Good day, everyone and welcome to the CME Group second quarter 2009 earnings call. As a reminder, today's call is being recorded. At this time for opening remarks and introductions, I'd like to turn the conference over to your host, John Peschier. Please go ahead.
Thanks and thank all of you for joining us this morning. Craig Donohue, our CEO; Terry Duffy, our Executive Chairman; and Jamie Parisi, our CFO will spend a few minutes outlining the highlights of the second quarter and then we will open up the call your questions.
Also joining us for participation in the Q&A session is Rick Redding, our Head of Products and Services.
Before they begin, I will read the Safe Harbor language. Statements made on this call and in the accompanying slides on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any forward-looking statements. More detailed information about factors that may affect our performance may be found in our filings with the SEC, including our most recent Forms 10-K and 10-Q, which are available on the Investor Relations section of our website.
During this call, we will refer to GAAP and non-GAAP pro forma results. A reconciliation is available in our press release and there is a file on the Investor Relations portion of our website that provides detailed quarterly information on a GAAP and pro forma basis.
With that I would like to turn the call over to Craig.
Good morning and thank you for joining us today. I'll begin by spending some time covering our second quarter highlights, and then Terry will take a few minutes to discuss the current regulatory environment and after that I'll turn the call over to Jamie for a more detailed discussion of our financial results.
I'm pleased to report another highly profitable quarter. On a pro forma basis, we achieved revenues of $648 million and operating income of $405 million. Earnings per share were $3.37 for the second quarter, and we continue to exhibit strong expense discipline and operating leverage as evidenced by operating margins of 63%. Pro forma operating expenses were $243 million, down 4% from the first quarter.
While the macroeconomic conditions in the first quarter were marked by ongoing certainty, in the second quarter the economy started to show increasing signs of stabilization. One closely monitored metric, the LIBOR-OIS, spread trended consistently downward over the quarter ending June at the lowest level in nearly 18 months. A decrease in volatility in many asset classes during the second quarter further indicates growing economic stability.
In our markets, the key measure of increasing stability that we have observed is increased liquidity as marked by improvements in depth of book and bid/ask spreads across all asset classes from Q1 '09 to Q2 '09.
Getting into a few highlights on volume, June saw 11.4 million contracts in average daily volume. This is the highest monthly volume of the year led by interest rate products as the steepening yield curve drove intermediate and long-term hedging activity by market participants.
At the peak of this activity, CME Group's interest rate complex saw the highest volume day ever on June 5th with 10.9 million contracts traded.
Our treasury complex has shown growing cash market penetration or treasury futures activity as a percentage of cash treasury trading activity over the course of 2009 ending the quarter at 53% up from 46% at the end of December. This positions us well for the return of more dynamic interest rate expectations.
Ten-year interest rate swap futures had both a record June and a record second quarter with average daily volumes of 9,500 contracts in June and 4,900 contracts in the second quarter.
Finally, the current environment has generated uncertainty further out on the yield curve and average daily volume in our back month Eurodollar contracts are up 21% for the quarter versus the same period last year.
Our FX product line also had strong volume in June, the fourth highest monthly volume ever with average daily volume of 702,000 contracts. In addition, CME Group's FX products gained significant traction versus the over-the-counter markets in June and in Q2.
Looking beyond product performance to our customers, we can see some moderately favorable trends in the customer segment data from Q1 to Q2. Proprietary buy-side traders have increased from 39% of volume to 41%. Hedge funds increased slightly and accounted for 6% of volume, the first quarter in a year that did not show a decline in hedge fund contribution.
Bank proprietary trading activity accounted for 14% of volume, other member activity 22% and non-member activity 17%. This segmentation is for legacy CME CBOT products only.
Additionally, we are seeing favorable trends in global customer acquisition with increased trading out of new proprietary accounts in the EMEA region.
Taken together, we believe all of these figures underscore that our customer base has remained relatively unchanged even following the impacts of the credit crisis, and that we are seeing increased confidence in overall economic conditions.
While we can't predict the timing for complete economic recovery, we do believe that our markets and products continue to demonstrate their value and that further improvements in the economy and financial markets have the potential to generate increased hedging and risk management activity.
I'd now like to discuss CME Group's strategic accomplishments this quarter. We are very pleased with the progress of the NYMEX integration and we achieved several key milestones this quarter including combining our New York trading floors and cutting over to the CME Group fee system.
In July, we introduced a new SPAN margin regime to create maximum capital efficiencies across our combined suite of products, which has gotten very good customer feedback.
In addition, we are starting to see the benefits of some of our cross-selling initiatives and we have seen the beginnings of NYMEX customer participation in legacy CME Group markets.
We continue to build out our suite of over-the-counter offerings with the upcoming launch of cleared OTC London Gold Forwards. This product reflects the innovation and customer focus that we strive for in our over-the-counter market and we continue to work with the buy and sell-side to develop new products on CME ClearPort across all asset classes.
In addition to these 114 products were launched on CME ClearPort in Q2 bringing the total of new products for the year to 220. We are pleased to see a rapid growth in many of our new product launchings.
In Q2, products launched since the acquisition of NYMEX contributed approximately 2% of total CME ClearPort revenues. Most of this revenue came from our innovative Day-Ahead Power contracts, but other product lines including petroleum and natural gas liquids saw a rapid ramp up for new product launches.
Innovation in our interest rate products continues to take hold with continued growth coming from users accessing our inter-commodity spread functionality for treasury futures, with volumes increasing from 13,000 ADV in January to 23,000 ADV in June.
Our partnership with BM&F Bovespa is also thriving with north to south order routing volumes of 21,000 contracts per day in June, up from 5,000 contracts per day in March.
