CME Group：庄家永远赢——[Business Breakdowns，EP.224]

Today, we're breaking down the Chicago Mercantile Exchange. My guest is Adam Chandler, co-PM at Claremont Global, and we get into the nitty-gritty of exchanges.

I find financial exchanges and clearinghouses fascinating. They're like the stagehands of capitalism: you don't really see them in the spotlight, but without them, the show would stop. Even though we know how critical they are to the system, I don't think we stop to understand how they operate, how they make the impressive money that they do, and how they quietly shape the flow of money.

As you can tell, I'm pretty interested and intrigued by the topic of exchanges and clearinghouses, and you will hear me pepper Adam with questions about all things around this business and its history.

All right, Adam, excited to have you here to talk about the Chicago Mercantile Exchange. I thought the best place to start might be stepping back and giving us a reminder or a lesson on the exchange business. Anybody who's a market participant understands it because they've lived with it their entire career, but maybe they don't stop to think about why exchanges exist and what role they play. Can you give us a brief overview of the exchange business and anything that you would highlight in terms of the details that revolve around it?

Hi, Matt. Thanks for having me on. I'll start at a high level, and then we can dig down. Essentially, exchanges serve 2 key functions: They bring together buyers and sellers, and then they ensure the transaction is completed and everyone gets what was agreed.

To draw a parallel, just imagine trying to sell your house without a real estate broker or an online platform. You're standing in your driveway and yelling, “House for sale,” hoping someone who walks by wants exactly what you're offering, will be willing to pay an acceptable price, and will be good for the money. It's a low probability, and that's what trading securities would be like without an exchange.

They effectively act as a trusted platform where buyers and sellers can instantly connect, but they do more than just match people. They create a deep pool of liquidity. We’ll probably talk about liquidity a little bit today. What we're really talking about is how easily and quickly you can trade without causing big price swings.

Exchanges are designed to concentrate that liquidity, bring everyone together in 1 place, and make trading smoother and more efficient. The second part is really making sure the transaction gets completed. When we sit in front of a screen, we tend to think that the trade is done once we hit “buy” or “sell.”

Behind the scenes, the exchange actually works with a clearinghouse to finalize the transaction. This ensures the money moves to the seller and the shares or securities move to the buyer. It's a little bit like the escrow process in real estate. It protects both sides and ensures that the deal actually closes.

One of the biggest risks in trading is that the other party might not follow through. But we never really think about that when we're trading, and that's because clearinghouses, which are coordinated by the exchanges, eliminate that risk. They guarantee the trade will settle even if 1 party defaults. So it's a bit like having a referee and a safety net all rolled into 1, making sure everyone plays fair and no one gets left hanging.

Let's bring the Chicago Mercantile Exchange into the conversation. How do they fit into the overall exchange industry? Give us a little bit of a sense of who they are, what CME does, and what they specialize in.

I think you're right that when most people think of an exchange, they may not immediately think of CME. Perhaps they picture the New York Stock Exchange, with the ringing bells, the stock tickers, and equity trading. But there's a whole other world of financial markets that don't trade stocks at all.

Instead of stocks, CME specializes in futures contracts. They're standardized agreements to buy or sell an asset at a set price on a future date. These contracts are essential for hedging risk or speculating on everything from interest rates to oil.

CME Group is the leading marketplace for derivatives globally. What really sets the company apart is the breadth and depth of its offerings. It's the go-to exchange for global benchmark products. Whether you're trading U.S. Treasury futures, S&P 500 E-mini contracts, West Texas Intermediate crude, or even commodities like cocoa, if it's a key asset class, CME likely has the most liquid futures for it.

It doesn't just offer a wide range of products. It also offers very deep liquidity pools, and that means tighter spreads, faster execution, and more efficient pricing. For institutional investors and sophisticated traders, that's a key distinction for CME.

To help put the markets in context, consider the U.S. Treasury futures market. By 1 measure, it's actually now larger than the actual Treasury bond market. Treasury futures trade about $800 billion in notional value a day, on average. That's about 10% more than the entire cash Treasury market, and it highlights how liquid these contracts are and 1 of the key distinctions for CME.

When I think of Chicago, I do think of the commodities that you just mentioned. It might have grown out of that, where commodities tend to have a very large futures market and you see a lot of hedging from the businesses going on there. But is there anything else that played into them becoming the market leader, particularly if I compare them to some of the other exchanges that you mentioned previously? From an equity perspective, the New York Stock Exchange perhaps could have had this large futures market. What would you say were the events or things that played out that gave them the market advantage they have today?

Its history goes back well over a century now. The story of CME really begins during the 19th century in the center of America. Back then, farmers faced a volatile mix of unpredictable harvests. There was poor storage, markets were broadly disorganized, and agricultural prices swung wildly.

By the mid-1800s, Chicago was transforming. There was a new canal and rail infrastructure, and it became a central hub connecting the Great Lakes to the Mississippi. That laid the foundation for centralized commodity markets, particularly in grain.

