Derivatives are changing fast: Can CME Group adapt?

Posted on March 7, 2013



By Sonali Basak
March 6, 2013

A $20.7 billion market cap. A 115-year-old company. Chicago-based CME Group Inc. is a massive company that’s endured periods of turbulence, and rapid growth, since its inception.

The world is changing, and CME is forced to change along with it. Ironically, the advanced technology and innovation that has driven its growth, making the company a world leader among derivatives-exchange operators, may be the same things that make CME vulnerable.

“It’s like sharks swimming around in water and you don’t know what’s out there,” said Evan McDaniel, an equity options trader at CME’s Chicago Board of Trade.

McDaniel trades on the floor of CBOT and is concerned about how technology is increasingly displacing the face-to-face “open-outcry” system that long prevailed. He said he feels that it means less personal access: “You never know if you’re trading against a person or a computer.”

The process isn’t likely to stop. “Everyone’s going to start adapting to electronic trading” even more, McDaniel said. “Markets are going to start moving faster and the individual trader is going to be squeezed by algorithmic strategies,” or ultra high-speed computer-driven processes.

While individual traders such as McDaniel fear the growth of electronic trading, the technology has fueled tremendous growth at CME. These days,over 80 percent of its trades are made through a screen, a trend which CME says grew in response to clients’ demand for greater speed and efficiency in trading markets.

How big was its growth exactly? Along with the surge in trading volume, CME Group, parent of the Chicago Mercantile Exchange, has been an industry consolidator, and over the last several years became the proud owner of the Chicago Board of Trade and the New York Mercantile Exchange, and recently acquired the much smaller Kansas City Board of Trade.

Although its roots trace back to the 1800s, CME didn’t become publicly traded until 2002. Early on, its shares traded, on a split-adjusted basis, at less than $7.00 apiece. The stock had a huge runup, and peaked at $142.15 before the 2008 financial crisis.

CME leaders have prided themselves on leading innovation in the derivatives industry.

But as McDaniel feared, growth was a mixed blessing for CME. From 2008 to 2012, a series of events stunted CME growth, and it has not been able to return to the rate of success it had previously enjoyed. So after riding a high in derivatives trading, CME has found a new set of challenges in its changing marketplace.

In 2010, a glitch in electronic trading in caused a massive flash-crash in the stock market, causing the Dow Industrial Average to drop over 1000 points. Though this rose again quickly, and CME reported that electronic systems stabilized the crash rather than contributed to it, investors did not react positively. There grew a strong mistrust in the computers that controlled the industry at large.

Adding insult to injury, CME Group’s clients, MF Global Holdings Ltd. and Peregrine Financial Group Inc., have both allegedly misused customer funds in derivatives markets, generating even greater pressure from investors and regulators to have CME provide increased risk management in derivatives exchanges.

As investors lost confidence in the markets, 2012 became a particularly difficult year for CME. In 2012, the company earned $896.3 million, or $2.70 per diluted share, down 51 percent from $1.81 billion, or $5.43 a share, the year prior.

Moving into 2013, CME will continue to face similar issues, but investor confidence has been steadily rising in recent months and CEO Phupinder Gill remains “cautiously optimistic.” CME will have to manage not only investor confidence, but also a changing regulatory landscape and new forms of competition that promise to complicate its relationship to investors and clients.

As the financial industry evolves at a rapid rate, the regulatory environment struggles to keep up. To increase transparency in derivatives markets to protect investors, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, making it mandatory for all trades to go through an exchange such as CME Group.

That means more business for CME. Thus, the US regulatory landscape proves favorable to CME, something that CME is prepared to take advantage of, Gill said in a conference call with analysts in February.

And some analysts agree. The company is “more optimistic for 2013 volumes given some promising early signs,” wrote Jillian Miller, analyst at BMO Capital, in a report. She said that CME is the most capital efficient of any clearinghouse or exchange and is one of the best positioned to benefit from regulatory change.

But there is a caveat: While Dodd-Frank regulations might be positive for CME, the legislation still creates barriers for CME clients and threatening to offset the benefit CME may see.. The Commodities Futures Trading Commission enacted regulations that make it difficult for individual traders to enter the market, said McDaniel. These regulations require a higher standard of collateral in trading, discouraging traders.

Beyond regulation, competition proves to complicate the story of CME. While CME may benefit from Wall Street reform legislation, so will its competitors. Derivatives exchanges are expanding their reach both at home and abroad.

CME’s largest competitor, InterContinentalExchange Inc., is a much younger company founded in 2000, but it has become a major player in the derivatives exchange. It recently agreed to acquire NYSE Euronext for $8.2 billion. CME was reported to have bid for the same company earlier in 2012.

As the industry’s consolidation continues, rumors recently suggested that CME was in talks with Deutsche Boerse AG — but that rumor that quickly dissolved. While CME leaders have been noncommittal, CFO James Parisi told Reuters this week that while “We have all the right pieces in place,” and “don’t feel compelled to go out and do any particular M&A deal,” he added that “If a great opportunity were to arise where we can create shareholder value through some type of M&A opportunity, we will certainty take a look at it.”

“At this point we are looking at organic ways to grow with our European clearinghouse as well as CME Europe, the standalone exchange,” said Derek Sammann, CME senior managing director, at an investor conference in Florida.

So far, the company’s battered share price has of late been moving in an uneven, but steadily upward trend. In the past 52 weeks, the company’s shares have fluctuated between $49.54 and $61.85, and the price-to-earnings ratio – based on Wednesday’s closing price of $62.01 — is now 23, slightly higher than that of ICE, at 21.40, and higher than the S&P 500 Index’s P/E of 17.5.

The company and analysts are fully aware of the changes CME will face going into 2013, globally and technologically. But some observers wonder whether CME is prepared to maneuver through this change.

Paul Gulberg, an analyst at Portales Partners LLC, said he prefers ICE shares as an investment because it is more of a growth entity, while CME is still “slow and steady.” But Miller, an analyst at BMO Capital, said the two stocks are not necessarily comparable. He said that 2013 will show which company is better positioned to respond to the evolving financial environment.

In the wake of the 2008 financial crisis and the 2010 Flash Crash, many investors might feel that slow and steady might not be a bad thing. Slow and steady might keep another bubble from bursting and bring about more transparency.

McDaniels, the floor trader, still remains wary of the changes at CME, but understands that it’s the new reality. “If you can’t adapt, you can’t learn the new way of trading, you’re out of the game… and you move on.”