Analysis: For CME Group, uncertainty is a two-edged blade

By @ibtimes on

Uncertainty is proving a two-edged sword for CME Group Inc .

Worries over a U.S. debt crisis have lit a fire under CME's interest-rate futures markets, as investors turn to contracts at the Chicago Board of Trade and the Chicago Mercantile Exchange to protect their portfolios from market gyrations, a top CME official said on Wednesday.

The surge in interest-rate trading -- up 50 percent in June -- is expected to help offset trading declines in other contracts. Trading of rate futures accounts for about a quarter of CME's revenue.

CME investors are also expecting a boost in revenue from Dodd-Frank-mandated rules forcing much of the $600 trillion over-the-counter derivatives market through clearinghouses.

Uncertainty over when and how regulators will put the new rules into place, however, has restrained potential clients from enrolling in the exchange's swaps clearing service, CME Managing Director Laurent Paulhac said Wednesday.

The delay threatens to rob CME of a key avenue for future growth and, some argue, much-needed protection for its booming rate-futures franchise.

If they can really get a decent portion of the market for interest rate swaps, which at the moment it seems like they have an upper hand in the United States, it can be a decent uptick to both their revenues and their earnings, said Michael Wong, a Chicago-based analyst at Morningstar. It would also allow them to hold back competitors.

CME, the biggest operator of U.S. futures exchanges, has so far had little trouble fending off its two main rivals in rate futures, two-year-old ELX Futures LP and NYSE Euronext's U.S. futures exchange. Together, they handled just under 2 percent of CME's rate-contract volume in June.

More worrisome, analysts say, are inroads by NYSE through its co-owned clearinghouse, New York Portfolio Clearing, where rate-futures contracts opened at NYSE's exchange are guaranteed. In just four months, NYPC has built its share of open interest in U.S. short-term rate-futures to 6 percent. CME controls nearly all the rest.

What is kind of scary is if NYPC ever hits a hockey stick inflection point, Wong said. Then you will see 25 percent of CME revenues up for grabs.

Investors use rate futures and rate swaps for many of the same reasons: to bet on, or guard against, swings in interest rates. Last year's landmark Dodd-Frank reform legislation will drive most swaps through clearinghouses, where they will be guaranteed against default. CME runs one of the world's largest clearinghouses.

Building an interest-rate swaps clearing service could shore up CME's dominance in rate futures and offer margins savings to those keeping rates-related bets at a single clearinghouse, Wong said.

But so far, CME has found it slow going, largely because regulators have taken longer than expected to write the rules on mandated clearing. On Tuesday, Commodity Futures Trading Commission Chairman Gary Gensler suggested it could take until the end of the year longer to complete the rules-making process.

What we've seen is a bit of a slowdown with respect to customers getting ready, Paulhac told reporters on Wednesday.

The lack of customer interest in clearing rate swaps stands in sharp contrast to a surge in appetite for rate futures contracts.

Asset managers -- typically long-term investors who use CME's markets to hedge -- now hold 20 percent of interest-rate contracts at CME's clearinghouse, double their participation in the third quarter of 2010, CME Managing Director Derek Sammann told reporters on Wednesday.

The increase bodes well for future volumes at the CME, he said.

It is very different from the price action we saw through the credit crisis, Sammann said. If anything, customers are participating to a larger degree and growing open positions as a result of the uncertainty in the market.

Sammann cautioned that he could not predict what would happen to volumes should lawmakers fail to reach a deal to cut the U.S. deficit and raise the nation's debt ceiling by August 2, when the country runs out of money to pay its bills.

CME next week is expected to report net income fell to $4.17 per share, from $4.43 a year earlier, according to analysts polled by Thomson Reuters I/B/E/S.

(Editing by Steve Orlofsky)

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