FTSE Global Equity Index Series

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DERIVATIVES REPORT: CME 70 reported to have combined ETF assets under custody of some $226bn (as of the end of last year), with the S&P 500, NASDAQ-100 and Russell 2000 ETFs accounting for about one third of that amount. New CME ETF futures contracts that are based on those indices began trading on the CME Globex electronic trading platform in June. Futures on the S&P 500 and NASDAQ- 100 indices continue to trade exclusively at CME. “Equity market CME Outperforming Peers participants want access to a broad array of products and markets, and the growth of our CME E-mini S&P 500, CME E-mini NASDAQ-100 and CME E-mini Russell 2000 contracts makes the ETF products a natural addition,”says Donohue. The move also portends a broader long term marketing initiative by the exchange. The addition of the ETF futures means, “we will be able to attract more new customers, particularly sophisticated retail equity investors,”he adds. Aggressive accretion of market share, wherever it might be, has been a priority for the exchange since at least the turn of this century. Between then and now the CME has assumed a more uncompromising character. It is a transformation kick-started by demutualisation in November of 2000 and a subsequent successful IPO in December 2002 with shares priced at $35 (these days the exchange’s shares trade in a high low range of $181 to $235). Contiguous developments include virtually continual product and technology innovation, expanding global distribution and the establishment of strategic partnerships in Europe and Asia. The results are impressive. 2003 and 2004 were banner years. The exchange’s net revenues rose 37% last year to reach $733bn, with net income up 80% to $219m based on an operating margin in the year of 50.1%, compared with 38.5% in 2003. But 2005 threatens to outclass even that performance. The trend, for the moment is but one way. Donohue explains that record volumes across all major product groups were and are “spurred by the phenomenal growth of electronic trading.” In particular, the exchange’s performance reflected the additional revenues generated from clearing Chicago Board of Trade (CBOT) transactions (of which more later).“Not bad for a company that began modestly in 1874 with the establishment of a private association in Chicago to help butter and egg dealers,”he smiles. The CME also currently manages more than twice as many futures and options on futures contracts than any other futures clearing organisation in the world, and over Average Daily Volume (round turns, in millions) 5 4 3 2 1 0 1Q 03 2Q 03 3Q 03 4Q 03 1Q 04 2Q 04 3Q 04 4Q 04 1Q 05 4.5 – CME 3.5 – Eurex 3.0 – CBOT 2.0 – Euronext. liffe 2Q 05 through May NOTE: Based on futures and options on futures. Excludes individual equity options. © Chicago Mercantile Exchange Inc. All rights reserved. 90% of all US futures contracts. “Our electronic trading business continues to grow rapidly due to our focus on expanding functionality, capacity, distribution and access to our CME Globex trading system,” says Donohue. “As new electronic trading groups and individual electronic traders continue to emerge in markets globally, CME is competing to attract their business.” The CME has also ridden a flow tide of business. According to the most recent Futures Industry Association report, the volume of global futures and options trading grew 8.9% to total 8.89bn contracts in 2004, with even more growth expected this year. Futuresonly volume, for example, topped 3.5bn contracts, up 16.3% on the year. Options trading grew more slowly however, rising 4.6% to 5.4bn contracts, mainly due to lower levels of trading in Korea’s Kospi 200 index option. Although volume rose in all sectors, trading in FX grew the most, surging 35.4% to 105.4m contracts worldwide. The largest volume in this category was, in fact, the Bolsa de Mercadorias & Futuros’US Dollar futures contract (up 42.7% to 23.9m contracts for the year). In context, volume on the CME’s Euro FX futures product almost doubled over the same period, rising 82.7% to 20.5m contracts in the year. Interest rate products apparently maintained their lead as the world’s most active futures contracts. And while the CME’s 3-month Eurodollar future gained an additional 42.5% to 297.6m contracts to remain the world’s largest futures contract, in a countertrend, Eurex’s Euro-Bund declined slightly, down 1.9% to 239.8m contracts. Meanwhile, in the dynamic top ten derivatives exchange league tables, the CME moved past Euronext.liffe in December last year to become the world’s third-largest global derivatives exchange. Performance records aside, in the sedate setting of the CME’s South Wacker Drive’s offices, Donohue muses over the emerging view of the CME as a latter-day Galactico among global exchanges.“Conversion from a membership organisation to a publicly traded company fundamentally transformed us,” declares Donohue, though he concedes, the going has not been easy and back in 2001, nothing was certain. Though bullish on “the future of our industry,” he stresses “it was not always so.” “Everyone says,‘well, it was easy, or that it was well timed.’I tell you, it was not obvious to us. The risk of failure was real enough. It was out there.” Challenges were becoming apparent even as the century opened and the global financial markets began to assume JULY/AUGUST 2005 • FTSE GLOBAL MARKETS
