Risk Management Here
A lot has changed in 115 years, but not CME’s core mission of providing a venue for risk management
Founded in 1898, CME Group has survived a depression, managed through multiple economic contractions and expansions, and witnessed technology transform the mechanics of trading. But through it all, its core mission hasn’t changed.
“The one constant is why the markets are here to begin with — to make sure that market participants, both hedgers and speculators, have a place to manage risk,” said Terry Duffy, CME’s executive chairman and president. “If people did not have a way to hedge their exposure, they would have to charge more for their products, whether it be a mortgage or any other product.”
As the world’s largest futures exchange, CME is a veritable supermarket of buy and sell orders for contracts that set a price today but delivery and payment at a specified later date. Just ‘below the fold’ of the Chicago-based company’s home page, there are markets for agriculture, energy, equity, foreign exchange, interest rate, and metals, as well as block trades and over-the-counter (OTC) products.
Chicago Butter and Egg Board, the predecessor to Chicago Mercantile Exchange, opened for business in 1898. CME Group expanded organically and via mergers and acquisitions over the years, and now operates five Designated Contract Markets under its corporate umbrella: CME, CBOT, NYMEX, COMEX, and KCBT.
To those outside the futures market, CME is most closely identified with open-outcry trading, which takes place in the ‘pits’ of the trading floor at its iconic Chicago Board of Trade building. CME hosts high school and university groups for tours of the trading pits, which were Immortalized in popular movies such as Ferris Bueller’s Day Off.
But floor trading comprises a much smaller proportion of exchanges’ business these days. Indeed, probably the most tectonic shift for CME in its century-plus existence has been the widespread, and fairly rapid, adoption of electronic trading, which has been credited with tightening bid-ask spreads and reducing transaction costs.
“We’ve seen a migration from the floor model to the electronic model, the bulk of which happened over the past 10 years,” Duffy told Markets Media. “We’ve lived through that change but we’re still living through that transformation. It is uniquely interesting and good for everybody by giving more people access to markets all over the world and creating deeper liquidity pools.”
CME’s largest complex is interest-rate futures, a financial derivative whose underlying asset is an interest-bearing instrument such as the U.S. Treasury 10-year note. Duffy noted the business has been doing well amid low and largely stable interest rates, so there is substantial upside.
“We’ve been in a zero interest-rate policy environment since rates were lowered after the housing crisis…interest rates have been a non-factor,” Duffy said. “We are dependent on macro events, but we are still seeing an average of 4 million to 6 million contracts a day traded in our interest-rate complex, in a very low-volatility, low-yield environment. If that changes, it would be very significant for CME.”
Of CME’s 2012 revenue of $2.92 billion, interest-rate and energy products comprised 20% and 22%, respectively. Other futures products that generated significant revenue were equities (15%), agriculture (13%), foreign exchange (6%), and metals (5%). Market data and information services weighed in at 13%.
CME posted strong results for the second quarter, its most recently reported earnings. Average trade volume was 14.3 million contracts per day, 16% more than the year-earlier period; volumes increased 18% in Europe, 28% in Asia, and 40% in emerging Latin America.
“Although we’re very pleased with the strong result from the quarter and the momentum we have experienced during the first half of the year, we are not satisfied,” CME Group Chief Executive Phupinder Gill said on an Aug. 1 conference call. “We still have plenty of work to do to keep the company well-positioned once we get past the headwinds we have faced over the last few years.”
As might be expected for a mature U.S. business in a globalized market, CME’s expansion plans lean heavily on overseas markets. “There is great potential for growth throughout Europe in the next couple of years, maybe longer,” Duffy said. “South America is also exciting because of their emerging markets, particularly Brazil.”
CME launched CME Clearing Europe in 2011, and the company plans to launch CME Europe, a derivatives marketplace that would compete with Eurex in the business of FX trading. CME planned to go live with CME Europe in September but the launch has been delayed.
“We’re in the process of moving forward with approval for our registered exchange in Europe to complement our CME clearing house in London,” Duffy said. “We already do a tremendous amount of business in Europe. Clients are well aware of us.”
CME owns a 5% stake in BM&F Bovespa, and it has high-speed connectivity, cross-listing and order-routing arrangements with the Brazilian exchange, the world’s third-largest. Brazil’s economic expansion has recently slowed but the region is still seen as growth engine, especially compared with developed U.S. and European economies.
To be sure, the home base remains a focus area for CME. “Right here in the U.S. there’s a lot of pent-up demand in the marketplace to put money to work,” Duffy said. “This is because people are concerned with a lot of different things, whether it’s lofty prices in the equity market that they don’t want to chase, or whether it is because they are not getting any yield on their money in Treasuries. But, that will eventually change, and I suspect we’ll see quite an exciting time.”
One domestic opportunity comes from the regulatory push to increase transparency and bolster market stability by moving OTC derivatives trades onto exchange. The initiative is proceeding in fits and starts and not all contracts are suitable for exchange trading, but the global derivatives market has been estimated at $632 trillion, so even a small sliver of that could represent a massive opportunity.