Both the number of participants trading and the variety of contracts traded are increasing, and we expect these numbers to further increase when the Ibovespa stock index futures contracts are approved for trading by U.S. investors.
I will now turn the call over to Terry Duffy, our Executive Chairman to address some of the regulatory issues currently facing the derivatives industry.
Thanks, Craig, and good morning and thank you for joining us all today. I'd like to give you a little bit of flavor for what is going on in D.C., and what we can support and what we are concerned with.
CME Group proudly supports the Obama administration's efforts to ensure that U.S. financial markets maintain high standards of integrity, safety and soundness for all participants. Specifically, we are in favor of the creation of the systemic risk regulator to work in conjunction with the existing regulatory agencies. And we support the administration's recognition of the distinct regulatory issues, facing the futures industry and the cash equity’s industry. CME Group has a 150 year track record of ensuring transparent, equitable and efficient markets to many economic and social political crisis, including the credit crisis of the past year. This fact is a key principle of our value proposition and we maintain this track record through vigilant and thorough market regulation and surveillance.
Our market protections at this time include position limits or accountability levels in all non-financial commodity products, including energy and metals, as well as a thorough process for annual review of any hedge funds exemptions issued.
With the current regulatory focus on the role of speculators in determining commodity prices, the word speculation has given a strong negative connotation, in some ways synonymous with the word manipulation. This connotation is undeserved
In healthy markets, speculators or non-commercial participants are a critical part of the market and provide essential liquidity to hedgers or commercial participants. Markets require both types of participants and we work hard to raise awareness of this fact.
While the role of speculators in determining energy prices has been fearlessly debated for the past 12 months, extensive empirical evidence indicates that fundamental supply and demands factors along with macroeconomic conditions have been determinative of energy commodities pricing, independent of the positions of various types of market participants.
The evidence and analysis leading to this conclusion are documented in studies by the CFTC and the U.S. Government Accountability Office, as well as studies accounted by independent research firms and in reports published by many of the widely filed analysts covering the energy sector.
At a time when it is clear that centralized clearing will bring capital and risk management benefits to market participants. There is a danger that restricting market access to a smaller group of participants and limiting positions will drive business to unregulated or foreign over the counter markets, out of the jurisdiction of US regulators.
In that event, the markets driving price discovery for energy products used by U.S. citizens would be many multiples less transparent than they are currently today. Given the options available to market participants, we must carefully consider the impacts that position limits and hedge funds exemptions have on overall market liquidity and the potential for over regulation to raise transaction costs and impair the hedging capabilities of commercial participants; creating outcomes that are at odds with the push to drive more volumes to essentially cleared markets.
Hearings are scheduled next week in DC on this topic and the CME Group will participate. CME Group will continue to fully support ongoing efforts to ensure efficient and fair markets. CME has worked extensively in Washington DC for many years and continues to be actively engaged to ensure that critical decisions makers are well informed on the issues that impact our markets.
We are confidant that final decisions on this and other matters facing regulators will be based on factual economic analysis and careful consideration of potential unintended consequences rather than political rhetoric.
With that being said, I look forward to answering your questions and I'll turn it back to Craig.
Thank you, Terry. In summary, the second quarter saw increased economic stability. We continue to manage the business to generate profit through current conditions and to maximize our strategic positioning for the future. This involves an intense focus on expense discipline coupled with investment in our various growth initiatives, particularly the over-the-counter clearing opportunities ahead of us.
Following the credit crisis, it was evidenced that existing regulation would be heavily scrutinized and we are now working through that process as Terry described. Many of the proposals put forward have potentially positive impacts for market stability and for CME Group while others of course have potential negative implications. There will be much discussion on all fronts but what truly matter is what legislation and/or regulations actually get adopted.
CME Group will continue our ongoing efforts to provide education and awareness on issues related to our industry in Washington, where we enjoy very constructive working relationships with regulators and with our elected representatives.
In closing, I would like to underscore that there is widespread recognition in Washington for the important and valuable role that regulated exchanges and clearing houses like CME Group play in facilitating economic growth and financial markets activity. That is an important and valuable foundation for us as we work through these issues in Washington.
With that let me turn the call over to Jamie.
Thanks, Craig and good morning everyone. CME Group turned in a sound second quarter financial performance despite the continued challenging economic environment.
Our GAAP results are summarized in the press release. Today I'm going to focus on the details of Q2 on a pro forma basis as if we own NYMEX for all periods considered.
The pro-forma’s exclude approximately $3 million of CBOT and NYMEX merger-related items on an after tax basis, as well as the impact of earnings on deferred compensation balances.
Included in our GAAP results are the impacts related to gains or losses on deferred compensation balances which are driven by quarterly equity market movement. Keep in mind that there is no bottom-line impact as the changes in deferred compensation gains and losses are booked as compensation expense, with an offsetting entry to investment income. We have removed these entries in our non-GAAP pro forma income statements for all periods considered, better reflecting the fact that this is unrelated to our core operation.
Now, turning to our pro forma results. During Q2, we generated $648 million in revenue, $405 million of operating income and earnings per share of $3.37. Average daily volumes were down 19% compared to second quarter 2008, but up slightly versus Q1 2009. Continued disciplined expense management resulting in a 4% reduction in expenses contributed to a sequential earnings increasing of $0.17 per diluted share.
