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

Got it. And then just as a check in here, right now, the overweight, equal weight, underweight are relatively evenly split. But 60% of responders are not involved. So that vein, let's talk a little bit about secular growth on a go forward. Brian, you might recall, when we had you here last year, and Chris was here, we talked a little bit about cyclical versus secular and what some of the demand dynamics might be around volatility and hedging. I guess it's worth exploring a little bit. On the secular side, outside just the shape of the curve and what like the trading environment is, what's the incremental user of SPX options or VIX futures and options? And how big is that addressable market that you guys are trying to tackle on a go-forward basis?

Jeremy, it's a target that we set out when we were talking a year ago and all of the quarterly updates, the quarterly calls that we had at the end of last year and even the beginning of this year was really on our push on organic growth and primarily our expansion into insurers, insure users and pensions and endowments, where there's a great opportunity we continue to see. Of course, we lost a great deal of time and engagement there. Right now, we're spending most of our time on existing customers who love the story and who are sidelined, kind of what we were referencing earlier. So the potential target of new users have not gone away. I would say we're a good 9 months behind where we thought we would be on telling that story and getting conversion over. But the case has not lost any merit. As a matter of fact, as I referenced earlier, a low interest rate environment on basic override strategy is the greatest, the easiest lesson that we can teach. And we spend -- we don't, but we commission a third-party and white papers commissioned on the very difference in just overriding basic equity positions and/or cash if you're on the sideline. So that's the most fundamental and easy, and then hedging dynamically in a different market environment based on your perception of risk, whether or not SPX have the money puts or some exposure to those very violent moves, they are able to hedge with fixed futures and options. So story hasn't changed, just our ability to penetrate has. But I think as we're all -- back to your first question, lessons learned. Business continues. The need to engage with customers is there. The willingness now for customers, just like us, accepting the new normal for now, it allows us to get back at it and make some more inroads. And again, making up for the lost months and just making the first shift to work from home, now it's time to look at strategies and solutions that will extend beyond this election, certainly beyond 2021.

And then do you think that there's an ability to use 2020, even though it delayed your client engagement process, there's a little bit of a Mini case studies that might unlock and unlock new doors and open up to engagement levels where people might have been a little hesitant to engage with you guys last year?

It's funny. Tail risk hedging, no better commercial that we can use if you had tail risk hedge on, were oftentimes, for some pensions seen as a drag on their returns. Wow, right? The payoff and allowed you to stay in the market and aggressively trade for very little -- in hindsight, very little expense. No better example than what we saw in the spring. I think, though, even in this elevated vol, premium harvesting will be back and back in a big way. If the curve, even if we stay elevated because of COVID and the uncertainty about how successful vaccines may be or where the tail of this pandemic will be, once through an election, the term structure will return to normal. Maybe elevated, but the shape will return to normal, which allows for a roll down strategy in premium harvesting like we've seen in the past. The difference between realized and implied volatility, that gap has never been greater. And that's opportunity. And that will not be lost on existing customers and new customers as we're all looking for how to deploy capital in the future.

And I think one of the common things we've seen is that this volatile market, this work-from-home environment has really solidified new things into workflows that weren't really there before, right? So I think is there -- and I think you guys have characterized this last year. The first couple of trades that a new client does with volatility-type strategies is really just dipping a toe in the water, and then you see engagement kind of skyrocket from there. So in that vein, as you look to do kind of new educational initiatives from here forward, how much of an opportunity do you think it is to solidify something that might be a little bit new to them into their work floor? And do you think that maybe the engagement cadence could be a little bit faster from new clients on a go-forward basis?