a more sombre cast (well before 9/11 in fact). The competitive game in which the CME was playing was in flux. Competition between futures exchanges intensified and the stage became global, rather than national or regional. Although liberalising legislation via the Commodity Futures Modernization Act of 2000 (CFMA), had given the CME added impetus with which to face the future, advances in technology and a more favourable regulatory environment simultaneously encouraged European exchanges – namely Euronext.liffe and Eurex – to mount a competitive charge on the benchmark products of the US futures market. The CME found that it faced a clear and present danger, perhaps for the first time. The specialist derivatives media added to the pressure. Chicago’s exchanges were simply not up to growing competition from abroad, they said and CME would be forced to cut trading fees to non-economic rates to encourage more volume, or that its mix of users would change and alter its profitability. Ironically, all that did happen, but not quite in the way the doubters expected. The CME realised it needed to overhaul not only its business structure and strategy, but also its international ambitions. Its response was rapid, accelerating changes that were already in motion, such as migration to electronic trading and a reduction in trading costs. “We always thought about competition in terms of three major industry trends: deregulation, rapid advances in technology, and globalisation of intermediaries and customers,” explains Donohue. “We built the financial strength and critical mass necessary for executing our long-range strategy of expanding our core business, broadening our product range, providing third-party transaction services and exploring new business opportunities and that process continues.” Investment in technology was intensified, as a priority. ”We spend more on technology today than was our entire operating budget five years ago,”says Donohue.“In the last 8 years we have invested over $1bn in technology and gone from having 125 or so technology specialists five years ago to employing around 450 today … the processing capabilities that we have, the global distribution network, even the backup and disaster recovery facilities point to us being more attuned to technology than ever before.” “Today, we have marketing offices, telecommunications hubs and customer support capabilities in major financial centres, including London, Milan, Amsterdam, Frankfurt, Gibraltar, Paris, Dublin and Singapore,” expands Donohue. In preparation for that, over the last decade, CME has developed, enhanced and refined, its electronic trading platform. “Our order Return Delivery Time is 25 milliseconds, among the fastest in the industry. CME Globex is also accessible virtually 24 hours a day, longer than any other electronic platform.” CME had launched the industry’s first electronic trading platform (or system), back in 1992. CME Globex revolutionised derivatives trading by delivering much faster trade execution and FTSE GLOBAL MARKETS • JULY/AUGUST 2005 trading anonymity. It also eliminated CME membership requirements for traders. Originally based on a DEC platform developed by Reuters, CME upgraded to its present multiplatform environment in 1998 – the service is built on top of a heterogeneous environment of IBM and Tandem mainframes, Solaris and Linux systems. Investment in enhancing transaction rates means more than just faster processing.The company makes money by charging for executing trades and then charging to settle those trades. Therefore, the faster its systems are, the more trades it can handle, and the more profitable the CME becomes. Migration to electronic trading has also spurred efficiency. Late last year the CME estimated that the average rate per trade (an important profitability measure) is around 77 cents for CME Globex products, compared with 52 cents for products traded via open outcry.The CME then simply earned 60% more revenue when a contract is traded on electronically than on the floor. Electronic trading is therefore elemental to earnings growth and simultaneously provides the CME with more room to compete with other exchanges on fees. As a consequence a number of fee cutting initiatives have been underway, particularly aimed at European customers, Asian banks and hedge funds. There are also other related initiatives. For instance, “we have expanded the market maker program to nonmembers, and non-member firms, so that an electronic proprietary trading group or electronic trading arcade that would like to meet our market making requirements can do so at very reduced fees,” acknowledges Donohue. Recent press reports would have it that around 80% of the market by transaction volume is trading electronically in CME Globex Eurodollars for between 14 cents and 18 cents, compared with prices anywhere between 50 cents and 80 cents on the open outcry floor, because of brokerage costs and the scale of the trade. Donohue concedes that few, if any, exchanges can compete at its lower price levels. Outrageous fortune has not come without its slings and arrows. Eurex US which to date has not succeeded in setting up a strong foothold in the North American market filed a second amended antitrust complaint with an Illinois District Court against the CBOT and CME in March this year. Eurex US had also filed an antitrust action against the two exchanges back in October 2003 for alleged anticompetitive behaviour. The complaint included allegations that the CBOT and the CME have violated the Sherman Act by lowering transaction fees to predatory levels and allegedly attempting to keep Eurex from obtaining clearing services. The CME dismisses the charges. The move nonetheless illustrates Eurex’s frustration over the difficulties in breaking into the US market, particularly as it was the first foreign exchange to establish a US subsidiary and enter into direct head-on competition with the incumbent exchanges. Eurex has however succeeded in establishing partnerships with important local institutions. In its home market, Eurex has been a champion of vertical integration, but in the US it has railed against the vertical 71
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