In 1948, the Chicago Board of Trade was established. As a central grain exchange, it allowed farmers and grain producers to sell their crops at set prices throughout the months between harvests and offered consumers more transparent prices throughout the year.

While it started with forward contracts, which are private agreements between buyers and sellers, a little bit down the track it introduced standardized futures contracts. These were centrally cleared and backed by margin payments, which dramatically reduced the risk of default. This innovation brought structure, trust, and predictability to the agricultural market. That was really the underpinning.

Much further down the track, the Chicago Board of Trade actually became part of CME Group. On the CME side, the Chicago Produce Exchange was established in 1874. It was created to trade perishables like butter and eggs. By just before the turn of the 20th century, it had evolved into the Chicago Butter and Egg Board, which doesn't exactly sound like a financial powerhouse, but it laid the foundation for CME.

After World War I, the Butter and Egg Board restructured into the Chicago Mercantile Exchange.

It's interesting to get some of those very tangible origins and how they were being used in terms of consumers and consumables. When you think about the evolution of exchanges, I can go back to thinking about a Chicago trading floor representing an exchange and needing to have a license today. I know a lot of this is more software-driven and digitally driven. Is it all essentially a software platform today? How would you describe the transaction elements and how they're taking place today in terms of the business?

There's a lot of focus on the matching engine, and the software is essential, but it's not just a software platform. I think that would underplay the importance of day-to-day operations and client relationships, product innovation, risk management, and the judgment that's required of that management team.

You want to ensure the smooth functioning of the system, and in particular, counterparties paying is a key component. Markets are obviously dynamic and can move to extremes, and so CME's clearing and risk management are designed to minimize the possibility that a clearing member will default on its obligations.

In the event of a member not quickly discharging its obligations, there's a transparent hierarchy of capital to fund the losses, beginning with the defaulting member's capital.

And we've seen at other clearing houses that this is not just a theoretical consideration, but I might be going a little bit too far into the detail here. We can talk about some of the benefits that are brought by clearing and maybe dig a little bit into how that works as well.

Yeah, absolutely. Any tangible examples of what these things would look like would be useful, whether it is the idea of risk management in terms of evaluating the counterparties and whether that happens with a committee in hand or whether there's a specific model that's used to do that, but also examples in terms of what the clearing house represents. Just some tangible things that can bring it to life. How does clearing occur?

For those who are less familiar, a clearing house is an intermediary between buyers and sellers. As the intermediary, or counterparty to every trade, the clearing house acts as the buyer for every seller and the seller for every buyer for each trade. To be clear—and this is important—they do not take proprietary risk. They're acting as a counterparty for each trade to help mitigate the counterparty risk, so you don't have to worry about the other end of your trade falling through.

In equities and equity options, there's a common clearing agency, and that allows fungibility of securities. This facilitates multiple venues for trading. If you were to buy Microsoft shares, say on Nasdaq this morning, and sell them this afternoon on a dark pool, you're able to do that in equities. Many traders probably aren't even aware which venue they are buying and selling shares on.

It's different when we get to futures contracts. At CME, there's a vertically integrated structure, so trading and clearing are bundled. CME only clears what it trades. It actually goes further than a commercial arrangement. It's getting into the weeds a little bit, but it's probably quite important to understand.

Under Section 403 of the Dodd-Frank Act, there's actually a part which says—and I'll quote this—“In order to minimize systemic risk, under no circumstances shall a derivatives clearing organization be compelled to accept the counterparty risk of another clearing organization.”

What does that mean? It just means the vertically integrated structure is justified by the systemic risk that futures fungibility could pose from poorly collateralized contracts. Just keep in mind that futures, given their inherent leverage, require collateral when you're initiating a position and are subject to mark-to-market calculations. The idea there is that you want to remove the debts by settling profits and losses rather than allowing outstanding obligations to accumulate in the system.

So futures are marked to market intraday, and it's obviously very important that the margining is adequate because that protects everyone from a clearing perspective and makes sure that the counterparty you're dealing with is money good. What's different from equities is that in equities, with margin, we might have 2 times leverage, and under the system now we have settlement of equities on a T+1 basis, just for a day. That's very different in futures, where you have contracts which span months and leverage may be 50 times.

There are very sound reasons for central clearing, and it's a key part of CME's competitive advantage because what it's doing is locking that liquidity into CME exchanges or CME products. On one hand, we've got the liquidity, which makes it a sort of low-cost, high-value “want to go where the liquidity is.” It's a real network business, and on the other hand, we've got this lock-in in terms of the non-fungibility and centralized clearing for their products.

I think this ties into another point that you mentioned, just in terms of understanding the counterparty risk. While CME is not proprietary trading in any way, it's not on their book. There could be counterparty risk to the extent that one side of the transaction is unable to meet its commitments.

So how does this risk-management function play a role in the exchanges and CME in particular? You did mention the inherent leverage that exists with these products is extreme. Was that just part of their DNA? Can you talk a little bit more about that, because it's emerging as a very interesting point within this business?

They clearly have systems which they're using for their margining, but it's one of the more technical aspects of an exchange that perhaps users are blissfully unaware of. But it's a real risk. Not at CME, but Nasdaq Clearing AB in 2018 is a good example of how important this risk management is.

