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

Great. Well, welcome, everybody. For our next presentation, I would like to welcome CME Group. With us today are John Pietrowicz, CME's CFO; and Sean Tully, Head of Financial Product as well as OTC Products at CME. So John, Sean, thanks for virtually being with us here today.

Well, thank you. It's great to be here.

Thank you, Alex. Thanks for the time.

Of course. So I was hoping we could start with a couple of questions around the interest rate business. Obviously, not surprisingly, this probably remains one of the larger overhangs on the stock. So I figure it's a good one at this point. But before we get into some of the forward dynamics, I was hoping to focus on some of the key observations from your customers behavior. And I know we typically like talking about CME's volumes in terms of Eurodollars versus treasuries or different durations, et cetera. But I'm curious how the -- sort of the composition of the client base has changed, pre pandemic versus today? And which customer segments are seeing the more pronounced sort of declines? And where volumes have actually been maybe a little bit more resilient?

Yes. It's a really good question, Alex. Thank you for that. This is Sean. When we look at the client base, if you look at it, it's actually been incredibly stable in terms of the amount of volume done by each of the different major client segments. If you look at our interest rate complex, clearly dominated by a combination of proprietary trading firms, banks, asset managers and hedge funds, so the buy side, the sell side and the proprietary trading firms. And if you look at the changes, I'll give you an example, we have seen year-over-year, so between 2019 and 2020 year-to-date, a slight increase in the buy side. So we've actually seen them take up 2% more market share this year than they did last year. So a slight increase overall from the buy side. But if you look at metrics that you might consider as kind of pre COVID, post COVID, if I look at the third quarter of 2019 and I compare that to the third quarter of 2020, which is already completed, those market share changes are surprisingly almost unchanged. If you look at proprietary trading firms, their overall share of the total market has increased by just 1%. If you look at the buy side, it's increased by about 0.5%. And if you look then at the banks, they're down by just over 1%. So it's actually remarkably stable. So we haven't -- we really haven't seen a big change in mix.

Got it. That's interesting. Let's focus maybe a little bit on some of the more recurring trends. And obviously, rate volumes have been under pressure. And in Q4 on a year-over-year basis, still trending down a little bit over 20%. But as you look kind of really on the surface, there's been some improvement, particularly at the longer end of the curve. So you're going to have the 10-year plus, which is clearly encouraging. So I was wondering if you could talk a little bit about what's happening at the long end of the curve? What needs to happen with that activity to trickle down to kind of the 5s and the 3s and maybe this trend? And I guess at the end of the day, it is the notion that, look, as long as the Fed remains active in QE, can the rates conflicts really work? How would you guys respond to that?

Yes. I think these are all really good questions. A few things I would note. Long end of the curve has clearly outperformed the short end of the curve substantially. If you look, in fact, during the month of November, we've seen the second and third largest or highest volume days ever for our Bond Futures and our Ultra 10 Futures on November 24. So those are doing very well. If you look at year-over-year growth or if you look at the month of November versus last year, either way very substantial growth. So if you look at our Ultra 10 Year Future, our Bond Future and our Ultra Bond Future, those volumes in the month of November running basically between 25% and 35% up year-over-year. So that long end of the curve has been very, very strong. Another question I get asked a lot also is about relative value trading in this environment. And in terms of relative value trading with our Treasury Futures, I'd look a lot at, what we call, EFPs or exchange for physical. So this is cash bonds traded as a basis to the Treasury Futures. And I also -- we also look a lot at Invoice Spreads, what we call, EFRs, exchange for risk. And in each of those cases, they are down somewhat. In each case, they're running down mid-teens year-over-year. But substantially less than the overall rates complex. So if you look -- whether it is the customer mix, as you asked in the previous question, or relative value trading, we don't see a drop in relative value trading relative to the outrights, we see a similar drop. In terms of the long end of the curve, other things that I think are exciting. So we actually saw in the third quarter, an all-time record open interest in our Ultra 10 Year Futures of 1.1 million contracts. And overall, very good strength. So I'd say very good activity online at the end of the curve. And this is clearly being driven by -- whether it's the short end or the long end, it's being driven by the Federal Reserve, right, and the U.S. Treasury. Obviously, the Federal Reserve's zero monetary policy, but in addition that their purchase of securities has dampened volatility. Nonetheless, the record issuance by the U.S. Treasury, especially in coupon securities, especially further out the curve, is creating a greater need further out the curve for more risk management right now. And as the Federal Reserve, I think, reduces their purchases of treasury securities, which will certainly happen over time as it did during the global financial crisis, there should be much greater need for products, especially those further out the curve as the pandemic recedes.