I think the cadence will, as we saw from the newest entrants in the discount space, the Robinhood [ of facts ], big quotation marks, and the leapfrog, I think the opportunity that the entrenched have to throw the infrastructure behind growth, and it wouldn't surprise me, is some of those that have been around a bit longer, Schwab and E*TRADE and TD, and I use sink or swim, them going directly at the new user with the infrastructure that they have behind them will be extremely powerful. If I look from Cboe's perspective in product rollout, we've got a Mini SPX contract that really is used by institutions who are looking for granularity. It is the same notional size as SPDR but has the benefits of being cash settled. So if you think about this, you're trying to manage -- you've been trading equities. You move over, you want a little bit broader-based exposure. So you move into SPDR, and yet you have to figure out how to deal with this physical settlement thing. And you may not have tens of thousands of dollars in your account, but you've got enough that you want to participate in the U.S. market more broadly. Cash settlement makes that settlement easy. You can hold contracts to their duration and not have to deal with the physical settlement. They deal -- they settle in cash. There's also currently a 60-40 benefit on tax treatment. Capital gains in derivative, short-dated derivatives are taxed and at short-term capital gains, gains in cash sell broad-based indices in the U.S. are a blended rate -- between a 60-40 blended rate between long-term and short-term capital gains. Huge things we've just missed is promoting a contract set that's already out in the marketplace. So we've got tons of opportunity, tons of cool things to do. And we all noticed the power of retail over these past few months, and we're all turning our attention to how to make the experience great, lasting, and to teach them both hedging and the benefits of changing a payout scheme from a Delta-1 line to bending the payout scheme and affecting a risk profile with the use of derivatives. Great stock coming.

And then I guess just last thing in the derivative complex for now. Obviously, when we historically think of VIX, we don't really think of much competition out there, obviously. But your neighbors across the street announced the launch of the Nasdaq-100 Volatility Index, which is supposed to launch on a product basis in October. On the one hand, I can think about the vol cube could be viewed as a substitute product for VIX. But on the other hand, the largest derivative exchange in the world just launched a volatility-linked product itself. So they're having a lot more eyeballs and mind share on volatility and hedging volatility in the go forward. So Ed, I guess, when you first saw the announcement, what was your first thought about being more of a substitute product or a real opportunity to grow the volatility high in aggregate where you guys are going to get your fair share?

I wish it was the latter. I wish there was -- this was -- we view this as an opportunity to really grow the vol space. Now the good news is a big checkbook across the street. So any awareness will be great. I just don't think it will show up in vol cube. The contract has a number of flaws, and the biggest one is around its settlement. There's not perfect convergence from a liquidity provider's perspective. In the VIX complex in the S&P 500, the settlement means at the moment of time of settlement, I am indifferent if I'm holding a VIX future or the strip of options that comprise the VIX futures contract. It is perfect convergence. It's one moment in time and single price settlement. So there's not residual risk by holding a future or the component strikes. A 5-minute VWAP allows for -- doesn't allow for convergence. So there's risk embedded just in the settlement process. And what do you do with that residual offset? There's not -- it's very difficult to hedge. Similarly, I think in the construction of the contract, it uses a very limited amount of strikes. And vol cube says that's a good thing, except most liquidity providers, market makers and people who had exposure to the marketplace find value in the out of the money options because they are predicting the likelihood of a 10% move in a short period of time, for example. And vol cube doesn't measure that risk. And they're concentrated at the money volatility. And that is a great window of that moment in time, but doesn't show you what the market is saying, where the spring, for example, isn't in that model. And that's -- we think that, that's not as great a measure of the true volatility surface as VIX's. Hopeful that any talk of vol gets more eyeballs on vol in general. But I just don't see this as the end all, be all for a competing vol product.

Got it. And maybe just a couple of minutes on cash equities. I know earlier this year, you guys received approval for market close initiative. I guess what's an early impact around volumes?

Why don't we turn it over to Brian? He's been so eager to jump in.

Sorry, Brian, got to get you more work.

