Nickel Market Turmoil
EU opens door wider for US derivatives clearers and exchanges
UK unveils bid to become ‘global hub’ for crypto
Gary Gensler remarks at the 41st Annual Small Business Forum
Robinhood Releases Crypto Wallet to 2M Users, Plans Integration With Bitcoin Lightning Network
Chart Of The Week
In the pre-COVID era MarketAxess counted itself as the best performing exchange stock in the entire industry. Since the beginning of 2021, it can now count itself as the worst. In the last week alone shares of MarketAxess are down -16% after Raymond James downgraded the stock & the exchange released a fresh volume report that failed to impress. A former darling of the growth stock crowd can’t seem to catch a break:
Why the big drop as of late? During Q4 2021 earnings, MarketAxess CEO Rick McVey was asked about market share dynamics & what could be done to see share grow again. The executive responded by re-hashing a natural dynamic in his company’s corporate bond platform - electronic market share normally jumps when volatility returns to credit markets & spreads start to widen. With a hawkish Fed in the offing, McVey & inquiring analysts both thought it likely that spreads & market share would see a good start to 2022 as rates began to rise. As predicted, IG credit spreads widened considerably in Q1 with March particularly volatile:
(Source)
Spreads widened - did MarketAxess share go up? I think you probably know the answer by now:
The sobering fact is becoming more clear by the month - corporate bond market share hasn’t hit new highs since January 2021 & remains stuck in a two year range since COVID began. Nothing, not even credit market volatility, seems to break this trend. What other levers can MarketAxess pull to get share gains back on track? Does a lever even exist anymore?
There may be some of you who see the above stock chart & think it prudent to try and catch a falling knife. Personally, I’m staying away from the stock for now. Shares remain quite expensive at more than 40x 2021 earnings and I don’t see future results beating expectations with sluggish industry volumes & market share so far this year.
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Disclaimer: I am not a financial advisor. Nothing on this site or in the Front Month newsletter should be considered investment advice. Any discussion about future results or projections may not pan out as expected. Do your own research & speak to a licensed professional before making any investment decisions. As of the publishing of this newsletter, I am long ICE, CME, TW, SPGI, NDAQ and VIRT. I am also long BTC, ETH, LOOKS and SOL.