11 Questions with "Hide not Slide"

Stock exchange specialist and author of the Substack "Front Month"

Here is another short interview with a sector specialist. The Substack author using the pseudonym “Hide not Slide” focuses on the global exchange industry - stock exchanges, derivatives exchanges and the like.

I reached out to him to learn more about the industry and what stocks he recommends buying.

1. Can you give a brief introduction to yourself? 

My interest in market structure began when I took a corporate job at a large exchange - I spent a number of years there learning how markets work, how an exchange thinks & does business, and about the incredibly interesting stories the exchange was involved with. I left the exchange a while ago but still found the industry fascinating & thought market structure topics as a whole weren't getting enough public attention.

In October of 2020, I started Front Month with the goal of teaching investors about exchanges & sharing the stories I thought were under-followed & worth telling. My core focus remains fixed on the exchange space but I also write about adjacent topics like crypto market structure, high-frequency trading & electronic market-making.

2. Can you explain in simple terms what exchanges do and how they make money? 

For decades an exchange's business model stayed more or less constant - they built platforms that offered trading in various securities like stocks, options, futures, fixed income & other derivatives. Exchanges would then charge fees to trade these products & access their platform's technology & liquidity. Exchange revenue was correlated with volatility in their underlying products (more fear means more trading, more trading means more revenue) and with broader adoption of the products they offered (as the world's reliance on oil increased, so too did its reliance on oil futures trading). Most exchanges have core trading platforms that operate this way today.

The early 2000s saw a new era of exchange business models take shape when the industry demutualized & became for-profit, publicly traded companies. Exchanges now had shareholders to please & growth targets to meet which made them re-think how to make money. The industry has since entered more steady, subscription-based businesses like selling market data to banks & institutional traders, index licensing, and analytics to help companies comply with regulations. These new sources of revenue are driven not by volatility or trading volume but by the demand for passive investing, ESG, digital solutions to analog processes and help with regulatory complexity.

3. What makes exchanges such attractive businesses, and what do you look for when assessing the quality of an exchange stock?

Exchanges are maybe the best example of a legal monopoly - they boast high barriers to entry, deeply entrenched network effects & in many cases have little to no competition. For example - if you wanted to trade VIX futures, a product that is a critical part of many trader & buy-side fund hedging strategies, you have no choice but to trade with CBOE, paying whatever fee they set to access the product. Many exchanges have launched competing VIX futures products to try and take share from CBOE, but all have failed because their market is too active & liquid to go anywhere else. The same dynamic applies to many other exchange products across asset classes. Market data revenue exhibits even more features of a monopoly - every broker and institutional trading firm is required by law to pay for NYSE & Nasdaq stock market data, for example, no matter the price. That's a great business to be in.

When assessing the quality of an exchange stock I look for:

1. Index exposure - owning the rights to an index everyone wants to trade has for years been an incredibly lucrative investment. For example - Nasdaq owns the rights to the Nasdaq 100 index, a widely-known tech benchmark with billions of assets linked to its performance. Licensing this index to ETFs, data platforms like the Bloomberg Terminal & other exchanges have over time produced a $450 million business with margins in the high 60% range. ICE, MSCI & S&P Global all have similar index businesses focused on different equity, fixed income & even crypto benchmarks.

2. Diverse sources of revenue - one well-known downside of owning an exchange is the lack of control it has over the macro conditions that affect volume in its markets. For example, If the Federal Reserve isn't planning on raising interest rates for the foreseeable future, interest rate markets will be less volatile & CME's rate futures products will see lower volumes. There isn't much CME can do to create more volume in its products other than hope macro conditions shift in its favour. But, lucky for them, CME owns multiple futures products across a wide range of asset classes, making it less likely that low volatility in one or two markets leads to a bad or low-growth quarter. The same diversity applies to transaction & market data revenue - exchanges like CBOE & ICE have invested heavily in new sources of stable subscription revenue that has rewarded the companies with premium valuations.

4. What are the key trends in the industry?

Regulation is the most important trend to follow in the exchange industry. The regulatory environment applies differently to each exchange depending on their product suite & long-term vision - for some, regulation can be a major headwind; for others, it can lead to years of prosperity.

