FMIs Have Navigated Market Volatility Well

At the turn of the year, we wrote in our 2020 outlook for the global financial market infrastructure sector that we expected "volatility to remain relatively muted, leading to continued low trading volumes in many asset classes, notably equities." Little did we know that within a couple of months the COVID-19 pandemic would spur a bout of extraordinary volatility and record volumes amid the extraordinary market gyrations of March and April. Equity, credit, and oil markets were briefly in free-fall, and money and repo markets fought off bouts of massive stress. Volatility has since subsided but remains elevated, and asset prices have substantially recovered. It was a rollercoaster ride for risk managers and operational staff at clearinghouses, also known as central counterparties or CCPs. (See "Global FMI Sector Outlook 2020: More Consolidation Amid Flatlined Markets And Low Growth," published on Jan. 17, 2020, and "So Far, So Good For Clearinghouses Despite Oil And COVID-19 Market Volatility," April 16, 2020).

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For the FMIs in the payments industry, the lockdown-induced collapse in household and business spending broke years of untrammeled volume growth, spurred by the unrelenting shift from cash to electronic payments (see chart 8 above). Only PayPal bucked this trend, thanks to its bias toward online payments.

Strong First-Half Volumes And Earnings Are Unlikely To Be Repeated

As FMIs' earnings have shown, the sector has so far proved operationally resilient, and the high market volumes seen in many asset classes provided a welcome fillip for industry revenues after years of cyclically low trading activity. Whereas equity and commodity volumes were generally strong, interest rates were the principal weak spot after cuts in policy rates--particularly the March cut in the Fed Funds rate, which followed a series of cuts in the second half of 2019. Dollar-sensitive trading volumes and net interest margins consequently suffered in the second quarter and will very likely continue to do so. In our view, the diverging trends across asset classes reinforce our view that diverse revenue streams--particularly by asset class--and a substantial share of recurring revenues are two features that underpin FMI creditworthiness.

Given the risk of delays and setbacks in the global economic recovery and ongoing political tensions, we do not discount further bouts of high volatility and asset price falls in the second half of 2020. However, our economists' macroeconomic base case is one of global recovery that will stretch out into 2022 amid a rock-bottom interest rate environment (see tables 1a and 1b). Our FMI sector base case is that market activity and asset prices will follow the trends seen in June and July. As such, we see the spike in FMIs' revenues in the March-May period as unlikely to recur, likely leaving full-year earnings typically only moderately ahead of our expectations at the start of the year. Indeed, we see a year-on-year decline in volumes in the second quarter and the so-so outlook as one reason why the stock price for CME Group has since March failed to see the strong rebound of other FMIs (see chart 9). The at-best modest cyclical support for volumes means that FMIs' execution of their organic and acquisitive growth initiatives will remain a critical driver of earnings growth, whether in 2020 or 2021.

Table 1a

Table 1b

Chart 9

The Sector Is Well Placed, Even If Debt Markets Snap Shut

Buoyed by strong creditworthiness, leading FMIs have continued to demonstrate their strength in the debt markets. After a brief market shutdown in mid-March, Mastercard and Visa led the way, issuing debt to bolster liquid resources (see table 2). Euronext and very recently Intercontinental Exchange (ICE) have come to market to finance acquisitions, of VP Securities and Ellie Mae, respectively.

Across the sector's issuance, we see two notable features: the typical long maturities, as U.S. FMIs in particular took full advantage of low policy rates; and the ability of FMI issuers from across the investment-grade spectrum to find strong investor appetite.

Table 2

Looking ahead, only ICE and VISA have maturities before year-end (both in December) and these were prefinanced already. Next year also is relatively light for maturities (see table 3). What the table misses is London Stock Exchange Group PLC (LSEG)'s planned £22 billion acquisition of Refinitiv and associated plan to issue around £9.5 billion of debt. Furthermore, SIX Group has indicated that it will look to issue term debt to repay the bank financing that it used to complete its June acquisition of BME. Finally, B3's leverage appetite implies that it may issue new term debt after it repaid its July 2020 bond maturity with own cash.

Table 3

Industry Negative Bias Remains Due To Idiosyncratic Risk, Notably Debt-Financed Acquisitions

In the first half, our rating activity for the FMI sector was the lightest among all bank and nonbank financial institutions sectors (see table 2). The negative bias to our ratings on FMIs is unrelated to the current environment (see chart 1). One reason why we see the sector as having low industry risk is that, overall, sector earnings show quite high resilience even in a cyclical downturn. We continue to expect sector credit quality to remain generally robust, thanks to resilient earnings, general low leverage, low debt servicing costs, and unimpeded access to debt markets.

