CME Group (NYSE: CME) is the world’s largest owner and operator of exchanges and clearinghouses for financial derivatives, and the first financial exchange to become publicly traded. Focusing on futures contracts and options on futures contracts, CME Group provides both a marketplace and the back end financial infrastgructure for administrating and settling these financial instruments
The CME Group is comprised of the Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), New York Mercantile Exchange (NYMEX), and Commodities Exchange (COMEX). Products traded and cleared by the CME Group include interest rate swaps and futures, stock and real estate index futures, energy and environmental products, agricultural and weather products, metals, credit default swaps (CDS), and foreign exchange (FX), all listed either on its exchangesa, through the over-the-counter (OTC) network CME ClearPort, or traded in private negotiation. In 2008, combined volumes on the exchange exceeded 3.3 billion contracts – worth more than $1.2 quadrillion in notional values.
CME Group has driven its rapid expansion by expanded contract offerings and the proliferation of its electronic CME Globex platform. However, the volume of trading conducted through exchanges owned and operated by CME Group is dwarfed by the over the counter exchange of key Interest Rates and foreign exchange products in the interbank market. The number of contracts that are bought or sold in a single transaction, also known as a single lot, is significantly higher in this market. For CME Group to continue its expansion it will have to significantly increase its depth and liquidity to attract these larger and more lucrative transactions.
To achieve this depth and liquidity growth, in 2006 the Chicago Mercantile Exchange and Chicago Board of Trade announced a merger, finalized by a vote of the shareholders of both corporations in 2007, that promised to increase access and participation on each exchange as well as diversify offerings in key interest rate and foreign exchange areas.
Futures and options on futures provide a way for individuals and institutions to hedge themselves from risk and potentially profit from it. Historically CME Group focused on agricultural products for farmers in the United States which were traded in Chicago. CME Group has transformed itself, however, into a primarily electronic marketplace for financial futures and options that can be accessed all over the world. CME Group serves as a marketplace for global risk management in Interest Rates, equities, foreign exchange, commodities and alternative investments. CME Group provides value over individual agreements between market participants by standardizing the contracts, guaranteeing each contract, and providing for the cash settlement between parties. In doing so, CME Group earns revenue on each contract traded through its exchange, and on each contract settled by its clearing house. In 2009, 83% of CME Group’s revenues came from fees for trading and clearing of its products, with the rest deriving from data, communication, exchange access, and related fees.
Second Quarter 2010 Results
During the second quarter of 2010, CME Group reported total revenues increased 26 percent to $814 million and operating income increased 29 percent to $515 million from the year-ago period. Second-quarter 2010 operating margin was 63 percent, up from 62 percent in second-quarter 2009.
Second-quarter net income was $271 million and diluted earnings per share were $4.11, up 22 percent and 23 percent respectively from the same period last year. Second-quarter 2010 results included a $20.5 million write down of goodwill of the company's subsidiary, Credit Market Analysis Limited. Excluding the write down, second-quarter diluted EPS would have been $4.43, a 33 percent increase versus second-quarter 2009.
CME Group acts as an intermediary between parties wanting to hedge risks, or speculate on future market direction. In order to do this, CME Group lists a range of contracts with prices tied to certain underlying financial instruments. These contracts are known as futures, which provide a legally binding agreement to buy or sell an instrument or commodity at some point in the future, or options, which provide the right, but not obligation to buy or sell an instrument at some point in the future. These contracts are commonly referred to as derivatives because they derive their price from some underlying asset.
CME Group provides a service by standardizing the terms of these agreements and providing legal enforcement of the contracts. Also, they provide a place for customers to quickly find counter-parties and discover market prices. For this service, they charge a fee for each contracted traded through the exchange. Fees can vary based upon whether the customers are members of the exchange and the volume they are transacting. Additionally, many customers are also given price breaks and fee caps based on the amount and frequency with which they transact.
CME Group owns its clearing house which clears, settles and guarantees every contract traded through CME Group. CME Group also provides these services for certain other exchanges such as the Chicago Board of Trade, and certain contracts through the New York Mercantile Exchange. The clearing house is a major attractor to CME Group markets because it allows for both the guarantee of contracts (virtually eliminates the risk of bankruptcy), and the fast and efficient clearing and settlement. The clearing house also provides synergies for market customers by netting out margin requirements on long and short positions and thus reducing the necessary capital required to participate.