There was an individual trader that bet heavily that the price spread between Nordic and German electricity would narrow, and it actually blew out; it went the opposite way. The spread widened sharply due to unexpected market movements, and it caused huge mark-to-market losses on his position. The trader couldn't meet the margin calls required by Nasdaq Clearing, and his positions were forcibly liquidated, but the losses exceeded his posted collateral, which triggered a default.

So Nasdaq Clearing had to step in and tap its default fund for over €100 million. That's a pool of capital contributed by all the clearing members, and that was to help cover the shortfall. Another example, which happened more recently, was in 2022, when we saw the London Metal Exchange botch its risk management. There was a short squeeze, margin calls couldn't be met, and the price of nickel surged. The LME canceled billions of dollars of trades, which caused significant losses for some market participants, and then that was fought out in the courts.

So these are all incidents—a reminder of systemic risk if the systems and people managing margins and collateral aren't up to it. Beyond that, the operational execution and the risk management are essential, and CME is right up there as best-in-class.

I'll admit I'm a tourist to the exchanges, so I might not have appreciated it nearly as much going into this conversation, but it's notable to me that you often hear about the regulations around banks and that same risk. Why do you think the exchanges don't get nearly as much press when it sounds like that's just as much of a concern, or something that needs to be considered? Is it simply a lack of tie to consumers? I'm somewhat surprised that I haven't come across as much material on the risk that can be inherent in exchanges.

I think it depends on the type of exchange you're looking at, and obviously futures exchanges are a little different from the most commonly known or thought-of exchanges, stock exchanges. So that would be maybe part of the reason. The other part comes back to what we were talking about before with exchanges not taking proprietary risk.

If we think about what happened as we went through the financial crisis—and it's been so well profiled—The Big Short is as good an example as any. There, you have OTC contracts and individuals who were trading with banks, but the banks are taking proprietary risk, so they might be the other side of that trade and they're holding that trade, and then they're also marking the positions. That creates an inherent conflict. With the exchanges, that's different. The exchange is not taking proprietary risk. They're not allowed to. And so what they're trying to do each day is monitor for that risk.

I think the other reason why you don't hear as much about this is because it's very rare that it is a problem. It's typically well handled. And the reason is you have this clearing house sitting in the back where they're demanding more margin. So as we move into an environment where things become more volatile, there's greater uncertainty, they're demanding more collateral be posted to protect the underlying buyer, and then obviously they have this capital hierarchy. So if someone can't meet a particular capital call, then there's a backstop there with that default fund.

Yeah, as you spelled it out, it makes sense in terms of the difference there, particularly with a proprietary book and how you're marking assets rather than just thinking about the margin of the counterparty. We could transition back to CME and just talk a little bit about how they win.

If I take what you've said thus far, I can think about them winning just purely by getting more volume traded on the exchange. Is that a fair characterization? How do you think about the growth lever of this business? Is it tied to volume specifically? What else goes into it?

It is tied to volume. Maybe just before touching on that, it might be worth thinking about how the exchanges have developed. We did talk about their foundations with commodities going back to the 1800s, where they were a market for farmers and producers and consumers, and that has clearly been central to the growth. But it also taught CME something which was crucial: how to build markets that manage uncertainty.

That same principle—hedging against volatility—was applied to entirely new asset classes. By the 1970s, CME had begun to reinvent itself, and it introduced the world's first currency futures, which was quite a radical idea at the time. No one had ever created a futures market for foreign exchange, and the timing was around the collapse of Bretton Woods. Currencies were suddenly floating and they were volatile, and the CME chairman at the time saw an opportunity. He proposed currency futures, but the idea needed some credibility.

Interestingly enough, he turned to Milton Friedman. I'll go off on a little tangent here, but he was obviously the Nobel Prize-winning economist who's very well known and documented. He actually wrote a feasibility study supporting the idea, and he charged about $75,000 for that, which certainly paid off. It opened the door to a whole new world of financial derivatives. Leo Melamed, who was the chairman at the time, called it the best investment CME ever made, and even today he's probably right.

Financial futures generate billions in revenue at CME each year. They continue to evolve, but in terms of volume, it is in some ways very much a volume game. Volume grows from areas including new clients, and the key push there is toward non-U.S. clients, which currently represent just over 30% of volume, but also toward retail. We're talking about more sophisticated retail, at least historically—high-net-worth individuals, for example.

They also grow by cross-selling to existing clients and through new products and markets. The move into financial futures is at the more extreme end for CME. New asset classes are less common. More recently, they've added crypto, but more of the innovation tends to happen around the edges. There are often extensions of existing asset classes, like the introduction of microcontracts, which take a standard contract and reduce its size to make it more accessible and enable tighter hedging. So overall, we do see some innovation, but really it's volume growth as markets grow, as the number of clients grows, through the push into international markets, and by using different products—I guess, a greater share of wallet from existing clients.

