"Stock exchanges – as opposed to futures or derivative exchanges – have become more prone to operational risk." This was the conclusion of ratings agency Standard & Poor’s last month as it released a report stating that technical glitches at some exchanges might result in their downgrade.
Although there has been much focus on Nasdaq following its Facebook IPO controversy and the three-hour glitch in August because of an outage in data-feed SIP that it operates, the firm is far from alone. S&P cites 23 instances of operational issues at global exchanges from March 2012 to September 2013.
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"There was a glitch at the London Stock Exchange that delayed the release of many company announcements by 1.5 hours, an outage at the Singapore Exchange in April that delayed dealing in derivatives contracts for almost three hours, and a typo at the Tel Aviv Stock Exchange in August that sent Israel Corp stock plummeting 99.9% and brought all trading to a halt," Olga Roman, credit analyst at S&P, says. Furthermore, in September NYSE Euronext subsidiary SMIA had issues that halted US options exchanges and a computer glitch at Goldman Sachs in August also disrupted exchanges. Frequency
The electronification of the financial industry means that such technical outages are likely to be more frequent. However, Barclays analyst Kenneth Hill reckons that the number of such glitches is not necessarily increasing, but simply garnering more media attention. "Operational risk has always been there for the exchanges. The Flash Crash, however, put technical glitches in the public domain."
But do these episodes require exchanges to be downgraded? "They have also drawn regulatory attention that is likely to result in tougher regulatory standards and oversight," says S&P. "While increased regulation may reduce operational risk, we do not believe it will completely eliminate it. It will also likely lead to higher compliance and investment costs for companies.
"Furthermore, the poor track record of outages and other operational problems at some specific exchanges could damage their reputation and their competitiveness in the marketplace, and the recent glitches could weigh on our assessments of both individual exchange ratings and the overall industry risk profile. We believe the combination of these factors could put downward pressure on ratings over the next few years."
Nasdaq CFO, Lee Shavel, however, tells Euromoney that the firm’s operational risk is limited to the exchange business, which is a small part of the whole business. "Technical challenges are something we have to deal with on a regular basis, and S&P correctly identified the risk that exchanges are exposed to," he says. "However, it is important to also remember that the credit risk is dependent on an exchange’s entire business and financial standing. While exchanges need to manage operational risk, [we have] diversified [our] business by leveraging our platforms across the globe to provide additional value to our various client constituents. Over 70% of our revenues come from recurring or subscription-based businesses and US cash equities trading represents only 10% of our revenue."
Hill at Barclays says that Nasdaq’s diversified strategy makes it unique among exchanges. Only 5% of its revenues are derived from cash equities. In its second-quarter earnings call, Nasdaq chief executive Robert Greifeld said he was proud of the diversification of the business although that did not mean the firm was not committed to the transaction business. Over the past two years Nasdaq has acquired Thomson Reuters Corporate Services, Norwegian-based clearing facility Espeed and a stake in a Dutch derivatives trading venue. It also provides data, market surveillance, and sells indexing licences.
Fragmentation
Standard & Poor’s additionally points to fragmentation of the exchange industry as adding to complexities and increasing operational risk. There are now 16 SEC-registered securities exchanges in the US and more than 50 alternative trading systems, whereas before 2005 the equities market was dominated by NYSE and Nasdaq. It is this interconnectivity that is fuelling operational risk. When Nasdaq halted trading in August, for example, other stock exchanges, including NYSE, Bats and Direct Edge, were also forced to stop trading in Nasdaq-listed securities.
Hill agrees that the fragmentation of the industry has caused it to become more complex. "The exchanges are pitching to the regulators to create a more stable market with a level playing field from a regulatory and reporting standpoint. They have been clear about the need to simplify the industry." If the SEC decides to move on this point it might lead to consolidation.
In spite of the perceived increased operational risk, Hill says earnings have seen no impact. Investors seem wary of exchanges – 40% of those surveyed by Barclays in September said they would switch from underweight in Nasdaq if there were decreased headline risk around the name and sector. In late September, it appeared that Twitter might have chosen to run with NYSE for its IPO rather than Nasdaq, a development that is a blow for the latter. However, Barclays analysts remain upbeat on the name. "We like [Nasdaq] longer term and believe the headline noise created by the recent issues will likely prove to be a nice entry level for investors who can stomach some near-term volatility as issues are resolved and the company’s longer-term, diversified strategy is better understood."
