The consolidation of exchanges in the US and global markets has been interesting from the conversion of the NYSE and NYMEX to publicly traded entities to the acquisition of foreign exchanges. I guess the evolution of electronic trading made it inevitable that things would turn out this way but I am a traditionalist of sorts and skeptical of the Utopian environment of one or two huge global exchanges that are open 24/7. Don’t think I want to go back to the Buttonwood tree but the “for profit” nature of the public stocks like NYX, NDAQ, CME, BOT, ICE, NMX, & ISE has changed things. At some point, competition and efficiency balance each other out and I suspect we are getting to the point where efficiency will not be incrementally beneficial to investors and a lack of competition will actually hurt them. Every time I hear more consolidation talk, the execs involved keep rambling about how great this will be for investors. Yet, I am not sure how bad it’s been up until now or how I am going to notice how wonderful it will be. Let’s get real, it’s not about investors (retail or institutional) - it’s all about the exchanges and their shareholders. Mind you, that’s the way it should be in a capitalist society. I’d just prefer to call it like it is.

With the current deals and those that are being rumored, the list of seven exchanges I just mentioned could easily drop to 5. And I don’t mean to slight the negotiations going on with the Deutsche Bourse or LSE or Borsa Italiana or OMX or Bombay or Singapore, etc. etc. exchanges. Except for the NDAQ and LSE rejection, I am a bit surprised that we are not hearing opposition to all the consolidation talk - either within US boundaries or from the EU. But I suspect that is coming given how few exchanges are left. As for this concept of self-regulatory bodies like the NYSE and NASD, that seems like a stretch if we keep heading to this “One World” financial market system.

I look at the fundamentals of the publicly-traded exchanges and I just shake my head. It’s almost impossible to use the usual fundamental valuation metrics on any of them and feel like they are not grossly overvalued. Pull up the your favorite fundamental screen for the 7 stocks I mentioned and you’ll find averages like these PE(ttm) of 48, PE(fwd) of 37, Price-to-Book of 9, Price-to-Sales of 14, Price-to-Cash Flow of 44. The only saving grace is the “projected” growth rates that hover in the 20% range. And that’s what you are paying for - growth. But then you have to deal with the real question, where is this growth going to come from? Financial innovation over the recent past has been fantastic with the expansion of the ETF world, Derivatives / Options trading, the commodity explosion but that was organic growth and I expect that it will not continue expanding at the rate of the past five years for the next 5. I know the “experts” are all telling you that growth will be exponential, if not linear but time will tell. I remember similar things being said about Internet/Tech companies a few years ago. Just compare the fundamentals (above) of the exchanges to 1999 tech stocks and it’s all too familiar.

The consolidation going on is all about acquiring growth from order flow and new products sitting at the exchanges that have what the others want. None of the targets are cheap and the selling stakeholders are in the driver’s seat. Certainly, there are fixed costs that can be squeezed out of floor exchanges, but I doubt those reductions will result in valuations anywhere near the market multiple. And that gets us back to the growth. The fact is that to obtain 20% per year we need a lot more trading volume and volatility. Or more realistically, the oligopolist environment we are approaching will give the last remaining exchanges the opportunity to raise listing fees and clearing and transaction fees. That may sound great for meeting the growth numbers of the publicly traded exchanges, but those fees are not vapor. They will have to get passed on to someone and that someone usually turns out to be the investor. When the consolidation is over and the inefficiencies of archaic systems have been removed, growth will have to come from pricing power. As near monopolies, they will either have that control or it will have to be regulated by a government body. Neither of those sound too appealing to me.