In those early days, take something like currency futures. Was the original idea that these would be used by corporations as hedging instruments? I know speculation tends to take over for a lot of the derivative markets, but in their origins, was there a tie to industry and corporations—a more tangible use case for the contracts?

In some ways, this hasn't changed, in that core liquidity wants real money rather than speculation. The speculation follows the real money, and that's perhaps part of the lesson from starting in those commodity markets, where you had the producers sitting there and wanting to hedge. Then the speculation comes in on top of that. We can talk about this more as we think about competition, but having that real money underpin the contracts is core to what CME is offering and to the liquidity and real money that underpin the system.

When I think about the landscape of exchanges, it sounds like they have carved out a dominant niche of the market, although calling it a niche is probably understating it. Why are there multiple players? Why isn't there just one exchange? Can you talk a little bit about their ability to bring more liquidity and capital to trade on their exchange versus others?

They do compete with a number of exchanges, but they tend not to compete directly for the same benchmark products. Part of that is because there is a natural monopoly around these businesses. It is a true network business. If we think back to that definition of market liquidity—the ability for a market to absorb the execution of a large purchase or sale quickly, without a large price impact—it means that, like any network business, the more people who use a service or product, the more valuable it becomes.

You can see that with CME. The standout product for them is on the interest-rate-futures side, where CME has around a 90% or greater share of U.S. interest-rate futures. The product they offer has a really high value-to-cost ratio as a result of that. On an average interest-rate contract, the fees are small. Average revenue per contract is approximately $0.50 against an $8 tick size, so they're only taking a small amount of the ultimate benefit that they're bringing to a consumer.

If they increase their rate per contract by a small amount, it's not going to have any impact on the value they're bringing to the end user or trader because of that spread size versus the actual cost. If you're trying to execute in large size, the key thing you're focused on is whether you can execute at a tight bid-ask spread without moving the market too far. While we've spoken about clearinghouses and collateral as other reasons, to be clear, the most important reason why contracts trade on CME versus elsewhere is the depth of the markets they have.

I guess, on the pricing point, how much does what they generate per contract move over time? Is there a trend line around it? You mentioned they're not taking a large percentage of the overall value provided. Can you talk a bit about their pricing—how it's set and how much it's changed?

Pricing is an interesting one. When I first started looking at CME, I was probably a little more diligent in trying to track it on a product-by-product basis, and eventually threw my hands in the air. It is hard to track. There are a number of factors that influence price.

The key ones are really the composition of members versus nonmembers. Generally, member customers are charged lower fees than nonmember customers. Secondly, there is product mix. There is variation in the rate per contract. At a high level, metals have the highest RPC, while interest rates have the lowest. Then there is also the grid structure they have. There are pricing grids, and higher volumes are rewarded with lower rates. So there are quite a number of different factors that impact the ultimate RPC per contract.

In recent years, it has become a little more complicated because CME has introduced microproducts, which are just smaller-sized contracts. On average, they're about one-tenth the notional size of their standard counterparts, and they have a lower RPC. But when we adjust for size, there's actually a 30% to 40% pricing premium. So smaller contracts are more accessible and allow for tighter hedging, but they are more expensive.

When you put all that together, it does become quite hard to track on a granular basis. What we do see quite clearly is that, as volumes go up, we see RPC come down within the different asset classes. Once again, that provides a little bit of stability for the business overall. In a lighter-volume environment, you're getting a higher price, and vice versa. From time to time, CME does take price, but they tend to do it very judiciously. As I said, it's hard to track because there are a lot of factors involved.

Is the fact that metals are higher-priced versus interest rates being lower-priced related to the size of those markets and how much liquidity exists? Does that somewhat correlate with the pricing that's charged?

I think we're probably at a point where it's more related to the legacy and where they have been, rather than being tightly correlated to specific factors on a monthly basis or whatever it may be.

Fair. You talked a little bit about the different products. Can you give us a snapshot of revenue by product? Is there anything you would use to describe where they're generating the most dollars, whether that's a revenue number, a profit number, or whatever it might be? Give us some breakdown of the business and what constitutes the largest percentage of it.

Sure. If we start at the revenue line, last year CME did just over $6 billion of annual revenue. In terms of reported revenue contribution, about 80% is from clearing and trading revenue, and around 10% is market data. I'm using round numbers. A large part of the remainder is the float on noncash collateral.

Keep in mind that people have to post collateral when they're trading on CME, so there is a float element to this business. The noncash collateral comes in at the revenue line, while the cash collateral comes in below the operating line, which is slightly confusing, or perhaps not what you would expect, when you first look at the business.

Within that 80% of revenue from trading and clearing, the largest asset class is interest rates. That's about one-third of trading and clearing revenue. Equities are a little under one-quarter, and below that we get to energy, which is in the mid-to-high teens. The majority of the money is made from clearing and trading.

Market data is often referred to in exchanges as the exhaust of the business. That's another way for things to be monetized. Alternatively, providing market data might be an entrée into developing a client relationship. Typically, what the exchanges talk about is that, as they see market-data sales go up, that's a good leading indicator for what is going to happen to open interest and trading volumes going forward, as people do their back tests and then move forward.

