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CBOE Holdings (NASDAQ:CBOE)

Q2 2011 Earnings Call

August 04, 2011 8:30 am ET

Executives

Debbie Koopman -

Edward Tilly - Executive Vice Chairman and Executive Vice Chairman of CBOE

Alan Dean - Chief Financial Officer, Executive Vice President of Finance & Administration and Treasurer

William Brodsky - Chairman, Chief Executive Officer, Chairman of Executive Committee, Chairman of Chicago Board Options Exchange Incorporated and Chief Executive Officer of Chicago Board Options Exchange Incorporated

Analysts

Niamh Alexander - Keefe, Bruyette, & Woods, Inc.

Matthew Heinz - Stifel, Nicolaus & Co., Inc.

Alex Kramm - UBS Investment Bank

Edward Ditmire - Macquarie Research

Patrick O'Shaughnessy - Raymond James & Associates, Inc.

Surinder Thind - Jefferies & Company, Inc.

Rob Rutschow - Credit Agricole Securities (NYSE:USA) Inc.

Gaston Ceron - Morningstar Inc.

Michael Carrier - Deutsche Bank AG

Kenneth Worthington - JP Morgan Chase & Co

Howard Chen - Crédit Suisse AG

Richard Repetto - Sandler O'Neill + Partners, L.P.

Jillian Miller - BMO Capital Markets U.S.

Christopher Allen - Evercore Partners Inc.

Roger Freeman - Barclays Capital

Justin Schack - Rosenblatt Securities

Daniel Harris - Goldman Sachs Group Inc.

Operator

Good day, ladies and gentlemen, and welcome to today's CBOE Holdings Second Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

At this time for opening introductions, I would like to turn the call over to Ms. Debbie Koopman, Director of Investor Relations. Please go ahead.

Debbie Koopman

Thank you. Good morning, and thank you for joining us on our second quarter conference call. On the call today, Bill Brodsky, our chairman and CEO, will discuss the quarter and our continued progress in executing our strategic initiatives; then Alan Dean, our Executive Vice President and CFO, will detail our second quarter 2011 financial results. Following their comments, we will open the call to Q&A. Also joining us for Q&A is our Executive Vice Chairman, Ed Tilly.

In addition, I'd like to point out that this presentation will include the use of several slides. We will be showing the slides and providing commentary on each. A downloadable copy of the slide presentation is available on the Investor Relations portion of our website.

As a preliminary note, you should be aware that this presentation contains forward-looking statements, which represent our current judgment on what the future may hold. And while we believe these judgments are reasonable, these forward-looking statements are not guarantees of future performance and involve certain assumptions, risks and uncertainties. Actual outcomes and results may differ materially from what is expressed or implied in any forward-looking statements. Please refer to our filings with the SEC for a full discussion of the factors that may affect any forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise after this conference call.

Now I'd like to turn the call over to Bill Brodsky.

William Brodsky

Thank you, Debbie, and good morning. I'm very pleased to be here today to share outstanding results for CBOE Holdings Second Quarter 2011.

Revenues were up 7%, net income allocated to common stockholders increased 32% and earnings per share grew 33% over the prior-year period. The company's operating margin was at its highest level in 10 quarters.

Significantly, this strong performance was posted despite a general slowdown in the economic recovery in April and May that made for sluggish markets and depressed trading levels industry-wide.

CBOE Holdings averaged 4.4 million option contracts per day in the second quarter of 2011, a significant decrease from the second quarter of 2010 when average daily volume spiked to 5.29 million contracts as a result primarily of the May 6 Flash Crash. As mentioned, U.S. markets generally languish in the second quarter of 2011, further compounding the challenging 2010 comparison.

However, we were pleased to see trading volumes begin to pick up for the end of the quarter when in June, total option's average daily volume at CBOE Holdings increased 10% over June of 2010.

Increased trading activity continued into the third quarter when option's average daily volume in July rose 19% over the same period last year. As a result, year-to-date option volume through July at CBOE Holdings is down just 2% from the close of July last year despite extraordinary volume spikes in May of 2010. Given the recent uptick in trading activity, we are optimistic that we can make up more ground during the remainder of 2011.

The benefits of product diversification at CBOE play out against virtually any market backdrop, even amidst overall dampened volume levels in the second quarter, we still saw noteworthy bright spots.

In the second quarter of 2011, trading of VIX futures increased 190% and trading of VIX options increased 34% over the previous year. Daily volume of VIX futures surpassed 100,000 contracts for the first time in June and more recently, average daily volume in VIX futures set a third consecutive record in July.

The company's success in growing profitability, even in periods of relatively low volume, reflects our ability to leverage the industry's most diversified product line while adhering to disciplined cost management. This approach has also enabled us to continue to fuel engines of future growth such as C2 and product innovation.

CBOE Holdings accounted for 26.1% of all U.S. options trading in the second quarter, down 1.1 percentage points in the previous quarter. Excluding dividend trades, CBOE Holdings combined market share for the quarter was 26.9%, down 1.3 percentage points from the first quarter of 2011. I'm pleased to note that the dip in market share began to reverse in June, when market share at CBOE Holdings increased month-over-month by 2.1 percentage points and remained essentially unchanged in July.