The clearing house uses a per contract fee structure. While fees vary on a per contract basis (based on type of transaction and exchange membership status), contract volume is still the leading indicator of revenue from the clearing house.
The Company’s interest rate products enable banks and other financial institutions worldwide to hedge interest rate risks. Its interest rate products allow the Company’s customers to execute transactions across the entire United States dollar-denominated yield curve. Customers may manage short-, medium- and long-term interest rate risk using its products based on Eurodollars, United States Treasuries, swaps and other dollar-related instruments. As a result of its acquisition of CBOT, the Company’s interest rate products include CBOT’s 30 United States Treasury bond futures and options on futures; ten-year, five-year and two-year United States Treasury note futures and options; interest rate swap futures and options, and federal funds futures and options. During the year ended December 31, 2009, it launched three-year Treasury note futures. In January 2010, the Company launched its Ultra T-bond futures contract.
The Company’s equity products permit investors to obtain exposure, for hedging or speculative purposes. It offers futures and options products (including its E-mini contracts) on key benchmark equity indexes covering small-, medium- and large-cap companies in the United States, Europe and Asia. These include the Standard & Poor’s, Dow Jones, NASDAQ, Nikkei, MSCI and FTSE/Xinhua indexes, and others. The Company has licensing arrangements with Standard & Poor’s Corporation (S&P), NASDAQ OMX Group, Inc. (NASDAQ OMX) and Dow Jones & Company, Inc. (Dow Jones), which allows it to offer futures and options on futures on their indexes, including the Company’s contracts based on the S&P 500 Index, the NASDAQ-100 Index and the Dow Jones Industrial Average.
The Company’s foreign exchange market serves as a means of risk transfer for the global foreign exchange market, bringing together an array of client segments by offering investment, as well as risk management opportunities. Its foreign exchange products provide the tools and resources to hedge foreign exchange risk, facilitating cross-border trade and commerce while mitigating the risks to profitability due to fluctuations in the foreign exchange market. Its foreign exchange market attracts both buy- and sell-side investors, including commercial and investment banks, hedge funds, commodity trading advisors, trading firms and individual investors. During 2009, it launched a series of smaller-sized foreign exchange contracts, called Forex E-Micros, designed to enable retail traders and investors to access the security, transparency and liquidity of its products. The Company also added Turkish Lira futures to its foreign exchange product suite. The Company offers approximately 40 foreign exchange futures and approximately 30 foreign exchange options on futures products, covering an array of emerging market currency pairs in more than 20 different currencies.
The Company’s commodity products help establish benchmark prices. These products provide hedging tools for its customers who deal in tangible physical commodities, including agricultural producers of commodities and food processors. It also added 11 agricultural swaps on CME ClearPort. Commodity products accounted for 7% of its trading volume and 10% of clearing and transaction fees, during 2009.
The Company offers liquid energy complex, which includes Light Sweet Crude Oil (WTI), Natural Gas (Henry Hub), and electricity products. During 2009, it launched over 300 new energy products on CME ClearPort. Energy products accounted for 15% of its trading volume and 29% of clearing and transaction fees, during 2009.
The Company’s metals futures markets include full-size contracts on gold, silver, platinum, palladium, copper and steel; as well as E-mini contracts for gold, silver and copper. It also extended its CME ClearPort clearing services to London gold futures. Metal products accounted for 2% of its trading volume and 5% of clearing and transaction fees, during 2009.
The Company’s markets generate information regarding prices and trading activity in its products. The Company sells its market data, which includes information about bids, offers, trades and trade size in its products, to banks, broker-dealers, pension funds, investment companies, mutual funds, insurance companies, individual investors and other financial services companies or organizations that use its markets or monitor general economic conditions. It distributes its market data over the CME Group market data platform directly to its electronic trading customers as part of their access to its markets and to quote vendors who consolidate its market data with that from other exchanges, other third-party data providers and news services, and then resell their consolidated data.
The Chicago Board of Trade is another financial futures and options exchange that coexisted with the Chicago Mercantile Exchange for decades. The CBOT's primary focus has been on grain agricultural, and interest rate futures, while the CME focused on live agricultural, foreign exchange, and short rate futures. Thus, while they were not direct competitors, many of their products were complimentary and they shared much of the same client base. In October of 2006, the CME and CBOT announced a proposed merger of the two companies. The combined entity created a $30 billion dollar company that provides tremendous synergies and savings for its customers.
