S&P updates ratings method for exchanges and clearing houses
Technology jumps up the analysis rankings
Exchanges and clearing houses have changed almost beyond recognition over the past 10 years.
They have been transformed from private mutual, member types of organisations in many instances with monopoly powers and business franchises to public and, in many cases, listed organisations. The old membership category has for the most part "sold the family silver" to be replaced by institutional shareholders, who demand improved financial returns.
At the same time, exchange and clearing house users demand improved, efficient, lower cost services, better liquidity and transparency for execution. Exchanges and clearing houses are responding to these demands but they are competing against each other, in some instances through merger or acquisition, to consolidate their business position.
Much of the response by exchanges and clearing houses has seen extensive deployment of technology internally and through onward sales and licensing of technology to users and other exchanges and clearing houses. Equally, increased commercial exploitation of data and information services generated by exchanges, clearing houses, and their users has focused on the by-products which technology has enabled to evolve.
Consequently, S&P has revised its rating methodology, a combination of qualitative and quantitative analysis. It now rates exchanges and clearing houses as "going concerns". Importantly, the deployment and commercialisation of technology forms an important element of the analysis for rating purposes.
Exchanges and clearing houses have to maintain adequate investment in transaction and operating systems in order to deliver reliability, speed of delivery of information, and transaction execution. Technology migrations, from R&D through systems purchases upgrades, are the largest cost for an exchange and generally involve very substantial capital expenditure. Where capital expenditure demands grow beyond the financial capacity and capability of the exchange or clearing house, that is normally a signal for acquisition or merger.
S&P examines the IT expenditure of exchanges and clearing houses in relation to overall costs and operating cash flows. This can provide an analytical challenge where IT spend, for example, does not include people-related expenditure and reflects only maintenance of existing infrastructure. Equally, where capital expenditure is included in R&D and those costs are capitalised and appear in the cash flow statement, costs of specific projects can be difficult to determine through financial analysis.
In terms of determining the rating of exchanges and clearinghouses, S&P analyses the risks, which it segments into three key components, though they do not have equal weighting: business risk, risk management, and financial risk. Within each of the risk categories, the analysis of technology is a consideration.
Business risk has two categories: market position/business diversification and management and strategy. Within both these risk categories technology has to be evaluated. For example, does the sale/licensing of technology and sale of information and data services provide a significant level of revenue diversification from dependency on uncertain and fluctuating trading revenues? Does the Exchange/clearing house technology have a "brand value"? What is/how good is the current technology strategy for the exchange/clearing house? What is the future technology strategy and what is the evaluation of it?
Risk management has two categories: operational risk and credit and market risk. The technology infrastructure is an important consideration in operational risk evaluation, including its capacity, reliability, speed, and accuracy of trade execution. Likewise, disaster recovery, its business continuity and technology back-up capabilities are factors for evaluation.
Financial risk has two categories: profitability/cash flow and debt leverage/capital. Exchanges and clearing houses typically have high fixed cost bases and relatively small variable cost bases. They depend on trading volumes to increase operating margins. Technology investment, current and future, is critical to reduction of fixed costs by increasing capacity and reducing fixed costs.
Equally, where technology can contribute efficiently to other income streams through licensing and software sales, diversification thorough sales of distributed prices and other market information and analysis modify the revenue dependency on the uncertainty of trading volumes.
It is interesting to note that S&P would apply its rating methodology for exchanges and clearing houses to "financial institutions that execute, clear and settle listed and OTC securities and commodities in cash and derivatives markets, as well as central securities depositories (CSDs)".
Institutions, seeking to build the new alternative electronic platforms permitted and encouraged under MiFID, Multilateral Trading Systems (MTFs) and Systematic Internalisers (SIs), may well give serious consideration to the rating methodology employed by S&P, as they build value in these new enterprises. The technology embedded in these enterprises may prove to be an even more important element in rating and valuation of such enterprises.
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