ASX: Competition cuts in - pt 2

The first part of this three-part series examined the threats and opportunities facing ASX’s traditional sharemarket businesses (actually, mainly threats). But the future for the group’s remaining businesses looks much brighter.

Derivatives

The ASX’s most important division after its sharemarket businesses is derivatives. It generates fees from the trading, clearing and settlement of futures and options over shares, share indices, commodities and interest rates (see Part 1 for an explanation of clearing and settlement). As Chart 1 shows, in 2012 this generated 31% of ASX’s revenues, with interest rate futures and options contributing just over two-thirds of that.

ASX has a monopoly over local ‘exchange-traded’ derivatives, for which it operates as a ‘central counterparty’ or ‘CCP’– acting as buyer to all sellers and a seller to all buyers. But it faces indirect competition from the much bigger ‘over-the-counter’ (OTC) market.

OTC derivatives have their origins in bespoke contracts made between two separate parties—that is, without a central counterparty. Their flexible nature enables the parties to create tailored exposures and manage specific risks.

But the most popular ones have become standardised under so-called ‘international master agreements’ and are similar to exchange-traded derivatives, but with less regulation and disclosure, typically higher costs and perhaps a little more risk in clearing and settlement. There are even OTC contracts, known as ‘lookalikes’, that are set up to function exactly like their listed counterparts.

So at the margin there is considerable overlap: the same exposures can be achieved through exchange-traded or OTC products. Which of these the parties might choose depends on the parties’ desire to keep things between themselves, and costs (which, especially for an OTC contract, would reduce as a percentage of the transaction the larger it is).

Tightening OTC market

In the wake of the global financial crisis, regulators around the world are keen to stop OTC participants from keeping things between themselves. They want it all out in the open.

As ASIC, APRA and the RBA put it in a joint paper last month, there is ‘an international policy consensus that embedding centralised infrastructure—trade repositories, CCPs and trading platforms—in OTC derivatives markets is the most effective mechanism for addressing many of the concerns of regulators and market participants’.

Australian regulators recommend a ‘broad-based mandatory trade reporting obligation’ for OTC derivatives and that central clearing for OTC interest-rate contracts ‘should be adopted by larger market participants, and that this should be a mandatory obligation if the existing industry-led migration stalls’.

All of this could play into ASX’s hands: after all, a highly standardised contract with a central counterparty and full disclosure might as well be done on exchange. This should support ASX’s plans to list new derivatives and increase activity in existing ones.

As we saw with the cash market in Part 1, there will be a trade-off here between price and volume: the cheaper ASX makes its services, the less attractive OTC alternatives will be. Here, though, there is more growth, so the balance will be about how much volume to gain rather than how much to lose.

ASX to expand into OTC clearing

ASX is also preparing to expand its clearing of OTC products; it already clears equity options and has signalled plans to clear Aussie dollar OTC interest rate derivatives. It may, however, be joined in this by LCH.Clearnet. Most of the talk at the moment is of LCH getting a clearing licence for the equity market, but internationally its main game is interest rate swaps and other derivatives, so it’s hard to see it stopping at equities.

Still, this is a growth area for clearing groups and there should be plenty to go around. But what if someone was able to launch a competing derivatives exchange, as Chi-X has done in the cash market?

New derivative exchanges have been regularly popping up in USA and Europe so one shouldn’t discount the possibility. But Australia is a small market and ASX has it pretty well sewn up. Short term, this isn’t a great threat but eventually, as markets globalise and international regulations are harmonised, competing exchange-traded products will appear here.

By then, we’d expect ASX to be competing in overseas markets itself, probably by way of a merger—if the politicians can get their heads around the idea. On balance, it’s fair to say ASX has more to gain than to lose from competition in derivatives.

Information and Technical services

From share price data displayed on our website to high-frequency traders getting data faster than the rest of us, ASX provides a huge array of information services, and it charges a huge array of fees for its efforts: in 2012 information services contributed revenues of $66.9m, or 11% of the total.

If you want to trade really quickly though (and we don’t recommend it), you can connect to ASX’s high-speed fibreoptic network, or even physically locate your servers at ASX’s Australian Liquidity Centre (ALC). Technical services added a further 7% of revenue in 2012, to give an overall 18% for Information and Technical services.

Table 2 shows how growth in this area has been lacklustre recently, although weak performances from information have been offset by strong growth in technical services following the launch of ASX Net (the fibreoptic network mentioned earlier) in 2011 and the ALC in 2012.

The chief competitive concern is that if ASX isn’t hosting the trading, then it won’t have the data or access to sell. However, only sharemarket trading is under direct threat at the moment; information and technical services for other areas should continue to grow. Demand here would also get a boost from new products, an improvement in market sentiment and, dare we say it, further increases in the popularity of high-speed trading.

Austraclear and ‘other revenue’

Austraclear clears and settles trades in local debt markets. It also acts as a depository, meaning that bonds can be left in its vaults to simplify registration and bookkeeping.

It only accounts for a small part of ASX’s revenue but, as Table 3 shows, has been a steady performer, growing at a compound annual rate of 13% over the past four years, helped by a 26% rise in 2010 following an increase in transaction fees. Austraclear has no competition and none is expected, so steady—though more likely single-digit—growth should continue.

The last piece of the jigsaw—‘other revenue’—consists mainly of penalties for failed settlement. If you’ve ever had an empty bank account when a direct debit has come knocking you’ll know what this is all about. Needless to say, if the trades aren’t happening on an exchange and ASX isn’t doing the settling, then it won’t be getting any penalties for failed settlement.

So that wraps it up for ASX’s operating businesses. In Part 3, to be published next week, we’ll look at two final sources of revenue—dividends and interest—before pulling it all together into a valuation. ASX's share price has fallen slightly since Part 1 on 14 Nov 12 (Long Term Buy – $29.10) and remains a LONG TERM BUY.

Note: The model Income portfolio owns shares in ASX.