The merger is important for CME Group because it will help attract more clients to its products, providing clearing and settlement synergies that will save significant amounts of capital that must be allocated to guaranteeing the contracts.
CME Group allows investors to trade in Volatility Index (VIX) futures and options. The VIX is a measure of expected volatility of the S&P 500 index. When prices are fluctuating more, there is more need for the financial hedging that CME Group products provide.
Liquidity refers to the ease and frequency one can transact in a market. For any exchange, liquidity is a key factor in attracting and retaining clients. Highly liquid markets reduce the costs associated with trading and allow clients to get better prices for their contracts. For futures exchanges, open interest, or the number of contracts outstanding at the end of a trading day, and total volume are the key measures of liquidity.
All measures of CME Group’s liquidity have been increasing at a rapid pace. Future revenue growth will hinge on CME Group's ability to continue attracting clients and improving the liquidity of its markets.
For many years, the futures and commodities markets were highly regulated. They had to satisfy requirements imposed by both the Securities Exchange Commission as well as the Commodity Futures Trading Commission. Both agencies had to review proposals for creating new exchanges as well as review and approve the individual contracts that could be listed on each exchange. The recent Commodity Futures Modernization Act, however, has significantly reduced these frictions. By eliminating the need for SEC approval of new products and exchanges the Commodity Futures Modernization Act substantially reduced the cost of entry into the futures market for both startups and existing exchanges.
Regulation is a two way street, however, and the Commodity Futures Modernization Act also has benefits for CME Group. By eliminating the need for SEC approval of many types of contracts, the CFMA has reduced the time to market for new products of CME Group. Additionally, it legalized the listing of single stock futures, which were already being traded in many foreign markets. While still a small portion of the futures market, the ability to list single stock futures should allow CME Group to better compete with the offerings of many foreign exchanges.
CME Globex is CME Group's proprietary platform for trading and execution of contracts. It can be accessed all over the world and provides real time market pricing and execution. A significant portion of CME Group's appeal is the ability of clients to plug into this platform and achieve faster and significantly cheaper order execution than by going through a broker. The rise of electronic trading (as opposed to tradition floor or pit trading) has significantly decreased the barriers to entry. As CME Group customers are no longer held by broker relationships and electronic execution provides increasing transparency into pricing and execution, CME Group is susceptible to competition from startup electronic platforms. As evidenced by Archipelago's merger with the New York Stock Exchange, the willingness of clients to switch exchanges for better pricing and more transparency cannot be discounted.
CME Group has made significant investments into its Globex platform in an attempt to ensure its position as the market leader. Even if competitors are not able to match the global reach or reliability of Globex, they may be able to provide enough competition to significantly reduce margins and adversely affect CME Group revenues.
The exchange traded futures market is small subset of the entire futures market. Product lines such as currency, interest rate, and short rate futures contracts are all dominated by the interbank market. The interbank market refers to the market making speculating activities of large investment banks. While not an organized exchange, most large banks are connected by financial data providers such as Reuters, Bloomberg, and the Electronic Brokerage Services (EBS). This connectivity allows similar price discovery and execution to that found on exchange. Because the market is not standardized, however, the contracts traded are generally individually negotiated, and can have variable terms. Also, there is counter-party risk in that the bank, or its other clients may not be able to hold up their end of a trade. Despite these drawbacks, the main reason for the rise of the interbank market is the willingness of banks to transact in much larger sizes than that which can be done on an exchange. This larger lot size, provides better execution for corporations and financial institutions needing to transact large volumes or notional amounts. According to the Bank for International Settlements, the interbank foreign exchange market has daily volumes approaching $2,000 billion. This dwarfs the amount traded on CME Group. Also, according to the Wall Street Journal, 73% of foreign exchange volume is done through 10 major investment banks. If CME Group is to continue growing, it will have to provide incentive and the ability to transact in similar amounts and volumes on its exchange.
In addition to the interbank market, there are several other competing exchanges including the Intercontinental Exchange (ICE), the European Futures Exchange, and the Amsterdam Stock Exchange. While the marketplace is fractured and CME Group only competes with these other exchanges in a few small areas, they all have the infrastructure and ability to list competing contracts as well as reduce prices to lure customers to their exchanges. These effects are causing listing of numerous new and different contracts including bond index futures and weather futures on CME Group to maintain financial innovation and attract new clients.