The Capital Cycle Podcast - Exchange Trade

Episode Date: August 28, 2026

Derivative exchanges appear under threat. Are fears justified? Edward Chancellor talks to Ian Deacon, a US Equities Portfolio Manager. For more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello and welcome to another episode of the Capital Cycle podcast. This is Edward Chancellor here. This is actually the first podcast of our third season, which is quite exciting. And I have with me Ian Deakin, who's portfolio manager for US large-cap equities and global equities. Welcome Ian. Pleasuredly. The late Charlie Munger liked to talk about how the finance sector resembled a casino, extracting layers of fees from clients, but always with the odds.

stacked in its favour. We're going to talk about the listed US derivatives exchanges, which you believe are an attractive bet. But let's start by discussing how they extract what Munger called the Kruppirs take. Pretty apt analogy. So in a casino, the players win or lose, and the house takes its cut of every hand either way. And derivative exchange works in a similar way with buyers and sellers may win or lose. The exchange clears the trade, takes a few cents and each side and does it all again the next day. In the case of the exchanges, the house doesn't even put up the chips as the clearinghouse is collateralised by the players themselves. And you say that they benefit in particular from volatility, unlike some other Wall Street players? Yes. So for a bank or

insurer, a volatility is the thing that endangers the balance sheet, whereas for exchanges, it's what makes people transact, whether the pension fund hedging duration, refiner locking in crack spread, or a macro fund taking the side of either position, they all pay. the same toll on the same day, and at most one of them can be right. The fact that direction doesn't matter to the exchange has enabled CME group and intercontinental exchange, ICE, to become two of the most profitable large companies in America, business with margins above 60% on very little capital and marathon portfolio holdings, I should add. And some believe that clouds are actually gathering on the horizon for these exchanges. Yeah, I mean, that's really why we're talking about

them. So both stocks have derated over the past year or so on essentially three worries, new competitors, a laissez-faire regulator letting in lighterweight rivals, and a sense that some of the growth might be speculative throth. The question for us is whether the market spotted the beginning of the end of the exchange model or whether this is a rerun of 2021 in payments when everyone was convinced that the new fintech were about to displace visa and mastercard. We wrote about that the time and the disruptions yet to materialise. So in a nutshell, it would appear that the capital cycle for the exchanges is entering a negative phase. I mean, the capital cycle would say that returns this high should pull in capital until those excess returns are competed away. So sure enough,

FMX launched in 2024 with backing from 10 of the world's largest banks and trading firms, offering cheaper fees, a cross-margined deal targeting CME's interest rate franchise. Now, if you'd not follow the history of future exchanges, you might have said that CME's returns were about to be competed down towards their cost of capital. How's this new futures exchange doing? Well, two years on, the share of rates futures is still in the low single digits and growth rates may look impressive in percentage terms, but that's what happens with small numbers. And what we watch is open interest, the stock positions held at each venue, and that simply hasn't migrated. And people not moving their book even for a discount. And that's because,

does you think the established exchanges benefit from network effects? Yes. A fee schedule can be copied overnight, but a liquidity pool can't. And what an exchange sells isn't really execution, which is almost incidental. It's the assurance that the other side of the trade will be there at a fair price today and in five years when you want out. Every contract that stays put deepens that assurance. So a would-be disruptor faces similar issues that the fintechs ran into with the payment networks.

a lack of distribution. And there's a less obvious competitive advantage that comes from clearing on the exchanges? Yes, clearing is another facet of the moat and it reinforces a liquidity benefit. ICE's latest margin methodology runs across more than a thousand energy contracts and lets a client net correlator positions, long gas here, short power there, and post materially less collateral than the same book would need if it was scattered across venues. And collateral is a real cost to client. So that's effectively a price cut that no entrant can match without the same breadth of product. And it compounds. Every new market participant improves the netting for everyone already in the pool. Now, you also write that having a dominant market share can, under certain conditions, make market

growth, what you call semi-indogynous. I'm never sure what endogenous means, let alone semi-indodgamous. Can you explain? It's jargon that I misappropriated from macroeconomics textbooks when discussing the nature of end market growth with my colleagues here 10 years ago. So we were thinking about the ultimate benefits of having a dominant position in a particular market of being a monopoly provider rather an oligopolis. In fact, we were talking about video at the time. But generally speaking, most companies need their end markets to grow. So it still needs people to drink more spirits, for example. And this demands generally considered exogenous from the actions of companies supplying that product. Now, the exchanges

on the other hand can manufacture their own end markets and effectively endogynized part of that growth. The same clearinghouse, same distribution, same rulebook can be pointed at any new source of price volatility at almost no extra cost. And because liquidity gravitates to where liquidity already lives, the new market's born with incumbent holding dominant share. They don't need more oil burns, more bonds issued to grow. They just need new things for people to be nervous about. And the world's rarely short of those. And I think in corporate finance jargon, or investment drug, and that's also known as real options theory. If you remember during the sort of dot-com, boom, they talked about the real options that some

of the tech companies had, and it's true that the likes of Google and Facebook and so on and so forth did have real options, benefited from them, and that optionality isn't always priced in by the market effectively. Now, there is one thing I'd like to talk to you about ICE. It's exploited its capacity for semi-indogenous growth by going into the mortgage market. And so far, that hasn't been profitable, I think, due to the weak housing market in the US. Can you tell us a bit about that? Yes.