When it comes to either of those buckets—whether it's the clearinghouse and trading representing 80%, or the product breakdown, with interest rates and equities making up the largest percentages—have either of those categories seen material shifts over time? Or are you expecting there to be material shifts, where there is really one growth engine that will make up a larger percentage of the business moving forward?

Yes, look, I call out interest rates. Following the financial crisis, interest rates were held down by quantitative easing, and there was low volatility. It was a hard time for CME on the interest-rate side of its business. That also compounded with the collateral and the float that they earn: it was lower, there was less trading, and interest rates were lower.

That's really changed. As we went through COVID in 2020, there was a lot of talk about rates being low forever. We could make the valuation stack up for CME if we were in a more anemic rates environment in terms of the volatility and trading, but there was that optionality to the upside. At some point, we expected there would be interest rates again.

Where we are today is that the U.S. has approximately $49 billion or thereabouts of Treasury securities outstanding, and a deficit at just over 6% of GDP, growing at just under $2 trillion per annum. So the underlying asset class is growing, and we're seeing obviously big moves in rates. The yield curve has certainly moved. We've seen curves steepening.

The 20-year part of the curve is now at, or close enough to, 5%. CME is a real beneficiary of that rates volatility. We saw that through 2022 as we went through that tightening cycle: volumes really jumped up, and so they were a big beneficiary there. But compared to where we were a decade ago, it was a very different story, and obviously that changes the composition of the earnings, particularly that clearing and trading revenue.

The other area where I’d call out some structural change is in energy, where we’re seeing US energy production increase, with Henry Hub and WTI ramping. The US is now the largest producer of LNG and the swing producer of oil, and we’re seeing more international benchmarking to US products, to West Texas Intermediate and Henry Hub. The important point is that it’s an increasingly risky and volatile world, and CME volumes are actually a beneficiary as a result of that volatility.

As things wax and wane, we do see different asset classes have greater or lesser contribution. That’s important, obviously, from the diversity of the earnings that CME has, which provides them a buffer as we move through different environments. A more balanced or stable revenue-growth profile tends to grow in that 5% to 8% range on the top line over time when we think about it on an organic basis, with a little bit of pricing. But volume, as we discussed, is really the key driver.

The other benefit of having those multiple asset classes relates back to the collateral that the client has to post. With more products, as well as the ease of having a consolidated platform, when you have to post collateral and you’ve got a broader set of instruments, there may be offsets. We might think about a long 2-year position, which could be offset by a short 5-year position. As a result, the exchange will require less collateral than if the 2 positions were held separately. As we all know, capital’s obviously a valuable resource, and we want to optimize there.

Those 6 major asset classes provide a number of different benefits, both to the underlying users and traders as well as to the business itself.

Should I think of volatility or the notional amount outstanding? If we’re just to use the interest-rate example in US Treasuries, what would be a bigger driver of volumes: the amount of Treasuries outstanding and the continued issuance, or volatility in the interest-rate markets?

I think it really depends on what time frame we’re looking at. Over a shorter time frame, volatility will be more important, but over a longer time frame, you can see that correlation between the growth in the Treasury market and the trading volumes on CME. One of the benefits of the deficit is that you’re going to see the stock increase.

As we touched on before, with that $8 billion in notional trading, that’s ahead of what the underlying trading in the cash market is. That just continues to feed further growth in that particular asset class. But you do raise a really good point, Matt, in terms of the difference between the notional and also the benefit from inflation as well in some of their product sets. As the amounts get bigger and the number of contracts needed to hedge or speculate grows, they’re a beneficiary of that.

Yeah, it’s an interesting multiplier effect. I know notional outstanding and volatility probably have a relationship in and of themselves, so to separate the 2 is a tricky endeavor, but that’s useful framing, I think. You mentioned the diversity of the business, just in terms of having these multiple sector or asset-class exposures. How does that compare to some of the other exchanges out there? Is it considered more diverse and less of a pure play? Does it look similar to other exchanges? I’m just curious.

We’d really have to take it on a case-by-case basis and think about some of their competitors, including Intercontinental Exchange, Cboe, Euronext, and Deutsche Börse. Intercontinental Exchange is their most direct competitor, but the product sets don’t actually have a lot of direct overlap. In oil, CME has the US-focused WTI contracts, while Intercontinental Exchange, or ICE, has the European-focused Brent contract. So maybe they are substitutable to a certain extent.

ICE’s origin is in the power markets, and that’s where they have historically been strongest, but they are a very acquisitive company and they’re doing a lot of different things in the mortgage market now, which is a direction in which we haven’t seen CME go at this stage. Cboe, on the other hand, is an equity and options exchange. Due to some history, Cboe has equity-index options on the S&P, while CME has the futures and options on the S&P. So there are, once again, slightly different product sets, but more broadly, there is some overlap.

Typically, as a risk manager, if someone wants to trade an option, they’ll use an option, and they’ll be very specific about the instrument they’re using. If they want to use a future, then they’ll likely go to CME. The other one is the London Stock Exchange, and through one of their subsidiaries, LCH, they have a big share in swaps clearing.