The overall pro forma rate per contract for all CME Group increased 5% to $0.816 compared with $0.775 in the second quarter 2008, due primarily to a positive products mix shift. The rate per contract decreased 2% from $0.833 in Q1 2009, due mainly to a product mix shift as interest rate volumes increased 14% sequentially, representing 42% of total volume in Q2, compared to 37% in Q1. We also saw a 1% decrease in the non-member volume mix overall with the CME and CBOT at 17% non-member in the second quarter, and NYMEX at approximately 36%.
Turning to our market data revenue of $82 million for the quarter; it was down 5% versus last year and down 4% sequentially. At the end of the second quarter, users subscribed to 407,000 base devices across CME, CBOT and NYMEX, down 18,000 versus Q1 of this year, reflecting the impact of reduced staffing at the larger banks. There is generally a lagged impact on device counts as banks downsize their staffing.
I'll now take a few minutes to review expenses. Total pro forma operating expenses were $243 million for Q2, down 4% sequentially and down 13% versus Q2 last year, as we continued our significant efforts to capture the NYMEX synergies and ring out discretionary expenses where possible.
Starting out with our largest expense, compensation and benefits was down $3 million sequentially to $85 million, due primarily to synergy capture and lower bonus expense. Our combined headcount at the end of Q2 stood at 2,250, down 25 from the prior year period and down 92 versus the prior year.
Our second quarter bonus expense was $8.7 million which is down from our quarterly average run rate in 2008, and down $1 million from the first quarter. We are currently running below the cash earnings target we set for ourselves at the beginning of the year.
Stock-based compensation was $8.2 million in the second quarter, down $500,000 from Q1 of this year. We decide to do move our stock option grant date from mid-June to mid-September to better distribute components of our pay throughout the year and to reduce expenses in the current year.
Non-compensation expenses of $157 million were down $29 million, versus last year, and down $8 million sequentially. The largest contributor to the sequential reduction was $2.9 million reduction in license fees related to reduced CME ClearPort and equity volume. We also reduced our marketing spend by approximately $2.5 million in Q2 compared to Q1, and within the marketing and other line we had a positive $2 million impact due to FX fluctuation.
Lastly, occupancy and building expense was down $2 million sequentially due primarily to lower utilities expense, the closing of the CBOT New Jersey data center and other miscellaneous adjustments.
On the synergy front, we realized NYMEX-related expense synergies of $11.4 million in Q2 or approximately $45 million annualized, well on our way to the $60 million of annual expense synergies we had identified at the time of the acquisition.
In terms of our expectations for full year expenses based on volumes near current levels, we expect annual pro forma expenses to range from $1.01 billion to $1.02 billion. Giving some further color on expenses going forward, we expect compensation expense in the second half to be similar to the first half with growth oriented hiring and the impact of the Q3 option grant offsetting merger related savings.
On non-comp expenses, we expect an increase in the second half of the year due to technology and building related expenses driven by the go-live date of early August for our new data center. In addition, we expect higher travel and marketing costs based on our current plans to continue to promote our business globally.
Q2 pro forma operating income was $405 million, down 15% from the second quarter last year. Overall, our revenue was down 14% versus the same quarter a year ago, while expenses dropped by 13%. As a result, we were able maintain a strong pro forma operating margin of 63% consistent with Q2 of 2008 and up from 61% last quarter.
In the non-operating expense category, second quarter interest expense and borrowing costs were $33 million and were offset by $8 million of investment income resulting in total non-operating expense of $26 million, down approximately $9 million sequentially.
As I mentioned last quarter, part of this variance is due to the one-time interest expense of approximately $5 million related to replacement of our bridge loan during the first quarter. The remainder of the variance is due to a dividend from BM&F Bovespa. We typically received the dividend payments twice a year and the timing and amount varies.
As I mentioned earlier, the impact to investment income that would historically have been related to deferred compensation balances has been removed.
During the quarter, we paid down approximately $110 million in debt, and as of the end of the quarter we had $3 billion of debt and $545 million of cash and marketable securities. We have $250 million of debt coming due in Q3, which we expect to pay down primarily from cash generated in the quarter.
Pro forma net income for Q2 was $224 million and diluted EPS was $3.37. For the quarter, our pro forma effective tax rate was 40.8% in line with our expectations of approximately 41% for the year.
Capital expenditures, net of leasehold improvement allowances, totaled $31 million in the second quarter and $66 million year-to-date driven primarily by our data center, software equipment and facilities.
We continue to review our 2009 CapEx plans and as a result we are reducing our 2009 CapEx guidance to between $150 million and $160 million for the year. This reduction from our previous guidance is driven by a deferrals from data center spend and of some office construction.
So far in July, we are averaging 9.7 million contracts per day. This is fairly similar to the pattern we saw in Q1 and Q2 in terms of the first month of the quarter.
In summary, despite the macroeconomic challenges, impacting financial markets and our customers, our strong financial results and expense discipline allow us to continue our focus on growing both the business as well as shareholder value for the long term.
As we reminded you last quarter, in order to get to everyone, we would like to limit all of you to one question and one follow-up and then feel free to get back in the queue for an additional question if time permits.
With this in mind, we'll now open up the call for your questions.
(Operator Instructions). And our first question will come from Mike Carrier with Deutsche Bank.
Mike Carrier - Deutsche Bank
If you look at in your customer base, I guess, when you look at the position limits, what percentage of the customers would have exemptions? I think, probably more importantly, it seems like the regulators are focused on the volatility in the markets and commodities that impact the end consumer. So even though, we all kind of agree on the whole, speculators need to be in the market and that's what makes markets.
If we look at what the regulators are trying to do, what are their options going to be? You have position limits. You have margin requirements, which have gone up and that really hasn't had an impact, but from your guidance perspective in all the years that you've been in the market. Is there anything that's changed or that they can do that can control the volatility that doesn't have a huge impact on your business?
