Cboe Global Markets, Inc. (CBOE) Earnings Call Transcript & Summary

I'm a member of Bill Katz's team here at Citi, and I'm a leading exchanges and market structure analyst. We're pleased to welcome CBOE's Executive Vice President, CFO and Treasurer, Mr. Brian Schell; and also, the Head of the Markets Division, Mr. Bryan Harkins. Also in the room is Head of Investor Relations, Debbie Koopman. So I'll kick things off, and then we'll open it up to any questions in the room.

But yes, so I think just to get things started, maybe we'll talk about the overall volume environment, in particular, the proprietary products. Brian and I were talking earlier before the session about kind of the rising up until yesterday, year-to-date equity market, but you're also seeing kind of decent mix movement. If we could maybe dovetail that discussion with broader health of the market and how you're seeing that lead up versus maybe the depth and breadth of the market prior to the February volatility event.

So I'll start off a little bit and obviously ask Bryan Harkins. We may have to use last names. So when you say Brian, we know who you're talking to is, again, if you think about kind of the conditions of the market and again, we try to remind everybody that there is no one model that's going to predict which product is going to be used more or less. We can tell you in a certain situation where we'd expect, oh, we would expect if you have a difference in implied versus realized volatility, to expect to see X contract be used more than another versus a SPX contract, options contract versus a VIX options contract or a VIX future. So the -- but what we do want to make sure we encourage people to -- as you think about it, is the entire product suite. And it's the totality of that product suite, that if you have dollar-denominated risk, CBOE's the place where you can express a view, whether you're trying to generate alpha or you're trying to hedge a portfolio. So in all environments, what we've seen is that it's been a very applicable and useful proprietary suite of products. And the volumes are going to fluctuate in the different environments. When we look back at -- you talked about the kind of the current environment. There's obviously the existing macro environment that there's a lot of known knowns, known unknowns with respect to the coronavirus and what is the ultimate fallout either in China or any of the other potential emerging markets that, that may have. We have the election results and where that's headed. If you look at the VIX futures term structure, you'll see a spike in the risk that you see in that October contract that's going to settle in November before the general election. You've seen a little bit more of a change as a democratic primary. And there's -- a frontrunner potentially is emerging and what has -- the potential impact on the markets there. I think the other is are people comfortable with overall valuations and where they are with respect to the market? And so the trends that we've been seeing, and Bryan can -- Bryan Harkins have spent quite a bit of time, particularly this last weekend, we're talking to a lot of our customers on the multi-list volumes that we've seen a lot of lately from spec institutions, the institutional systematic orders with looking at the top 50 names and the big names as far as driving a lot of that volume, as well as kind of the index volumes that we've seen a big spike up, certainly, with yesterday's sell-off. And the interesting observation from that, it was a much more of an orderly sell-off with respect to the SPX and the VIX. Obviously, the volumes, if you look at the entire suite of proprietary products, was a $5 million, $6 million contract day on just the proprietary products, which is more than 2x of a normal day that we would see in proprietary volume contracts. So it was a large day. But it was, again, we've seen large volume days before that were less orderly. Yesterday was much orderly. And the other thing I'll just -- I'll mention before I turn it over to Bryan for any additional insights is -- I was talking to our research group getting ready for thinking about what are we seeing as far as the market goes is, when they look back at it -- and as they've seen the S&P hit new highs, you've typically seen the VIX or the overall risk level at kind of a lower level, call it, $12, $13, historically. With this recent run-up, as we've seen before, before yesterday with the S&P raising new highs, the VIX was actually higher, say, $15, $16 levels. So clearly, the market was factoring in. There's a higher level of uncertainty in reaching these new highs and this growth than what we've had historically. So the market appear to be better positioned with respect to potential sell-off, potential risk, potential hedge than what maybe had -- we've seen in the past. And sometimes, when you see a big sell-off, people reevaluate their strategies, where they're going to come back in is you may not see as stronger volumes coming back in. We're not necessarily sure that that's going to be the case here, given the positioning. Now again, that's not a forecast that we're going to continue to see huge volumes. But again, just kind of looking at the dynamics and where we were. And the last thing I'll throw it is that we've continued to see that increase on the VIX call options. Again, to the point of that as far as that open interest goes, is that people appear to be positioning themselves for such an occasion with respect to potentially hedging there, where they are in that overall position, so...

