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The 27th of May 2020 might go down in SGX’s history as its version of independence. At the very least, it was a watershed event, with MSCI ending its 23-year-long partnership with SGX.
The ensuing stock price decline and series of sell-side analyst downgrades signalled the significantly negative impact this termination has on SGX’s business. Nevertheless, in this article I will argue that the future of SGX is not as bleak as what the market expects.
My two main arguments are: 1) SGX is starting from a position of strength, and 2) SGX has, in earnest, already been pursuing a diversified growth strategy that will mitigate the impact from the termination of this licensing agreement.
First, SGX is starting from a position of strength. This is supported by strong industry tailwinds and SGX’s strong financial position.
Strong industry tailwinds will help SGX maintain its relevance in the financial eco-system. With the right strategy and focus, in relation to its place in the financial architecture, SGX can turn relevance into importance.
One well-documented industry trend is the shift from active to passive investing. One of the tenets of passive investing is the availability of standardised on-exchange products that allows investors to express a view in a cost-efficient manner. This include index products that track an underlying benchmark such as Japan’s Nikkei or even to bet on whether companies will pay dividends. Being a main provider of these products, SGX will be able to capitalise on the trend towards greater passive investing.
Another industry trend is the rise of factor investing. These are quantitative methods that allows investors to attribute risk and return to individual factors such as size, momentum, value, and only invest in specific factors that they believe will outperform. BlackRock estimates that the global size of the factor investing market will reach US$3.4 trillion in 2022. With the recent acquisition of Scientific Beta, SGX is taking a step further to build out index products that can take advantage of this trend.
One final industry trend I see that plays to SGX’s benefit is the shift from over-the-counter (OTC) to exchange trading. Given regulatory shifts towards greater requirements to hold higher margin and capital on OTC derivatives trading, this strengthens the case to conduct trading activities on exchange. This is positive for SGX’s trading and clearing business.
SGX’s financial position is robust. Up until its acquisition of Scientific Beta, SGX did not carry any debt on its balance sheet. Nevertheless, the S$300 million in borrowings as of March 2020 is manageable considering the $845 million cash that SGX has as of the same date. In addition, the business is innately cash generative, with operating cash flow of about S$400 million in each of the past five years.
More importantly, SGX’s ROE is consistently one of the highest among SGX-listed companies. With an operating margin of 55% and ROE of 44% in the quarter ended March 2020, one can argue that SGX is very much like a technology company with high barriers to entry that can sustain this level of profitability.
Second, SGX has already been pursuing a diversified growth strategy that will mitigate the near-term impact from the MSCI termination. Although SGX expects between a 10-15% hit to net profit, this does not consider continued growth areas in other business lines, separate strategies to raise overall trading activity, or product innovation and collaboration with other partners.
Most of the loss of MSCI-related revenue will come from the equity derivatives business which has in any case already been growing at a slower pace compared to the Fixed Income, Currencies and Commodities (FICC) business. Year-to-date March 2020 revenues from FICC was up 32% to S$130 million, compared to 13% growth in the equity derivatives business to S$271 million. Looking ahead, it will be interesting to see if growth in SGX’s derivatives business in currency and commodities, together with its indices business will be able to bridge the gap caused by the exit of MSCI.
SGX has also been focusing on strategies to increase the overall volume of trading on its exchange. One of the unique propositions of SGX is its offering as a multi-asset exchange. With a full product suite that covers equities, fixed income, currencies, and commodities, it allows global institutional investors with diversified portfolio trading strategies to access Asian opportunities on a single platform. In addition, SGX’s expansion of overseas offices has facilitated market participation in non-Asian hours, which has proven to be a boon, with volumes up 38% in FY19 compared to the year before.
Product innovations and other strategic partnerships are further areas to look forward to. The launch of Asia’s first total return futures based on the Nikkei 225 index and the launch of Asia’s first portfolio compression service from OTC products to listed derivatives are some examples of SGX’s product innovation. In addition, nascent talks to build out a potential stock connect between India’s National Stock Exchange (NSE) in GIFT City and SGX bode well in terms of building deeper liquidity pools and facilitating price discovery.
In summary, it is undeniable that the near-term looks shaky as revenue contribution from MSCI products get phased out. In the longer term, however, this should galvanise the leadership team’s fighting spirit to accelerate growth in its non-equity derivatives business, while developing independent product solutions in its equity derivatives business. In the process, I hope SGX will maintain focus on its core purpose as an exchange while taking advantage of the broader industry trends.