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Why the banks want a TMX more like Deutsche Boerse

Deutsche Boerse

Hannelore Foerster

Wondering what big banks and pension funds see in TMX Group Inc. as an acquisition target? The answers lie across the oceans in Hong Kong and Frankfurt.

Banks including National Bank of Canada, Toronto-Dominion Bank and Canadian Imperial Bank of Commerce have sought backing from pension funds like Ontario Teachers' Pension Plan to find a way to stop the TMX's plan to merge with London Stock Exchange Group PLC.

Their codename for the project is "Maple," but what they are trying to do is not just keep the exchange in Canadian hands. They want to make money, and grow. The tradeoff is that to do it, TMX would have to start taking a bigger cut of the action from those who trade on Canadian markets.

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What the banks and pension funds appear to be considering as an alternative is trying to create a smaller version of the biggest sharks in the exchange industry tank - companies such as Frankfurt-based Deutsche Boerse AG and Hong Kong Exchanges and Clearing Ltd.

Deutsche Boerse is able to make an offer to buy NYSE Euronext, the owner of the New York Stock Exchange, because Deutsche Boerse shares trade at a rich multiple. Hong Kong Exchanges is the world's most valuable exchange operator, with an even higher multiple than Deutsche Boerse. When it decides to make a purchase, nobody will be able to stop it.

What do Hong Kong and Deutsche Boerse have in common? They are what industry players call vertically integrated. They offer stock trading, as well as derivatives, and they also offer clearing and settlement. In other words, they take a cut at every stage in the process.

Investors love the clearing and settlement business because it isn't facing the tough competition of plain vanilla stock trading, and they reward companies that have an integrated model.

At the end of 2010, before all the merger and acquisition activity started skewing prices, Deutsche Boerse shares traded at 23 times its earnings in the previous 12 months. Hong Kong fetched 38 times. NYSE and TMX were minnows by comparison, at 14 times and 13 times, respectively.

The dream is that with the banks behind it, TMX could be a similarly vertically integrated company with a premium multiple, able to make acquisitions abroad.

TMX doesn't have a profit-generating stock clearing business, but the banks could change that. The banks own a big chunk of the country's stock-clearing utility, CDS Inc., in partnership with TMX. At the moment, it's run as a non-profit industry partnership so TMX gets no real value for it from investors.

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As part of a deal for TMX, the banks could toss their CDS shares in the kitty. That would give TMX control of CDS. TMX could start charging more and making significant money from clearing stocks.

TMX investors would love it. Investors who trade other stocks on TMX's markets might not. CDS this year released a pricing study of nine clearing systems, including Clearstream and Hong Kong, that found Canada's was cheaper than all but in the U.S.

"Trading platform operators that are publicly owned and that also own the associated clearing function tend to generate a significant portion of their overall profitability from the clearing function," CDS said in its submission to the Ontario government panel looking at the TMX-LSE deal.

The price to clear a Canadian trade on a stock exchange has dropped to less than 1 cent today from 18 cents in 2005. The price for a domestic institution to settle a trade via Deutsche Boerse's for-profit Clearstream business is 47.5 euro cents (66 cents), before any volume discounts.

Another way to juice TMX's valuation is to eliminate competition in stock trading. The banks own Alpha Group, the trading system that has been competing with the Toronto Stock Exchange and TSX Venture Exchange. Ending the vicious fight for market share in stock trading should reduce the pressure on TMX's margins in that business.

However, that means putting Alpha and TMX together, which would create a near monopoly on trading. That's rarely good news for users.

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Should the banks make their move on TMX, Canadians may have to choose what's more important - cheap trading or a powerful local exchange company. What price a Canadian champion?

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