Yes. The only thing I would add is, also, don't underestimate the retail contribution. So as we know, the retail brokers went to free commissions. First, it started in equities. More or less, it is spilled over into options. And I think yesterday was a prime example that 39 million contracts traded in the multi -- in the options industry, which is the second highest of all time. And talking to the retail brokers over the weekend, they are seeing pretty astute trading patterns out of the retail base. I will also echo what Brian was talking about is we get -- as exchange, we get -- our customers come to us about listing longer-dated options. That's been going on frankly since last fall. And you're seeing a lot of positioning around Super Tuesday coming up. People trying to express a view there, as Brian said, with a frontrunner potentially emerging. And even in our futures exchange as well, I think the settlement dates around the election is driving a lot of interest in our products as well.

Great. And then maybe if you could spend a little time just post C1 migration and the capacity that you've been able to see through that and how that may have played out or factored into the volume you were seeing yesterday, messaging. And then just more broadly, the general increase in capabilities and more rapid and easier to deploy product updates across that platform?

Sure. So we pulled together some stats as far as the volumes going, given what was going on. So -- and these are for C1, which is obviously the largest exchange -- options exchange. And we had on January 31, the record for orders that had come through was $10.4 billion in one day. Don't -- again, I don't know if the prior technology would have handled that as efficiently. But again, this was obviously January of this year. Yesterday, that number, actually, we set a new record on C1 of $11.3 billion orders. And so again, the technology is holding up beautifully. I think our Chief Operating Officer is going to be asking for a larger CapEx budget. Just kidding. Just because, again, to make sure the capacity is there. So -- and that's built in. And so -- but that's a wonderful thing to have to say, I need more CapEx and -- because we have -- we're seeing more and more capacity. That's a wonderful thing to have to pay for it to do. But again, that's not a change in guidance. That's just -- it's something that we hope that trend continues. So that's a, as far as the order of magnitude of what happened yesterday and as far as what the system has been able to handle. If you look at what do we see as far as the technology migration and what has that enabled us to do, I think what you're seeing -- and this is something that we haven't talked about it as much, but the trend just continues to hold, is that we continue to see tighter spreads than pre migration. We continue to see more liquidity at the inside. And those are all things that, while we can't point and say, "Hey, that attributes x amount more transaction revenue." We do know that a better market and those market statistics generally should help promote more trading and should be a better experience for customers seeking to use CBOE exchanges and using the products and those exchanges specifically to trade on. So we have continued to see that. That has not changed as far as that goes. We've continued to enhance -- or not continued, but with that migration, we saw a change in our VIX settlement process. We continue to see that tighten than where it was before. We continue to see more participants being added to the settlement. Again, all increasing the healthiness of the environment that people are trading around that. That's all very positive. And I think with some of that capacity freed up, it's enabled Bryan to maybe -- you can talk about a few of the things that you guys are launching and thinking about launching.

Yes. I think besides performance, I think the most exciting thing about post C1 is that our resources. So we've been largely just focused on -- it's been a multiyear process to make sure we got the integration right. And so I think one of the things that our tech team is best at is being really focused, which means, frankly, sometimes you have to say no to a lot of new product enhancements that are on the docket and allow us to compete. With all of that, with all those resources essentially freed up, we like to say we're going really back on offense. And that's not just in our derivatives franchise. It's across equities. Because really, the same people are the ones we run one common platform across futures options and equities and even our European platform. So just a few examples. You're going to see us really putting out a lot of product in equities this year. We launched Retail Priority. We have the CBOE Market Close coming. You're going to see us differentiate around products that gear towards institutional and really more asset manager usage. In our options business, we're seeing a great interest in FLEX Options. So FLEX is just essentially -- typically, a lot of the -- it's almost sort of customized options that have typically, a lot of times it's longer dated, and they've traditionally gone traded over the counter. But there's been strong asset manager demand they want essentially cleared on exchange product. And we are really building out a full product suite around our FLEX Options. So you're going to see us continue to invest in that product. And even things like how we compete in the more competitive options landscape is going after large block liquidity that has typically gone to some of the competing floors. So you're going to -- so those resources allow us to enhance our product to compete for the market share that we want.