Through the end of July, the company's total option market shares stood at 26.5%. CBOE Holdings has maintained an overall market share in the 26% to 28% range since last September. Significantly, we have achieved that stabilization without sacrificing revenue per contract. CBOE is deeply committed to increasing both the quantity and quality of our market share.

VIX futures, which command our highest revenue per contract, represents a key metric in the company's performance. While accounting for just 1% of overall trading at CBOE Holdings, VIX futures accounted for 5% of our second quarter transaction fees.

VIX options are a feature of our premium index options product line, which generates our second-highest rate per contract, highlighting the significance of double- and triple-digit gains that we continue to enjoy in VIX options and futures trading, even in periods of low market volatility.

C2, our electronic options exchange, continues to gain traction in the options marketplace, posting consistent volume gains since its launch in October 2010. C2 volume in the second quarter averaged 191,000 contracts per day, an increase of 18% over the first quarter of 2011, C2's first full quarter of trading. The upper trend continued into July when volume averaged more than 220,000 contracts per day and accounted for 4.8% of all option trading at CBOE Holdings.

As mentioned in the last quarter's call, we continue to closely monitor the quality of our markets and adjust our fee schedules and incentives in order to drive additional volumes to C2. In February, we modified transaction fees in 5 classes, including SPDR options. As a result, C2 market share in this highly competitive class grew from 1.5% in January to 3.8% in July. We expanded the modified fee schedule to all C2 classes in May. C2's market share in Qs, another highly competitive ETF option, rose from 1.8% at the end of April to 2.2% in July and the overall market share of U.S. options volume grew from 0.8% to 1.3% over the same period.

I should also note, that last week, C2 introduced complex order functionality for all listed classes. We expect automatic execution of complex orders coupled with C2's opportunities for price improvement to further enhance the user experience and attract more business to the C2 marketplace.

Now an update regarding SPXpm on C2. There's been considerable buzz among our customers about this much-awaited contract, and we're prepared to offer for trading as soon as we get the greenlight from the SEC. We had hoped to receive an affirmative decision by early June. However, on June 3, the SEC announced an extension of its review period to include a new 30-day comment period followed by 15-day rebuttal period, which ended on July 25. The SEC must now act by September 6 to either approve or disapprove the proposal or to extend its review for an additional and final 60-day period. Although disappointed by the delay, we remain cautiously optimistic that SPXpm will ultimately be approved.

The SEC's extended review focuses on pm settlement. CBOE has responded with extensive data, documenting the long-established use of pm settlement in many exchange traded products including index options, SPDRs and equity options. We have also noted that pm settlement is a common feature in the OTC market, making SPXpm an alternative to those trades and thus aligning it with the Dodd-Frank mandate to bring more OTC trades onto exchanges. Further, we reiterated our view that launching SPXpm as a pilot enables the SEC to prudently monitor this product without stifling customer demand or impeding innovation. We are confident that after reviewing the facts of the matter, the SEC will concur. We very much look forward to launching this highly anticipated product.

We continue to roll out new initiatives to leverage our expertise in R&D and investor education to further develop the volatility frontier. Last Friday, we introduced the VIX Tail Hedge Index, which tracks the performance of a portfolio based on one month out of the money VIX cost. Our research team created the index to provide investors with a benchmark for VIX space tail hedge strategies. CBOE may also create -- may also use the index to create tradable products or to license it to others for trading.

We have a number of other new equity in ETF-based volatility products in the pipeline, which we plan to roll out in the months ahead.

On the educational front, I'm pleased to note that due to strong customer demand, CBOE's Options Institute has launched a new class devoted to VIX trading. The class, which will be offered several times over the year at the institute, will also be webcast to online participants. In addition, the institute last week published a book devoted to the trading of VIX options and futures.

In other product development news, CFE announced plans on April 19 to offer futures contracts on several Radar Logic 28-Day Real Estate Indexes, daily spot market equivalents to housing asset valuations covering major U.S. metropolitan centers, pending regulatory approval.

As announced earlier this week, CBOE's Board of Directors authorized a new share repurchase program for up to $100 million of unrestricted common stock, and the company raised its quarterly dividend by 20%. These actions reflect our strong commitment to returning capital to shareholders as well as our confidence in the long-term growth of CBOE Holdings. We remain confident that CBOE's unique focus on options and volatility products leaves us strategically well-positioned to take advantage of the considerable secular growth prospect for the options industry.

As we look forward to the balance of the year, we are encouraged by the volume rebound we have experienced during the last 2 months. We expect to improve margins in the second half of 2011 and beyond as volumes increase and we grow our top line while continuing to prudently manage expenses.

Specifically, we continue to build on the initial success of our C2 platform, work for the approval to launch SPXpm, expand our product offerings, including our VIX product line, and position CBOE to benefit from regulatory reform.

Finally, our strong operating cash flow and debt-free balance sheet provide us financial flexibility to continue to invest in innovation and growth while continuing to reward stockholders.

And with that, I will turn the presentation over to Alan Dean to discuss our financials. Alan?

Alan Dean

Thank you, Bill, and good morning, everyone. As you saw from this morning's second quarter earnings release, we achieved another strong quarter, highlighted by a 33% increase in diluted earnings per share to $0.36 and increased cash flow from operations over the second quarter of 2010.