It's Craig. I'll start and maybe my colleagues will want to add. But I think to begin with it's important to remember that we have already very extensive position limits and position accountability level requirements in all of our commodity and energy markets and we have a very rigorous regime for reviewing those limits and levels as well as for granting exemptions.
We actually have a very small number of exemptions that are typically granted for market users and that's a process that we tend to manage on a very kind of active real-time basis. So, unlike other platforms and the over-the-counter market, we already have all of that regulatory infrastructure in place, and so I think the impact on us is likely to be less than it might be elsewhere where they don't already have those kinds of limits and levels and exemption processes in place.
In general, it's hard to speculate because we don't yet have a clear point of view from the regulators or from the industry in terms of what may evolve. That's part of the discussion that we are going through right now. But I think it's important to just remember that we have a very strong foundation to build on given the fact that we already have limits and levels and criteria for granting exemption.
If I could maybe add a little bit to that, Craig. Mike, one of the things that you mentioned and is very true, Washington is focused on volatility a lot when they talk about excessive speculation. One of the things that we've been working very hard on is to explain to them what volatility will do when you limit the participation in any market whether it's energy or any type of an equity market.
When you start to walk them through what a lot of our clients do to provide this liquidity so the commercials and other producers can manage their risk in these products they get it.
But you're right, a lot of it has been based on volatility, but they understand the less participants, the increased volatility will go up. And on the margin issue, a lot of our clients are already fully collateralized on our positions, where margin wouldn't even affect those participants; it's the commercials that the margin would have a huge effect on.
Mike Carrier - Deutsche Bank
Just a follow-up on the expenses. Some good color there, I guess just looking out, it seemed like it was better than expected for the quarter. Any other areas where you think there is more opportunity may be not even in the next six months, but over time just given all the consolidation that has taken place. And when you kind of review the expense base where there are other opportunities? And then just on dividend if you could give any size of that on the BM&F side?
With regard to the expenses you can rest assured that we look at all of the areas of expense to try to manage that down as best we can. And I believe we've done a very good job. If you look historically, we are a bit different than a lot of other exchanges out there given that we've been through two mergers now and we've gone through two expense synergy exercises. So we've done some deep dives on the expense side across all the major categories. So we will continue to do that going forward.
With respect to the BM&F dividend, I want to say it was in the neighborhood of about $4.5 million for the quarter.
And our next question will come from Rich Repetto with Sandler O'Neill.
Rich Repetto - Sandler O'Neill
Yeah. I guess, Terry, since you've been so gracious to do the regulatory sort of overview. As you go down there next week, I guess the question is on Tuesday as the hearing starts, what's the biggest misperception? You spend a lot of time I know in the past as well, but what's the biggest misperception you think that the regulators – maybe that's a negative connotation, but what would be your main objective to sort of get through to the people you are going to meet with?
Well, Craig is going to do the testimony at the commission next week, but one of the things we'll say we were there yesterday and we are explaining to the regulators and the legislators that people have alternatives to regulated markets, and this administration has called for transparency in all products. And what the commission appears to be doing and what other members of Congress appear to be doing, was taking liquidity from highly regulated entities and pushing it to unregulated entities with some of the actions that they would be taking.
So we are clearly walking them through that and they see that if they don't have an answer for the OTC market and other foreign jurisdictions where this business could go. They are doing something that is in complete opposite of what their President has asked them to do, which is to bring transparency to U.S. markets.
So, we are clearly walking them through a lot of these different scenarios, and I think one of the biggest misdirects out there also coming out of the commission is this issue on fungibility. When the Chairman is managing fungibility, he is talking about trading platforms not about clearing platforms. And I think the press has kind of got that a little bit backwards also.
So I think that is an important thing to note that the Chairman is calling for multiple platforms to be going into clearing houses not from a trade and in a clearing house to be transferred from one clearing house to another.
Rich Repetto - Sandler O'Neill
And wouldn't that be from what I understand the fungibility, just on the OTC side not on the exchange listed?
He's referring to OTC, but some are trying to draw the distinction with the futures model that we have today.
Rich Repetto - Sandler O'Neill
Understood. I guess, moving on to expenses. Jamie, you take the guidance that you gave the 1.01 to 1.02, and you subtract what you've done in the first half, and you are coming up with like $520 million in the second half or $260 million average. So I know you sort of hinted at some things that can go up. But that's $260 million or close to it would be much higher than the $243 million you ran at this past quarter. It seems like a pretty good investment in those things, in the back half?
Yes. That's a good point, Rich. We are seeing in the second half of the year increases across several of the categories. In the compensation category, we'll continue to hire people for the growth initiatives and to continue to beep up our regulatory team.
On the stock based comp, we do have that grant coming out in later in this year, so that will be a little bit of a pick up. Depreciation is going to increase as we continue to add CapEx and then with the data center that we've been building, we've been investing in that over time and all that investment has been put in work in progress and that data center will now go live in August or at least get lit up in August, and then a depreciation starts to hit there.
We've got a lot of marketing events and what not that are backend loaded in the year, back in the second half. And then if you look in that other line, for example, you had the one-time FX fluctuation that was a favorable impact of $2 million you can't expect that every quarter going forward.
And then just generally, going back to the data center as we light that up there's going to be other expenses associated with that, you know, significant utilities, equipment, hardware maintenance, that sort of thing. So a lot of it tied to the growth initiatives that we are undertaking and with the growth of our infrastructure.
Next we will hear from Daniel Harris with Goldman Sachs.
