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

Thanks, everybody, for joining us this afternoon, after lunch. I'm Patrick O'Shaughnessy, capital markets technology analyst here at Raymond James. And up next, we have CME Group. And on their behalf, we have a handful of folks here. We have CFO, John Pietrowicz; we have Lynne Fitzpatrick, Deputy CFO, on the end there; and then Tim McCourt, Global Head of Equity and FX products. So with that, let's get this underway. Maybe John, if you can kick us off. For people in the room who are a little bit less familiar with the company, can you provide a couple-of-minute overview on what CME is and does?

Sure. Yes. Well, thanks, everyone. And thanks, Patrick, for your hosting us. And it's great to see everybody. So what is CME Group? Well, CME Group is the world's largest, most diverse derivatives exchange. We're vertically integrated with our clearinghouse, which provides risk management expertise and provides our clients significant capital efficiencies, which, in this day and age of increasing capital cost, is extremely important. We have Globex, which is our trading platform, which can be found in 150 countries around the world and provides access to our markets which operate nearly 24 hours a day. And most importantly, we've got deep liquidity pools of globally relevant benchmark products, which allows clients to move large positions in and out of the market without moving the market. So about 57% of our revenue comes from financial products, and that includes, in interest rates, the entire U.S. yield curve. In equities, we've got exclusive rights to all the main U.S. indices. So think S&P, Dow Jones, Russell and NASDAQ. And in FX, we are the only exchange globally that has deep liquidity in all the major currency pairs. About 25% of our revenue comes from commodity products, and that includes in our energy business, the WTI, or West Texas Intermediate global crude benchmarks. The Henry Hub natural gas contract. We are the agricultural markets. And in metals, we have the leading precious metals exchange, and we've got a growing industrial metals business. The balance of our revenue comes from market data and other services and products that we offer to our clients. So CME has a highly defensible business model. We produce a tremendous amount of cash and we've got a great platform for growth.

Terrific. That's a very helpful overview.

So John, how would you describe CME's philosophy in terms of how you manage the business? And I would argue, from where I sit, there's aspects of, hey, you kind of treat it like a cash cow in terms of really high incremental margins, a very healthy dividend policy, tight reins on core operating expenses, great free cash flow conversion. But at the same time, I think you would probably push back and say, "Hey, we're still investing for growth." So what's the philosophy that you guys apply?

Well, first, you call our business a cow? So -- no, so seriously, when you look at CME Group, we're a network-based business. So we're very focused on bringing in new clients and offering our clients new products. So why is that important? How do we do it? So we have invested in a global sales force. And in fact, nowadays, more than -- well, about 60% of our sales force is now outside of the United States. And what they're doing is they're bringing on the clients that make up the entire ecosystem of our exchange 24 hours a day, right? So we want that liquidity going across our platform from morning, noon and night. And we do this because the more clients we can bring on to the platform, that creates more liquidity, that tightens the bid-ask spread. And the bid-ask spread is the most costly part of a trade, so by bringing in more clients, everybody on the platform benefits. So that's really bringing in the customers. And now let's talk a little bit about innovation because one of the things that we've done a tremendous job of is creating new products and services for our clients. And when you take a look at our exchange since 2017, so products launched since 2017, is generating 6.4 million contracts a day on the exchange. And that is -- that equates to $0.5 billion in revenue in 2022 from products just launched 5 years ago, and that's very unique among the exchanges and something that we're very proud of. And we do this by managing our costs, right? So we've got a core expense growth rate of, call it, about 3%. But what we do is we manage our day-to-day operating cost of the business down. That frees up capital, where we can invest it in new client acquisition and new product development. This also includes -- or I should say we also have recently invested in our Dow Jones -- S&P Dow Jones joint venture. And it's a very important joint venture for CME Group because it gives us exclusive access to the S&P and Dow indices as long as we own a portion of that business. Plus, we generate about $250 million in pretax earnings from our 27% ownership of that joint venture. Well, we've invested about $400 million recently in that business, and that gives us -- that allows the IHS Markit Credit Indices business to be included as part of the S&P Dow Jones JV, which will allow us to create new products, such as cross-asset class indices. Finally, in terms of managing the business and growing the top line, we've got an important partnership with Google. And the way I look at it is it's both growing the business part of the partnership and also managing costs. So both growing the business and managing our costs. So in terms of growing the business. We are able to leverage all of the technology that Google has invested in. So we think about artificial intelligence, machine learning and big query and applying those to our business, not least of which is also moving to the cloud, it should allow us to be much more flexible and allow us to launch products faster. So leveraging our -- the technology that Google has and the expertise they have, and then also the fact that we're moving to cloud is also beneficial from speed to market. On the expense side. Through this partnership, after we invest in moving to the cloud, we're going to be able to reduce our costs. And we expect to be cash flow neutral in 4 years and then positive after that. So it's got a very good financial character. So when you summarize what we -- how we manage the business. Like I said, we're a network-based business. So we're focused on new client acquisition and really developing that network and then leveraging that network through offering new products and services that we can offer our clients.