This continued solid performance, along with the previously discussed actions to return significant cash to stockholders, is consistent with our optimism about CBOE's prospects and demonstrate our ongoing commitment to deliver value to stockholders.

Now let me begin with an overview of our operating results. For the quarter, operating revenues were up 7%, operating income grew 35% and operating margins increased by 980 basis points to 46.9%, the highest in the last 10 quarters.

Looking at the P&L in more detail, as shown on Slide 18, operating revenues increased to $120.3 million in the second quarter. This improvement resulted from a $14.7 million increase in access fees offset somewhat by a $7.8 million decrease in transaction fees. In addition, Other revenues increased primarily due to higher revenue from licensing fees and other miscellaneous items.

The increase on access fees compared with last year's second quarter resulted primarily from the implementation of a new trading permit program following our demutualization in June of last year. Next quarter will mark the anniversary of the new access programs so the numbers will be more comparable.

However, the year-over-year comparison will be impacted by the sliding fee scale we implemented in January, where market-maker trading permits used in multiple listed products, whereby our form was committed to a certain number of permits for the full year.

We are holding our full year guidance of $65 million to $68 million for access fees. As I pointed out in our previous call, the demand for trading permits fluctuates with market conditions, resulting in inherent volatility. Based on the slow and uneven economic recovery and choppy markets, we believe it prudent to continue to take a conservative stance regarding these fees. Again, I would point out that this guidance does not include the additional access fees we expect to introduce in conjunction with the launch of SPXpm and C2.

We experienced a $7.8 million or 8% decrease in transaction fees in the quarter driven by a 16% decline in trading volume that was offset somewhat by a 10% increase in the average revenue per contract. As Bill noted, we were up against difficult comparisons with last year's second quarter, when in May 2010, the Flash Crash resulted in record trading volume.

While volume was down, our revenue per contract increased to $0.308 compared with $0.281 in 2010 second quarter, reflecting a shift in product mix towards higher margin index options and futures contracts, which represented a greater percentage of contracts traded in the quarter. In addition, volume discounts achieved through our sliding fee scale were down due to lower trading volumes.

As this slide depicts, our index options accounted for about 25.1% of the total contracts traded in the second quarter this year in comparison with 23.8% in last year's second quarter. Futures contracts, our highest margin product, accounted for 1% versus last year's second quarter, when it was not material enough to know.

This next slide details our operating expenses, which totaled $63.8 million, a decrease of $7 million or 10% compared with last year's second quarter and reflect our continued cost discipline. Breaking this number down, we look at our expenses in 2 categories: core operating expenses and volume-based expenses. Core operating expenses of $41.8 million were down $2.8 million or 6%, primarily reflecting lower cost for outside services and travel and promotion expenses, offset somewhat by higher employee costs.

Employee costs were up due to a $2.5 million increase in continuing stock-based compensation. Last year, the second quarter only included about 2 weeks of stock-based compensation expense versus a full quarter this year. Excluding the continuing stock-based compensation expense, core operating expenses of $38.7 million decreased by $5.3 million or 12%.

With regard to operating expenses, we remain focused on diligently managing our cost structure and aligning resources as best we can with the trading volume trends. For the full year, we are adjusting our guidance for core operating expenses to a range of $170 million to $173 million from our previous guidance of $173 million to $177 million. This takes into account our year-to-date performance and our decision to pull back on discretionary spending in light of the uncertain economic outlook.

Volume-based expenses, which include royalty fees and trading volume incentives, decreased $6 million in the quarter as a result of a $4.8 million decrease in trading volume incentives and a $1.2 million decrease in royalty fees, which relates to lower trading volume in CBOE's licensed index products versus last year's second quarter.

Trading volume incentives decreased $4.8 million, primarily due to lower trading volume and equity options and ETFs, which were down 25% and 7% respectively, compared with the second quarter of 2010 and by changes in the criteria for quantity-based fee waivers.

Second quarter operating margin was $56.5 million, resulting in an operating margin of 46.9%, up 980 basis points from 37.1% in last year's second quarter.

Our effective tax rate for the quarter was 40.7% and compared with 40.1% in last year's second quarter due to an increase in the O&I state tax rate that was effective January 1 of this year. While our tax rate has and will continue to vary quarter to quarter, we are maintaining our full-year guidance range of 41.7% to 42.0%.

We are reaffirming our full year 2011 guidance provided in our February 10 and May 5 earnings press release with the exception of the downward revision to core operating expenses, which I noted earlier. Slide 25 provides a detailed outline of our guidance.

Now let's turn briefly to the balance sheet. As shown on this slide, our cash balance was down slightly to $106.5 million compared to $115.7 million at the end of March. This decrease primarily resulted from our payment of income taxes of nearly $49 million.

In addition, we used cash for capital expenditures of $11.2 million, dividends of $9.2 million and stock repurchases of $3.1 million. The stock purchased consisted of unrestricted common stock surrendered in the quarter to satisfy employee tax obligations upon divesting of restricted stock. Divesting a number of restricted stock grants during the quarter resulted in a net addition to shares outstanding of just over 413,000, bringing total shares outstanding to 90.5 million, of which all are unrestricted common stock. Of course, the share count will change as we execute our share repurchase program. We will provide updates on share purchases in our quarterly earnings reports.