Great. And then just wanted to spend a little more time on the proprietary products. And this time, last year, you had recently made some key hires to really bolster the organic growth effort there. And just wanted to see if there's any update you can share on either progress with those new hires. Are you looking to continue to add kind of how you're measuring the success there?

Yes. So just my background is I run our Markets Division, which is essentially the strategy and the sales of the business development for our products and our exchanges. And so for the proprietary product growth, we use the phrase, know your customer. It's just -- it's seemingly obvious, but the closer you are to your customers and the more information we can glean to improve our products and also to educate customers on our product offering. So over the last year or 2, we've brought in specialists. I'll give a few examples. So it may be a regional specialist. So we're -- we've built out the European derivatives sales team. So we now have 3 people based in London who are derivatives experts themselves, meaning they've either worked to their bank or they've been customers of the exchange. And really, we have -- we haven't focused as much on the European region as we would have liked. Now with really a dedicated sales force there, that's an example of a regional approach. We're going to have the same playbook in Asia. So we're building out the Asia sales team. Here in the states, I think it would be more of a product focus. And so for example, we talk about the insurance segment. The insurance segment is increasingly using derivatives to hedge the -- if they're underwriting, let's say, an insurance policy, they want to go out to the market and hedge that risk immediately. They're particularly also tied to what I said earlier on the use of FLEX Options. So we actually have dedicated sales coverage to penetrate and foster the insurance segment. On the -- let's take an example of the asset managers and pension funds. So one example is we look at, for example, Ontario teachers is, if you read a lot about their usage of derivatives, a very sophisticated usage. They understand the use of derivatives, how it can enhance risk-adjusted returns. That is like the model. And if we can take that through sales coverage and really try to penetrate the pension and potentially even the endowment industry about how can derivatives enhance portfolio, we have -- that is a dedicated sales effort. And the last example I'll use is, again, it kind of comes back to knowing your customers, staying close to your customers. We've hired really a coverage person entirely focused on the banks and the high-touch volatility traders. So I call it the know your name strategy. So this person's job is all the volatility traders. It's a fairly small community, understanding on a daily basis who is using our products, what are the use cases. And I call it Know Your Name because they should know the person's name, their spouse's name, the pet's names and making sure that, again, that feedback on the people who are clicking the buttons on our products on a daily basis is really essentially drives our strategy and how we're going to enhance the product going forward.

Great. I'll open it up to any questions in the room. Just click on the mic and the red light. I'll keep things going. So did want to talk something kind of very recent SEC proposal that came out Friday night on potential SIP restructuring, market data and market collection and just broader thoughts from an industry perspective, but then also kind of CBOE's position on what might ultimately happen, time frame, how you may not necessarily -- I think we've looked at the revenue risk, but if you maybe want to talk about that and help us kind of size the revenue pool. But then also, if you see an opportunity potentially benefit down the line and being part of the process of helping form that change.

Sure. So I'll just cover the, just a framework that kind of the revenue, we'll call it, risks or subject to, and then I'd ask Bryan to kind of cover off with the other broader questions about some of the elements in those proposals. So over the last 4 years, the biggest revenue component with respect to SIP is the equity SIP. And for us, over the last -- it's averaged over the last 4 years $104 million in each of the last 4 years and a high of $106 million and a low of $102 million. So it's been incredibly consistent over the last 4 years about where that number has played out for us. On proprietary market data side, in the aggregate, we have about $86 million. But the equities piece alone for proprietary market, it is about $36 million. So that's kind of order of magnitude of what we're talking about as far as the dollars overall. And like you said, we'll -- then Bryan works with us all the time. He's very engaged with the teams and is a leading voice within the equities industry, in addition to the other markets. But -- so I'm going to turn over to him to talk about some of the other questions about the proposals themselves.

