S&P Global Ratings expects muted performance for U.S. financial market infrastructure firms (FMIs) in 2019, mainly reflecting a slight decline in trading activity, but we expect the diversity of FMIs revenue streams will provide resilience to overall earnings.

Lower volatility during the first quarter of 2019 (compared with the same quarter last year) weighed on trading and clearing revenues, and, although volatility picked up in the last two months of the second quarter, overall trading volumes were down across a majority of asset classes (notably in equity derivatives) during the first six months of 2019. This will likely constrain top-line growth in 2019, in our view.

That being said, the continued shift in U.S. FMIs' revenue mix toward higher-growth data services (including proprietary indices), which is more stable than trading and clearing revenues, should support overall revenues in 2019. Additionally, a rebound in the initial public offering (IPO) market in 2019 should boost listing revenues at some U.S. FMIs.

Separately, after having provided some significant tailwinds since the 2008-2009 crisis, the regulatory environment for U.S. FMIs is now becoming more neutral. Some potential headwinds include the SEC re-examination of past approved exchanges' data fee increases, as well as the SEC's decision to implement a transaction fee pilot.

FMIs we rate include exchanges, central counterparties, central securities depositories, and payment systems.

Sector Trends

Exchanges

After record volatility last year (especially in the first and fourth quarter of 2018) that boosted trading revenues for U.S. FMIs, the return to more muted volatility in the first six months of 2019 weakened large U.S. exchanges' trading volumes across a majority of asset classes (and notably equities). Although volatility increased in May and June, trading volumes overall declined over the first six months of the year (and year over year), ranging from a 15% decline for Cboe Global Markets Inc. to a 7% decrease for Intercontinental Exchange Inc. (ICE) and a 2% decrease for the CME Group Inc. and Nasdaq Inc. This will likely constrain revenue growth of U.S. FMIs, with trading revenues, which can be uncertain, still representing over 60% on average for these groups, despite the recent growth in annuity-like revenues such as data and index services.

Trading volumes on U.S. equity options were down 6% in the first six months of 2019 (in aggregate, according to Options Clearing Corp. data) in the wake of lower volatility (see chart 1). Cboe Global Markets lost market share to its competitors--NYSE and Nasdaq--as the company implemented fee changes in 2018 and lowered volume-based discounts. This, however, resulted in an increase in revenue per contract. Trading volumes on equity index futures traded at CME showed similar declines.

Chart 1

U.S. cash equity trading volumes were muted overall because of lower volatility. Both NYSE and Nasdaq gained market share at the expense of Cboe Global Markets. Cash equity trading volumes on the NYSE were up 8% as the company gained market share by 200 basis points (bps) over the first six months of 2019, to 24.5%, compared with the same period a year ago. Nasdaq also gained some market share, with cash equity trading volumes rising 3%. At Cboe Global Markets, U.S. cash equity trading volumes contracted 18%, while market share declined 320 bps to 15.9% (see chart 2). As a result, management adjusted pricing in May to recoup lost market share.

Chart 2

Trading volumes across nonequity asset classes at the large U.S. exchanges were more mixed during the first six months of 2019. For example, trading volumes in interest-rate futures at ICE decreased 15% because of a very strong last year (reflecting European Central Bank actions last year) but rose 3% at CME as volumes rose 24% in the second quarter after declining 14% in the first quarter (see chart 3). The surge in interest-rate volumes during the second quarter at CME was due largely to strength in Eurodollar volumes, as volatility rose on the increased likelihood of a cut in interest rates by the Federal Reserve.

Chart 3

Trading volumes in energy products at ICE decreased 8% because of lower Brent Crude volumes and declined 11% at CME, reflecting lower West Texas Intermediate Crude and natural gas volumes (see chart 4). Trading volumes in other commodities were mixed, with volumes in agricultural products holding relatively well because of the impact of tariffs, while foreign-exchange volumes and metals were down double digits.

