Welcome to another issue of Front Month, a newsletter covering the biggest stories in exchanges 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:
This newsletter sets out to build a growing collection of knowledge about exchanges in an effort to better understand their businesses & stocks as investors. Any buy-side analyst will tell you that understanding a business’s customer base is as essential to predicting performance as it is understanding the business itself.
Who are primary customers of exchanges? I split the field into three buckets - banks, the Big Three asset managers, and high frequency traders. Most of the trading volume we see come through the tape does not come from a typical mom-and-pop investor wishing to “take profits off the table” or “buy a new stock on the cheap”. The market-moving volume comes from sophisticated institutions with deep pockets, complex strategies, and technology that goes beyond most people’s understanding.
I want to take a look at this technology in the context of a recently announced transaction: I Squared Capital, a Miami based PE firm with ~$13B AUM, purchased a large portfolio of infrastructure assets from GTT Communications for $2.2B. In the deal’s announcement, I Squared says the purchase “builds upon I Squared Capital’s overarching global digital infrastructure strategy”. Kind of vague, right? It gets interesting when looking at one asset in particular included in the deal:
“The infrastructure division sale consists of selected network and data center assets accumulated from several GTT acquisitions, including Interoute, Hibernia, and KPN International, that comprise… Three transatlantic subsea cables, including GTT Express, the lowest latency route between Europe and North America.”
(Source)
GTT Express - previously named Hibernia Express - is a 2,900 mile cable running along the floor of the Atlantic Ocean from Halifax, Novia Scotia to the UK. The cable was installed in the early 2010s at a staggering cost of $300 million. Special cable about 1 inch thick and weighing 1.2 tons per mile was packed with steel plating & optical fibers, coiled, and put on a ship. That ship spent the next six weeks sailing across the ocean, feeding this cable down to a submarine sea plow that crawled along the ocean floor, clearing debris and laying the cable just beneath the floor’s surface. A short video below visualizes the full cable-laying process:
(Source)
Besides filling us with the pride of human achievement, why does this matter?
When fully laid, communications can be sent through GTT Express across the Atlantic Ocean in under 59 milliseconds, or 6x faster than the blink of an eye. This is currently the fastest way to send data between New York and London, which is a critical tool for an exchange customer bucket I mentioned above - high frequency traders.
Let’s illustrate the value of GTT Express to high frequency traders with a hypothetical example. The London Bullion Market Association (LBMA) runs a spot market for gold bullion, with auctions taking place every day at 10:30 am and 3:00 pm London time. These auctions are viewed as the premiere benchmark for the price of gold, with LBMA prices used as the input for the SPDR Gold ETF (ticker GLD). GLD is listed on the NYSE in New York, and the LBMA auctions take place in London. If the spot price of gold changes in an LBMA auction, the price of the ETF based on these auctions should in theory change in equal measure.
An arbitrage strategy could be set up where a trader buys spot gold & sells the GLD ETF at a higher net asset value or vice versa, profiting off geographic differences in price for the same underlying asset. In order for this to work, however, you need to be the first one to see & capitalize on the opportunity. This type of trade is not a secret; everyone knows it exists, including GTT. Speed is the only variable separating a profitable HFT firm from competition, making the fastest route from London to New York the only way to win the race. The cost to access GTT Express runs north of $300,000 per month according to a source quoted by Bloomberg - quite high, but tolerable considering the potential profit of a winning trade.
We see some references to the importance of undersea cable access from firms like Virtu Financial, a public market making firm I’ve spent time covering in the past. Here’s a snippet from Virtu’s most recent 10-K:
"Our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which we are located. This may include a disruption involving electrical, satellite, undersea cable or other communications, internet, transportation or other services facilities used by us, our employees or third parties with which we conduct business."
(Source)
The cables are even factoring into Brexit & the UK’s evolving relationship with the EU. Because most of the high speed data lines run through London before moving on to continental Europe, many institutions are forced to have a British presence and find it too costly to move elsewhere, despite regulatory pressure.