Well, I mean, ICE has made a number of acquisitions, but it's built up a portfolio of mortgage technology businesses, which combined together, have very strong, if not dominant positions, in both mortgage origination and servicing technology. Now, with interest rates where they are, without a significant rebound in new. issuance that's closer to the trough end of the cycle. But we are hopeful that at some point that demand cycle will swing back up and there could be value or greater value in that part of the business. And the recent results of the exchanges aren't reflect any particular pressures. They've had good recent results, correct? Yeah. So in the first quarter, CME did 36 million contracts a day, a record of 22%. In fact,

with records up in all six asset classes at once, which hadn't happened before. And ICE tells a similar story. The exchange segment runs at around an 80% adjusted operating margin. Last quarter, group revenues grew 18%. Adjusted earnings grew about twice that. And that growth is not just due to events in the Persian Gulf. Partly, no doubt, but management points out that the buildup in open interest started well before this year's flare-ups. And the disclosed numbers back that. I'd still put it a bit more carefully than they do. but over the past decade, volumes grown much faster than the stock of open positions behind it, and turnover the books roughly doubled, and in energy, volumes are up over 50% on an open interest base that's actually shrunk. So it's not so much the stock of hedges that's grown, but the speed

at which they're churned, and both earn fees. There are fears that potentially the greatest threat to the exchanges comes from the regulator that Trump administration's taken a laissez-faire approach to financial regulation that creates a potential problem for the exchanges. Yeah, so this is the risk I take most seriously precisely because so much the moat is conferred by regulation. So to run a clearinghouse, you need designation, capital, default funds, and tolerance for being supervised as systemically important, which deters the casual entrance. What the regulatory body, the relevant one the CFTC, is done, is let Calci, the prediction market, offer sports and political event contracts.

and lately Bitcoin perpetuals, under a much lighter wrapper than a traditional designated contract market carries. And it's sort of breaking news that Cowish has now said it wants to offer equity perpetuals. Yes, so these perpetual futures are more akin to contracts with difference. So it's not surprising we see that in equities affecting the retail side. But none of that competes with the institutional franchises yet. The worry perhaps is drift that the lighter rulebook creeps towards rates, energy, equities. and the playing field tilts.

And how the exchanges responding to this threat? So CME sued its own regulator in June, which tells you that they take it seriously. But the pendulum might already be swinging back. And Cal she's defending something like 19 separate state and federal actions over whether its sports contracts are just unlicensed gambling. In April, the CFTC brought its first insider trading case involving event contracts. And that case, I think, involved a US service member who'd allegedly used insider information to profit from the Trump administration's military operation in Venezuela,

leading to the removal of President Maduro. So what else? Yeah, the swamp. Well, in June, the CFTC proposed rules retighting the public interest test, the same one had just loosened, which rather proves the point that a regulatory advantage or disadvantage can be withdrawn by the same body that granted it. Now, our base case is that a lighter wrapper survives for small retail event contracts, but not for markets that are systemically important.

And let's go back to your semi-indogenous growth, namely the capacity of exchanges to enter new markets. They're now trying to profit from the AI revolution. Yeah, because AI compute starting to behave like a commodity. Prices that swing, buys who need certainty, producers who want to lock in returns on enormous fixed investments, to renting one of Nvidia's H-100 chips for a year cost about 40% more in March than it did in October last year.

And historically, that's exactly the sort of price behavior that summons a futures curve into existence. It happened with oil in the 70s and electricity in the 90s. What's CME doing about this then? What they've always done with a new source of volatility, they're listing it. So CME has GPU rental rate futures coming with an index provider called Silicon Data, subject to approval, and ICE has announced its own compute contracts and is expanding its data center estate to sell low latency access. In fact, they stand to benefit from the same.

AI boom without owning a single GPU and earn more, the less anyone can agree on what the computer's worth. So, Ian, in summary, what risk do you see for these extremely profitable businesses? Two real ones. The regulatory and we've covered, the idea that barriers built on regulation are only as durable as the regulator's convictions. And the second one is pricing mix. If growth keeps skewing towards the cheapest contracts, at some point that starts showing up in revenue. So the numbers I watch a fee per contract and open interest rather than the headline volume. But you think all in all those risks are priced into current market valuations? We think so. So ICE and CME have now lagged the index for a decade. CME trades at just over 20 times forward earnings. Ice somewhat below that,

which is at or below the S&P market average. For businesses with margins above 60%, almost no capital requirements and revenues geared to uncertainty itself, and CME now sits among the quality franchises left behind by a market proclified with the AI story, even while it builds the venues where the story will be hedged. So in short, as you say, the market's interest in the exchanges may have lapsed, but yours remains open. It does. Thank you, Ian. Thank you for your time today. I hope you will listen to the next edition of the capital cycle. This communication is provided for information purposes only, please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.