Daniel Harris - Goldman Sachs
Can you talk a little bit about, and I think you touched on it in your presentation, the depth of the market specifically within the Euro/Dollar business. It certainly seems like its improving and the open interest trends for a new months there, the beginning part of the year, were certainly moving higher. How should we think about that as it impacts your thoughts on volumes there and obviously you are not looking for guidance, but the different types of clients that are coming back into the market that might have been gone before or what they are doing differently now versus what they were throughout 2008?
Daniel, I think there is couple of things going on. You mention euro/dollar, but if you look at kind of the fifth month contract, kind of the lead month contract, the improvement in the depth of kind of the top of the book, the top five prices, actually the depths increased by about 60%. So you've seen some dramatic changes, and Craig alluded to it earlier. As you've seen the kind of LIBOR/OIS spread come in, people have been able to take a little more risk than they have in the past.
As volatility declines people are willing to put more into the book. We've been talking about this concept of de-risking for over a year now and you can actually see the positive sides of it now in the second quarter.
So, if you look across all the financial products, you can see improvements anywhere from 10% to 75% in the depth of these marketplaces. The other thing that's important to notice is the bid-ask spreads have come in noticeably on the exchange markets here. I think you've scene some comments about the over-the-counter markets about the bid-ask spreads actually widening out dramatically. We've actually see them come in dramatically here at the exchange. So I think you did see the market stabilize in the second quarter and that was a very positive effect on a lot of what our market users were able to execute during that period.
Daniel Harris - Goldman Sachs
Then for my follow-up question, the BM&F Bovespa, you talked about 21,000 contracts from North to South in June. Clearly this is something that you guys are focused on in terms of a growth opportunity over the next few years. What are the near-term things that you are looking for in terms of high-frequency traders or algorithmic traders getting more involved with those markets and what are the things that maybe holding them up or that look like they're going to be positively impacting things in the back half? Thanks a lot.
Well, I mean, obviously that's a big part what we are trying to accomplish is introducing our algorithmic proprietary trading group customer base into the BM&F markets. Just in the last 12 months BM&F has gone from essentially zero direct market access to roughly I think 15% of their average daily volumes are now done through direct market access. Yet approximately 1% of their volume on a daily basis is actually algorithmically driven.
I think you saw earlier in our own customer segmentation data that we are closer to roughly 40%. So we think there's a lot of opportunity there as we've seen some of our leading customers get very active in North-to-South order routing and with the implementation of the collocation services in Brazil. Obviously we are hopeful that that's going to expand into more of our customers who will take advantage of those opportunities.
So, we are working very actively on joint marketing with BM&F Bovespa to get our customer base involved in their markets. I mentioned as well that I think there is a lot of interest in the Ibovespa stock in next futures contract. The BM&F Bovespa's application for getting access for U.S. investors to that product is pending and we hope nearing completion at the CFTC. So that should be further positive to customer's interest in getting involved.
One other thing if I can add Daniel is actually, late in the second quarter we did introduce some incentive programs, Latin America and South America incentive program to incentivize traders to also reverse that flow and bring flow from south to north as well. So we are working hard to get that volume flow into our markets as well.
(Operator Instructions). We'll go next to Howard Chen with Credit Suisse.
Howard Chen - Credit Suisse
Terry and Craig I appreciate all the thoughts on the regulatory environment, I know it's a fluid one. Maybe one follow-up for Rick, with all the regulatory discussion, can you just give us some flavor, Rick, both positive and negative on how all of this has affected customer behavior and new customer pipeline and acquisition? Is all this discussion, is it helping or hurting, can you even tell?
Well, I mean I think as Craig and Terry both mentioned; it really is hard to tell until you know what the regulation and what some of the thoughts they are thinking. I mean, on the positive side it is forcing people to think about the exchange model and the benefits that we provide in both the transparent marketplace and in clearing and I think some of that is actually being manifested in the better liquidity and the depth of book that we talked about. So on the longer term, I think it's extremely positive focusing people on our businesses model. Again, as I said, until you really know what they are going to focus in on, I think it's hard to tell. I think it's too early to really have a lot of impact on what customers are going to do.
Howard Chen - Credit Suisse
As a follow-up, I guess for the entire team. As we see this play out and we see potential changes to regulation or not, what are our management's specific goals? What are you hoping to accomplish when all the dust settles?
Howard, in terms of what, in terms of the regulation and regulatory changes?
Just going back to some of the comments that we've all made during the course of the call I mean, obviously, we think that, there actually is a lot of recognition and respect for the sort of model of exchanges and clearing houses. We are trying to make sure that, we can continue to grow the core business as people migrate to more standardized listed markets that are essentially cleared. That's obviously good for the core business. But, I think as you are aware, I mean, we are doing a lot to position ourselves to be more broadly successful than we already are.
In OTC clearing we've got a great foundation for the oil and gas and power contracts that we are clearing to ClearPort, but we are getting very actively involved in interest rate swaps and credit default swaps, agriculture commodity swaps and other products. Expecting that government ultimately will adopt incentives if not requirements for Central counterparty clearing of at least some segment of the over the counter markets. A lot of that remains to be seen, but that's how we are trying to address what we think are some of the larger trends.
Again, just to add to what Craig said, as you can see by the Secretary Geithner remarks of last month or so when he talked about clearing of standardized OTC contracts and using capital incentives to entice that business to come on exchange or be cleared. I mean, that's something that we've been out front for a long time supporting that type of behavior versus having it mandated like some of the Legislators in D.C. are calling for which they believe is a quick solution just to mandate everything to go on exchange from OTC. So, I think the secretary has come out with a plan that makes a lot of sense with capital incentives to go forward on clearing some of these standardized products.