Chart 4

Positively, IPO activity in the U.S. surged during the first six months of 2019 despite the government shutdown in January. According to Refinitiv, a total of 61 IPOs listed on U.S. exchanges during the second quarter of 2019, including high-profile companies such as Uber Technologies Inc., Lyft Inc., Tesla Inc., Pinterest Inc., and Tradeweb Markets Inc. Proceeds from IPO listings totaled $31.6 billion during the first six months of 2019, up 3% from the previous year. We expect proceeds from IPOs (and revenues at NYSE and Nasdaq) to increase significantly this year, possibly exceeding the record high established in 2000, because of a backlog of technology deals.

We believe that the regulatory environment--which benefited the U.S. FMI industry since the financial crisis--is turning more neutral. The implementation of the mandatory clearing of plain vanilla derivatives in more jurisdictions is still benefiting large central counterparty clearing house (CCPs) like CME, notably in Latin America, where it has gained significant market share. New regulation, such as increased margin requirements for noncleared derivatives, is also resulting in more players clearing with CCPs (as centrally cleared derivatives attract significantly lower capital charge).

This being said, we believe that the SEC decision regarding market data fees (that reverses a previous SEC decision allowing NYSE and Nasdaq to increase data fees) is a setback for U.S. exchanges. While the ruling affects the fees on depth-of-book data, the SEC also remanded more than 400 market-data fee increases challenged by Sifma and Bloomberg back to the exchanges for reconsideration. Although the rule is not retroactive, we believe the SEC decision will dampen future data-fee increases at the exchanges. Further, the ongoing consolidation in the market-making industry (for example, VFH Parent LLC (Virtu) buying KCG and ITG) leaves very large players (such as Citadel Securities L.P. and Virtu)--pushing for lower data prices, with a large sway over regulators (given their substantial market share of the U.S. wholesale market), potentially at the expense of NYSE/ICE and Nasdaq.

Furthermore, in December 2018, the SEC approved the transaction fee pilot, targeting the exchanges' fees and rebates that push trading activity to their venues (some exchanges charge a fee from market participants for removing liquidity while offering a rebate to liquidity providers). Proponents of the pilot argue that rebates influence broker-dealers' order-routing behavior by directing orders to the highest-paying exchange, as opposed to obtaining the best execution for their clients.

Under the pilot, the SEC will randomly assign eligible stocks to three different buckets (two test buckets and one control bucket). Each of the three buckets will include approximately 730 securities. In test bucket one, fees will be capped at $0.001 rather than the current cap of $0.003. The second test bucket will prohibit any rebates and volume-based pricing discounts. Based on the data generated from the pilot, the SEC will assess the impact of fees and rebates on order-routing behavior of broker-dealers.

It is too early to tell how changes in the current fees and rebates could affect the order-routing behavior of broker-dealers and what the final impact on exchanges like NYSE/ICE, Nasdaq, and Cboe could be. But, if these rules become permanent, they may impact the business model of these exchanges. In February 2019, NYSE/ICE, Nasdaq, and Cboe filed a lawsuit opposing the SEC's pilot program, and in March the SEC announced it will partly delay the pilot until the exchanges' lawsuit is addressed by the court.

In response to rising market data fees faced by market participants, nine firms, including market-makers (Virtu and Citadel Securities), retail brokers (Charles Schwab Corp., E*TRADE Financial Corp., TD Ameritrade Holding Corp., Fidelity Investments), and large banks (Morgan Stanley, UBS Group AG, and Bank of America Corp.), jointly created a new low-cost exchange called Members Exchange (MEMX). The new exchange could launch by early 2020, pending regulatory approval. In our opinion, the entry of a competitor such as MEMX could increase competition for exchange operators like NYSE/ICE, Nasdaq, and Cboe, given the massive control of investor orders that MEMX' nine owners possess. However, the process of building an exchange may be a long path for MEMX, as illustrated by the journey of IEX Group--an exchange launched in 2016--that has so far managed to achieve a low-single-digit market share compared with roughly three-fifths of the market share held by ICE/NYSE, Nasdaq, and Cboe.