We generated cash flow from operations of $14.3 million in the second quarter and $92.6 million year-to-date, increases of 63% and 30% respectively over the same periods last year. We expect to continue generating cash from operations that will provide enough resources to fund our ongoing growth initiatives.

Since it is difficult to predict future market conditions and their impact on trading volume, we stay focused on what we can control, and we will adapt our cost base to the evolving market environment while simultaneously making investments to position ourselves for continued long-term success.

In conclusion, I believe we are prudently managing the company with the right balance of short-term earnings performance while driving long-term shareholder value.

So with those comments, I'll hand the call over to Debbie so we can start taking your questions. Thank you very much.

Debbie Koopman

At this point, we would be happy to take questions. We ask you that you please limit your questions to one per person to allow time to get to everyone, feel free to get back in the queue. And if time permits, we'll take second questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Rich Repetto with Sandler O'Neil.

Richard Repetto - Sandler O'Neill + Partners, L.P.

I hate to be so narrow on the question, but the trading incentives, Alan, so dramatically dropped. Your expenses were certainly -- drove a lot of upside here. Can you give us -- I know you revise the pricing when you have to route out. What was the difference quarter-to-quarter in the trading incentives? Volume incentives?

Alan Dean

Yes. As I mentioned in my prepared remarks, volume was down in the multi-list products quarter-over-quarters, equity and ETF. When you compare the 2 product lines, that was down. So that accounted for a significant reduction in the line item. And as you insinuated, we reduced the threshold at which we will pay for the way exchange fees when we route a customer order to another exchange. So we've been working hard on this line item for a while, trying to trim it down as best we can while still doing what we think is best for our customers and the exchange in general. And so we're very happy with the results that we saw this quarter.

Operator

Our next question is from Chris Allen of Evercore.

Christopher Allen - Evercore Partners Inc.

Just wanted to ask on SPXpm. Obviously, it's in the SEC's hands. But I mean how are you addressing the push backs there and how do you think it's progressing? And if it does go against you, what's your backup plan in case you need to scrap SPXpm and go a different route?

William Brodsky

First of all, the SEC is using a different process than they have used before. So what we've just been through has been a new thing. Quite frankly, I was pleased to see that there was only one negative comment letter, not surprisingly, from ISC because they tend to oppose anything we try to bring forward. But we addressed all of the comments in our rebuttal letter. So #1, it's moving along. The timing is such that the SEC has under the present procedure until June 6 to either approve it or disapprove it or extend its review by a final 60-day period. Having said that, delays in approval, historically, are not unusual. I remain cautiously optimistic about it. But that said, there are no guarantees. So we do have contingencies. But it would be premature to discuss them at this point.

Operator

Our next question is from Alex Kramm with UBS.

Alex Kramm - UBS Investment Bank

Just want to touch base quickly on the buyback here. Can you give us a little bit more color in how you seek to approach that over the next few quarters? I mean you've got $106 million in cash, you throw off like $25 million to $30 million a quarter. And maybe give us an update of how much cash you actually need on your balance sheet to run the business so we have a better idea of -- the stock, obviously, has come down a lot here. So I would expect you being a little bit more opportunistic right now.

Alan Dean

I think, Alex, opportunistic is the key word. We plan to be opportunistic. And we do generate significant cash as you mentioned. We don't plan on borrowing nor will we borrow any money to fund the stock repurchase. We have adequate cash reserves on our balance sheet. And we'll generate additional cash in the future. We need about $40 million to $60 million in cash on our balance sheet to comfortably run the business. So with that level, you can see that we can easily come up with $100 million to do the stock repurchase.

Operator

Our next question is from Jillian Miller of BMO Capital.

Jillian Miller - BMO Capital Markets U.S.

So you mentioned in your comments that you have a number of new VIX products kind of in the pipeline to launch in the second half. I just wanted to get some more detail there on what those products might be.

William Brodsky

We don't get into new products before we announce them. So if we haven't announced them yet -- we're not going to announce them at this time. But this is something -- we always have a pipeline. And one of the things that I think is terrific right now is that the marketplace is recognizing the value of the VIX product line, not only in terms of the index values that we disseminate, but also the products that we're trying to create through VIX. And as I said, we've launched a very heavy educational effort through our Options Institute, training people about VIX. So this is all part of a bigger package that as you come up with a whole new concept in trading, which is a volatility suite, we have to educate parallel to bringing on new products.

Operator

Our next question is from Howard Chen of Credit Suisse.

Howard Chen - Crédit Suisse AG

My question's on the competitive landscape. Bill, I heard your comments loud and clear on balancing revenue growth with market share. But we are seeing others in recent quarters consolidate on some of their single equity options market share and now that you see AmEx potentially semi-mutualizing, I just wanted an update on how you're all thinking about the competitive landscape and some of the things that are coming off.

William Brodsky

Howard, I think that what's important is that the industry really is broken into 2 groups: you have the commoditized products and you have the premium products. And we don't want to yield any market to anybody. But quite frankly, we continue to battle every day in the multiply listed area. But our growth story stems from our leadership role in index products and the volatility suite. So even in the lackluster quarter we just went through, we believe that we've knocked the cover of the bowl in the VIX and the futures and options. That's our growth edge. So we're going to be a competitive business. But we think we can add tremendous value by what we bring to the table that nobody else does.

