CME Group Inc. (CME) Earnings Call Transcript & Summary

All right. Welcome back, everyone. And as always, we hope you're enjoying the music and the networking break for the music. We can thank my colleague, Laura, who handpicked each and every song that you're listening to today. We're moving on to talk about repo and specifically how you can embrace repo electronification and how you can leverage new technology to streamline your repo execution, clearing and reporting workflow. And together with Dan James, we have James Wallin, Senior Vice President of Fixed Income AllianceBernstein; and John Edwards, Managing Director of BrokerTec, part of CME Group. Dan, over to you.

Great. Well, thank you very much. Hello, James. Hello, John. Thank you very much for your time today.

Good morning.

I guess going straight into the session, repo remains one of the last marketplaces that hasn't been fully electronified. And why do we think that is, and what realistically the buy side are looking for and wanting to achieve from these electronic solutions? James, maybe that's something you could give us some background to.

Yes. And I think the reason is that it's a pretty specialized area to market where a lot of people have been practitioners for a long time and who have a way of doing things that works for now. But I think we've seen, with the COVID crisis and some of the other challenges, that the markets had -- over the last several years, that it's time now to automate and integrate the repo market into the mainstream electronic fixed income trading world. And some of the challenges we have there are, first of all, to coming up with a holistic approach where we don't look at each asset class separately in terms of how to finance it, and how we don't finance -- run our financing business based on our trading business, but rather separate in two, then come up with a logical way of is not only communicating and record-keeping for repo transactions, but putting them into the proper category so we can properly manage the risk. For example, we have money market and cash equivalent-focused funds where there's a need to avoid portfolio drag and we repo every night on a rolling basis. But in those cases, it's pretty predictable how much collateral and cash we'll have and securities as collateral are pretty much fungible with cash. In the more volatile asset classes, that's not the case. And we need to focus more on understanding our documents, understanding the way to avoid volatility in both marks and haircuts. And understand the fact that -- well, we understand it, but understand the practice and put into practice procedures that take into account the fact that cash and securities are not fungible when you're talking about sub-investment-grade on our volatile asset classes. And specific areas where we need to improve is to upgrade the communication links. Right now, we're relying on voice in Bloomberg, coming up to procedures, particularly with our custodians to come with more reasonable cutoff times for rolling and closing open positions. STP connectivity, particularly for rolls and transactions like that -- where right now the counterparties and particularly the custodians are treating it as 2 separate transactions and as not an automated transaction. So we get unrealistic closeout times or cutoff times. And consistent with all of those, the reduction of operational risk. And we're in the process of trying to fully automate the evergreen and that extendable repo trades, which I just referred, to try to incorporate some vendor solutions to communicate with counterparties and automate the margin for issuing process, incorporate, again, vendor solutions for dealer-to-dealer margin disputes, create coupon-tracking functionality, including automated constructions, as opposed to our internal accounting system and then to develop operational capabilities to deal with the uncleared margin rules, which again present other challenges in new -- it's 10 years old now, but the new -- the Dodd-Frank environment, where we're still evolving in terms of making true that the creditworthiness on these transactions is maintained. So that's helpful.

No, it's a great open. And John, maybe that's sort of quite a segue to perhaps understand from yourself as to how an electronic platform will approach some of these challenges and how does it differ from the DCP environment in which you've previously been operating in. And therefore, what are the demands of the DTC environment that we're talking about here?

Thank you, Dan. Yes, it's -- I'm excited to be here and to be a part of this discussion. I think it's a really interesting time in the marketplace. I think as James mentioned, there's definitely been an acceleration of interest and appetite to this throughout this year and in particular against the backdrop of COVID-19. But I think this sea change actually probably started a couple of years ago. And really looking at increasing the automation in terms of the execution initially, but then tackling all of the problems that James has been referring to in terms of areas where they need to focus and improve that, that efficiency, typically in the STP and the post-trade environment. But I think really, from a European perspective, this was -- the catalyst for this was MiFID II and the regulatory change. And although that had a very limited impact in terms of -- on the repo or the securities financing market, that was a little bit of an eye opener to a number of people, both within the dealer community but also to the -- within the buy side in terms of the regulation, which was then accounted to come in the guys of SFTR, which obviously was implemented this year. And I think looking at just a whole host of things, which that drives in terms of changing market behavior, greater transparency, reporting, best execution, being able to establish an audit trail around certain functions and things like that. But for us, this is obviously -- this is a journey. We -- BrokerTec has been established, both in the U.S. markets and in the European and the U.K. markets in terms of that dealer-to-dealer environment. But the step into the DTC was not necessarily an obvious step, but it's a very good extension of our expertise, and our load-in looks to build upon the dealer community in terms of the liquidity providers within a D2C repo request for type of environment. And although regulation may have been the catalyst at some of this change, once you start to look into that, you realize that the repo market was a long way behind a lot of the other asset classes in terms of embracing that. I'm not sure I can put my finger on exactly why that was. But I think once you start to realize that the regulatory change is going to drive some different behavior, then you look at the efficiencies that this brings in terms of both the operational aspects, but also for a lot more of your sort of plain vanilla financing or funding type of transactions, which are happening in both -- in a whole host of different asset classes and collateral types. The cost savings that, that brings over time is huge. And then what we've also seen is a significant investment, which is now being led from the dealer community in terms of auto pricing. So rather than actually having to manually respond, even in a more electronic-automated environment, there is now the ability to look at building auto pricing. So if you're more the plain vanilla type of transactions, the overnight type of business, which is there or even indeed, some of the more structured sort of term transactions, there is an ability now to auto price that. So with very little sales or trader intervention into that, and that enables them to focus on the transactions which have got a lot more meat on the bone in terms of opportunity.