And now we'll hear from Niamh Alexander with KBW.
Niamh Alexander - KBW
I guess, following up from that point in terms of the opportunities from regulatory change, I know Rick has been doing a lot of work with Craig as well as a lot of others; what milestones should we be looking towards here? Do you feel like you've made progress with kind of discussions with key dealers on interest rate swaps clearing, because we think that there should be a good offset with euro/dollar contract there but we have not really seen or heard much momentum from the dealer side towards shifting to central clearing, I don’t know what they are doing with the LCH.
I think when you look at what's going on in all the other over-the-counter markets, whether it's interest rates or others. As I think people are trying to figure out what the best solution and what the best offsets will be in the marketplace, because what is coming out of this crisis that we've been through is, people really do need to save capital going forward and I think, people as they study what we will be able to offer and what others are able to offer, I think they will see that there's significant capital savings because of the underline product straight here as well. So, I like to call it wherever an exchange has the under like hedge we should have the home court advantage in trying to pick up that business.
Niamh Alexander - KBW
That's helpful, Rick. But help me understand what to look for in terms of progression towards getting the business on board? Do you think that we will have to wait for the regulatory or the increased capital requirements to come through or maybe should we expect something in the next quarter or two in terms of (inaudible), something like that?
This is Terry Duffy. I think Rick's answer was a good one, but I also think you have to look at what these regs are going to be. As Craig said in his opening remarks, we don't know what they are ultimately going to look like. Everything has been bantered around Washington a lot. And I think a lot of the bigger dealers need to be careful about how they are going to proceed with their future business until the regs are a little clear.
Right now you have the Secretary calling for capital incentives for clearing of OTC standardized products, but at the same time the legislatives have not voted this in yet in a full derivatives package.
So I think in order to run their businesses properly, they need to have a little clear view of what the future is going to look like on regulation before they just start to jump from one product line to another or one clearing entity to another.
And one other thing I want to add is ClearPort. I mean obviously you've seen tremendous success from ClearPort. That's not being driven by the regulatory process. People are seeing the benefits of putting this into an exchange cleared environment and getting those offsets. So you are seeing us expand that platform into gold and the metals business. You've seen us expand it in the agriculture and you will see us continue to move into other asset classes.
And we'll move on to Mike Vinciquerra with BMO Capital Markets.
Mike Vinciquerra - BMO Capital Markets
Good morning. If I can come back to the CFTC issue on the position limits, I want to make sure we understand what the CFTC is really focused on here. Is it really a question about how and why you grant acceptance to your limits or what is it that they are focused on here in the energy markets?
Mike, I'm afraid it's a little more complicated than that. There is a wide range of issues and it really depends on who you are talking to. I mean, I think in general it just starts with this sort of concern about non-commercial participants in the market and the degree to which at least some people perceive they might be impacting pricing. So for some people it's about access to the market by certain kinds of participants and better understanding. What are they actually doing? Are they speculating? Or are they actually hedging inflation risks and engaging in what I think most of us would view as bona fide portfolio management and trading strategies.
For some people it's about whether we have hard limits versus accountability levels. For some people it's about whether the CFTC should have a more active role or whether the exchanges should have the kind of direct and primary responsibility. For some people, it's actually less about the domestic exchanges and more about the lack of reportability for limits on OTC exposures. For some people, it's about the lack of limits or reportability of transactions that happen on, what we call exempt commercial markets here in the U.S. and foreign boards of trade.
So there is a wide range of different issues that people are focused on here. I would say the vast majority of this is oriented more towards the platforms and exchanges that are sort of not like CME Group, the designated contract market where we already have these kind of regimes. We are involved in the mix, but I think a lot of the scrutiny and a lot of the concern is on the positions that are being established on platforms and exchanges that are either lacking in limits or lacking in regulation and transparency or reach by the U.S. government.
Mike Vinciquerra - BMO Capital Markets
And as a follow-up to that, this whole process that they are going to have with four meetings over the next 40 days or so, I guess it is. What is your sense for the timing of when they are going to come up with their either recommendation or do they just come out with a few months down the road, a blanket statement about how the markets are going to change or what the exemptions have to be?
Well, I mean ultimately, we can't answer that question. That will be for the commission to determine. But, I mean, I would expect that, they'll get through these hearing. They'll get industry input for the balance of this month and through August. And then depending on what that looks like, my guess is they will try to put something forward in sort of the early fall. But we really don't know and probably can't speculate beyond that.
Mike, one of the other things, that's important to note is, what they come out with in rule making. What they have the ability to do and what they may need to go to Congress to do. So the timing could be completely two different things. If they come forward with recommendations that have to go through a legislative process, I'm sure, the timing will be a lot different than if it is a simple rule-making process at the CFTC.
Mike Vinciquerra - BMO Capital Markets
Some lot of uncertainty kind of, sounds like still remains at this point.
Well, I mean, I don't know how fast Congress is going to move on certain issues. But I'd just say, if the CFTC make certain recommendations, they may need congressional approval to go forward. They don't have the ability to do everything by themselves.
We'll hear from Chris Allen with Pali Capital.
Chris Allen - Pali Capital
Just wanted to follow-up a little bit on over the counter opportunity, particularly in relation to interest rate swap clearing, you guys have been talking about this for a little while now. Just wondering where the platform stands. Is it up to speed in terms of mimicking on how the over-the-counter markets act, or is it just a matter of the DOs waiting for a clear up on the regulatory front before you guys launch it?