Operator

Our next question is from Daniel Harris of Goldman Sachs.

Daniel Harris - Goldman Sachs Group Inc.

I just want to go back to your commentary around the trading volume incentives and the earlier answers to the questions. So obviously, you made some changes this quarter. I just want to talk about the sustainability. Historically, that number has been roughly about 14% of the single-name and ETF fees that dropped about 7% this quarter. Is that sort of the run rate we should be looking for going forward or is there any sort of issues in the mix shift this quarter that drove that down?

Alan Dean

No, nothing in the one-time nature this quarter that would make it an aberration going forward. To expand on my earlier answer, in the past, we would reimburse the way exchange fees if the size of the order was under 500 contracts. And so that cost us a lot of money. What we did during the quarter is we reduced that threshold from 500 contracts to 100 contracts. So if the order size is 100 or less, we paid the way exchange fees. And that reduction meant a lot for us combined with the reduction of volume.

Operator

Our next question is from Dan Fannon of Jefferies and Company.

Surinder Thind - Jefferies & Company, Inc.

This is Surinder Thind calling in for Dan Fannon. I just wanted to follow up on the share repurchase program. Can you talk about the process and thinking that the program as being, perhaps, your best use of cash versus maybe being more aggressive in other areas or other investment possibilities, whether it's trying to find partnerships even outside the U.S.?

William Brodsky

We exploit all the different issues. As Alan said, I think what's significant in this is that we continue to produce cash. So we do not look at this as precluding us from doing the kind of things you talked about. And we will be opportunistic in terms of how we use the cash that we continue to generate month in and month out. So this is not something that will exhaust our cash for the foreseeable future, just cash we built up since we have the IPO, even after the tender offer, even after the dividend payments. Alan?

Alan Dean

Yes. Also, I want to say that this reaffirms what we've been saying all along in our quarterly earnings calls and meetings with investors is that our priority is making sure that we invest what we need to in our business to make sure it grows at the maximum level that it can. And beyond that, cash should be returned to shareholders unless we have a good reason to keep it. So we looked at all the possibilities, as Bill mentioned, and if something should come along on the acquisition side, some expansion of our business external, that is not organic, we have our balance sheet to lean on. And a debt-free balance sheet is a very good thing.

Operator

Our next question is from Matthew Heinz with Stifel, Nicolaus.

Matthew Heinz - Stifel, Nicolaus & Co., Inc.

On C2. It looks like you've had some nice sequential momentum there after the May fee adjustment and you just rolled out some complex order functionality. So I guess where do you think you can take the ADV, both the SPXpm rollout, which may be sooner or later. But what levels of volume, I guess, would make you happy as a management team next year?

William Brodsky

Bill Brodsky, Matt. The whole C2 rollout has been doing very, very well. And as you can see, we're tweaking the fee structure, and it's been very effective. So I think we'll continue to see a growth in C2. And when SPXpm comes on, that should change it. But until that happens, we're going to just keep growing as we have been organically. And it's always going to give you a little further insight.

Alan Dean

So I think we see the potential. We gave guidance for this year in that 1 to 3 percentage range. We still haven't realized the full potential. As you point out, we're looking forward to an S&P 500 product certainly trading on an all-electronic fashion on C2. But pointing to the highlights in the slide that was in the deck, and we can see that in the SPDR and Q volume was pretty terrific for us. So it's certainly something that we'd be shooting for in the other multi-list classes, and it gives us confidence that we're onto the right model. C2 is performing well. The customer experience is a positive one. So I like those numbers. It's something to be shooting for. But we remain in our 1% to 3% range for the remainder of this year. And again, we look very much to launching the S&P 500 pm contract to really help us realize that goal.

Matthew Heinz - Stifel, Nicolaus & Co., Inc.

Okay, that's helpful. And then any plans in the future to roll out VIX to C2?

Alan Dean

The difference in structure in VIX and the debate whether or not there would be the full benefit that we anticipate for SPXpm is that our users of VIX contracts today can choose to trade VIX in an all-electronic fashion on CBOE's hybrid platform. That of course is different with the current SPXam contract when comparing that to the potential SPXpm all-electronic. So while we haven't ruled it out, the benefit certainly that we see with electrification in the S&P 500 may or may not be a huge benefit for us in VIX, but it's certainly a conversation we're having.

Operator

Our next question is from Michael Carrier of Deutsche Bank.

Michael Carrier - Deutsche Bank AG

Alan, the tax rate this quarter dipped a bit. If you look across the exchanges, you guys are at the high end. I think one of your neighbors is talking about trying to figure out some initiatives to bring the tax rate down. Just wondering given the higher Illinois tax rate, what your thoughts are on that.

William Brodsky

Michael, this is Bill Brodsky. Let me first respond to that and if Alan wants to augment it. We are in dialogue with the officials in the state at the highest level to help them better understand our tax situation, and work to create a better economic climate for business, obviously generally, but also for the kind of business that we're in. So this is a little early to tell you what might occur because as you know, this happened early this year without a lot of warning. And I can tell you I'm personally involved with the highest levels in the state government to see what we can do to help bring this down.