Take the US equity exchanges for example. For years the SEC has been concerned with promoting competition between exchanges like the NYSE and Nasdaq to prevent them from holding too much power. In the early 2000s, it enacted Regulation NMS which allowed dark pools & wholesalers to compete with exchanges for order flow. Fast forward nearly two decades & these off-exchange venues control ~50% of the US equity market, taking significant trading & data revenue away from the public exchanges. The SEC has recently been re-visiting this policy as it relates to payment for order flow, which if changed would likely swing the balance of power back towards legacy exchanges.

Another key trend in the exchange space is the evolution of blockchain & crypto in all its forms. Whether you're a crypto maximalist or not, it's hard to argue with the fact that blockchain technology & crypto as an asset class is having profound impacts on the global exchange industry. Crypto is breeding new exchange competitors like Coinbase, FTX & Binance that have made disrupting traditional exchanges a clear goal of theirs. New crypto products are driving competition among incumbents to own a piece of this growing market - Bitcoin ETFs & crypto futures among them. Recently we've seen transactions like CBOE's purchase of ErisX, ICE's spinoff of Bakkt & FTX's purchase of LedgerX hit the newswire, underscoring the large amounts of capital & resources that are being focused on crypto. Taking the time to learn how the crypto markets work & which exchanges are best positioned to capitalize on its growth is in my opinion a worthwhile endeavour.

5. How do you assess value in the industry?

This is an interesting & complex question to answer in the modern investing era. I believe the practice of valuation is having an existential crisis amid the low rate, easy money paradigm global central banks have created. Exchange valuation is no different.

I've found success evaluating the exchange industry through the lens of each company's narrative. Like most stocks, narrative drives price more than we'd like to admit, especially in the short term. Because an exchange's shareholder base is still largely institutional, the narrative is formed & controlled by sell-side Wall Street analyst consensus. I like to find situations where I believe Wall Street's narrative about a company is wrong or is about to change and use that as a starting point for further research.

For example, late last year I voiced my concerns about MarketAxess's 2021 prospects given tough comps vs. a volatile 2020 and high P/E multiples relative to competitors (~70x P/E vs. industry average of mid 20s - 30s). I also started a long position in MarketAxess's top rival Tradeweb because I wanted exposure to a beneficiary of rising interest rates & thought it was a cheaper way to benefit from growth in electronic corporate bond trading. Fast forward ~10 months, and Tradeweb has outperformed MarketAxess by a whopping 70% as the narrative about each company underwent dramatic shifts. The narrative that MarketAxess had a long, un-contested pathway to dominant corporate bond market share quickly soured as Tradeweb's growth caught up to its rival & inflation fears spurred its large US Treasury business.

6. What’s the universe of listed exchanges here in Asia, and how do you see the landscape changing over the next decade?

I think Asia will likely be the hottest battleground for every major global exchange over the next decade.

First, there are the large & growing national exchanges of Hong Kong, Singapore, Australia & Japan that are spending heavily to modernize & expand beyond their borders. 

The universe of listed exchanges in Asia

Exchange groups in the US and Europe are working with governments & banks in the region to open offices, launch new products & outright buy companies that give them an Asian foothold - ICE's purchase of SMX, LSE's Refinitiv deal & CBOE's recent purchase of Chi-X Asia are examples of this. 

Market data firms like MSCI & S&P Global are forming joint ventures with Asian data & rating agencies to launch their own subsidiaries & control the supply of popular Asian indices. 

We can't forget the crypto exchanges either, armed with deep war chests & clear ambitions to compete with legacy exchanges across asset classes.

I expect the next decade will see intense competition between these groups for market share that should make Asia's markets more liquid, diverse & accessible.

7. What do you think will happen to HKEX now that Chinese tech companies are delisting from US exchanges and Hong Kong is absorbed into the mainland?

HKEX can be considered a crown jewel of Hong Kong's financial system, a symbol of the country's economic success & global influence. HKEX has ranked #1 in global IPOs for 7 of the last 10 years, trades over $4 trillion in equities notional per year, and is a top 5 global exchange by market cap. I can assure you that whoever governs Hong Kong will make the success of HKEX a top priority.