Broadly, among some of the other derivatives exchanges, there are clearly similarities and differing amounts of diversification. I would classify CME as being more of a pure play in the derivatives space, but within that space, it is well diversified. The other one that’s probably worth calling out is that Howard Lutnick has created a rival exchange, FMX, for US interest-rate futures. That’s backed by some large banks and trading firms that have equity in the venture, and the London Stock Exchange is also involved with that swap side of the business.

So, once again, as we were talking about before, you need the real money, and exchanges don’t just want to have prop firms sitting there churning contracts. They want real-money accounts, and with FMX, both Citadel and Jump involved, they probably don’t want to be on the other side of each other for every single trade either. So it’s an interesting dynamic on FMX.

As a side note, it’s interesting that we spoke about liquidity before, but in times of stress, that’s when the need for liquidity is greatest. When traders want it, they want to be on the dominant exchange. There was a little bit of irony around Howard Lutnick representing the US president with a tariff board on that windy day back in April when the tariffs were announced, because it created a lot of volatility and generated incredible volumes for CME. At the same time, it disincentivized the use of some of the smaller exchanges that had similar products but less liquidity.

It’s still early days for FMX in the key product where they compete, the SOFR contract. That’s the short-term interest-rate contract. Their market share at the moment is pretty thin, circa 10 basis points, and we’ve seen them have days where there are just no contracts trading.

Over the years, there have been a lot of challenges to futures exchanges, and I’m sure we’ll touch on the profitability and the financial characteristics, but it’s clearly an attractive space to be in. From memory, CME has seen off about 8 challengers to date. There have been plenty of attempts, including by some of the same characters who are backing FMX, but it just highlights how hard it is to get traction, given some of those barriers to entry that we spoke about: the liquidity and the vertical integration of trading and clearing.

It’s very interesting when it comes to the launch, and particularly the banks backing and having equity in this business. Was there a catalyst that drove that when it came to competition or frustration with pricing, or anything along those lines? I’m just curious.

There are always going to be people who see profit pools and then decide to start something new and go after those profit pools, but was there more to that story that triggered that push?

We could speculate as to what the key drivers are. More broadly, what you’ve seen with the banks is that, following the financial crisis, there has been an element of disintermediation. We’ve seen that with OTC contracts and the capital that’s required to be held against those. Having a contract on an exchange is more efficient than having it as an OTC contract, generally speaking, and so there have been real incentives to move to exchanges.

But that obviously has implications for the banks and their profit pools as well. I guess the other reason is that CME is such a big player, and it’s just that balance of power. Perhaps it’s a way to try to address that.

You touched on profitability. Let’s get towards that, whether it’s a margin profile or however else you would want to frame the profitability of the business. How does CME stack up? We’d be curious, in terms of comparing it to some of the competition, whether there’s a rule of thumb for exchanges. But start with CME and what the margin and earnings profile looks like for the business. Maybe if we start with the costs in the business, then we can work from there.

As a percentage of the cost stack, compensation is about 40%. That’s without a doubt the biggest cost. Licensing fees are the second-biggest expense, so that’s a mid-to-high-teens percentage of costs. Then we’ve got technology, and that’s about a low-teens percentage of the cost stack. After that, it’s amortization and depreciation.

Management are very cost-conscious. They’ve been excellent expense managers, and it’s been consistently tight. Some of the dynamics we spoke about before, including pricing and how they use that judiciously, obviously flow into this.

For most businesses, when you think about price, it tends to be a big margin driver. CME is a little bit different. While that’s true, price may not be the biggest margin driver each year, and that’s because there’s no need for another factory run of widgets when they’re doing incremental volume.

So the incremental margins on new volumes are very high, circa 90%. As we think about that cost base and then the high incremental margins, what you have is a fixed-cost base and low variable costs, which leads to a highly profitable business. To put that into context, adjusted operating margins are currently over 70%. On a GAAP basis, operating margins are almost 70%.

It’s also probably worth calling out that there’s float on cash collateral, which we touched on before, below the operating line, and also their JV with S&P. That’s below the operating income line. So when we look at before tax, it’s actually an even higher margin. Income before tax is higher than the operating margin; that’s currently running north of 75% on a GAAP basis. Incredible margins, which might speak a little bit to the competition and desire to tap into those pools.

I always find this interesting when I think about the business: the number of employees that they have and how that translates in terms of profit per head. At CME, they’ve got fewer than 4,000 employees. On a net-income-after-tax-per-head basis, that works out to just below $1 million a year last year. So I think it’s fair to say that CME is a very profitable business.

Yeah, certainly not bad. When it comes to converting that into free cash flow, are there any unique dynamics with working capital or capex that stop it from spitting off a lot of cash?

No. When we think about capex to sales, that’s in the sort of 1.5% range. The infrastructure is there, the systems are there, so it’s quite extraordinary in terms of the cash that it does generate. Maybe it helps to put it in context to think about the capital allocation historically. CME has allocated excess capital to dividends, so they have a regular dividend and then they do a special dividend at the end of each year, although in the last 6 months—correct me on this if I’m wrong—they have introduced the potential for buybacks. I don’t think they’ve used that yet; if they have, it will be very recent.

