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The CME Group (NASDAQ:CME) announced that it will start clearing OTC interest rate swaps (IRS) in London. According to the company, the OTC interest rate swaps launched in Europe will initially include seven currencies: GBP, EUR, CAD, AUD, CHF, JPY and USD. The swaps in USD, EUR and GBP will be for maturities of up to 50 years while the maturities for all others will be up to 30 years. 
The move is significant because interest rate contracts constitute the largest value creating segment within the CME group accounting for nearly 25% of the value of the firm according to our estimates.
We believe that the announcement is timely and will help the company capture the growing OTC derivatives clearing market. We expect the average daily volume of interest rate contracts traded on the company to increase from 4.83 million in 2012, to almost 8 million by the end of our forecast period – at an annual growth rate of nearly 7%.
Our price estimate for the company is $58.30 per share, which is marginally lower than the current market price of over $61.
See our full analysis for CME Group
The Potential Market For Centrally Cleared OTC Derivatives Is Large And Growing
According to the Bank for International Settlements, the total outstanding amount of OTC derivatives was $639 trillion at the end of June 2012. Out of that, interest rate contracts accounted for almost $494 trillion. 
A significant portion of this large and unregulated market is now set to come under the purview of centralized clearing as regulations around the world aim to reduce the systemic risk in OTC derivatives markets.
In 2009, after the mortgage crisis of 2008, the G20 nations called for centralized trading of standardized OTC derivatives. Since then, Japan has already implemented such regulations, and the process is underway in the U.S. and Europe. The Dodd-Frank Act in the U.S. and the European Market Infrastructure Regulation (EMIR) in Europe will make centralized cleating of OTC derivatives mandatory for all eligible parties, latest by the end of 2013.
Further, the Basel III regulations discourage banking institutions from participating in non-standard OTC derivatives, which will still not be centrally cleared by requiring them to maintain higher level of collateral when trading in these contracts.  This is likely to ensure that assets continue to flow into standardized OTC contracts over the next several years.
The Growth Will Be Faster If The Economy Improves
The Fed has kept interest rates at historic lows for the past couple of years and the only direction they can go from here is higher. Going forward, the markets are likely to closely watch macroeconomic data such as unemployment numbers and inflation figures to estimate the probability of the Fed raising interest rates.
As market participants anticipate changes in interest rates or look to hedge interest rate exposure going forward, this should bode well for the interest rate derivatives volumes. In a whitepaper published last year, the CME Group estimates that over 50% of all U.S. Treasury securities have been sold to overseas investors, and this may lead to a surge in trading of interest rate derivatives from external sources, whenever speculation about the Fed increasing interest rates rises. 
The CME Group Is Well Positioned To Exploit The Market
The CME Group is uniquely positioned to benefit from the growth in centralized clearing of OTC derivatives as the company is already the world’s leading clearer of interest rate futures with average daily volume (ADV) of interest rate futures over 5.5 million for February 2013. 
The company has also been present in the clearing interest rate swaps in the U.S. since 2010, a factor that provides it with added advantage in terms of capability and experience. 
The centralized clearing of OTC derivatives also creates an opportunity for the company to innovate new products in this segment, and the CME Group seems to be using it to enhance its product portfolio. Since the company started offering these contracts, the average daily volume of these products has increased to 3,226 in February 2013. 
The Timing Of The Move Is Perfect
The announcement about CME’s launch of OTC interest rate swap clearing in Europe comes just a week after the deadline for category 1 entities – which includes swap dealers, major swap participants and active funds – to comply with the central clearing of OTC swaps expired in the U.S.
The CME Group is already witnessing a significant growth in open interest for OTC interest rate swaps – the open interest in these products increased 16% in the first 15 days of March, from $873.29 billion to $1,013.8 trillion. 
The strong growth is likely to continue in the future as the deadlines for category 2 and category 3 entities expire on June 10 and September 9 of this year, respectively. Category 2 includes commodity pools, hedge funds and non-swap dealer banks so long as the entity is not a third-party sub account. Category 3 includes all other entities required to clear, including ERISA plans.  Once these deadlines expire, we can expect several category 2 and 3 entities to move their assets into the centralized clearing channel, and the CME Group should be well positioned to benefit from it.Notes:
- CME Clearing Europe Expands Services with Introduction of Interest Rate Swaps, Press Release, March 18, 2013 [↩]
- OTC derivatives market activity in the first half of 2012, BIS [↩]
- The Changing World of Derivatives and Risk Management: John Hull on OTC Derivative Regulations and the Creation of Basel II.5 and Basel III, John Hull, December 19, 2012 [↩]
- A New Dawn for Interest Rate Futures?, CME Group, May 2012 [↩]
- CME Group ADV Reports for January and February 2013 [↩]
- CME begins clearing interest rate swaps, Reuters, October 18, 2010 [↩]
- Interest-Rate Swap Futures Surpass $130 Million at CME Group, Bloomberg, December 04, 2012 [↩]
- OTC IRS Market Data, CME Group [↩]
- OTC Interest Rate Swaps Mandatory Clearing Summarized, LCH.Clearnet [↩]