Derivatives business is driving deal for NYSE
The Germans may be buying the New York Stock Exchange — but not for the stocks.
Germany’s leading stock exchange firm is nearing a deal to buy the parent of the NYSE at a time when both companies have suffered flagging profits from traditional stock trading.
Instead, Deutsche Boerse and NYSE Euronext envision a rosy future in the more arcane business of trading derivatives, which are financial instruments such as corn futures and credit default swaps that derive their value from other assets.
The deal, expected to close as soon as Tuesday, underscores the degree to which stock trading has ceded its central role for institutional investors to more complex financial transactions.
“The actual trading of stocks has become much more of a secondary business at the exchanges,” said Darrell Duffie, a finance professor at Stanford University. “Derivatives and all the other stuff are more in the front seat, driving these changes.”
The shifting dynamics are on display throughout the industry. Shortly before the Big Board and Deutsche Boerse disclosed their negotiations, the London Stock Exchange announced plans to acquire the Toronto Stock Exchange for much the same reason, and more deals are expected.
“Before the next month or two is out, we’ll probably see another big exchange merger,” said Larry Tabb, the founder of Tabb Group, a financial analysis company.
The declining importance of stock trading has been years in the making. Regulations passed in the United States during the 1970s and 1980s ate into the profit margins from stock trading.
In addition, a variety of new high-tech exchanges have sprouted in recent years and forced industry leaders to slash costs to compete. Where brokers used to have few options when placing a trade, now they can go wherever the costs are cheapest — and that is frequently a computerized exchange far from Wall Street.
That puts a premium on cutting costs. Deutsche Boerse and NYSE Euronext have said they could save more than $400 million by combining operations.
Although the profit margin on stock trades has slipped, the complexities involved in trading derivatives such as credit default swaps and interest rate futures have kept the profits from those transactions much higher.
Big Board revenue from derivatives trading jumped 14.2% last year, while stock-trading revenue slumped 10.5%. Stock trading accounted for $1.2 billion in revenue last year, though derivatives trading is catching up, hitting $826 million.
Last year, the NYSE derived 56% of its revenue from conventional securities trading and 18% from derivatives, according to Tabb Group. But a combined NYSE and Deutsche Boerse would get 39% of its revenue from stock and securities trading, and 26% from derivatives.
At Deutsche Boerse, stock trading already accounts for much less than half the revenue.
The derivatives business is expected to grow even more swiftly after the passage of last summer’s financial reform bill, which mandates that many kinds of derivatives be moved onto new exchanges.
Pointing to these possibilities for growth, analysts have cheered the deal.
Michael Vinciquerra, an analyst at BMO Capital Markets, wrote in a note to clients that the deal “could be highly attractive and create a true powerhouse in Europe and the U.S.”
The companies also have experienced strong growth from technology services, such as software sales, and from the behind-the-scenes job of processing trades for all sorts for clients.
The potential benefits have not protected the deal from American critics, who worry about one of the crown jewels of U.S. capitalism moving offshore. The combined company would be incorporated in the Netherlands, with Deutsche Boerse as the majority owner.
Over the weekend, former Goldman Sachs Chairman John Whitehead said the deal “would be an insult to New York City and New York State, and indeed to all America.”
Sen. Charles E. Schumer (D-N.Y.) has pushed to ensure that the name of the new company would begin with New York.
But industry experts said it has been a while since the NYSE has been either a quintessentially New York company or, for that matter, one that is focused on its storied trading floor.
“It’s no longer just about stocks,” said Menachem Brenner, a professor at New York University’s business school. “It’s about all the other things that they are doing.”