And then another growth lever that CME can pull is pricing. You guys are leaning into pricing a little bit more in 2023 than you historically have. Is that just kind of a function of elevated inflation right now? Or should we think about this as maybe a change in philosophy at CME Group?

I wouldn't say it's a change of philosophy. I definitely wouldn't say it's related to inflation. I mean, because I mentioned previously, our core expense growth is approximately 3%. So the way I would look at it is we don't approach pricing with an answer and then back into it. What we do is we do a bottoms-up build of our pricing. We look at every single product, every single market, and we do a few things as we think about pricing. First, we take a look at the total cost of trade on the platform. So that includes transaction fees, market data fees and collateral fees. And then we look at how those clients can get exposure off exchange and how much it costs for them to get that exposure. And what we want to do is we want to be very attractive because for all the reasons I just talked about. Increasing liquidity is extremely important for us because, as a network-based business, it drives a tremendous amount of value and it creates high barriers to entry. So we'll go through and look at that. We'll look at a number of other things. We take a look at the health of the clients, the health of the marketplace. And after doing that, we decided that it was appropriate for us to adjust our fees by 4% to 5%. And really, it reflects the value that we're creating for the clients, developing that liquidity. We had a record year last year in terms of volume on the exchange. We created a lot of capital efficiencies for the clients because that is real money to the clients. And then also, we launched a large number of new products, which have been tremendously helpful for our clients. So we factored all that into determining what the appropriate price was. And I wouldn't say this is a -- this is not a new philosophy. Since the 9 years I've been CFO, we have done this every year. And we do have, like I said, a bottoms-up build, and we're very tactful and surgical on how we adjust our prices with an eye towards not impacting volumes.

Lynne, perhaps a question for you here. So turning to your futures contracts. Your largest asset class by revenue is interest rate futures. To what extent do you think there's still a secular growth story there versus volumes being tied to interest rates?

Yes. So I'd say that we see growth expectations on both sides. So on the structural side of the equation, if you look at the last 10 years since 2012 through 2022, much of that time was a 0 interest rate policy environment. Despite that, over that 10-year period, we saw an 8% CAGR in growth in our volumes across our interest rate complex. A lot of that growth was driven by new product innovation. So if you think about the successful launches like our SOFR complex or Ultra 10-Year bonds or a number of new options products to allow our customers to really hedge their interest rate exposure across the whole U.S. yield curve. We've seen a lot of growth there from new product innovation. We also are focused on the international growth, so expanding our client base across all of our asset classes. But rates, in particular, given the exposure that many international participants have to U.S. rates, we see that as a good growth opportunity going forward. On the cyclical side, we certainly are seeing the benefits in the current rate environment. In 2022, we saw an environment where everyone knew rates were going up. It was really a question of how much. So would it be a 50 basis point move or 75 basis points? What we're seeing in 2023 is a different story, where there's a lot more disparity in views so where the Fed might go next. So will they continue raising rates? Will they fall? So will there ultimately be cuts? So that, from a risk management perspective, is a really healthy trading environment, on top of the fact that we are seeing rates at higher levels than we've seen over recent history, is providing a lot of room for hedging in our current environment. So every new piece of economic news is leading to strong trading volumes as people look to readjust their positions and their hedges in that environment. The last thing I would say from a cyclical perspective is we're coming into a phase of quantitative tightening. So with the Fed unwinding its balance sheets, we see that as a potential tailwind for the long end in our treasury complex.

Yes. So following up on that point. To think that QT is a tailwind for you, would you expect it to impact your treasury volumes much more so than the SOFR Eurodollar volumes?