Still reshaping the U.S. FMI industry is the shift to passive investing and the expansion of exchange-traded funds in the fixed-income space, pushing more fixed-income transactions to go electronic. FMIs are competing for a growing pie and working hard to enrich their fixed-income offerings. CME acquired BrokerTec (from NEX Group), and ICE acquired TMC and BondPoint--two fixed-income platforms--last year.

After data services such as investment data, market data, and indices, we believe fixed-income trading could be the new frontier for U.S. FMIs. The recent success of the TradeWeb IPO is another illustration of this.

Payment systems

The growth of the global economy and the ongoing shift in payments from cash to electronic transactions (credit, debit, and prepaid) should continue to be a source of robust revenue and earnings growth at the payments companies at least over the next year.

We expect Visa Inc., Mastercard Inc., and PayPal Holdings Inc. each to grow revenues at a double-digit rate and maintain low leverage over the next year. The pie of global payments is expanding with economic growth, and the piece of that pie made up by electronic payments is growing as more consumers opt for cashless transactions. Visa and Mastercard benefit greatly from these trends because of the breadth of their rails--the connections they have to thousands of banks and millions of merchants and consumers across the majority of the countries in the world. PayPal is a far smaller player than Visa or Mastercard but has carved out a good market position in online payments.

New and existing entrants will continue to look for ways to gain market share in payments--Facebook's Libra is a potential example of this--and we cannot forecast how new technologies will evolve and whether an advancement ultimately will diminish the market positions of Visa, Mastercard, and PayPal.

That said, we don't expect any major disruption to occur at least in the next one to two years. The strength of the market positions of the existing payments companies makes them very hard to displace in a meaningful way.

We also expect Visa, Mastercard, and PayPal to look to expand further in business-to-business (B2B) payments. The card networks can use their rails to allow businesses to both send and receive payments. Such technologies also may include messaging. Mastercard has pursued B2B payments in multiple avenues, including through its 2017 acquisition of Vocalink. Vocalink designed and operates the fast automated clearing house system in the U.K. and also designed a system for The Clearing House, the largest payment system operator in the U.S.

We don't expect Visa, Mastercard, or PayPal to win a material portion of B2B payments in the next few years, but any growth in this area will add to their already-strong revenues. Our ratings on these companies do not factor an expectation of substantial growth in B2B payments. If they generated significant revenues in B2B, this would provide greater diversification and protection against any disruption in consumer payments.

Rating Trends

On May 23, 2019, we extended the CreditWatch Negative placement on the 'AA+' long-term issuer credit rating on the Options Clearing Corp. (OCC). We originally placed the rating on CreditWatch on Feb. 21, 2019, following the disapproval of its capital plan by the SEC. OCC is yet to file an amended version of its capital plan with the SEC. We plan to resolve the CreditWatch negative placement when we get more information about the new plan.

On July 15, 2019, we raised the issuer credit and senior secured debt ratings on Liquidnet Holdings Inc. to 'BB-' from 'B+' following the removal from under criteria observation and maintained the positive outlook. The upgrade reflected the firm's maintenance of sufficient liquidity at its holding company. Because this reduces exposure to regulatory interference on dividends from its regulated brokerage subsidiaries to the debt-issuing nonoperating holding company, we notch the holding company ratings down one notch from group credit profile instead of two.

Related Research

• Liquidnet Holdings Inc. Upgraded To 'BB-' On Criteria Update; Outlook Positive, July 16, 2019
• Options Clearing Corp. CreditWatch Negative Placement Extended Pending Submission Of Its New Capital Plan To The SEC, May 23, 2019
• Options Clearing Corp. 'AA+' Rating Placed On CreditWatch Negative Following Disapproval Of Its Capital Plan By The SEC, Feb. 21, 2019