So do you see that there is a need for greater standardization in terms of transactional types and the way in which systems operating? I guess, James, to you as well, is that the case? I mean is that something that you would welcome? Because a very optimistic argument that certainly a lot of buy side entities have rigorous processes, and they're very restricting in terms of willingness to change or adoption to accommodate a particular system. And one system is not ever going to fit all, but if there are more standardization across the contracts would that help.

I think the answer is yes. And I think there's an esoteric aspect of this, which is that I think there are swift in other solutions for STP each side of the repo transaction, but nobody's got around to effectively doing a combined STP messaging protocol that encompasses both sides of the transaction and the fact that both sides of the transaction may not always be the same. So what happens is when you transmit to your counterpart, you -- or to your custodian, because the custodian is an important part, or you're a safekeeping agent of whatever, however you characterize it, is an important part of these transactions because of the collateralization aspect. And once you break that chain of SDP, even if you do it by sending 2 messages that were on their own would be SDP-able, then you turn it into a manual trade and you invoke qualities, crazy cut on times and a lot of labor that's not really necessary.

I think clearly, there is -- with the increasing presence of electronic execution venues now in this space, there is naturally some form of standardization which starts to get sorted of fitted into that. I know from our experiences over the course of this year, we've been working -- we have a fixed API. But in some cases, we've been working with a number of participants, primarily dealers, at this point in terms of the order management aspects of that, but also the STP component in actually helping to try and standardize some logic and some workflow into that. And we're not the only people who are operating in this space. I still think it's relatively early days. But I think there is still very much a need for a little bit more level of bespokeness. And that's something which we see as being really important in terms of building out our offering, giving as much optionality and richness of functionality. And there are a number of examples where we've worked with existing clients to try and support some of the nuance flows in which they may manage their orders or in terms of the post-trade and the trade confirmation how we can support that. I do think that over time, those things will start to go away as you start to see more automation right the way through from the order entry through to the settlement of that, but I think it does take time. And I think as a response to that, we need to be able to adapt and respond quite quickly. We will be bringing on more clients. We're going to launch in the U.S. at the end of October, and we're going to need to be very reactive in terms of how can we support specific needs from certain clients on that product. So we have a very agile development process which is key to staying on top of that.

Yes. I mean, I would agree with everything John just said and underscore that, that's exactly what we're looking for is vendors and other market infrastructure supporters, to address the fact that there are 2-leg cities transactions and there's different fermentations as a result, that we need to have STP support for.

So for, maybe on from there then, we should probably talk about credit and counterparty, basically is something James touched on at the top of the call. But I think it's worth expanding that out a little further. And perhaps, John, you can help even add in some color on the central clearing models as well and how that interacts with credit and the counterparty management, or credit risk management.

Yes. I think there's an important -- well, it's clearly an important and central aspect to the financing transaction that you have good counterparty and credit risk management. But that takes on a different specter depending on what asset class you're talking about. Again, the counterparty and credit risk management, from both ends of the transaction, they're looking at us, we're looking at them. If we're talking about cash equivalents and just doing overnight transactions, the numbers and the mark speak for themselves, and there's not a lot of room for discussion over what you can post than what you need to post on a given day. It's very black and white. But when you start getting into the more volatile asset classes, and you get into a market-stress situation, like it did during March with COVID, there's a huge challenge in counterparty risk management in terms of making sure your creditworthiness is properly evaluated by the counterparty, to making sure that the counterparty isn't going to get away, which, in this case, the counterparties themselves weren't stressed unlike 2008. But from the standpoint of investors needing financing, there was a huge lift in terms of counterparty and credit risk management in terms of properly presenting -- probably presenting your assets to the counterparty, making sure you got accurate marks and making sure you weren't overreaching in terms of haircuts. And again, the somewhat bespoke and manual way that this market is organized currently doesn't lend itself to efficiently and consistently having that conversation with your counterparties. There's a lot of backfilling people, had to do a lot of scrambling people, had to do to make sure that there was a meeting of minds as to what had to be -- how much had to be posted and what would be sufficient in terms of -- sufficient and appropriate in terms of collateral.