Got you. So I guess, as we're thinking about some of the key leading indicators from the outside looking into your rates complex, would you say at the end of the day, it's the Fed's purchase activity is the one you would watch to kind of get your sense of some of the anticipated increase in the volumes in the complex? Or is there something else that you would watch sort of from the outside looking at?

Yes. So I'd look at a few different things. One of the things I've been looking at very closely and talking to investors about is macroeconomic variables. So if you look at this crisis, I would say that this crisis relative to the global financial crisis, is extremely time-compressed. We're seeing a much more violent changes in the macro economy over a much shorter period of time, and we're clearly experiencing a V-shaped recovery. So for example, if you look at the Fed balance sheet, it took 5 years during the global financial crisis for the Fed to increase the size of its balance sheet by $3 trillion in terms of boosting the economy with quantitative easing. Now the Federal Reserve did that in 5 months during the global financial crisis. Another indicator I'd like to look at is the unemployment rate. Look at the unemployment rate during the global financial crisis, it was down 4.5% if you look at 2007, and it rose to 10% in October of 2009, and it didn't get down to 6.9% until November of 2013. So it took more than 4 years to get back down to a 6.9% from a 10% rate. If you look this crisis alternatively, back in February, we were at 3.5% unemployment rate. By April, we were at 14.7%. In October, we were already down 6.9%. So without question, this is a V-shaped recovery. It's the fastest recovery we've ever had. Last thing, from a macro perspective that I'd like to look at is the equity market. So if you look at the equity market, the S&P peaked during the global financial crisis in 2007 and it didn't reach that peak again until November of 2013. So on the other hand, as we all know, right, we saw a massive downdraft in the equity market, and we're already experiencing new peaks in the S&P. So those are good macroeconomic variables. But let me take those macroeconomic variables, then let me actually look at some variables and direct indicators of our markets that might be more directly applicable. But I think that those -- that macro environment is driving volatility. And so I think it's an important way of thinking about where we are. Again, if you look at those indicators, it looks like 2013 time frame to me. But if you look then separately at things like large open interest holders, we got last night, the CFTC's latest report on large open interest holders. And we're seeing some very interesting things there. I mean, obviously, I mean, you never seen big success in our equity franchise this year. But last night, we saw an all-time record number of large open interest holders in our equity complex. So doing extremely well and 9% above 2018 levels, putting things in perspective. So great growth there. If you look at rates, for example, it hasn't made new highs. But as of last night, we have recovered 45%, okay, of the loss that we had in large open interest holders from the beginning of this crisis. Putting that in perspective relative to the global financial crisis, it took 33 months during the global financial crisis for the rates complex to recover 50% of its large open interest of the loss -- excuse me, in large open interest holders. So we've achieved in 5 months, almost as much in the last 5 months as we did in 33 months during the global financial crisis. The last one is foreign exchange. If we look at foreign exchange, it took 18 months to recover 50% of that lost large open interest holder number during the global financial crisis, and it's taken just 5 months. So we've already retraced 50% of the loss there. And if you look at the levels, FX is 3% above the 2018 level. If you look at our rates complex, it's at the -- basically 2% above the 2017 level, and it's about 10% below the 2018 level. So you've seen a massive recovery first from the macroeconomic perspective and then we're starting to see it with our own indicators.

Great. Yes, that's helpful. So I guess maybe shifting gears a little bit, standing on the rates complex, but moving on from the [ background ] to some extent. I was hoping you guys could spend a couple of minutes on some of the organic growth initiatives that you're still driving in the rates complex, despite, obviously, it's being still sort of a challenging environment? So the one that stood out to me on the last quarter call when you talked about opportunities between combining the cash treasury business and futures onto a single platform, obviously, on the back of the next integration. So maybe help us contextualize a little bit what that means in terms of the volume that you mentioned of having both of these kind of cash and leveraged asset classes on a single platform? And anything else on the organic side, you guys are working within rates?

