CME Finally Gets Approval To Start London-Based Derivatives Exchange

March 14th, 2014 by Trefis Team
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Chicago Mercantile Exchange Group (NASDAQ:CME) has attempted to expand beyond the U.S, specifically into the European derivatives market, for some time now. Back in 2012, the member nations of G20 mandated that over-the-counter (OTC) derivatives be traded on an electronic platform and processed through clearing houses only. [1] This presented exchange operators with a lucrative opportunity to grab share in the fast-growing global market for OTC derivatives trading. However, CME’s attempts to enter the European market by acquiring the London Metals Exchange and merging with Deutsche Börse Group (ETR:DB1) failed to go through. Instead of trying for the failed acquisition again, the company’s management decided to build its business from scratch under the CME Europe banner.

CME Group initially intended to start foreign exchange (FX) product trading on CME Europe, its London-based futures exchange. But the exchange could not start operations last year, first due to regulatory reasons and later due to a delay caused by a technical issue with the delivery of physical currency. Meanwhile, the company explored the option of offering aluminium contract trading in the metals market as it waited for approval of FX trading in Europe. This week the company announced that the U.K. Financial Conduct Authority finally approved the exchange for launch by the end of April. Below we take a look at how the new exchange affects the company’s Forex trading divisional value and the impact of aluminium traded products on its commodities business.

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CME To Finally Set Foot In Europe

The company has been enthusiastic about entering the European FX trading business since 2012, as it estimates that almost 65% of foreign exchange transactions take place during European business hours. [2] Observing these trends, Deutsche Börse’s Eurex exchange gained approval from regulators to start trading operations for FX futures and options this summer. [3] Additionally, NASDAQ OMX (NASDAQ:NDAQ) is looking to offer trading and clearing of spot Forex and derivatives on its London-based interest-rate derivatives business later this year. Its FX trading business is still subject to CME convincing regulators that its clearing members can physically settle FX contracts by the time trading starts. Management is confidant that they will be ready by the time the launch date comes. [4] CME could especially benefit from foreign exchange products as looks to replicate its U.S. FX portfolio of 56 futures and 32 options for European markets. Taking a conservative estimate, even if CME Europe adds about 10% to CME’s overall average daily trading volume of FX products by the end of our forecast period, we could see a 3% upside to our $70 price estimate for CME’s stock.

Besides FX traded products, CME has obtained approval to start the trading of commodity products in Europe and intends to roll out aluminium contracts. CME will now compete with the London Metals Exchange (LME) in a market segment that the latter dominates. About 80% of worldwide non-ferrous metals trading is conducted on the LME, which includes 40% of the world’s aluminium trading volumes. [5]

Over the last year, there has been criticism about aluminium trading conducted by LME because of a lack of transparency in aluminium pricing. Reports indicated that LME’s offered price and the actual price of physical aluminium market had some difference due to the time lag in delivering the metal from the exchange’s warehouses. In spite of the measures suggested by LME to improve the situation, major aluminium producers such as Alcoa (NYSE:AA) and Rusal (HKG:0486) have referred to LME’s plans as “counter-productive” and “objectionable”. [6] [7] On the recommendation of investors, corporate users and producers to address the issue, CME has rolled out plans for aluminium trading. The growing skepticism among individual and institutional traders towards the near-monopoly created by LME could provide a perfect opportunity for CME’s aluminium trading to draw near-term benefits, as it rolls out aluminium contracts next month.

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Notes:
  1. OTC Derivatives Reforms Progress, Financial Stability Board, September 2013 [↩]
  2. CME Plans London-based Derivatives Exchange, Wall Street Journal, August 2012 [↩]
  3. Eurex Hopes To Steal March On Rival CME With FX Launch, FX Week, February 2014 [↩]
  4. CME Cleared To Launch London Exchange, Reuters, March 2014 [↩]
  5. CME Takes On LME With Aluminium Contract, Financial Times, February 2014 [↩]
  6. Alcoa Hits At LME Warehouse Plan, Financial Times, September 2013 [↩]
  7. Rusal Attacks LME Plan To Cut Metal Queue, Financial Times, September 2013 [↩]