Operator

Our next question is from Ken Worthington of JPMorgan.

Kenneth Worthington - JP Morgan Chase & Co

On CFE, it's been doing very well. But the volume is really concentrated in that core volatility, the core VIX product. You've launched some new products, you've got some really ones that I would think would be quite attractive, including that Gold VIX product. What's the strategy to build interest in them and kind of diversify the futures platform beyond just launching products? How do you get volume in them?

William Brodsky

This is Bill, Ken. Building volume is an art as much as it is a science. In fact, it's more of an art. It's education. It's getting the right markets makers. It's interesting people who might be the more likely users. We are developing a major initiative to take the whole CFE to a new level. We now are trading at the rate of 1 million contracts a month at CFE. I would dare to say it's probably the most successful new futures of initiative in many, many years, and we are working on that. We have an Oil VIX product as well. So there's a whole host of things we're doing, including working with the futures community, which is different than our normal user base. So it will take time, but we know how to do it. We've launched products and it often takes a while to get it really where you want it to be.

Kenneth Worthington - JP Morgan Chase & Co

Can you guess on timing?

William Brodsky

Very hard to guess on timing on that as there are many factors. But I will tell you that we're seeing -- if you look at the VIX futures, in particular, that's being fueled by these ETNs, where we have literally dozens of ETNs near to the VIX. And we're working with the managed futures community, which we think is the next logical place to go to build interest because they understand the commodity-based VIX products better than the securities firms would understand the S&P 500 VIX products.

Operator

Our next question is from Justin Schack of Rosenblatt Securities.

Justin Schack - Rosenblatt Securities

On complex orders, there's a lot of focus on the industry on those different exchanges, instituting new pricing, you guys going on the Web [ph]. Can you give us a sense of what the size of the market is there, how much of the total options market comes from the complex options side?

Alan Dean

I'm going to ask Ed Tilly to respond to that, Justin --

Edward Tilly

It is a growing interest here at CBOE. And I think someone mentioned earlier, we did add the functionality to C2, so that for the first time at CBOE Holdings, our market makers can actually rest orders in our complex order books. We think that's a huge value add for our market maker and liquidity base. But if we look at volume across the industry, I think we'd put it in the high teens, low 20s in the percentage, but of course, differs by product and primarily a statistic and a fine note here that it may not get into this morning. I'd be happy to furnish more numbers in complex orders looking forward. But rest assured it is a priority here and you can watch us as we roll out enhancements to that complex order book. And as I say again, I'll reiterate, most recently adding the functionality for market makers on C2, that's a first here for CBOE Holdings.

Operator

Our next question is from Gaston Ceron of MorningStar.

Gaston Ceron - Morningstar Inc.

Just a quick follow-up on the SPXpm situation with the SEC. I know you guys took a few questions on that already, but if you would indulge me with one quick more. Just wondering, you said something to the effect of that you're seeing sort of a new process from the SEC or a different kind of a process in evaluating these product launches. How is that going to affect, not so much as the SPXpm because that's already in the pipeline well advanced, but more like product development going forward? I mean should we kind of assume that everything will take as long as this product has in the future or what's your guidance on that from the commission?

William Brodsky

That's a great question and I don't have a great answer for you because we actually work hard with a couple other exchanges to get a provision in the Dodd-Frank legislation that's forced on the SEC specific hard deadlines. Because in the past, there were delays that would seem infinite. If this seems long for you, in the past they were longer. And so various exchanges got together and say, "This is not fair. We're going to give the SEC through the statute hard deadlines." So what you're seeing now is the statute being played out where the SEC is being -- actually has hard deadlines that they have not chosen, the statute imposes that on them. So this is kind of a test case. And I think it's going to be as much a function of the nature of the product and what we ask of them. So there may be products that don't create issues to them, that things will be a lot faster. This is related to, from our perspective, because we bring up more new products, more novel products, and we were frustrated that SEC was taking so long. So in a perverse way, we're now being -- this is now being used as it relates to us in the case of first impression. But it related very specifically to when we took -- it took 3.5 years for the SEC to approve GLD options. And so I helped lead the effort in Washington and say, "3.5 years? This is ridiculous, and look at the way that thing trades." So this is procedural. It could work for us, and I think in some respects, it's much more favorable for us because it has finite deadlines where in the past, it literally went on for years.

Operator

Our next question is from Patrick O'Shaughnessy from Raymond James.

Patrick O'Shaughnessy - Raymond James & Associates, Inc.

So obviously, your overall rate per contract went out because of the makeshift towards indexes. But even in the index product group itself, we saw a nice sequential increase from the first quarter to the second quarter. How much of that is due to the VIX options contracts growing faster than the SPX? Or what else is taking place to make that index rate per contract go up?

Alan Dean

Pat, that's probably a part of it, I don't have those numbers right in front of me. I'm sure it is part of it. But I think a significant reason why RPC went up beyond the change in the mix is that our sliding fee scales that we have in place. When volume is down, the average rate that we're paid goes up, and that just happens automatically. And so I think that also had a significant impact in the overall RPC.