Sure. One of the things I'd say is, if you look at the listed side, we've been constantly focused on delivering greater efficiencies to customers, right? So execution, margin, capital, operational, total cost efficiencies, in this case as well, technology efficiencies. So that's what we're going to be doing with cash markets. And when you have the cash markets and the derivatives markets both, and you've got -- you own that data. You own that data, right? You can bring these together in ways that no one ever has before in order to create, in particular execution efficiencies. In addition to that, on the listed side, this drive for efficiencies, our innovation around those efficiencies is something that is basically in our DNA now for several years in the listed rates business. And I'd say the cash market side hasn't been that way so much. But you saw when we first took over the cash markets business, we did a couple of things, right? We reduced the minimum price increments in 2-Year Notes. In the cash market, we also reduced them in the Treasury Futures. That had a significant uplift, about a 3% uplift to the overall complex in each case. So just changing the minimum price increments, making a lower total cost to execute transactions. If you look at what we've just done, we recently just launched new 3-Year Note Futures on the rate side. And in that case, we did it at half the minimum price increment, and we are seeing good growth there, about 90 different firms trading it, about 5,000 contracts a day, 8,000 contracts open interest. So incredible actually during such a low volatility environment that we're seeing very good traction where we'll be able to create this new ecosystem on this new contract. Similarly, we're in the process of moving BrokerTec over to the Globex platform. And one of the things we'll do shortly after we migrate BrokerTec over to Globex is, we're going to reduce the minimum price increments in our 3-Year Notes on that cash platform, again reducing those costs, so as another example. And so you can see also how we're taking a lot of the same actions across both platforms in order to take advantage of what we understand about the marketplace and how to drive efficiencies. Another thing that I'm really excited about there is when we move over to Globex, now Globex has a lot of technology and functionality that wasn't available on the BrokerTec platform. In particular, one thing we're going to introduce is RV or relative value trade order type. We believe that on the order of 10% to 15% of the cash treasury bond market is curve trade. So trading is the curve between 2s and 5s or 5s and 10s, 10s and bonds. If you look at it historically, BrokerTec didn't have a functionality to trade those spreads. If you wanted to trade a 2-year versus 5-year or 5s versus 10s or 10s versus bonds, you had to trade each of those instruments individually, you had to leg into the trades. And so that's incredibly inefficient. What does that mean? That means you have risk, legging risk, you're getting into the trade, number one. Number two, when you -- a curve trade is much less volatile than an outright trade. And so with the much lower volatility of a curve trade, we can also offer -- when we offer curve trading as an order type, we can offer it at a much smaller minimum price increment. So we can significantly reduce the cost across that bid offer spread. Then last, the Globex technology has something called implied that we're very excited about. It's been hugely successful in our Eurodollar Futures. And in fact, a very large portion of all Eurodollar Futures trading is spread trading, a very high percentage on the order of 40%. So a huge portion of that marketplace. That also shows you a part why I'm so excited about having that technology now available in treasuries. In Eurodollar Futures, we also have this last thing we're going to apply it in this relative value trading to BrokerTec implied, some may call it implied. What does that mean? That means if you have an order book in your outright to your notes, and if you then have kind of a bridge which is your order book of that spread between 2-Year Notes and 5-Year Notes, that should create theoretically an outright order book in 5-Year Notes. And that's exactly what it means for implied. So we take that theoretical construct that should enhance and build more liquidity than in 5-Year Notes and they get cheaper to trade the outrights in 5-Year Notes, and we actually use it. So that's just a couple of examples of things that we're doing. I can also talk about SOFR Futures. SOFR Futures have gone very, very well. Earlier this month, we had a record day of 240,000 contracts in SOFR Futures. So really -- think about this rate environment, right? We've got a product that's, what, 18 months old, and we had a day with 240,000 contracts. In addition to that, we did 87,000 contracts a day in the month of November. And as of yesterday, new all-time record open interest in our SOFR Futures to 680,000 contracts, about 1.5 trillion notional equivalent. So just some examples of some innovation that we're working on.