Yes. So maybe just to dig into the quantitative tightening just a little bit. So if you think about the amount of treasuries that the Fed is currently holding on its balance sheet, those are bonds that are not being held by market participants that may look to hedge. The Fed does not hedge its exposure to U.S. rates. So as we see this tightening process move forward, with $95 billion coming off the balance sheet each month for a total of about $1 trillion in 2023, those are bonds that would go into the hands of participants that may look to hedge that exposure. The other element is having that Fed in the market as the buyer of last resort does remove some of the normal market dynamics. So having that removed from the market is positive, both from more bonds in circulation, in the hands of potential hedgers, but also removing some of that dampening effect that you get from some of that government intervention. So we do see those as positive tailwinds for our treasury complex. It's hard to say how that will play out versus what we're seeing on the short end of the curve because we also see those positive factors around the disparate views that I talked about, which are driving strength on the short end of the curve. So I'd say that we view positive factors across the whole U.S. yield curve, and it will play out over the course of the year, which one has a stronger outlook. But we are excited about the underlying trends that we're seeing at both ends of the curve.

Got it. And then on the competitive front for your rates franchise, BGC Partners is now speaking to launching its interest rate futures exchange at some point, I think, in mid-2023. They've actually been somewhat successful in launching on the run or spot U.S. Treasury's trading platform. And so they feel like they can extend that into the interest rate futures space. What do you see is the difference just between cash treasuries and treasury futures that might make it more of a challenge for them to compete against you in the futures space?

So we certainly always take competition very seriously. We've seen competition in the past crop up in our interest rate futures complex. I think we continue to believe that we have differentiators in that area, mainly around the depth of our liquidity and around the capital efficiencies that we can provide. So if we look at our interest rates complex, year-to-date, we're averaging 13 million contracts per day in interest rate futures and options. That leads to a very deep and liquid market which decreases the bid-ask spread, which is typically the most expensive part of the trade. So replicating that level of liquidity is very difficult starting from scratch. The other element that we provide is really the capital efficiency point. So if you looked across our entire interest rate complex, having the depth of liquidity across SOFR, Eurodollars, treasuries, it enables us to provide capital efficiencies and margin offsets to our customers. If you look at the fourth quarter, we had a record level of portfolio margining. We saved our clients over $8.4 billion in margins during that quarter. So those 2 elements, the liquidity, which leads to the tight pricing, and then those capital efficiencies, are very helpful to replicate and help provide some of that moat around our business.

Helpful. Maybe shifting to Tim. Your equity index futures franchise has been probably the standout growth story for CME over the last couple of years, just really strong volume growth, revenue more than doubling in 2022 versus 2017. You've had product innovations in areas such as micro contracts and weeklies, and volumes have also benefited from higher equity market volatility. Do you see these growth drivers as sustainable going forward?

Yes, I think it's a great question. So when we look at the growth of the equity complex at CME, certainly, the Micro E-mini contracts are a central character of that growth story. We introduced the Micro E-mini contracts in May of 2019. And still, to date, they're the most successful futures product launched in CME Group's 180-year history. It's an example of innovation and, to John's point, leveraging the IP portfolio that we have. But it's just one of the innovations that we've done over the year. Patrick, you also mentioned -- or sort of the weekly, and now it's become the option expirations at CME in the equity complex. We also had a bunch of other product innovations that are more maybe order types or what I often refer to as evolving that sort of transactional handshake that occurs in the market. And I think it's sustainable, right? Because what's interesting is when we look at the strategy that CME has deployed for product innovation, it's really listening to customers. Our customers in the marketplace are a tremendous source of inspiration, and we focus on solving customer pain points and the ever-evolving risk management needs of our clients. So as the risk that clients and market participants are looking to manage are continuing to evolve, so is our ability to innovate around those solutions and pull together the totality of our portfolio. Not even just within equity, where we have a tremendous amount of capital efficiencies between, say, the S&P 500 and the NASDAQ, but they could also offset against other contracts at CME. The margin offsets are not just contained to one asset class, it's across everything that sits in the base futures and options fund within the clearinghouse. So the totality of that is, when we do innovate a new product, and not only it's facilitated by the Globex distribution platform or electronic trading platform, the vertical model that John spoke of, the clearinghouse. What really also makes it work is that contract for the financials, and we're talking rates, FX and equities, when we put that new contract on the machine, it works the same way for the most part as all the other contracts that we have. So if you're already connected to CME, it's really easy to trade and use our new products when we're rolled out. And that's been immensely helpful for options. Options, where we've had -- we've introduced Fridays, Thursdays, Wednesday, Tuesdays, and Mondays. And it's because the market is -- wants more precision in their risk management. There's been a multiyear trend towards shorter-dated options, and that certainly accelerated over the last 18 months, and I think it's amplified by a raising rate environment. Clients want to be more precise about either the economic events they're managing around or they don't want to overpay as a function of the embedded carry cost of options as a function of higher interest rates. So that precision is of utmost importance to the client. And I think if we stick to that story of success of engaging with clients, solving risk management problems, using our IP portfolio to further that innovative frontier of what we offer at CME, certainly sustainable for the future.