In September, CME applied with the U.S. Commodity Futures Trading Commission to become a swap execution facility, handling commodity-swap trades. Regulators have set a Nov. 1 deadline for mandatory trading via SEFs, though market participants expect it will take a while for the kinks to work out of the system and liquidity to pool.
In swap clearing, CME offers margin and capital efficiencies on six asset classes. “We are seeing a few firms taking advantage of the capital efficiencies we offer by putting their swaps transactions in our clearing house and getting the offsets against our futures, saving what amounts to more than $1.3 billion in initial margin,” Duffy said. “We put a fairly good investment into our clearing of OTC products, and I think people are realizing that benefits them.”
Exchange operators are always looking to grab a percentage point or two of market share from rivals, but a better expansion route is to develop the next big product that will catch on and ‘grow the pie’ of the broader industry. That’s easier said than done though — most new exchange products either don’t catch on or bring in only incremental business.
This year, CME rolled out new swaps products linked to aluminum, short-dated wheat, and Malaysian palm oil. Duffy was coy about what’s in the pipeline.
“We keep that to ourselves until we are ready to launch or others would copy what we’re doing,” he said. “We invest a lot in our people and rely heavily on them to come up with new ideas and new applications. We have some interesting things in the hopper.”
“We trade across all asset classes,” Duffy continued. “With regard to creating a whole new asset class, it’s important to remember that commodities only recently became an asset class; that wasn’t the case 10 years ago. Energy became an asset class over the last 20 years. There are a lot of new and interesting ideas associated with different asset classes, including FX and equities.”
Duffy, 55, spends his free time with his wife and two sons. He is a fan of Chicago Blackhawk hockey, golf, boating in Florida, and riding his Harley-Davidson ‘Screamin’ Eagle’ Streetglider motorcycle.
Duffy attended the University of Wisconsin-Whitewater, before reportedly quitting to take a $58/week runner’s job at CME. He was president of TDA Trading from 1981 to 2002. He joined the board of CME in 1995 and then rose through the ranks, to vice chairman in 1998, chairman in 2002, executive chairman in 2006, and president in 2012. Gill, who replaced Craig Donohue as CME chief executive in 2012, reports to Duffy.
30,000 Feet Up
As a long-time futures trader, Duffy had to focus on the details and granularity of each trade. But in his current role, he often serves as the face of the company and the big-picture voice, for example appearing on CNBC to discuss the economy, politics, and government.
Regarding the successor to Federal Reserve Chairman Ben Bernanke, who is stepping down in January, Duffy said “the new Fed chairman will have an opportunity to do things the current one is not doing, that is, to get back into a more normalized rate environment. This will be beneficial for the entire country for a whole host of reasons.”
Duffy is constructive on financial markets starting to separate themselves from central banks and governments, whose activity has been hugely influential for much of the past five years, spanning the global financial crisis of 2008-2009 and its aftermath. “It’s about time we stop trading government fundamentals, and start trading more corporate fundamentals,” he said.
Duffy cited an inflection point during the lead-in to the U.S. budget sequestration in 2012 — a Friday when it was announced that $85 billion in automatic spending cuts was forthcoming, yet the stock market rose. “Sequestration is a word that can spook markets and people,” Duffy said. “That was a very telling day of how investors were starting to trade more corporate fundamentals, and since then we’ve seen more of that.”
The decoupling is also happening in Europe. “Spain, Portugal, and Greece used to be page one news; then they were on page three; now it’s not even in the paper anymore,” he said. “We’re seeing people go back to regular fundamentals.”
CME maintains an active lobbying presence in Washington, and Duffy said some perennial financial-services battlefronts such as excessive speculation and the need for transaction taxes have been quiet recently. “People have become more educated that speculators are not driving prices up,” Duffy said. “Fundamental macro markets reflect real-time prices, which are set by folks all over the world, not a small cartel.”
The domestic market structure, often maligned when periodic glitches occur, is fundamentally sound, Duffy indicated. “Our market structure has been emulated around the world and we compete with markets all over the world, so you could put U.S. exchanges at an extreme disadvantage if you changed anything,” he said. “I don’t see that happening.”
CME Group is an oft-rumored suitor to Chicago Board Options Exchange, whose headquarters is right across the street from the CBOT building. Futures rival IntercontinentalExchange’s planned purchase of NYSE Euronext may add fuel to the speculation that more exchange consolidation is forthcoming, but Duffy contends that CME has sufficient scale.
“ICE acquiring NYSE Euronext doesn’t change a thing for CME Group,” Duffy said. “We were very aggressive in 2007-2008 and beyond, with the two major transactions of CBOT and NYMEX. We’ve subsequently done bolt-on transactions with Mexico, Brazil, Kuala Lumpur and other places where we have equity stakes and partnerships. So we’ve already put the pieces of the puzzle together and now our competitors are playing catch-up.”
For ICE, the crown jewel within NYSE Euronext is Liffe, the London-based derivatives exchange that focuses on interest-rate futures. “We were already competing with Liffe when they were with Euronext and when they were with NYSE, and we’ll continue to compete with them,” Duffy said. “Competition is the lifeblood of this industry. It is what makes this business better. We will not get complacent.”
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