Great. That's very helpful. Let's talk a little bit more about BrokerTec, and you mentioned the cutover and integration with Globex. So maybe we'll get an update there. You recently pushed back the time line of BrokerTec platform integration by about, I think, 2 months to move that [Technical Difficulty]. So maybe walk us through Jack on kind of what's behind the small delay here? And any implications where you think about with respect to EBS cutover later in 2021 or sort of timing of any of the expense interviews that you guys anticipate to get on the back of that?

Yes. So I'll talk and then I'll also let John jump in as he feels fit. But in terms of the delay, clearly, the COVID crisis has been a huge challenge for our customers. And we're customer-centric, we stand in the shoes of our customers every day. And so while we had thought that we were going to have all of our customers fully onboarded and ready, fully tested, we had several mock trading sessions -- we've already had several mock trading sessions. We had several mock trading sessions before we had planned to cut over later this year. What happened was it just -- we didn't have the full suite. We didn't have every single customer. It didn't appear like each and everyone was going to be ready. And not enough of them in mock testing and not with a positive enough experience in the mock testing. One of the challenges that everyone has faced, I'm sure you've experienced it, right, but the work-from-home as we're doing here, that's why we're not in person, we -- I've done this, I think, 3 or 4, 5 years in a row now with you. Obviously, this is the only time we've ever done on a Zoom call, but that requires technology enhancements as we all know. And every institution, a lot of our customers had real challenges for a period of time, some lasting longer than we had thought they would where their technology freezes on new platforms and adjusting to new platforms because they had their technology resources focused on that work-from-home environment and making sure that they got that right and safe, especially in today's cybersecurity world where that's hugely important. So a little bit more challenging than we had thought, a little bit more challenging for our customers than we had thought, but we do expect it to get it done in the first quarter. And we've stated publicly, and John will reinforce, this will have absolutely no impact. We don't see any impact on our synergy capture. And John, I don't know if you want to talk about that?

Sure. Yes, thanks. Thanks, Sean. Sean is exactly right. I mean, this really is a customer-driven situation. And really, when you look at facing the freezes, the holidays, also unique to this year was the election. All of that came into play as we were looking at the [Technical Difficulty] and it really became a fairly easy decision to make -- to push it when you put that all into consideration. And we didn't -- it didn't impact our synergy capture that we committed to. So we're well positioned, we worked with our clients to make sure that the time line is something that they can achieve and we're really expecting to have a really positive experience for our customers as they move on to Globex. And as you know, Globex is a premier -- the premier matching engine out there. So I think it is safe to say that clients are pretty excited to get on there. It's just really came down to a timing situation.

Great. Let's shift gears a little, I was hoping to spend a couple of minutes on your gas/oil complex as well. Now obviously, there's a lot of macro issues in this space today as well and given the speed of the recovery, that may change fairly quickly. But I guess if you look at our open interest in WTI, it's at a lowest point we've seen in several years. And some of that is likely a function of oil production, some of it is likely a function of lower oil volatility more recently. I guess, as you look out into '21, talk a little bit about how the complex is positioned? And if we were to see a more range bound sort of oil production levels in the U.S. but rising prices, which one of these factors matters more from a customer activity perspective?