Table 4

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However, the sector remains hugely acquisitive, and in the past few years sector leverage has crept up--whether in support of in-market consolidation (such as that pursued by Euronext NV and SIX Group) or growth in ancillary lines of business (such as for ICE and LSEG). Indeed, the huge amount of additional leverage that ICE and LSEG are willing to take on demonstrates again the marked difference in financial risk appetite across the sector. Idiosyncratic pressures continue to underlie our negative outlooks on Options Clearing Corp. (OCC), Cboe Global Markets, and Liquidnet. The sole positive outlook, on PayPal, reflects in part its strong countercyclical performance, but more importantly our view of its strong secular growth prospects and likely sustained low leverage.

Looking beyond this relatively benign base-case cyclical scenario for FMI revenues, a more negative macro scenario remains possible where global economic growth stagnates and asset prices fall significantly and remain depressed. The effect would not be felt evenly across the sector. While trade volumes might briefly spike, as in March and April, this environment could be distinctly unhelpful for the least diversified FMIs that continue to draw the majority of their income from cash equity listing, trading and settlement activity and, by construction, have limited flexibility to cut costs.

Aside from PayPal, we see very limited upside for ratings in the sector for two reasons. If volumes and revenues outperform for cyclical reasons, it's likely that FMIs would reward shareholders with heightened distributions, rather than further reduce their leverage. Second, growth is likely to support, rather than improve, their already low business risk.

Table 5

Plenty To Look Out For In The Coming Months

Sector M&A will remain in the headlines

We expect that ICE will move quickly to close its Ellie Mae transaction in September. However, market attention remains centered on the LSEG's Refinitiv deal that was first announced in autumn 2019 and is due to complete around the end of this year. In the context of the European Commission's Phase II review of the transaction, LSEG has commenced exploratory discussions that may result in a sale of LSEG's interest in MTS or potentially the Borsa Italiana group as a whole (see "Bulletin: London Stock Exchange's Potential Italian Assets Sale Could Smooth Path To Refinitiv Deal And Boost Financial Metrics," published July 31, 2020.) While there can be no certainty that LSEG will decide to proceed with a transaction relating to either of these businesses, we expect that they would be attractive to other FMIs or even the Italian state.

Deal integration kicks off

ICE is far from alone in its deal-making. Having now closed their recent acquisitions of VP Securities and BME, respectively, Euronext and SIX will now move to integrate them. SIX anticipates moderate change over the coming year, but Euronext's record with the Irish Stock Exchange, Oslo Børs, and NordPool is one of quite swift progress, and we expect VP Securities to be no different.

Two favorable court rulings haven't eliminated headwinds for U.S. securities exchanges

June was a good month for U.S. exchanges in the federal appeals court: it said that generally applicable market data fees could not be challenged as unfair denials of access under the securities law, and that the Securities & Exchange Commission (SEC) did not have the authority to adopt its transaction fee pilot. However, three headwinds persist--none of them individually game-changing--but together they drag on incumbents' revenues.

• Following SEC approval in January, Cboe is free to launch its "Cboe Market Close"--an end-of-day matching mechanism that crosses buy and sell orders in U.S. stocks at the listing exchange's closing auction prices. This could divert some trading volumes to Cboe from NYSE, NYSE Arca, and Nasdaq, hurting the fees these exchanges earn on their closing auction trades. We expect the overall loss in fees to be (at a maximum) in the low-single digit million dollars on a run-rate basis.
• The SEC has proposed to expand the content of low-cost consolidated market data feeds (the so-called SIPs) to include data that exchanges today bundle in their costlier proprietary data products. While we expect this to lead to some revenue attrition, we note that revenue from SIP market data and proprietary U.S. equity data constitutes only a modest proportion of U.S. security exchanges' total revenues.
• Over the past decade, NASDAQ and NYSE have won a swathe of listings of Chinese companies, but a series of accounting frauds and strained U.S. – Chinese foreign relations have spurred toughened U.S. regulations on foreign companies. In turn, a growing number of U.S.-listed Chinese issuers are making secondary offerings in Hong Kong, and the flow of new Chinese listings in New York will likely slow. For now, this represents a crimped revenue opportunity for these U.S. exchanges—but if it ever came, a wave of delistings of Chinese companies would be worse for revenue. Delisting could be at the choice of the issuer or required by the SEC, for example if issuers don't meet planned stricter regulations on audited financial data. U.S.-listed Chinese companies account for over $1 trillion (or around 3%-4%) of U.S. equity market capitalization. That said, we regard high market quality as supportive of exchanges' long-term franchises.