I appreciate that. Thank you. I would say that right now is our timing was unfortunate as far as launch and kind of getting that going. Once we finally received approval from the SEC, which I think it was nearly 2 years in the waiting as far as in hold mode, we picked great timing and, call it, mid-March launch and what happens. So we go into COVID mode. We go into work from home. We get -- appropriately so, the market community is focusing on its own, I'll call it, in-house infrastructure, work from home, keeping things going. And by the way, the industry obviously did an amazing job withstanding lots of colors and adjustments. But anyway, so the timing wasn't great. So we didn't get a lot of traction. You had a couple of exchanges coming online, again very important. Let's make sure they're connected. It's just now recently where we're seeing connections, and we're seeing the pipeline that we'd established. We'll call it interest as to why we brought out to market are now actually coming back in and say, "Let's get connected." So we're starting to see some traction there. Again, immaterial right now. The other thing, 2 more points I'll make is that it was so long ago that when we launched it, I think the market is continuing to move as far as what it wants out of this particular order type. So we've got some adjustments that we'll make there on it. And then finally, I'd say the other impact that it's had is that it's as much defensive as offensive as we've seen the other exchanges who have a large part of their volumes with this order type. We haven't seen the price increases in that particular order type that we had seen historically. So if nothing else, if they're going to address -- if they're going to go after pricing in the transaction side, it's not going to be here. It's going to be on the transaction side and continuous market, which is where we obviously compete. And that's not a bad outcome as far as we're concerned. So long story short is that we're excited. We'll have some more evolution, starting to get traction, but again, not material yet.

And then I guess just kind of sticking to that point, with intraday trading kind of being the bread and butter of like the Cboe cash equity complex, until this moves forward a little bit more, obviously, I think we have 3 new exchanges making forays into the cash equities business that either have launched or will be launching relatively soon. I guess, how do you view this in terms of a business? Any sort of threat to a pretty sizable market share of intraday trading? And I think one of them at least put out a -- one with some deep pockets put out a pricing grid at some point, too. So any color you guys might have on that one would be pretty...

Let me start. And I think, Brian, having been the disruptor, you can add some color. We take the launch of MEMEX seriously, but recognize that inverted pricing on its own as its own strategy is not sustainable for the long term. We believe MEMEX will gain some intraday trading market share. This is an incredibly powerful consortium. We don't take it lightly. But there are a great many reasons to look at a new exchange. MEMEX has offered really nothing new other than an inverted pricing scheme. There is not a new order type. There's not a slick algo that's different that they're bringing to the marketplace. It is pure pricing, and we can compete with pure pricing because it's just quite simply not sustainable. And there's many reasons that investors have invested in MEMEX. And one of them is for a different pricing scheme and both intraday trading and for the services that the exchange offers in addition. Again, nothing breaking through here as new. So we know how to compete on price. And I think if you look at our ability to compete over multiple medallions, multiple pricing schemes, multiple algorithms is totally different than trying to be one thing for one person or for all people on one medallion. Very difficult to do, Jamie -- Jeremy. But this will -- I think this will be a good successful launch in the single-digit market share over time. But it remains to be seen what is sticky after the inverted scheme narrows or actually, they have to start making money. Brian, you've been there.

Yes. So I would -- just 2 things I would add to that, to those points is, one, it is a very different environment. A lot of people were saying, "Hey, it's back to 2.0." It's again, consortium, go with low pricing, get that market share to stick and then go from there. Well, the different environment is that we're not a $0.10 capture and continues trading anymore or more like, call it, 2 to 3. And so I'm not sure where else you could go from a profitability standpoint. That market share in no way -- market share gains that you get from the SIP revenue is going to offset that negative cap. It just doesn't. It's an offset, but it's not going to cover it. With the absence of nontransaction revenue on their P&L, I don't know how they're going to be profitable. And again, I don't know how long that is sustainable, being inverted. And even if they are, call it, in a positive capture, the ability to make money without it, without the nontransaction revenue is extremely difficult. And it's not like they're operating in Lenexa, Kansas. They are operating in New York. So the cost structure may be a little different. And they may be very efficient. I don't know their P&L, but I'm sure there -- it's again knowing who the players are behind it, it's going to be a well-run organization. So it's just a different order. And you have the best [ ex ] execution is much more -- it's a much stronger environment than, say, where it was 10, 12 years ago. So the ability to move flow isn't as much. Obviously, you're going to have some people who can internalize and move it on exchange. And that's not necessarily taking share from anyone other than pulling stuff on exchange from where they're doing, and they can choose to do that. But we haven't set still, to Ed's point. We're used to competition in this space. And a lot of people cut their teeth in this particular market that are part of the larger Cboe. And so we have proactively launched our own pricing changes in September to continue to try and create some capture, try and make it painful for people to want to switch, trying to get incremental flow from the TRF as well as continuous trading. We've continued to launch new products with the periodic auctions. You mentioned the Cboe market close. We've talked about retail priority, how that has gained a lot of traction over time. We've talked about -- we've launched the Quote Depletion Protection. Again, all of that to gain incremental flow to be an incredibly competitive force, again independent of just we're going to lower pricing.