Well, great, great question, and thanks. We're very excited about the WTI and the importance that the WTI has in the global markets. And really, what you're seeing right now is a supply and demand issue globally. So the U.S. and OPEC production cuts have put somewhat of a floor in terms -- on the supply side. And you see that the global demand is still under pressure, really which has led to a tight trading range and lower volatility. And you can see it on the demand side, whether things we track are things like miles driven, jet fuel used, and you still haven't seen that recover. And what does that do? Well, really, that creates a range by market with a flat forward curve. And it's been a -- it's a global phenomenon. So when you look at the WTI and the Brent, the market share has remained relatively stable over the last [ 60 ] years in the 52% to 55% range. And our open interest has stayed in the range of about 44% to 47%, which is in the same range and stable since lifting the crude oil ban around 6 years ago. So we haven't seen a material shift in terms of the usage of WTI versus Brent. So when you look at prices rising, what does that mean to our volumes? Well, you've seen the prices rise over the last few weeks as there is election uncertainty and also there's been positive, as everybody knows, positive vaccine news. And so what that will do is that could likely be a catalyst for a breakout to the upside in terms of pricing. That means that Wells will become more profitable, more production happens. There's going to be an anticipation in terms of the recovery. And all of that would lead to a steepening of the curve, more volatility. And CME is really well positioned in that scenario because we've got very good penetration of the financial players. So that rising prices tends to bring more market participants in, it's also a good condition for financial players. So really positions us well. Another thing we track in term of the WTI's amount of oil that is exported. And if you look at exporting over the last few weeks, it's been in the actually probably last -- yes, probably last few weeks to few months. It's been in the 2.25 million to 2.5 million barrels per day in terms of exports. That's pretty close to the 3 million barrels a day that we saw pre pandemic. And really, again, showing the importance of WTI as a global benchmark. One thing also to note in terms of energy complex is our nat gas business. It's been performing very well. We've seen Henry Hub futures up about 26%. We've seen Henry Hub options up about 56%. And that are -- those are high RPC products compared to the WTI, $1.15 for the futures, $1.52 for the options. So that's been performing very well. And we've also seen really a lot of usage of Henry Hub globally. Our volumes up about 82% from global participants in the Henry Hub which is really, again, shows the importance of the Henry Hub as a global benchmark. And also, as you know, nat gas is a good clean energy option. So I think we're really well positioned for the recovery. And certainly, rising prices is something that is helpful towards activity in our complex.

Great. Great. All that makes sense. Maybe shift gears a little bit and talk about some of the financial aspects of the business. And the first question I wanted to ask you guys is around pricing. But clearly, volumes, [Technical Difficulty] in the first part of next year, and that's going to weigh on CME's overall revenue growth. And I imagine as part of that, the customers want to hit some of the discounts here that they might have had over the last, call it, 12 to even 18 months or so. Maybe kind of help us think through the RPC implications for next year maybe holding mix by product aside. But if you think about within individual product buckets, how are you guys thinking about RPCs? Is there anything you potentially could do on the pricing side? I know historically, you talked about roughly 2-ish percentage point kind of adjustments in the pricing that kind of helped the firm's revenue growth over tax. So how should we think about that into next year?

Sure, Alex. Thanks. Pricing is something that Sean, myself, Derek, others of the business line managers, all really review pricing on a regular basis. It's something that we discuss often. And as you pointed out, we have differentiated pricing. We generally -- you don't see a decline in the face rate to the customer. So when you see shifts in RPC, it's really around mix, whether it's asset class mixes or commodities tend to have a higher RPC than financials, it could be mixes within an asset class. For example, in rates, the short end has a lower RPC than the long end. When you look at -- if you look at our equity complex, the micros have a lower RPC than the normal-sized contracts. All of that plays into the RPC. You also, as you pointed out, have volumes tiers. Yes, volume tiers across almost all products, except for agricultural products. Ags are probably the only ones we really don't have a lot of pricing tiers. So all things being equal as volumes will decline, you should see the rate per contract then increase. When you talk about price actions, generally speaking, it will adjust pricing during our budgeting process. We're going through that budgeting process now. It's something that we review. We don't really have anything to talk about in terms of any price changes. I will say, as Sean kind of kicked off, this has been a unique year in terms of the environment, also we're going through the major migrations, as Sean pointed out. So there is definitely a lift from a customer perspective relative to the migration. So all of that, we take that into consideration as we make pricing changes, so that's definitely something we'll update everybody on with our first quarter earnings call once we get the budget completed.

Great. We have a couple of minutes left, and I want to hit on a couple of other topics here. So one would be market data, and we've seen really good momentum in market data revenue growth for you guys. And Julie talked about how almost entire -- almost all of this growth is really driven by new subscribers, which is great to see. Talk to us a little bit about the sustainability of that growth. Is that a solely kind of work-from-home dynamics? So it's a one-stop -- onetime kind of step-up function higher as we saw maybe in the last quarter or 2, or there is more tail to the sort of growth momentum that you're seeing in that part of the business?