Well, I mean, I think what you're seeing happen in the interest rate swap in particular is there's a lot of infrastructure that needs to be replicated throughout the industry, whether it's the buy side, the sell-side or the exchange. I mean, to clear them as interest rate swaps is a little more complex than the existing infrastructure at most of the firms. So there is work that has to go on. There is work that is going on. So it is not just tied to the regulatory issues.
Chris Allen - Pali Capital
Any idea in terms of timeframe, in terms of when that work may be accomplished?
We haven't given any guidance to this point.
We will move on to Ken Worthington with JPMorgan.
Ken Worthington - JPMorgan
Hi. Thanks for taking my questions. I guess, one more on OTC clearing. Is it possible for you to either prioritize or rank order the opportunities in OTC clearing, maybe beyond energy? So we've got CDS, where you’ve got a platform, interest rate seem like the biggest market out there, but FX seems to have the least competition. Is there a way to rank the opportunities for CME in the OTC clearing realm?
I mean, there certainly is. I mean, it's more complicated than just looking at the size of the gross national exposures by asset class in OTC markets. But that's certainly is one way to do it. That's typically how we have tried to put some sort of color and perspective on the opportunity, which is to look at, for example, the much larger size of the interest rate swaps market versus the credit default swaps market.
But I think the other thing that we've said, and this is where it becomes very hard to answer your question as each of these sort of segments of the OTC market, not unlike the exchange and listed markets is different. The players are different. The trading dynamics are different. The systemic risk and other issues are different. So what we are trying to do is focus broadly on being a services provider of clearing and risk management services broadly for all OTC products.
I mentioned that we have initiatives underway to capitalize on CME ClearPort and extend ourselves from oil, gas and power contracts into interest rates and credit default swaps. We are already clearing agriculture commodity swaps. We are doing a lot of innovation of new products that can be cleared through ClearPort, but the ultimate timing isn't something that you can actually predict very well, and we are trying to be very responsive to customers' interests in terms of what they would like to do with us in terms of clearing.
Next we'll here from Roger Freeman with Barclays Capital.
Roger Freeman - Barclays Capital
Just on the interest rate swaps, I guess couple of things I wanted to do get your thoughts around, our discussions with (inaudible), actually there has actually been a lot of discussion on this topic. And I guess two things, one it sounds like we are getting set up for a separate U.S. European clearing solution similar to CDS because of regulatory concerns.
And secondly, around the cross-margining opportunities that people seem to think is kind of a [shoving], I guess it sounds like there is some issues around the legal organization of futures versus swaps businesses because swaps businesses are set up overseas, you don't actually get that cross margining and I am wondering if you have a work around on that?
Unidentified Company Representative
Our approach, for the risk offset has been with the over-the-counter products to do two things to help facilitate better capital efficiencies with the over-the-counter and the listed derivatives. One is to pursue an approach where we have a buying financial safeguard package. So we are clearing the over-the-counter products and the listed products under an umbrella guaranteed package in a sense.
The other elements that we have pursued is to have a customer protection regime that is for the over-the-counter products basically identical to the customer protection regime that's in place for the futures. The segregation of funds under the CFTC regulation and that is something we are pursuing for the over-the-counter products as well that facilitate better capital efficiencies between the over-the-counter and the listed products.
As far as the cross border part of your question we are pursuing setting up our clearing presence in Europe. We are pursuing that initially. The initial product that will be launched there will be the credit clearing facility in conjunction with some of the regulatory moves in Europe. But we intend to extend the European clearing presence to other asset classes or other products that are better serviced from a European point of view. And there is a precedent for cross border ability to get risk offsets. We have now in place our interest rate products with (inaudible) clearing house. So we are open to pursuing other varieties of [risk asset].
Roger Freeman - Barclays Capital
Then, Terry, just wanted to follow-up on your answer to Rich's question about the fungibility on the OTC that Gensler talked about, why would that discussion not migrate to the futures platform? I mean what would make those two different, why it could make sense for one and not the other?
Well, there is many differences between futures trading and securities trading that we have pointed out historically on fungibility. So my point is, the Chairman is not raising the issue of fungibility on futures style contracts or clearing. What he is pointing out is platforms for trading of OTC contracts should be open to go into a clearinghouse. That's all he is pointing out. But it seems the press has portrayed this as something other than that and I was just trying to clarify that point. No one is raising the issue of fungibility on futures exchanges or the models that CME Group deploys today. So that's the only distinction I was drawing from that.
Next we'll hear from Don Fandetti with Citi.
Don Fandetti - Citi
Hi. Most of my questions have been answered, but Rick, just real quickly on the interest rate complex. I was just trying to see if you could provide some context on how you see that recovering, just given the deleveraging and the lack of participants? Could we get back up to sort of peak levels or how do you see that in a bowl scenario?
I think what really drives those markets is people's rates expectations, and I think you saw in the second quarter. I mean, if you would have asked the question at the beginning of the year, we would have a record interest rate in our products this year given the crisis. I don't think anyone would have believed us, if we said we would have.
So, if you're actually seeing the market participants still there are as rates move, as expectations of rates have changed, that drove a lot of volume. So a lot of these people that [saw] a lot of the participants were actually gone from the marketplace. I think, the second quarter proves that those people are still there. And as expectations for rates change, you'll see that behavior.
You can actually also see it in kind of the Eurodollar complex where people are looking kind of in the greens where volumes actually up on the year relative to last year, which was a phenomenal year because people are looking out the curve and really starting to think that at some point rates are going to back up here and everyone is going to have to hedge those portfolios.
When you think about the treasury complexes, there has been such issuance. The issue is issuance isn't the thing that drives the volumes. It's the fact that so much more inventory is in the marketplace. And as peoples' views on rates change there is a lot more inventory out there for people to hedge. That's what drives those decisions and that's what drives the volume.
