Jim W. Huang, CFA
[Greene County IL, Apr 21] Crypto Exchange Coinbase (COIN) went public at NASDAQ on April 14, ushering a new era in the history of US financial markets. At $312 a share at today’s closing price, investors gave Coinbase a market capitalization of $58 billion, making it the third biggest US Exchange behind CME Group (CME) and Intercontinental Exchange (ICE). Interestingly, Coinbase is now valued at twice the size of Nasdaq (NDAQ), the marketplace where its shares are listed.
The Exchange Business Model
Coinbase is not the first Exchange that became a public company. Eight so-called “legacy” Exchanges went before her. In December 2002, Chicago Mercantile Exchange (CME) went public at $35 a share. The IPO of Nasdaq was also held in the same year. These followed by Intercontinental Exchange and Chicago Board of Trade (CBOT) in 2005, New York Stock Exchange (NYSE) and New York Mercantile Exchange (NMX) in 2006, Chicago Board of Options Exchange (CBOE) in 2010, and BATS Global Markets (BATS) in 2016. CBOT, NYMEX, NYSE and BATS have since been acquired and delisted, making the total number of publicly traded US financial Exchanges at only five, with Coinbase included.
What is a Financial Exchange? It is a regulated public marketplace where buyers and sellers trade (“exchange”) stocks, futures, options, debts, trust units and other financial assets. How do Exchanges make money? By levying a fee on transactions made or cleared on their venues. The table above shows share of Exchange revenue from transaction fees, which ranges from under 40% to nearly 90%.
While there are subscription revenues such as real-time market data, the Exchange business model is primarily a transaction-based one. We may consider transaction revenue as a function of total volume traded and the average rate charged on each trade. Most Exchange strategies center on either growing volume or raising rate. Launching new contracts and expanding globally fit the first category. Strategies focusing on mini-size contracts and retail accounts usually result in higher rate per trade, comparing to fee charged on larger contracts or to members and institutional accounts.
In 2020, Coinbase earned over $1 billion in transaction fees, about 86% of its total revenue. Its market price now commands a whopping 200 price/earnings multiple, where the other public Exchanges have P/E in the 20s and 30s. Is Coinbase priced right? How do we make sense of this moonshot valuation?
Let us take a look at the history of US financial markets. Disruptors with creative innovations and technological advances are the driving forces behind the exponentially growth in the past 200 years.
The 19th Century: Standardization
In 1848，eighty-three grain merchants established the Chicago Board of Trade in Chicago. This was the first organized commodity Exchange and the birth of modern futures industry. In 1851, CBOT offered the earliest “forward” contract ever recorded; forward contracts began to gain popularity among merchants and processors.
In 1865, CBOT formalized grain trading with the development of standardized agreements called “futures” contracts, world’s first such agreements. CBOT created world’s first futures clearing operation when it began requiring performance bonds, called “margin,” to be posted by buyers and sellers in its grain markets. In 1870, CBOT developed first octagonal futures trading pit, shown in the historical photo below.
Other Exchanges started in this period include Kansas City Board of Trade (KCBT) in 1856, New York Cotton Exchange (NYCE) in 1870, Memphis Cotton Exchange in 1874, Minneapolis Grain Exchange (MGEX）in 1881，and New York Mercantile Exchange and the Coffee, Sugar and Cocoa Exchange (CSCE) in 1882. In 1898, Chicago Butter and Egg Board opened for business in Chicago. In 1919, it was reorganized and renamed as the Chicago Mercantile Exchange.
The 1970s-1980s: Financial Revolution
After World War II, under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. The IMF was created.
Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary. The U.S. was only responsible for maintaining the gold parity. There were no exchange rate exposure in international trade in a world of fixed rates.
In early 1970s, the ending of fixed exchange rates brought new risk exposures to international trade. The Chicago Mercantile Exchange, led by the visionary Leo Melamed, introduced foreign exchange futures, interest rate futures and stock index futures. These innovations revolutionized the hundred-year-old futures industry and the world entered into the era of “financial futures”.
Exchange Timeline courtesy of CME Group:
l 1972 — CME launches first financial futures contracts, offering contracts on seven foreign currencies
l 1975 — CBOT launches first interest rate futures, offering a contract on the Government National Mortgage Association (Ginnie Mae)
l 1981- CME launches first cash-settled futures contract, Eurodollar futures
l 1982 — CME launches first successful stock index futures contract, S&P 500 Index futures; CBOT launches first options on futures contract for U.S. Treasury Bond futures
The 1990s-2000s: Electrification
For over 140 years, commodities trading was always done by “open-outcry” method via brokers face-to-face on the trading floors. If you were not a member of the Exchanges, you had to call your broker on the floor, and provided trading instructions for him or her to execute your trade.