Yes. Thanks for the question. Yes. We're very, very pleased with the way market data has performed this year. It's up 7.4% quarter-over-quarter. So really good growth. And the thing that I'm very happy to see is that it's across all aspects of our data business. So that's been very positive. Certainly, the work-at-home dynamic, the multiple working environments has been helpful. I wouldn't be surprised to see us continue that as we come out of the pandemic and as the recovery happens, these change in work habits, I can see that certainly continuing to some extent. So that -- it has been helpful, but I do think that there is some sustainability there. And as I said, it's across all parts of the business, not just subscribers, but we've seen an uptick in terms of our usage of derived data as well. I think it really reflects a couple of things. One, the importance of our data and the faith and confidence people have in our data to use it as an input into the products that they produce on the derived data side. So very, very pleased with that. Also, what we've done, which has been helpful and a positive for our data business is we've combined our sales forces. So our market data sales team and the rest of our business, we've combined those sales forces and that's really also been helpful in driving continued sales. So certainly the work-from-home environment has been helpful, but that's not the only reason why our data is up and something that change in leadership in terms of our market data business, combining those sales forces, it's all been positive for us, really good to see.

Great. Well, that's helpful. Let's shift gears a little bit and talk about expenses. To your expense guidance for Q4 I think implied something near [Technical Difficulty] million kind of core expense base and annualized that gets through a little bit under $1.7 billion. Now clearly, you're still realizing synergies from NEX, which I think there's $90 million of that left. And presumably, majority of that will be realized next year. But maybe given the more sort of challenging year-over-year backdrop for revenue growth next year for you guys, just given the high comps in the first part of the year, can you talk a little bit about the flexibility you guys may have in sort of the core expense base for us to think about into '21?

I'm really pleased with the entire organization and how they've really managed our expenses, not just this year, but for the last several years. I mean, I think we've really done a great job in terms of making sure that we're spending it as efficiently as possible. What's really great is it's not just the CFO calling you, it's -- the entire management team has been very proactive in terms of managing our expense base. You're right, we've really done a good job this year, in particular, we're down $70 million from -- in terms of our guidance compared to where we started the year, the guidance at the beginning of the year. So pretty material decline in terms of our expected expense spend. We are expecting a significant amount of synergies going into next year. We're going to be at -- and we're on track as we talked about a few minutes ago, we're on track to hit our $110 million of run rate synergies at the end of this year. We're expecting to be at $200 million at the end of next year. So we're on track in terms of synergy capture. We've also been proactive in terms of managing our expense growth going into 2021. We've frozen wages, and we've deferred promotions, and that's reduced our expense growth in the neighborhood of $20 million to $25 million already. So that's -- so we're being very proactive in terms of using the levers that we have in managing our expenses. I will say that, going to 2021, we are very focused on our expenses and managing that expense base. So I would say that we've done a great job in terms of managing our expenses. We're doubling down on that and really laser-focused going into 2021.

Great. Well, and then hopefully, that will coincide with better revenue environment as well and the incremental margin on that as we now have. So I guess the last question I have is around the variable dividend. Obviously, it's the holiday season, so is the season foreseeing these variable dividend? Can you help me frame the key considerations for this year and maybe timing?

Yes. Great. Thank you. Yes, we have a very unique capital return policy. It's been very positive in terms of acceptance and reaction from the investor base. So I think it's really served our investors well. In addition to our $0.85 regular dividend, we've got the annual variable dividend. The annual variable dividend, generally speaking, is announced early part of December, paid in January. That's what it's been historically. Obviously, it's a Board decision. But the general way we manage the variable dividend is we have our $700 million in cash that we keep on our balance sheet. Anything above that, we tend to sweep that to our investors at the end of the year. It is -- we like it. It's been something we've been consistently applying since about 2012. And it's very transparent. We're a very transparent business. Our annual variable dividend is a very transparent mechanic in terms of our capital return policy. So we are -- we very much are focused, like we said, on managing our expenses on innovating and growing our top line and that really feeds in well to the annual variable dividend.

Great. Well, I think with that, I think we're out of time. So I want to thank you guys both. John, Sean, thank you both for joining for dialing in and doing this remotely. And again, hopefully, this time next year, we'll get to do this in person.

Well, thank you very much, Alex, and thanks, everybody, for your interest in CME Group. And I hope everybody has a happy holiday. So thank you.

Great. Thanks, happy holidays.

Thanks, Alex. Thank you, everyone.

Thank you.