Yes. I suppose from the solution that we are providing to the marketplace, I think what -- we see this as a bilateral relationship. We're not looking to build a complicated or complex credit metrics within our platform. We have a fairly easy permissioning in terms of liquidity provider, liquidity consumer. They have the correct documentation in place. They have a credit line or the ability to transact with each other, which should bring anybody new on either side of that transaction on to our platform, that's holders already on trading and on the platform. But that is something that -- in terms of managing that credit, that's something that we see as still being the risk responsibility of those 2 parties and in being able to establish whether they can transact. However, ultimately, one of the newer areas, which is -- which has been emerging over the last couple of years but is still sort of in its early stages is the sponsored access clearing. And obviously, we currently support that under LCH non-incurring house limited operation for their U.K. built repo business. There's a couple of active participants who are using that when they transact. So that enables, obviously, a -- typically a nonmember of a buy side firm to be able to trade with a market counterparty, a dealer, about how somebody acts as agent for them so that, that trade can be placed into the clearing or the netting system. And that, longer term, they're going to extend and roll that out to their euro business under LCHSA sometime in the early part of 2021. We're also in discussions with URS clearing around being able to support their sponsored clearing models that they operate. So I think this is an interesting area. It starts to -- clearly for the clearing member, the dealer participant, there is some -- there are some better fits at the more trades as you get into that peering, that's CCP service. The likelihood is the greater your net down is. So your balance sheet becomes -- your balance sheet is being more efficiently used in terms of both settlement and balance sheet netting. And I think there are some benefits and some advantages in terms of the buy side. That increase in efficiency of the transaction may mean that there is, in some cases -- not all cases, but in some cases, there may be some slightly more aggressive pricing which is made where they can leverage that sponsor clearing program. So I think that's something that we are ready to support. We do see that as being sort of a medium to longer-term build-out. At the moment, most of the business is being transacted in a more traditional bilateral disclosed arrangement.

And do you guys think that, given the proliferation of some of these platforms, that we might actually see more liquidity in the market with perhaps new liquidity sources of clearing.

Well, I don't know if necessary proliferation of platforms will help that. I think the establishment and the emergence of good platforms that can provide connectivity on an agency basis, in particular, mean that right now in the typical bilateral repo arrangement, you have to line yourself up with a very creditworthy counterparty that's highly capitalized. But the aggressive pricing that I think you're alluding to could be helped if you had a couple of major intermediaries in the market that were reliable from the standpoint of quickly getting paperwork in place or having standing paperwork and quickly allowing you to seek broader liquidity on the other side of the trade on an agency basis and essentially allowing both sides of the trade to be from the broader market instead of that small group of highly creditworthy counterparties.

I'm not so sure there is a proliferation in terms of liquidity. I think the ease of -- ease of access, the ease of reaching either existing clients through a more standardized execution venue or indeed the opportunity to reach out to new potential trading participants is clearly key. So it does -- to some extent, it does help a little bit of the development and the diversification of who you want to transact with or talk to. And those introductions are a little bit easier than they are in a manual format. I think there is -- there's a lot which helps to build the business and to give you better clarity and visibility in terms of things around market data sources. Within the -- within our BrokerTec quote offering in that dealer supply and space that market data is the preserve of those 2 counterparties only. But we have a number of existing products as sort of market data derivatives from our central limit order book, and we have a repo index in terms of dealer-to-dealer activity in Europe. And there's a lot of developments, which are obviously happening on the back of -- so far in the U.S. markets as well. So we're in quite a unique position that we have a dealer today in the market. We have we have visibility. We have market data. We have certain indices or index of products from that. And we also -- we are investing quite heavily in terms of data analytics. So if you look at it across different execution modalities or execution venues, there's a lot of color that you can give to trading participants in terms of the levels they're trading in a bilateral disclosed market. Who are they trading most with? What's their hit rate? Where are they missing transactions? Are -- they're strong in Germany or they're strong in bills rather than longer-dated maturities, et cetera. So there's a lot that you can do in terms of providing a lot more information or analytics, which starts to become quite a powerful product in itself. And it's all part of the -- I suppose, the total cost and the optionality that you get in trading with a particular venue.

So I guess, perhaps if I'll try to -- try and summarize, it feels like we've moved a long way. And probably it's still a long way to go. And I think there's a real priority to get some kind of standardization in there to help with that STP challenge, a potential to look to improve liquidity across different venues through what could be in future stress points.

Yes. I think that's a pretty good summary of where we are. It is -- it does -- this journey is just starting, and I think there's a lot of out, but the opportunity is significant. And at the moment, we're looking at the major asset classes. When you think about European government bonds, U.K. deals, U.S. treasuries, but we need to offer a truly global solution. We think we're in a very, very strong position with that or with the CME footprint. And there is a plan that will extend this to a whole host of other collateral types and asset prices in terms of really being able to provide a complete solution. Yes.

Yes. Again, I would agree. And this is the start of a journey. We're hoping to integrate our financing and repo activities into the broader electronic infrastructure that already serves us well. And I think the emergence of clearing intermediaries, as we just discussed, are going to help the market source liquidity and to get more aggressive pricing.

Well, that's great. James, John, thank you so much for your time, and I look forward to watching the developments with great interest.

Yep. Thanks.

Thank you.

Then, James, John, thank you so much.