Economic Moat of Exchanges… or is it?

 Exchanges is a place where buyers and sellers come together to trade these things like stocks, currencies, and even commodities like oil, in a safe, organized way.

When I was researching for Hong Kong investment opportunities, I stumbled upon Hong Kong Exchange (ticker: 0388). I had a flashback on those HK dramas that related to stock market, like Divine Retribution (世紀之戰) and The Greed of Man (大時代).

Putting aside my nostalgia, I did learn a few things about exchanges and their economic moat.

So, let’s start with…

Toll-like Revenue

If you want to trade financial products, chances are you must buy them through an exchange, directly or indirectly. There is no way around this. Hence, they earn their revenue through all transaction fees.

Yet… this “toll-like” revenue is established through a few factors.

Barriers to entry

While in some countries, like Singapore’s SGX and Hong Kong’s HK Exchange, there is only 1 exchange, which gives them an almost monopoly-like business in their country.

Most countries have high capital requirements and uphold certain standards to ensure the exchange function as it should be.

Apart from functioning as intended, should another company wish to set up another exchange, that company need to show a business plan to the country government to explain the need of another exchange.

Hence, it isn’t as simple as having the capital to obtain the license. 

For HK and Singapore here are some links to read if you are interested in the requirements need to open and maintaining the exchange:

HK SFC requirement: https://www.elegislation.gov.hk/hk/cap571?xpid=ID_1438403465394_001

MAS requirement: https://www.mas.gov.sg/-/media/mas-media-library/regulation/notices/mpi/notice-sfa-02-n04-notice-on-capital-requirements-for-recognised-market-operators-that-are-formed-or-incorporated-in-singapore.pdf

Intangibles – Data

There will be an ocean size trove of data available for interested parties to analyses, to make sense out of it, etc.

Traders will want fast accurate data depending on their trading style, as some of them believe the speed of data matters to their prosperity. Investors probably wish to know other information like the companies’ management transaction and announcement. They want this information to be timely and wholesome. Brokers need this data to implement into their platforms and let their clients use them.

And who has this firsthand data to give them? Spoiler alert: Exchanges. 

Data like Real-time quotes, corporate data, order book data, market news etc.

Exchanges recognized that brokers and financial institutions want this data and are willing to pay them.

Hence, granting them another subscription-like income.

Intangibles – the country matters

While the exchanges have no part to play in this matter, the country’s reputation where they reside matters too.

Imagine the country’s bureaucracy is slow and inefficient, police do not do any enforcement at all, and law is just a book.

Investors may not trust the listed companies’ financial reports. Companies may not wish to list in that exchange. Even if the company does, it takes a long while to get it.

Should there be any white-collar crime, will there be anyone enforce it?

In the opposite scenario, a country that has efficient bureaucracy, transparent and clear laws with good enforcement. Companies and investors have a high trust in the country and may consider listing or trading/investing in that exchange’s listed companies or financial products.

This may increase the volume of transactions, foreign capital flow into the exchange.

Some exchanges may cater to a specific type of investment product and entrepreneurs may choose that exchange to list in instead.

For example, Singapore Tech Company, SEA LTD listed in NYSE instead of SGX and Oversea REITS choose to list in SGX due to the high preference of dividend stocks.

This leads to another topic…

Their challenges

The high barrier to entry created by regulations and their valuable intangible assets makes them virtually unchallenged in their home country. Exchanges business isn’t almighty.

Because they may face…

Prefer to list in another foreign country exchange

Like my pervious example, SEA Ltd chooses to list in NYSE instead of SGX. This shows that companies do have an option to list which exchange they prefer to.

Hence, it isn’t a guarantee that a company will be listed in their home country exchange.

Certain exchanges may have more diverse and deeper investor pools, providing access to a wider range of potential investors than the domestic market. This can lead to increased demand for the company's shares and potentially higher valuations.

While other exchanges may attract concentrated pools of investors interested in the company's sector or industry, leading to better understanding and valuation.

Depending on the country’s tax law, foreign companies may get certain tax advantages.

Companies considering listing may take these factors into consideration.

Government Policies may affect exchanges

Sometimes the government may impose policies for certain intentions well in mind. It doesn’t mean the exchange may get the benefit.

Strict regulations, complicated reporting requirements and unclear policies may protect investors from several issues. But they may also deter companies from getting listed, which reduces the exchanges potential.

For example, US exchanges allow investors to buy a single share of the company, allowing retail investors to invest in the company of their choice with little capital. While SGX can only transact in terms of 100 shares (1 lot).

Almost a monopoly moat

Despite facing challenges like cybersecurity threats and regulatory hurdles, traditional exchanges offer several advantages, including asset-light operations, healthy profit margins, and limited competition in certain markets. Technological advancements in areas like trading platforms and data analytics present opportunities to further streamline operations and attract new investors or traders.

The rise of cryptocurrencies has introduced new dynamics to the financial landscape. While crypto exchanges strive to gain a foothold, the recent SEC approval of crypto ETFs presents an indirect benefit for traditional exchanges. With their established security infrastructure and extensive operational experience, traditional exchanges can offer a safe and regulated platform for investors interested in accessing crypto assets. This can potentially lead to increased trading volume, broadened investor, and trader bases, and increase its revenue.