Operator

Our next question is from Niamh Alexander of KBW.

Niamh Alexander - Keefe, Bruyette, & Woods, Inc.

Earlier you said when and not if for the S&P going electronic. So I guess we'll watch the space. But my question was going to Alan on the expenses. Your guidance is carrying -- you're almost nearly $10 million ahead of where you're tracking. In the first quarter, you came in below the guidance and you said you'd kind of stick with the guidance. Here, you're bringing it down slightly. But it still looks like the expenses should go up. I mean what's driving up those expenses in the next few quarters?

Alan Dean

It's easier to tell you what we reduced in the first half of this year rather than what will go up and maybe that will help you in coming to an answer. What we looked at is employee costs in the first half of the year. So hiring, incentive compensation, we focused on outside services dramatically for the first half of the year. Travel and promotion, another area that we looked at, very hard and training volume incentives also, there's a couple of questions on that so far this morning. So what we try to do is in periods where we see lackluster volume, we can dial down expenses somewhat, not completely, nor do I think we should it in a drastic way. These are short-term things that we're able to that in terms of delay or elimination or reduction. And we'll do it again if we see volume trail off. And I hope that gives you the color that you're looking for.

Niamh Alexander - Keefe, Bruyette, & Woods, Inc.

Okay. Fair enough, Alan. So if volume kind of stays at similar levels, then you'll probably come in below the guidance then. Is that fair?

Alan Dean

Well, I would say that if I -- I saw that July has been a very good month. August is starting out wonderfully. So current levels is -- I wouldn't compare current levels to what we saw in April and May, for instance. June was a little bit better. So no, current levels I think is a lot better than what we saw earlier in the year.

Operator

Our next question is from Ed Ditmire of Macquarie.

Edward Ditmire - Macquarie Research

Because of a bifurcated financial market regulation in the U.S., you have to host your VIX futures on a separate platform or the term regulatory structure, et cetera. Can you quantify how much this has cost CBOE in terms of the costs that wouldn't exist if you could trade these products on your existing option exchanges?

William Brodsky

This is Bill Brodsky. We host VIX futures on the same trade engine that we host CBOE. One, the basic option exchange, C2, the CFE. So we've built our electronic systems so that it could trade stocks, futures and options and it does that today. It was built that way. I would tell you that there's no significant cost because of the bifurcated situation. The bifurcated situation creates a problem for us when we try to do these different products, which is what I was referring to in the question a few minutes ago from the MorningStar gentleman. That's where this becomes an issue. That's why we actually put that language in Dodd-Frank bill because the hangup sometimes becomes SEC-FTC. So it tends to be more what I'll call, "regulatory rather than systems or operating expenses."

Edward Ditmire - Macquarie Research

Maybe I'll just ask it in a different way. Do you think a large-scale incumbent futures player could make more money off these popular products than you could?

William Brodsky

I don't know. Right now our margins are very good. We're very happy with where we are right now.

Operator

Our next question is from Rich Repetto of Sandler O'Neill.

Richard Repetto - Sandler O'Neill + Partners, L.P.

Just a follow-up. Bill, you mentioned Dodd-Frank and the OTC derivative opportunity. I wonder if we get more specific what your opportunity, and I guess I'm looking at the S&P 500 options, the over-the-counter options and how your licensing might benefit you if the over-the-counter options and the S&P 500 have to be cleared and the arrangement with the DTCC.

William Brodsky

Yes, Rich, I think there are a couple of things mixed up there. But fundamentally...

Richard Repetto - Sandler O'Neill + Partners, L.P.

Excuse me, OCC.

William Brodsky

Yes, OCC. So what we did last May, a year ago, before Dodd-Frank had even passed, is we amended our contract with S&P to the extent that if Dodd-Frank, that was then in process but hadn't been signed, were to require the clearing of OTC derivatives as it related to S&P 500 index options, which are the very commonly used in OTC derivatives, if the legislation were to require that they be centrally cleared, that CBOE would get a financial benefit. If we were clear at OTC or theoretically, some other clearinghouse, even if we didn't trade it, that was a major modification to our contract. It speaks to the relationship we have with S&P to be able to amend the contract when need be, and that sits there pending all the things that are going on in Washington now as it relates to what the rules and regulations will be on centralized clearing of OTC products. And in the equity derivative space, it's our understanding that the S&P 500 is the most commonly used vehicle for OTC option trading.

Richard Repetto - Sandler O'Neill + Partners, L.P.

Okay, that's very helpful. So there is an agreement, I'm sure you're not going to outline it, but there is going to be revenue if it's forced to be cleared.

William Brodsky

Right. And actually, we signed that right before IPO. It was in the S1.

Alan Dean

Rich, this is Alan. The revenue structure in the agreement allows us to realize fees that are comparable to what we realize on our trading floor today for SPX. So we try to be -- structure the change in the contracts so that we wouldn't be negatively impacted.

William Brodsky

Yes. And Ed Tilly wants to add one more aspect to that, Rich.