And then building off of that and maybe kind of similar to what we talked about for interest rates. How do you think about cyclical growth for your equity index franchise versus secular growth?

Yes. It's certainly interesting where market volatility certainly helps, right, and helps sort of increase volumes, but it's not what we rely on. So even if we look over -- I've been at the exchange a little under 10 years. And even if we look over the time period mentioned, 2017 to '22, the volatility we saw in 2020 was not that different than some of the volatility we saw in 2018, but the volumes were significantly higher even across the traditional E-mini futures as well as the micros, as well as the options. And that's because the velocity of trading at equities at CME is continuing to increase. People are trading more of these products against each other. They're more trading further out the curve as well in terms of some of the option trading that we have. They're managing more risk. So all of these things that come together really amplify when the market cooperates. But then let's look at something like the over-the-counter market. There's an enormously robust over-the-counter market for equities, whether it's on OTC index options or where it's things like OTC swaps on sectors or total return indices in the equity complex. So one of the things that we've done a really nice job of is porting that OTC flow to the listed and centrally cleared model at CME. And that is something that is not going away. When we look at -- we introduced total return futures, dividend futures, sector futures. We've recently introduced something called derived blocks, and these are all around porting those businesses from the upstairs or OTC market to CME. We've had strong success in equity, but this also applies to things like rates and FX and things such as uncleared margin rules, or UMR, or some of the SACR implications that we're starting to see in FX. All of these things are making capital more expensive. They're making it -- the cost of goods sold, so to speak, of customers allocating or deploying your investment model and their allocations is increasing. And then again, amplified by a raising rate environment, the more efficiencies we can introduce on the capital front tier by moving things to essentially cleared model at CME out of the OTC market, that is something that will provide a tailwind for years to come that is agnostic to the market volatility itself.

Let's turn to energy futures now. Revenue in that asset class has been down 3 of the past 4 years. It seems like the ingredients for success are in place. We have energy volatility. We have growing production. We have increasing global relevance of WTI. Why do you think those elements haven't translated into healthy revenue growth in 3 of the last 4 years? And what gives you optimism that the trajectory will improve?

Yes. So if you look at the last several years, it's been a tougher market for energy. Some of the factors that you can think about is -- you had the demand shocks of the pandemic when everyone is working from home, not traveling. So you had a lot of demand shocks. And then we go into the war in the Ukraine, where we end up having a supply shock. So that market has had quite a few issues that have come up from external factors. What we found is some of the impacts like a war, that's very difficult for people to model if they're looking to take risk management exposure. So if you are a market participant and you have direct exposure to that asset, you're going to continue to participate. If you were a financial player and you are participating for that financial benefit or taking a position on where you think that market is going and there are binary outcomes because of something like a war, you're likely to take a step back from that market. And that's something that we saw in 2022, where a lot of the financial players maybe took a pause on some of that trading which was less directly required for their business. Now if we look at the longer term for energy, we are seeing some of those positive trends. So as the U.S. is an exporter and is viewed as a more safe supply of energy in the longer term, we're seeing more of not just Henry Hub; but also our WTI, West Texas Intermediate crude oil being exported to both Europe and Asia to replace some of that Russian supply. So in the longer term, we are viewing our contracts as more important on a global scale and a global benchmark. So we do see some positive trends there. And we're starting to see some build back in the open interest as -- unfortunately, as the war continues on, people are getting a little more used to that environment and now looking to go back to some normal risk management tools and exposures.