(Source)
The benefits of owning GTT Express mirror the benefits of owning an exchange - exposure to a high margin toll-road with strong barriers to entry & an eager, wealthy base of paying customers. I Squared Capital was launched in 2012 by a group of Morgan Stanley alumni with specialty in infrastructure finance. The buyers of GTT Express are keenly aware of its value to the financial system, as both current owners & past customers.
Undersea cables aren’t the only pricey toys of exchange customers. High frequency traders have banded together in the past to build networks of wireless towers connecting the US and Asia, have fought viciously over line-of-sight access to exchange data centers, and are investing in advanced forms of fiber-optic cable to move closer to light-speed exchange connection.
I say all this to stress how other-worldly the tools, methods & agendas of top exchange customers really are, and how important it is for exchange investors to put themselves in the shoes of these entities when assessing long-term drivers of these stocks.
Some examples of HFT thinking’s value to understanding exchanges:
Exchange regulatory pressure & the impact of SEC rule changes will start to make more sense.
The value of new products will become more clear - things like portfolio trading, API upgrades, and trading products that create more strategies for HFT to trade against.
The severe consequences of technical glitches & network outages will gain a proper weight in the minds of more investors.
December Volumes
(Source - monthly volume releases of each exchange)
Another month has come and gone, and that means more volume releases from the public exchange groups. Here are the main highlights worth knowing:
December is a slow volume month. Across asset classes & exchanges, December is normally a light month for volumes as Wall Street goes on holiday & news begins to die down. 2020 was no different - every exchange’s futures markets showed seasonal softness in activity with December the slowest month of the year in many cases.
Cash equities and options are the notable exception. December equity volumes continued their steady rise throughout 2H 2020, hitting a six month high in December. Never-ending political volatility mixed with a fresh round of stimulus checks are sure to be a driver. On the options front, the blistering pace of volumes hasn’t slowed down in the slightest - December’s 33 million contracts per day makes it the seventh month record volumes were logged in the US in 2020.
CBOE’s equities market share is slipping. December marks a new low for CBOE equity market share with just over 14% of volume trading on its exchange. This is down from 20% in early 2018, before pressure from off-exchange and startup trading venues began to increase dramatically. Industry volumes are up which has helped CBOE’s results despite the loss in share, but investors are concerned that either market share or pricing will continue to slide as competition ceases to let up.
MarketAxess corporate bond market share hits records. One side effect of a slow month in the bond markets is when the big bank trading desks take holiday, liquidity for large block trades dwindles considerably. Smaller trades fill the gap left by the vacationing dealers, and these trades are being increasingly found on MarketAxess’s electronic platform. Market share rose to a record 25% in December on this phenomenon, a truly impressive milestone.
Honorable Mentions
Virtu is planning to set up a permanent office in Florida and move 30 positions from New York to Palm Beach Gardens, following other firms like Citadel Securities, Goldman Sachs & Moelis making similar moves.
The NYSE flip flopped multiple times this week on the subject of Chinese share delistings in the US - an original decision to ban Chinese telecom companies from the NYSE was abruptly reversed on January 4 only to be put back on January 6. The back and forth comes amid growing tensions between the US & China and opposing sides in Congress.
Bloomberg and the Block both reported that Bakkt, the crypto startup majority owned by ICE, is on the verge of going public via a SPAC that would value the firm at over $2 billion.
CBOE closed on its acquisition of BIDS Trading, originally announced in October 2020.
Chart of the Week
Plenty of spotlight has landed on the leading equity market challenger launched in September 2020 - MEMX, the upstart exchange owned by a consortium of banks, brokers & market makers looking to disrupt the incumbent exchanges. Not much attention has been brought to the #2 challenger, also launched in September 2020 - MIAX Pearl, owned by Miami International Holdings.
Building on a successful carve-out of options market share, MIAX is quietly growing its equities business using the same tactics that have shown returns in the past - giving ownership in the exchange to top customers. While they’ve gathered only a fraction of MEMX’s market share, the trend looks promising, and MIAX’s multi-year path to profitability in options suggests Pearl is here to stay.
(**Note - the above chart excludes trade dates 12/3 and 12/4 with outlier market share figures to make the chart more legible)
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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, CBOE, NDAQ and VIRT. I am also long Bitcoin.