In mid-1990s, electronic trading made futures trading accessible by millions of investors around the global. With the popularity of Globex electronic trading system, CME became the world largest futures exchange holding company.
l 1987 — CME pioneers electronic futures trading with development of CME Globex platform
l 1992 — First electronic futures trades are made on CME Globex electronic trading platform
2010s to Present: Digitalization
In December 2017，CME and CBOE separately launched new futures contracts based on Bitcoin price indexes. In February 2021, CME Ethereum futures (ETH) debuted. In the post-US Dollar era，a new global financial ecosystem based on crypto currencies begins to emerge.
In a letter to investors, Coinbase founder Brian Armstrong singled out “trust” and “the ease of use” as the most important factors in successfully growing his nine-year-old Exchange. CME Bitcoin and Ether Futures, along with Coinbase IPO, earned my praise in this regard. Any investor with a futures account could trade BTC and ETH futures, just the same as you trade Treasury futures and E-Mini S&P 500. The contracts are US-dollar based, and you could replicate Crypto returns without ever owning a crypto coin. Likewise, investors with a regular brokerage account can now indirectly participate in cryptoeconomy by buying Coinbase stock, just as easily as buying Google stock.
Crypto vs. Legacy Exchanges
While examining Exchanges, we need to look beyond the fancy buzz words written all over annual reports, and ask two simple questions: 1) Do they have liquidity? 2) Do they have pricing power?
A deep liquidity draws trading volume to the venue, while pricing power affords you to charge a comfortable rate for your services. This goes back to the transaction fee equation I presented earlier.
Large futures Exchanges have a deep pool of liquidity. If you want to trade Eurodollar futures, you go to CME, while CBOT is the venue for Soybean. Such monopoly-like position allows futures markets to have higher transaction fees. As a result, CME Group and ICE have operating margins in 60%-70%.
Stock Exchanges face higher competitions. For example, stocks listed on NASDAQ could be traded on dozens of dark pools and Exchange-like ECNs. Transaction fees on stocks are extremely low, and as a result, equity Exchanges have operating margins in the 20%-40% range.
Crypto Exchanges are a different story. On the one hand, Bitcoin is traded on hundreds of venues. No Exchange has a big share or deep enough liquidity. On the other hand, they have a user base dozen times bigger than the legacy Exchanges. As of 2020, Coinbase had 43 million verified users. In the same year, there were only a few million futures accounts for all US Exchanges combined. Additionally, Crypto prices are not very transparent. Transaction fees levied by Crypto Exchanges are significantly higher than those on futures or equity Exchanges.
“Coinbase powers the cryptoeconomy.” This claim, if materialized, may set Crypto Exchanges apart from their legacy counterparts.
Financial Exchanges are critical infrastructure in a global economy. Traditionally, Exchanges focus on the one thing they do best, which is to provide trading venues more efficiently to their customers. Futures Exchanges cover hundreds of commodities, but they do not participate in the production, processing, transportation, storage, and distribution of those commodities. Stock Exchanges trade stocks that make up the most important financial asset for American families, but they do not engage in saving, asset management, payment service, or lending and borrowing.
There is an unwritten rule that Exchanges do not step into the primary businesses of their members, which include hedge funds, investment banks, asset managers, commodities brokers, etc.
Crypto Exchanges expand way beyond trading. Although this has not yet shown up on income statement, but one day, when one billion consumers could use a Crypto wallet to handle all her financial needs, the potential growth is unimaginable.
I can’t help but think about how I used WeChat Pay in China a couple years ago. I could walk out the door without carrying a wallet. No vendor would refuse WeChat Pay or Ali Pay. There was simply no need for cash or credit cards. I have even purchased international airfares with WeChat Pay twice.
With a ten-year tenure at the CME Group, the experience being part of the 2002 IPO taskforce, and my involvement in earnings call material preparation, I am hoping to provide a different angle for readers to evaluate the Exchange business model.
[Declaimer: The material contained in this writing is for your information only, and may not be viewed as a recommendation to buy or sell stocks. As of April 21, 2021, the author does not have beneficial ownership of any stock discussed in this writing.]
About the author: Jim W. Huang, CFA is a veteran of financial futures markets. He is instrumental in the successful launch of China’s DCE Egg Futures (2013), DCE Soybean Meal Options (2017) and DCE Live Hog Futures (2021). Jim is a leading voice on China’s livestock and poultry markets, and frequently quoted by Bloomberg, Reuters and the Wall Street Journal. From 2001 to 2011, Jim was an Associate Director of Product Strategy at CME Group, the world’s largest Financial Exchange holding company. Jim received an MBA from Chicago Booth and studied under Nobel Laureate Eugene Fama in an empirical research paper of futures market liquidity. You may contact Jim by email at email@example.com.