TOP CONTRIBUTORS

HankRearden

This article is about the publicly traded company. For the exchanges operated by the company, please see Chicago Mercantile Exchange or Chicago Board of Trade.

Update: CME and CBOT have merged and the new combined entity is CME Group Inc.

The Chicago Mercantile Exchange (NYSE:CME) is the first publicly traded financial exchange in the world. Focusing on futures contracts and options on futures contracts, the CME provides both a marketplace, and the back end financial infrastructure for administrating and settling these financial instruments.

The CME has driven its rapid expansion (28% total volume growth in 2006) by expanded contract offerings and the proliferation of its electronic Globex platform. However, even with total volume of 1.3 billion contracts in 2006 (a notional amount of $824 trillion), the CME 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 the CME 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 October of 2006, The Chicago Mercantile Exchange and Chicago Board of Trade announced a merger proposal that would increase access and participation on each exchange as well as diversify offerings in key interest rate and foreign exchange areas. Due to an unsolicited rival bid for CBOT by the Intercontinental Exchange (ICE) and regulatory hurdles, the outcome of the proposed merger is still in question and provides significant risk to CME's expansion plans.

In mid-2008, the company acquired Nymex Holdings (NMX).

Overview and Revenue Sources

Futures and options on futures provide a way for individuals and institutions to hedge themselves from risk and potentially profit from it. Historically the CME focused on agricultural products for farmers in the United States which were traded in Chicago. The CME has transformed itself, however, into a primarily electronic marketplace for financial futures and options that can be accessed all over the world. The CME serves as a marketplace for global risk management in Interest Rates, equities, foreign exchange, commodities and alternative investments. The CME 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, the CME earns revenue on each contract traded through its exchange, and on each contract settled by its clearing house. These clearing and transaction services (while not broken down individually) together account for 79.5% percent of all revenue and grew at 24.5% in 2006.

Exchange

The CME acts as an intermediary between parties wanting to hedge risks, or speculate on future market direction. In order to do this, the CME 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.

The CME 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. In 2006 these fees averaged 64.5 cents per contract. This figure shows a modest decrease from the 2005 average of 66.4 cents per contract. Because the fee structure is variable depending on how many people transact, each customer's membership status and the size with which they transact, per contract fees can be highly variable and may not be indicative of future fee structure.

Clearing House

The CME owns its clearing house which clears, settles and guarantees every contract traded through the CME. The CME 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 the CME 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.

Business Drivers

CBOT Merger

The Chicago Board of Trade is another financial futures and options exchange that has coexisted with the CME for decades. The CBOT's primary focus has been on grain agricultural, and interest rate futures, while the CME has focused on live agricultural, foreign exchange, and short rate futures. Thus, while they are not direct competitors, many of their products are complimentary and they share 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 would create a $30 billion dollar company that would provide tremendous synergies and savings for its customers. The merger itself should save the companies more than $125 million annually and would significantly increase the reach and breadth of contracts offered on the Globex platform.

The merger is important for the CME because it will help attract significantly more clients to its products, provide clearing and settlement synergies that will save significant amounts of capital that must be allocated to guaranteeing the contracts.

Even though the merger was a joint proposal of CME and CBOT, its outcome is far from certain. The merger still must meet regulatory approval from the Commodity Futures Trading Commision, which is the US governing body for futures exchanges. While the exchanges are not direct competitors, rivals such as the Intercontinental Exchange have insinuated that the combined company would create a monopoly on interest rate, and foreign exchange futures. It is doubtful that the Commodity Futures Trading Commision would block a merger, as there is significant competition and relatively low barriers to entry, regulatory approval still poses a risk to the merger.

Additionally, Intercontinental Exchange has proposed a unsolicited rival bid for the Chicago Board of Trade. The Intercontinental Exchange is a far smaller exchange than the CME and its proposal has raised significant questions about whether ICE technology could handle the increase in volume the merger would create. Furthermore, post merger, the Chicago Board of Trade contracts would have to be migrated from the CME clearing house to the Intercontinental Exchange NYCC system. This poses significant integration risk, and would severely hinder the ability to provide cost savings to clients from netting margin requirements on different contracts. Whether the 17% premium of the Intercontinental Exchange bid is enough to assuage these concerns remains to be seen. The Chicago Board of Trade is expected to complete its review of the ICE proposal and put it to a shareholder vote in the second quarter of 2007. The CME would still have a chance to provide a counter offer if its proposal is rejected, but this could precipitate a bidding war that would significantly reduce the positive effects of the merger.

Volatility Index

CME 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 products provide.

Liquidity

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 liquidity have been increasing at a rapid pace. Future revenue growth will hinge on the CME's ability to continue attracting clients and improving the liquidity of its markets.

Regulation

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 the CME. By eliminating the need for SEC approval of many types of contracts, the CFMA has reduced the time to market for new products of the CME. 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 the CME to better compete with the offerings of many foreign exchanges.

Electronic platforms

Globex is the CME'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'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 customers are no longer held by broker relationships and electronic execution provides increasing transparency into pricing and execution, the CME 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 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 effect CME revenues.

Competition

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 the CME. Also, according to the Wall Street Journal, 73% of foreign exchange volume is done through 10 major investment banks. If the CME 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 the CME 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 the CME to maintain financial innovation and attract new clients.

Additionally, the fractured nature of the market place is changing with numerous mergers taking place such as the merger of the New York Board of Trade and the Intercontinental Exchange (ICE). The CME is taking part in this consolidation with its proposed merger with the Chicago Board of Trade.

References