To put that dividend in perspective, and the cash that this business generates in perspective, the company has returned $29 billion in dividends since they implemented that variable dividend policy in early 2012. $29 billion has gone back in dividends. The market cap at the end of 2011 was $17 billion. Today, CME’s market cap is $99 billion, so it just highlights the incredible profitability and conversion into cash flow. Typically, the conversion ratio is over 100%.

Are there limitations to growth from a capacity perspective that would require major investment or could cause things to not quite keep up with demand in the market? Is there anything that limits their ability to grow?

With capex being low, it’s obviously not on that side, but they do need to continue to innovate and grow and change with markets. If we think back to when they were just a commodity exchange doing eggs and butter or whatever it might have been, or pork bellies, if they hadn’t innovated and grown with the markets and the real asset classes, this business would not be what it is today. So I don’t want to diminish the importance of innovation, but it tends to be less capital-intensive. There has been some change on the IT side, but the way that’s been funded is also quite interesting and has maintained their sort of capital-light position in some respects.

You mentioned innovation a few times. Is that really coming in the form of the new products that they’re offering? Is there anything else in regard to innovation that you would highlight as a tangible example of what that looks like for a customer?

Not to overstate it, I’m not sure the company would say it quite this way, but the majority of the revenue is coming from their core products. Think about it in terms of the framework rather than the absolute numbers, but that Pareto-type model where 20% of the products produce 80% of the revenue. Within equities, you’ll have the S&P 500-linked contracts or the E-minis and the micros. That’s where a lot of the trading volume is going, which you would really expect, given everyone’s trying to tap into a pool of liquidity and efficient markets.

R&D is not split out, so I think it’s safe to assume that’s not a big expense. Product innovation has been where we’ve seen movement from standard contracts to microcontracts, say, or the introduction of the crypto asset class, rather than that revolutionary change which we saw with the introduction of the financial futures. It definitely happens, but it’s more the work that’s going on behind the scenes to ensure that they’re meeting client demands and people aren’t drifting off to an alternative provider because they can’t get the product they need on the CME.

The way they tend to do that is to work closely with clients through sales and research, listening to customers and hearing customer requests. CME then takes that away and innovates. But what they’re looking for is to make sure that the product can scale over time. They don’t want a million contracts and fragmented liquidity and to do things which only appeal to a very small subset.

Certainly, what impact, if any, does the move towards passive investing over active investing have on the business? Is there a change in volumes that happens from that, whether higher or lower? It is such a theme in the market, so I’m just trying to think of every possible theme and what impact it might have on CME.

It is a positive in terms of those. For instance, with the S&P 500-linked contract, as the S&P ETF moves, people are using different instruments to hedge or try and arbitrage indices against futures. There are obviously more use cases as passive tends to grow. So, yeah, definitely a positive for CME on that side of the business.

It’s probably, in some respects, more tied to the risk management, if you like, for the whole financial ecosystem. I guess there are ups and downs, but, yeah, overall positive for certain parts of the business.

The last point on the income statement, financials, and capital allocation would just be around capital allocation. You mentioned dividends being a priority, potentially buybacks. Acquisitions and M&A have been a theme in the sector. How do you view CME’s stance on future M&A? How much of a theme do you expect that to be in the market, both for CME and the broader industry?

Yeah, the market is obviously quite consolidated. So if we think about the corporate actions that CME has been through, they demutualized in 2000 and moved from member-owned to a for-profit company, and then they went public 2 years later. They were the first U.S. exchange to go public, so they beat out Nasdaq. Nasdaq’s IPO got delayed due to the dot-com crash.

CME has made 2 really key acquisitions since listing. Firstly, the Chicago Board of Trade. It was an incredible acquisition because it gave CME control over both the short and long ends of the U.S. interest rate curve. Prior to that, they had the short end; the Chicago Board of Trade had the long end. That enabled the curve to be put together from a futures perspective on 1 platform and created that—well, it’s almost a monopoly on U.S. interest rate futures.

They also bought the New York Mercantile Exchange, including COMEX, and that added energy and metals to CME’s portfolio, giving it a foothold in 2 of the most globally traded commodity markets. So those are the key ones that they’ve made. There was also the NEX Group acquisition. The jury is still out, I think, on that one, focused on the Treasury market and also on FX. But put that one to the side. I don’t think you could put that in the same basket as being such a step forward for the exchange.

Where we are now with the exchange space since 2000 and the demutualization, there’s been a lot of consolidation, and so opportunities to really meaningfully move the needle are quite limited. What we’ve seen with competitors like ICE is that they have gone into more ancillary markets, like the mortgage market. So they have a more acquisitive approach and always have. CME tends to be a little bit more organically focused. But where the opportunities have come up, they have definitely done strategically sensible acquisitions which have really helped transform the business.