Yes. I think, first, I mean, this has been a multiyear debate. So I think we saw this coming. Let me just kind of outline where we came from in CBOE'S view. So first, improving the SIP is something that CBOE has always supported, and that's not only improving the governance. So giving the industry a seat at the table, including votes on how the SIP is operated and improving the SIP in its performance, i.e., making it faster, more resilient and a higher performing industry utility. And it has gotten materially better over the past few years. That said, if the industry wants even more improved governance and potentially now the SEC is saying there should perhaps be competing SIPs. So why does it -- why should there be one SIP operator? Let's have potentially multiple SIPs competing both on technology and on price. I think, generally speaking, we are supportive of that as well. It's all against the backdrop of a good SIP is good for the industry. Competition is always a wonderful thing. Now you'll see our public comments over the coming months be more revolving around making sure multiple SIPs, competing SIPs is not confusing to the investors in any way. Things around best execution and what SIPs can you use. So there'll be -- that's really kind of where the -- there'll be a lot of detailed focus. On improving the SIPs from a content perspective, the -- right now, the SIP lacks some of the information that the exchange proprietary data feeds have. So we believe in more information on the SIP is a good thing. So everything you're hearing from us today is this is actually -- we welcome this. And if CBOE wants to compete in running a SIP at some point, maybe we'll take a look at that. But I think also, in a word, if the industry has been frustrated, let's finally put this behind us. Now this will take a few years to play out, and there'll be a pretty rigorous public debate on making sure that the industry gets this right. So we are supportive of moving forward and finally getting this industry frustration behind us.

Great. Wanted to touch on new products. And the MarketOnClose is set to launch in a couple of weeks here. But if you could talk about that specifically. But then just overall, you mentioned some new products you'd be launching in the options space and just more broadly. But wanted to see if you could level set for us maybe expectations around volume potentially gained from the MarketOnClose product and then also ancillary impacts to intraday volume or pricing impacts that you might see from that launch in that product.

Okay. So we'll start with the CBOE Market Close. This was this -- we still have a lot of work to do. But this was a good win for CBOE, good win for the industry. It's a long, long process. To size the market, it's about 9% to 10% of the entire industry volume is now occurring at the close. That's on the exchanges and brokers and their dark pools and ATSs have competing products. I would say, overall, we believe that the close continues to grow as a percentage of the volume. So we needed a product in this segment of the market. I'm not going to give any volume predictions today or market share predictions. I'd say this is just the start of us entering this market segment. And it creates a whole host of possibilities for us. For example, we're going to be matching orders before the close. Maybe we start to match orders after the close. So we believe that batching of liquidity is something that the industry may be moving towards. So we've considered potentially a midday cross to aggregate liquidity. There's typically a dearth of liquidity during the middle of the trading day. And it also allows us another stickiness factor that we can offer our clients. So no other exchange other than the primary markets are going to be offering an on-close facility. If you come to CBOE, that's a differentiation, especially in the face of increased competition coming. Having this product allows us to create a stickier value proposition with our customers.

And then just dovetailing back to the SIP discussion. Should you gain market share that should maybe offset some pressure from any sort of SIP reform more broadly?

Yes. I mean we wouldn't be in the equities business or the exchange business if we were afraid of change. We're very adaptable. We're pretty nimble. We have, I like to say, a war chest that we can tap into. So when we think about any potential changes to the SIP, which I think, as I mentioned earlier, I would argue, on balance, are pretty good for CBOE in the sense that the industry is debating -- has been debating it. So give the industry what it wants so this way, we can put it past us. So I'd say our overall strategy is going to be threefold. One is doing what we need to do short term tactically to grow and defend our business. It's a hypercompetitive business. I'm talking about equities now. And we embrace that. We're good at competing with scale and competing with razor-thin margins and defending our business where we need to. The second is product differentiation. You're going to see a lot from CBOE, especially in light of those freed up resources that we talked about earlier, whether it's Retail Priority, CBOE Market Close, institutional-geared order types and products. And then the third is going to always be industry leadership, thought leadership around how do we continue to evolve market structure so that it's serving investors better. The SIP -- our SIP leadership and some of our thought process around SIP for the last few years is an example of that. Things like how do we improve outcome for investors? How do we level the playing field on competition and making sure that we're always advocating for the exchanges are a bedrock of the industry. And we need to make sure that we protect liquidity providers and the public quote. So that's really the threefold strategy on how we look at the world.