Brexit nears its conclusion

The U.K. formally left the EU on Jan. 31, 2020, but the real effect comes at end-2020 when the transition period ends and the U.K. leaves the single market and customs union. Within the coming months, the terms of the future UK-EU relationship will be clearer. It remains possible that the two sides will strike a free trade agreement of some kind, but this will not cover financial services--in effect, the outcome is a "hard Brexit" scenario for the industry. At that point, from an EU perspective, U.K.-based FMIs will be treated as third-country institutions, as U.S. FMIs are today. Despite the residual uncertainties, we see the rated FMI groups as relatively well-positioned:

LCH Ltd. and ICE Clear Europe.  The European Commission (EC) has long recognized the unique financial stability risks that could arise from disruption in derivatives clearing. On July 9, 2020, it confirmed that it will adopt a time-limited equivalence decision for U.K. CCPs, ahead of a potential long-term recognition deal in 2021. This second step would rely on the implementation of revised recognition arrangements under the EMIR 2.2 regulation (the amended European Market Infrastructure Regulation). Although the scope and framework of regulatory oversight will adjust following this recognition, we expect no meaningful changes to operational arrangements.

London Stock Exchange.  EU-based members will still be able to trade all U.K. shares in the U.K. However, for stocks listed on EU exchanges, the LSE would need an EC determination of equivalence under the MiFIR (Markets in Financial Instruments Regulation) Article 23 share trading obligation (STO) to allow EU-based members to continue to trade them in the U.K. The U.K.'s intention to implement MiFID II in U.K. law post-Brexit should in theory make an equivalence decision straightforward, but the EC has not yet confirmed its position.

Euroclear.  ESMA has already recognized Euroclear's U.K. entity, Euroclear UK & Ireland (EUI), as a third-country central securities depository (CSD) in accordance with Article 25 of the EU CSD Regulation Central Securities Depositories Regulation). This enables EUI to continue providing its services to EU-based clients. The position is more complex for Euroclear's multicurrency settlement services for Irish securities, which it currently delivers from EUI. However, the EC has granted temporary equivalence to EUI until March 30, 2021, allowing it time to migrate the Irish securities market to Belgium-based Euroclear Bank as the issuer CSD.

A further evolution of CCP and CSD risk practices and regulatory requirements

Globally, CCP and CSD risk management has strengthened markedly in the past five years, in response to regulatory initiatives and in reaction to market developments. Amid these developments, we see four notable trends:

• CCPs' further refinement of risk measurement and management of members' concentrated trading positions--an area of apparent continued divergence among EU CCPs, see "ESMA's Stress Test Gives Clearinghouses Food For Thought," published Aug. 5, 2020.
• CCPs' expanded implementation of Value at Risk-based and expected shortfall-based margining models, such as CME Clearing's planned transition to its SPAN II model.
• Refinement of stressed liquidity requirements on CCPs and international CSDs, notably the modeling of these FMIs' stressed liquidity uses and the adequacy of reliable resources. Options Clearing Corp. is one example, but we see this as a live topic at other FMIs also.
• Finalization of the EU's recovery and resolution rules to CCPs, amid an ongoing debate among CCP stakeholders about a fair split of burden-sharing between CCPs and their members, and regulators' use of intervention or resolution powers.

Related Research

• ESMA's Stress Test Gives Clearinghouses Food For Thought, Aug 05, 2020
• Credit Trends: Global Financing Conditions: Bond Issuance Is Expected To Finish 2020 Up 6% After A Strong Second Quarter, July 27, 2020
• Economic Research: The Global Economy Begins A Slow Mend As COVID-19 Eases Unevenly, July 1, 2020
• Credit Conditions Asia-Pacific: China First To Recover, June 30, 2020
• Credit Conditions Emerging Markets: Slow Recovery, Prevalent Risks, June 30, 2020
• So Far, So Good For Clearinghouses Despite Oil And COVID-19 Market Volatility, April 16, 2020
• Clearinghouses Continue To Up Their Risk Management Game, Jan. 29, 2020
• Global FMI Sector Outlook 2020: More Consolidation Amid Flatlined Markets And Low Growth, Jan. 17, 2020

Annexes

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Table 7

Table 8