The Hong Kong government is HKEX's largest shareholder & elects most of its board, making national politics an overwhelming part of the exchange's prospects. If Hong Kong is absorbed into China it would put a major financial hub under CCP control, giving HKEX a number of meaningful benefits at the cost of autonomy & global confidence. Western economies are becoming more wary of China investing in their markets - HKEX's attempt to purchase LSE in 2019 failed in part because of British national security concerns, and Chinese companies are being delisted from US exchanges. What HKEX loses in overseas influence it gains in support from China & its increasingly educated & wealthy population. 

HKEX's Stock & Bond Connect programs allow Chinese investors to trade HKEX-listed stocks & vice-versa, making the Hong Kong bourse a valuable conduit between foreign markets & the Chinese mainland. If China were to fully absorb Hong Kong in the future, my guess is this Connect partnership would become a central part of the exchange's strategy.

The average daily trading volume HKEX’s Stock Connect program

Overall I view HKEX as an economic pawn caught in a tug-of-war battle between China & developed economies. The risks of Chinese influence are clear, but the financial & political support is equally as powerful.

8. How do you see the future of Singapore Exchange (SGX)?

I'm encouraged by SGX's plan to pivot away from mature businesses like cash equities & futures towards higher growth areas like FX, fixed income trading & index licensing. The exchange has made a number of strategic investments to advance this strategy, including acquisitions of trading platform BidFX and index business Scientific Beta, along with numerous joint ventures with exchanges like Trumid, Nasdaq & LSE.

SGX has a broad & diverse business across Asia - its top products include futures on Vietnamese, Indonesian & Taiwan equity benchmarks and a large Asian currency trading platform. As Asia continues to attract interest & inflows from Western economies I think SGX is well-positioned to remain one of, if not the largest source of liquidity in the region.

9. If you had to choose one exchange stock in Asia to own on a 3-year time horizon, which one would it be? 

I want to double down on SGX and pick them over a 3-year time horizon for a number of reasons:

• First, I want exposure to a developed & free-market economy like Singapore's - owning SGX is a bet on Singapore equities & further financialization of their economy. There's also less political risk around China & its influence affecting Singapore's top exchange, at least in the short term.

• Second, SGX is poised to benefit from trends I think still have room to run over the next few years - trends like ESG, passive investing, electronification of fixed income, and pro-exchange regulation. Even if volatility fades & trading volumes in its core business underperform the exchange has secular drivers that should boost revenue over the next three years.

• Third, SGX has underperformed the broader averages in 2H 2021 after guiding to higher than expected expenses as it invests in its FX and fixed income businesses, which I think is a short-term reaction to a strategy management has said will pay off over the medium term. I'm willing to trust SGX with this medium-term goal & think the stock's underperformance will reverse as revenue growth catches up.

10. What are your favourite books about the exchange industry?

Most exchanges have long & very colourful histories going back to the late 1700s in some cases. I think learning about this history is a fun way to understand the industry & learn about how each exchange evolved to where they are today.

One such history book is "The New York Stock Exchange In the Crisis of 1914" by Henry George Stebbins Noble, president of the NYSE during World War I and the exchange's longest shutdown in its 200+ year history.

Another is "Zero-Sum Game: The Rise of the World's Largest Derivatives Exchange" by Erika Olson. This book tells the story of CME's multi-billion takeover of the Chicago Board of Trade in 2006, from the perspective of a CBOT executive. The story is a wild one - ICE starts a bidding war with CME and nearly takes the deal out from under CME's nose - and one that shows how M&A is an integral part of the exchange industry's past & future.

Other than history books, I'd recommend some introductory posts I've written about how to start investing in the space. You can find them here, here and here.

11. Where can people go to learn more about your Substack?

I write a free newsletter every Friday on the latest headlines in exchanges & market structure, and I also offer a paid newsletter where I write industry deep dives & analysis twice per month. You can find both services here.

Thanks for the interest!