And then of CME's other asset classes, ForEx, agricultural commodities and metals, what would you guys call out is some of the more interesting growth opportunities looking forward?

Yes. I think when we look at sort of the rest of the portfolio, I think similar to what Lynne was saying about energy, we've certainly seen sort of what is referred to as bad volatility, right, in some of the agricultural markets as a result of some of the events from the Russia-Ukraine war. But when we also look across, just even the start of 2023 here, the metals complex is off to a very strong start at CME. And I think that speaks to the product portfolio diversification of CME. When we think about, we have the 6 major asset classes that are -- we often say the 6 major investable asset classes, and then we point, and crypto, which we can debate if that ever becomes the seventh. But it's because these ebb and flow in terms of their use to clients and their volume growth. So while we're seeing some things struggling as a result of the geopolitical events, we're seeing really strong spots in things like metals and the base metals and foreign exchange, right? I'm personally very excited about foreign exchange because they're coming off of a sustained protracted period of single-digit, extremely low volatility. And then if we look in 2022 with -- to Lynne's comment, the sort of disparate policies that we're seeing across the various central banks across the globe, you're seeing the interest rate differentials in the currency pairs really widen to periods we haven't seen for a really long time. And it's almost agnostic in an interesting way to whether or not the dollar is appreciating or depreciating. When we saw different dollar-driven moves in Q2 and Q3 of last year versus Q4, but in Q4, despite the dollar depreciating, we saw the interest rate differentials grow among some of the major currency pairs, which not only presents a tremendous amount of trading opportunity, it also increases that fundamental need to manage risk in people's portfolio, especially when you think about those companies and those market participants that have multinational business operating models. They have real currency risk across the globe and they're just needing to increase their risk management around that. I think when you then look at some of the things I talked about, whether it's uncleared margin for FX or SACR, these are all sort of tailwinds that are really starting to make the banks pay attention to the FX futures and options space. They're benefiting from the listed and centrally cleared model at CME. But what I'm also excited about, as John alluded to, we recently completed our integration of the next businesses onto the Globex platform, which again, is our electronic trading platform. And part of that is EBS, which is a spot cash-based FX platform. And I'm really excited as we go from this period over the last 4 years of integrating those businesses onto our platform, to now being able to focus on innovating within those businesses. And what do we do by bringing together FX spot markets, the nondeliverable forward market alongside a very robust centrally limited order book-driven futures and options on future business at CME, I'm really excited when you're sort of thinking about what does the coupling of the totality of CME FX, inclusive of the cash business, mean in this type of volatility environment that we've seen manifest over the last 18 months. I think it's a really exciting opportunity for foreign exchange.

So earlier, we talked about pricing in the context of transaction pricing. How do you think about pricing for your market data solutions and as part of the overall growth algorithm for market data?

Okay. So let's talk about market data. So what's pretty excited about market data is that -- and we saw it through pandemic. The importance of our information to the world in terms of what is going on in these markets has never really been higher. And you're seeing that reflected in a number of areas. Number one, we see strength in terms of the number of people utilizing our data. We see strength in new products that we're launching with our data. So think of things like derived data, which is basically using our data as an input into another product that somebody else sells. So that is becoming increasingly something that is very valuable for our clients and also a great opportunity to further leverage the information that we generate off our exchange. So we've done a couple of things in the market data business. One is the Google partnership as I indicated at the start here. We think that's going to be very powerful in terms of applying their technology and their expertise to our products. So if you think about artificial intelligence, machine learning, big query and also Google's capabilities to manage large amounts of data and the analytics that they can provide, will make it much easier for clients to be able to get insights into what's happening in the marketplace through utilization of our information. We did make an adjustment to our pricing in market data. It's up -- we anticipate it being about 4% impact. That begins January 1. When we talked about the price changes in our transaction business, it's 4% to 5%, but that is increasing in February. So we get a partial quarter impact this quarter and a full quarter impact by next quarter. So again, we made that an adjustment and we're creating a lot of value for our clients, and our data has never been more important.

Terrific. Well, I think on that note, we're up against the clock, so we can wrap it up there. But thank you, everybody, for attending. And thank you, CME.

Thank you.

Thank you.

Thanks, everyone.