So, a lot is going on in the rates complex and the thing to think about in the treasury side is the outstanding inventory coming into '09 was about $4 trillion. Most people think we are going to issue $2 trillion of coupon-bearing treasury this year. So there is a pretty fundamental shift in policy. So at some point, as people view rates are going to move, we think that that will be a positive catalyst for the business.
Next question will come from Dan Fannon with Jefferies.
Dan Fannon - Jefferies
Just a quick question, since the ELX has been launched as a competitor, have you heard any feedback from customers or has there been any value proposition that they've presented that you've heard from people that trade on your platform as well?
No, not really. We are still searching for the value proposition that exists on that platform.
Dan Fannon - Jefferies
So, as you think about, other than price there really is no difference, the execution, the speed really hasn't changed or …?
What you have seen is the end customers are seeing the fact that the bid/ask spreads are still so much tighter on CME's products and it will ends up costing a lot more money to execute those trades, regardless of what the exchange fees are. So it's all about liquidity at the end of the day. And people still realize that markets are tighter and what we've talked about earlier, the depth of the book here has increased so much. The penetration versus the cash treasury has increased. So I think a lot of people realize that the CME's treasury complex has been a safe haven in all the storm.
Next we will hear from [Rob Rutschow with CLSA].
Rob Rutschow - CLSA
I wanted to ask you about the data hubs that you operate in outside of the U.S. and if you can remind us how the revenues and expenses for those are accounted for and whether it's been material and what sort of activity you are seeing from outside the U.S.?
Sure, this is Jamie, Rob. First of all, I think that the activity coming through them is pretty substantial. If you look over the past several quarters, we are in the 800,000 or 900,000 contract a day coming through the hub. Any other revenue associate with that is just going to come through our clearing and transaction fees line. And as far as the expenses go, I believe it's coming through the technology and communications lines on the income statement and it's not very expensive to run these hubs. On a regular basis, I'd say they are somewhere in the neighborhood of $500,000 to $1 million per year per hub. So it's not a large commitment relative to the volumes coming through.
Rob Rutschow - CLSA
The second question I had, wanted to ask again on the regulatory or on the position limits. If you can give us an idea of what percentage of your open interest is attributable to customers that have exemptions? And if you can't answer that, was hoping that then may be you could give us an idea of how much of your volume the ETF represent as a percentage of total for some of these commodity contracts?
Rob, it's Craig, I think it's probably a little difficult to get into that here especially just given that that would be highly variable across the very many products that we trade. So you'll have to probably look for some of our testimony and other public information for us to give you that.
But I mean in general to give you some color I would say that obviously the vast majority of participants in our market are commercial participants and other liquidity providers and market makers. These markets are not overwhelmed by ETF managers, particularly not in the sort of average daily volume terms. We have people who are long-term holders who are rolling positions forward. They might have a higher degree of kind of open interest but pricing isn't really determined by open interest as much as by the trading activity in the market and they are not that significant a part of that.
And we'll hear next from Justin Schack with Rosenblatt Securities.
Justin Schack - Rosenblatt Securities
You guys obviously have addressed the ELX competitive threat. I wonder if you might just provide some general comments on how you view NYSE Euronext as a competitor over the long term? Clearly either a long way away, but they're doing some interesting things with respect to joint venture with DTCC and that seems to be a unique approach to competing with CME that others have not yet attempted. And I just wonder if you can provide some thoughts there.
Well, I mean, I think in general, I mean, we're certainly always regarded NYSE Euronext as a sort of formidable competitor and one that certainly has expressed a strong interest in becoming a confident player in the U.S. markets listed Futures and Options markets. As you know, they don't have very much current activity there and their success has primarily been sort of a legacy success in the European market, particularly in the short-term interest rate area.
So we regard them as a competitor and assume that they'll continue to look for ways to build their business. I think we like to pride ourselves on our ability to innovate and bring new products and services to market that meet customers' needs. I'd like to think that we have very deep and substantial expertise leading technology and clearing services capabilities. So we are well positioned to compete with just about anybody in the market, but they certainly will be active in competing with us.
Justin Schack - Rosenblatt Securities
Well, particularly and just like this is a quick follow-up with respect to the U.S. futures business. I should have mentioned that that was where my question was really directed. Particularly on the capital efficiency side, where this new joint venture is going to be offering some capital efficiencies, the kind which Rick referred to earlier as a home field advantage. Would you say that that even though they don't control the trading of the cash products, clearinghouse will be offering some capital efficiencies there?
Could you consider that a similar type of home field advantage and what if anything can you guys do to respond or do you think you even need to respond at this stage?
I guess, what I would say is that I think the value proposition of what we offer is multidimensional. I think that capital efficiencies while they can be valuable in and of themselves are not determinative. You have to have liquidity. You have to have trade flow. You have to have great technology. You have to have robust clearing and capital, and performance bond efficiencies can be a useful part of that overall equation. But there is a lot of things, I mentioned there is quite a bit more in terms of what I think ultimately makes the difference.
And I should point out that I think we've been a leading player in not only providing capital and margin efficiencies as a result of our clearing processing arrangements and mergers and acquisitions, but we've probably had more cross-margining arrangements between and among large clearing houses than any other exchange in the world not just domestically, but globally and including FICC. So we're pretty well positioned from that perspective.
And there are no further questions at this time. Mr. Donohue, I will turn things back to you for any additional or closing remarks.
Thank you very much for spending time with us, and we look forward to talking with you again next quarter.
That does conclude today's conference call. Thank you for your participation. You may now disconnect.
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