And then I guess just to wrap up today, we've got the last couple of minutes here. Just talk a little bit about capital and M&A, where you guys have obviously been incredibly active, right? I mean EuroCCP, MATCHNow, Hanweck FT Options, Trade Alert. I guess what do all these new companies have in common to augment the core? And then from a use of capital perspective on a go-forward and inorganic growth, what makes sense from here that maybe could fill in some extra white space that you augments what you've already done so far?

Yes. Great question. Let me take the first part. And then, Brian, you can handle really our view on capital just more broadly. The M&A is really in key buckets that has always been interesting to Cboe. MATCHNow is a geographic extension into Canada. Great market, a similar customer base, similar use case, a great team that will join the North American equities team, simple core. We were very transparent with you all on EuroCCP and really our desire to bring a U.S.-style derivatives trading to Europe. Transparent, lit markets, simple clearing, common clearing, multiculture, multicountry, risk, all cleared in one central clearinghouse. That story is phenomenal for us. It's our core, derivatives trainings where Cboe was born. And then we've been very vocal with us wanting to arm our customers with information pre and post trade. And we've been successful in that. Our LiveVol and Silexx have been great offerings for us. We lacked at-trade information. So Trade Alert and FT, right to that core. And then the analytics behind the Hanweck acquisition really arms us perfectly for pre, at and post-trade information solutions for our customers. So we're buy versus build all the time, and we're really looking at the customers' needs. So if there's geographic possibility for expansion, we've got to look at it. We don't have to do anything. We've got a balance sheet, and Brian will talk about, that's ready to move if we need to. But we take a look at the globe, and we take a look at the use case and the needs of our customers and we move. And we've proved that we can do that in the most trying of times, during the middle of a pandemic, closing these 4 transactions and aggressively moving toward implementation. So it's been quite rewarding to get to these closes, many of which were started pre-COVID, but some of them even during and full turnaround. But Brian, more importantly, I think, more broadly on capital allocation in general?

Yes. I mean you could probably summarize our capital allocation approach if you look at our last 6 months, right? So as we've talked about our prioritization of capital allocation, you could actually see it in action over the last 6 months. And the -- if we go back and you'd say, from the IPO itself, we've always had an approach of we want to continue to look at increasing the dividend on an annual basis. Check the box, we announced that increase. I think it's been 15%, 16%. And the dogs agree. Over the last 3 years, over the last time, we said, "You know what? We're going to buy back shares opportunistically." And then Ed mentioned that where does it make sense if we're going to buy versus build, what are those acquisitions that can help increase the -- or supplement the proprietary growth of some of the products or growth in general of what we're trying to accomplish strategically. And we've been able to finance it. Mostly that was actually cash on the balance sheet that's been generated from operations. So all of those things combined enable us to do that. And again, no cash is going to sit on the balance sheet unused. We want to deploy it for a positive shareholder return and look for positive return on invested capital. So you've seen us do that simultaneously all within the last 6 -- now 9 months, of which we've announced, and we don't plan on changing that. So I think that's -- the approach has been relatively straightforward. We think somewhat simple. And like I said, we try to be very transparent about what our approach is to returning capital to shareholders and making sure that enabled us to do that has been a, I'll call it, a delevered balance sheet from what the original from the Bats acquisition has been.

Right. Well, we are at time. But Ed, Brian, thank you so much for being here. We really appreciate it.

Jeremy, great to see you. Thank you very much.

Thanks, Jeremy.