CME Has Benefited From Higher Interest Rates as Volatility Returns to Its Markets

Equity Analyst

Michael Miller

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CME Group has enjoyed favorable market conditions in 2022 and 2023 as volatility across multiple asset classes drove increased trading volume, leading to strong revenue growth. Prior to 2022, the most significant headwind for the company had been the impact that low short-term interest rates had on its interest rate futures, which are its largest source of revenue. When interest rates are expected to stay low there is less need for interest rate hedging and less incentive for speculation, creating a drag on CME's trading volume. With interest rates now well above the 0% rate we saw during much of the past decade, the drag has been removed, benefiting the company's growth. That said, this was a one-time benefit, and we expect CME's revenue growth to return to the low to midsingle digits going forward, particularly as 2023 featured unusually large price increases from CME.

CME has also benefited from increased retail interest in the equity markets. These markets saw a surge in trading volume in 2020, with equity derivative products seeing a larger and more durable increase. CME's equity index futures business has produced impressive performance as a result, with multiple years of double-digit revenue growth. We do, however, expect volume growth from CME's equity derivatives to decelerate as equity market volatility returns to normal levels. However, the broader adoption of futures by smaller traders and the success of CME's smaller micro futures will provide a permanent tailwind to CME's equity business, so we do not foresee a full retracement. 

CME has a dominant position in many of the contracts that trade in its exchange and is well diversified across multiple product lines. In the long term, we anticipate that the company will continue to benefit from secular growth in the need to hedge commodity, energy, and interest rate exposure. CME also has a history of generating incremental growth through the introduction of new futures contracts, like the micro E-mini S&P 500 contract. We also expect the company to enjoy increased operating leverage against its mostly fixed cost structure as revenue increases, providing a tailwind to margins over time.

Business Strategy & Outlook

CME Group has achieved a Wide Morningstar Economic Moat Rating as a result of its position as a leading venue for trading US futures contracts. More than 95% of US interest rate futures trade on CME’s exchange, the company has exclusive licenses to issue futures contracts on the S&P 500, Russell 2000, and Nasdaq indexes, and the company is the dominant venue for trading WTI oil futures. We see the company’s strong competitive advantages allowing the firm to earn excess returns on capital for the foreseeable future. 

CME’s position in the US futures market has proven durable as attempts by NYSE Liffe and ELX to enter the US interest rate futures market failed to gain traction despite having contracts similar to CME’s. This is because competition among futures exchanges is largely dependent on implicit trading costs and collateral efficiencies, not the transaction fees the exchanges charge themselves. For example, the minimum tick size for CME 10-year treasury futures contracts is $15.625 per contract compared with transaction fees that range from $0.30 to $0.75. Even if another exchange charges less than CME, a 1-tick size worse execution on even a fraction of contracts would wipe out any savings to the customer from lower transaction fees. This gives CME considerable pricing power and has allowed the firm to enjoy an operating margin that has historically been around 60%.

The ability to trade on an exchange efficiently is dependent on the amount of liquidity present on the exchange already. This creates powerful network effects as the number of traders that already utilize CME’s exchanges ensures that its contracts have good liquidity, increasing their value to other customers. A potential competitor would need to attract a critical mass of trading volume before it could offer its customers comparable execution to CME, a difficult prospect as its initial user base would need to be willing to accept higher trading costs during the startup process. This process would be even further complicated by CME’s model as a vertically integrated clearinghouse and the restrictiveness of futures contracts. Contracts purchased at CME’s exchanges cannot be closed at another exchange and vice-versa. This keeps CME’s liquidity pools captive to its exchanges and creates additional barriers to potential competitors.

The firm’s clearinghouse also benefits from network effects. If one of CME’s customer’s fails to settle a contract, the exchange will step in and close out the transaction after seizing the collateral of the defaulted counterparty. Any potential losses by the counterparty are covered by a waterfall structure in which CME first covers the losses up to a certain amount. After CME’s contributions hit their limit, any remaining shortfall is then covered by a guaranty fund paid for by the clearinghouse members or direct assessments on the clearinghouse members. This substantially reduces the systemic risk for investors and helps attract additional trading volume to exchanges. However, like other clearinghouses CME’s potential contribution to the risk pool is limited, with total potential payments capping out at only $250 million. The majority of the potential credit risk is split among the clearinghouse members themselves with the guaranty fund and potential assessments adding up to just under $22 billion at the end of 2020. As a result, the risk mitigation provided to investors is tied to the number and size of the clearinghouse members at a clearinghouse, not just the financial strength of the clearinghouse. Additionally, it is more efficient for collateral purposes for clearinghouse members to participate in as few clearinghouses as possible. This discourages the introduction of new clearinghouses, as a new entrant provides little risk mitigation to its members until it can establish a userbase. This adds additional challenges for a new exchange to enter the market using the same vertically integrated model clearinghouse model as CME. 

CME also benefits from intangible assets as a result of the company’s 27% ownership stake in S&P Dow Jones Indices. In addition to receiving revenue from every S&P 500 license, this ownership stake practically ensures that CME Group has an exclusive license to issue the S&P 500 e-Mini and e-Micro futures contracts. In addition, CME’s position within S&P futures likely contributed to the exchange’s ability to attract additional equity index futures license agreements for the Nasdaq and Russell 2000 indexes, which returned to CME Group in 2017. These two futures products are licensed from other exchanges but trade on the CME. It is much more efficient for customers to trade two different equity index futures on the same exchange as this allows futures traders to net their positions out when posting collateral. For example, if a trader opens a long S&P futures position and is short the Nasdaq futures contract on the CME, the exchange can record the offsetting contract positions and reduce the amount of collateral they need to post. Additionally, like other exchanges, CME has been able to increasingly monetize the trading data generated on its exchange. This data is proprietary and is highly valuable to investors. The firm has considerable pricing power for its data services as the lack of competition in many of its products means it is an exclusive source of data. 

When looking at CME’s ability to generate excess economic returns from its economic moat, we focus on its adjusted returns on invested capital excluding acquisition-related intangibles. While not a regular acquirer, CME has considerable amounts of intangible assets on its balance sheet from its purchases of CBOT and Nymex in 2007 and 2008, respectively, and its more recent purchase of NEX in 2018. CME does not amortize the intangible assets it acquired from CBOT and Nymex, instead choosing to leave them on the balance sheet, inflating its invested capital. Despite this, we do not see a large pool of intangible assets from past acquisitions as impairing our belief that CME has established maintainable competitive advantages in its business model.

Wide

Economic Moat

CME Group

CME Group, Inc. operates a derivatives marketplace, which offers a range of futures and options products for risk management. Its exchanges offer a range of global benchmark products across all major asset classes based on interest rates, equity indexes, foreign exchange (FX), energy, agricultural commodities and metals. It offers futures and options on futures trading across asset classes through the CME Globex platform, fixed income trading via BrokerTec and FX trading on the EBS platform. In addition, it also operates CME Clearing, a central counterparty clearing provider. The company was founded in 1898 and is headquartered in Chicago, IL.

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