CME Group (NASDAQ:CME) has had a tough year as uncertainty regarding market regulations and unfavorable economic conditions have led to a sharp decline in trading volumes. The aggregate average daily volume in the nine months ending September was down 15% from the same period in 2011. Trading activity is quite important for the exchange as it derives 83% of its $3 billion revenues from clearing and transaction fees. The drop in volumes has led to a 11% drop in revenues.
Despite the decline, we remain positive on CME and our $60 price estimate for CME Group’s stock implies a premium of 10% to the current market price. The main reason for our optimism is that we expect the Dodd-Franklin regulations to be imposed in 2013. The bill requires over-the-counter (OTC) trades to be cleared through a central clearinghouse. One report estimates that the bill will lead to an annual revenue opportunity of around $1.2 billion.  CME along with its main rival, IntercontinentalExchange Inc. (ICE), is gearing up to grab a piece of this lucrative pie.
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Interest Rates Contracts
Interest rate contracts are the most important asset class for CME, accounting for around 27% of its clearing and transaction revenues. Influenced by the tough economic environment, the average daily volume for this class fell by 21% in the first nine months of 2012. This drop is also due to the fact that the industry is in a transition period as the Commodity Futures Trading Commission (CFTC) brings the Dodd-Frank Consumer Protection and Wall Street Reform Act of 2010 into play. To attract market share once the bill is implemented, CME is planning to launch interest rate swap futures contracts.  Guaranteed by the company, these contracts will help traders negate the higher capital requirements that they will have to post for an interest rate swap once the Dodd-Frank bill comes into play. CME claims to offer margin savings between 45% and 73% over cleared interest rate swaps.
Interest rate swaps are used by several institutions to manage their exposure to fluctuations. We expect a steady increase in average daily volume of interest rate contracts 2013 onwards.
CME has also introduced portfolio margining to allow customers to cross margin positions in over-the-counter (OTC) interest rate swaps and Eurodollar and Treasury futures, offering a reduction in capital requirements up to 90%. Read our article CME Group To Allow Cross Margining To Gain OTC Market Share for more details on the new initiative.
The effect of the Dodd-Frank bill will be felt across all asset classes, including energy which accounts for a quarter of CME’s clearing and transaction revenues.
Apart from clearing and transaction revenues, CME earns a sizable chunk (almost 15%) of its revenues from the market data segment. The division has also suffered in the pessimistic macro-economic scenario as several customer firms have discontinued their service as part of cost-cutting measures, leading to a decline in device count and a subsequent 4% decline in revenues.
CME has increased its basic data service fee from $61 per month to $70 per month for each device in service to mitigate the effect of declining subscribers and also acquired Pivot to offer an instant messaging service under the name “CME Direct Messenger”. We expect a slight increase in monthly fees going forward as the company tries to wade through a difficult stretch.Notes:
- Analysis: Commodity exchange battleground switches to “swaps”, Reuters, 11th October, 2012 [↩]
- CME to launch interest rate swap futures, Reuters, 30th November [↩]