Categorized | Featured, Long Ideas

Clearing Firms Rally Into Year End

IntercontinentalExchange (ICE) As we wind down 2009 and look forward to the year ahead, I have been taking some time to read a few books relating to the financial crisis and how the events transpired.  The Greatest Trade Ever by Gregory Zuckerman details how John Paulson turned a profit of more than $15 billion by betting against the unrealistic housing and mortgage bubbles.  It’s inspiring to see how careful thought and methodical execution allowed this now legendary trader to vault from an “also ran” mediocre fund manager to one of the most respected investors of our time.

ZachStocks Free NewsletterHouse of Cards by William D. Cohan is a bit of a darker read as it chronicles the collapse of Bear Stearns over a fateful spring week in early 2008.  The Bear Stearns failure is especially interesting to me as I personally worked on the same floor as Bear Stearns’ Atlanta office during the time that the firm went under.  It is quite sobering to see just how vulnerable our major financial institutions were (and many still are) due to the enormous leverage used as these companies aggressively pursued profits.  Many of the derivative tools which were used to drive trading gains (and eventually to bring down companies like Bear, Lehman, and AIG) are still actively traded and could potentially cause market chaos again.

As the political machine moves from emergency bailouts to the much more difficult process of making sure a similar financial catastrophe never happens again, new regulations are being put into practice which are expected to discourage institutions from taking similar excessive risks.  Now I could write a number of pages on why political regulation will likely fail at reigning in human greed and fear, but rather than dive into the intellectual side of that argument, let’s look at some investments which could profit from the additional regulation.

One of the most recent regulatory reform bills which was debated in the House attempted to require all financial derivatives to be traded on exchanges and cleared.  The purpose was to provide both transparency and a sense of risk control.  As exchanges posted data on which derivative contracts were being traded, at what prices, and at what volume; investors would have a better sense of the liquidity of such vehicles and what price the market was willing to pay for exposure to particular investment and trading agreements. The risk control would come into play as the derivative agreements were “cleared” or guaranteed by a third party.  Companies like IntercontinentalExchange (ICE) and the CME Group (CME) act as intermediaries between trading counterparties, guaranteeing that the trades will be settled.  As the clearinghouses are taking on the counterparty risk associated with each trade, the market becomes less vulnerable to the risk that one of the parties will default on a major trade (or basket of trades).  The clearinghouse must manage its own risk and will therefore require each party to put up a certain level of margin or collateral depending on what is at risk with the particular trade. Clearinghouses must carefully manage their own risk, but if the business is handled appropriately the profits can be quite lucrative.  Not only does the clearinghouse get to charge fees for each trade cleared, but the firm holds a large amount of capital which it can invest while counterparties leave the trade on the books.  ICE and CME are both expected to be major beneficiaries of the push to have more derivative trades directed through the clearing function. Of course not everything goes according to plan in Washington (thank goodness), and it is unreasonable to expect that 100% of derivative trades will be forced onto exchanges.  Dealers and other market participants will still transact some business without a third party intermediary.  However, Morgan Stanley (MS) believes that the volume of derivatives cleared could increase from the its current portion of 20% to as high as 60% in 2012.  A tripling of market share could certainly boost the profits of the established players and potentially lead to sharp investment gains in 2010.

Other Articles of Interest Banking in 2010 – At Risk if You Do, More Risk if You Don’t Fortress Investment Sees Better Times Ahead WSJ: How Overhauling Derivatives Died FT: CME Nears Deal with Banks on DCS Clearing

One of the benefits of operating a capital intensive business like a clearinghouse is that it is very difficult for new competition to enter the market.  With a clearing business, trust and reputation are the most important assets as traders do not want to clear unless they believe that the clearinghouse has the capital to truly absorb the risk if a counterparty defaults.  This reputation cannot be easily built without a significant amount of time in the business, and it is difficult to manufacture that experience without clearing major trades.  So there truly is a “chicken or egg first” difficulty in starting a new clearing franchise.  Also, large financial institutions are not likely to enter the clearance business because they would rather make their profits on the trading side.  So for now it appears that ICE and CME are the leaders and have a sustainable advantage in collecting profits from clearing derivative trades. Neither CME or ICE are trading at extremely cheap multiples.  That is because the market has begun to realize the strong potential for earnings growth.  However, as the political climate continues to drive banks and dealers toward greater disclosure and stronger risk controls, it is likely the earnings growth will be even greater than expected for CME and ICE.  The result will likely be a sustainable advance in the stock price of both clearinghouses and while there could be moderate volatility the trend should remain intact for months to come. IntercontinentalExchange (ICE) CME Group Inc. (CME) FD: Long position in Sound Counsel Investment Advisers client portfolios Enjoy this article? Sign up for the ZachStocks Newsletter, Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

Clearing Firms Rally Into Year End

1 Comments For This Post

  1. Dionna Marwick Says:

    I really liked your post.Thanks Once more. Am going to read more…

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