Yeah, it’s an interesting market, exchanges as a whole, in terms of the key players seemingly having won their spaces—and time can change all of that. But it’s interesting to see how these markets consolidate over time. I have some questions on risks, but I would just ask you first: what would be the main risks that stand out to you for CME?

As I sit back and think about it today, they’ve been a well-run organization. A return to an environment with lower interest-rate volatility would be a risk to volumes in the short or medium term. I think ultimately you can only suppress volatility for so long, but that would be a risk to their trading volumes and their revenue. Not that they haven’t handled themselves well—they have been, as I said, best in class—but a significant operational misstep would always be a risk.

Cyber risk, I don’t think that’s unique to CME. Most businesses which involve software, which is pretty much every business, are subject to that risk. And then regulatory change would be the other one. They’d be the 4 that would really stand out. I think acquisition risk, and moving into another area which is ancillary and not as profitable, is less likely from my discussions with management and what they’ve said publicly and what they’ve done. They’ve had a really good track record.

There was speculation around Cboe as an acquisition a number of years ago. I don’t think there was much truth to that, but there was an initial market reaction to that story. I think the reason there is that within the exchange space, to my mind, equity exchanges just aren’t as high quality because they don’t have that vertically integrated clearing. So what that means is you can actually settle transactions across different exchanges, and that has led to a lot of fragmentation in the industry.

I think there’s over 60 venues that you can now trade equities on, and so that leads to more competition. We’ve seen what’s happened in equities in terms of the cost of trading equities, both on the broking side and on the exchange side: It has been a race to the bottom. So I don’t think that is a risk, but if they were to go that direction, that would present a different proposition.

On that point, when it comes to something like commodities, you gave a good example of the Brent contract—Brent crude versus WTI—and they are different products. I don’t know what the differential is right now in terms of pricing, but there are all types of things that factor into that. Is it the case that CME doesn’t even offer a Brent futures contract and vice versa, or are they offering it but with just a much smaller percentage of the market share?

Yeah, it’s the latter case. When people are using those contracts, they want to go to the spot where the liquidity is. You’ll see ICE have similar products to CME, but they won’t really be trading in any notable volume when compared. Typically, they tend to stick to their own areas.

Once again, that comes back to the idea of the core products producing a lot of revenue. For something like oil, I think it depends on what the underlying producer—the hedger—is benchmarking to, and then that will dictate their use of the particular futures contract.

Quite interesting, just to hear the nuances of those separate markets. Before we wind down to the closing question, I wanted to touch on the regulatory environment, and you mentioned it as a potential risk. I think you tend to see regulation either around M&A or if there's a major issue. It's only after the fact that regulation gets involved.

But I understand the point on the bank situation being different. Is there anything, as it regards to leverage or the capital requirements that are required for exchanges, that could change in future years? When you talk about regulation, what would stand out? You could put some probability or likelihood around that to the extent you want to.

Regulation is constantly changing, and it's a hard question. They cover a lot of ground. What I would say is Terry Duffy has done an exceptional job managing that regulatory risk, ensuring that Congress is well informed, working both sides of the aisle, and keeping CME in a good place.

There's always something on the radar, and they're not existential threats for CME. Things tend to evolve, and that may impact trading volumes in a particular area. But some of those core areas, which we spoke about, given the systemic importance of what CME does, I think it's going to be a very brave act of Congress to change some of those key planks for the business.

Overall, it is changing and evolving. Nothing that I'd call out as being a really big risk. I wouldn't attempt a probability on that. I think overall I would regard that large change as a small probability, but that's just my view—one to keep on the radar, but nothing beyond that constant monitoring.

This has been a fascinating discussion. I admit that I have selfishly learned a lot about exchanges throughout this conversation. It's something where, when you step back, you say, “Ah, you understand the market mechanism that they provide,” but as you get closer, there's a lot of detail and a lot of nuance to it.

What stands out to you as the key lesson, or lessons, that you could take away from CME?

Thanks, man. Hopefully it hasn't been boring getting too far into the weeds. I think the key lesson from CME—there are all the obvious ones in terms of the benefits of a dominant market position, driven by the network effects and the natural monopoly. I don't think it's news to anyone that having a business where you don't have as much competition tends to be pretty good for profitability and shareholder returns. There's obviously the benefits of scale and operating leverage as well.

Maybe I'd look at it slightly differently. I think CME is most unique due to the value of the optionality within the business. This is a business that truly benefits from volatility, and that makes it quite unique. There aren't many businesses like this if I look at the S&P 500 where they are a direct beneficiary of that volatility.

Now, everything can get taken to extremes. So if we move to an environment where we have a horrendous market crash and people are going bankrupt, obviously that will impact trading volumes. When we get to extreme levels of volatility, that's not good for anyone. But for me, that's the key lesson.

As we looked at the business previously, we always thought there was that call option, if you like, to a more volatile environment. That's the key takeaway for me.

Well, Adam, again, thank you for this. I do not think it was too in the weeds. I think it was the proper amount of detail and nuance for our listeners. I appreciate you joining us.

Thanks very much for having me, Matt. Really enjoyed it.