Edward Tilly

Rich, you asked a great question. We're focused a lot on the opportunities coming out of the rule-making process. And I don't want you to forget that if the incentives that come out of rule making, whether it's by margin or the handling required that OTC trades need to be exposed to a lit market, then CBOE's electronic flex mechanism leads the industry in its automation and its functionality. So we have the ability to automate exchange lookalike OTC contracts by using our CFLEX system. And then ultimately, as we continue to pound the table over the benefits of an SPXpm contract that can bench a pm settlement, was really attractive ultimately to OTC players. And it's one of our key focuses. So we think we have the 3 most obvious moves of OTC to listed, that being directly to OTC clearing, a lit market through our CBOE Flex system and then ultimately, the most transparent market in a pm settled all-electronic contract on C2.

Operator

Our next question is from Roger Freeman of Barclays Capital.

Roger Freeman - Barclays Capital

I know a lot's been covered. I just to come to 2 things hopefully haven't been fully vetted out. Just on the share buyback. I saw the comments about the cash, sort of minimum cash balance, you want to keep it. Just want a perspective, I'm thinking if from the members, right? The lockups are now over members a lot still. And is part of your thinking around buybacks at all tied to when you are getting indications that there may be built-up interest in selling and you want to try to help manage that process?

Alan Dean

Roger, Alan here. No, that wasn't the motivator. We saw an increased selling pressure resulting from the last lockup. We evaluated all the alternatives available to us and decided on our approach of raising the dividend by 20%, which we did, and combining with the stock repurchase. So it wasn't motivated by that. We believe in the long-term prospects of CBOE and believe that this approach, this comprehensive approach, was in the best interest of our shareholders, all of them.

William Brodsky

And I'll just add, Roger, whatever selling pressures there might have been in the past has been mitigated by institutional buyers, who I'm sure, recognize the long-term intrinsic value of our franchise.

Roger Freeman - Barclays Capital

Yes, absolutely, okay. And then the other thing is on the VIX product, not looking for specifics but just more generally speaking, do you have more interest from dealers, like what some of Barclays has done in terms of the, ETN, new dealers or existing ones that are looking to launch new products with you?

William Brodsky

We have an ongoing dialogue with a variety of major players who recognize that they don't want to be recommending a Barclays product to their clients. They want to make their own products. There's continued interest in the area, notwithstanding the volatility of volatility.

Alan Dean

So there's some more specific. There are 40 to 50 sponsored and licensed ETNs that track different ranges of volatility in the volatility curve, and the most successful, obviously, Barclays in that short-term volatility exposure. But there are others certainly, as Bills points out, roughly 40 to 50.

Roger Freeman - Barclays Capital

And do you think that when we get into -- we're in, obviously, a period of more volatility seeing the VIX move up again, and we had been in a declining period. Do you think that will spark more interest? I know it's just very short term here. But were that to persist, do you think that might generate more dialogue?

William Brodsky

We can't help but do that. Again, I think that VIX, as a new frontier, we are just in the beginning stages. You can look at it from an institutional point of view. People now look at VIX, They can't not pay attention to it. But it is a learning curve, and we're going to be at the forefront of it. We just came with a new book on trading VIX. And volatility spikes tend to take the whole VIX thing to a new level. So we've seen this a couple of times. It grows even when there isn't volatility, but it's going to grow more when there is volatility.

Alan Dean

I think you might have missed Bill's prepared comments. But launching the CBOE VIX Tail Hedge Index really plays to those that have already adapted VIX in their portfolio and need a benchmark to track their success. So we have details out on our website on that tail hedge index. And we think that's a tool that will bring even more visibility to the benefits of balancing the portfolio with the VIX components.

Operator

Our next question is from Rob Rutschow of CLSA.

Rob Rutschow - Credit Agricole Securities (USA) Inc.

I wanted to follow up on the C2 launch of S&P. I'm wondering, I don't know if you can tell us the specifics of what the sticking points are with the SEC, but I'm wondering if you can give us a little color on your conversations with them and if you can give us any confidence that they won't delay the launch further given the operational issues that they're having.

William Brodsky

Well, first of all, the sticking point, if we want to call it the sticking point, I think it's point of focus is the way I'd like to look at it, is the pm settlement because if you're old enough to remember, which I am, what it brought it about, it was for many, many decades ago, when the New York Stock Exchange specials basically had to close the stock and on Expiration Fridays, it was up against the world and it did not allow for easily handling of imbalances. And there've been incremental changes that have allowed many new products that we have brought on and others along the way that the SEC has allowed a pm settlement, but this product brought back a lot of those issues to them. And that's, if you want to call it a sticking point, that's the sticking point. So I can't tell you exactly what will happen. I can't promise that it will happen on September 3. I can't promise it will happen, period. But if you look at the letters that went out, the circular that they put out, the questions they asked and the lack of response in any meaningful way on the areas that they raised would give me a reason to believe that they now have done a very thorough vetting process. And if there are concerned commentators on these issues, they would've said something. Having said that, I'm in dialogue with the SEC. They are heavily loaded or overloaded on dealing with Dodd-Frank deadlines. That's not a secret. So to a large extent, I think if there are delays, I can't, again, guarantee the results. But I think some of the delays are not related to our issues. They're related to the fact that there's so many deadlines they have to meet.

Operator

Our next question is from Justin Schack of Rosenblatt Securities.

Justin Schack - Rosenblatt Securities

Just a quick follow-up on something you had talked about before with the electronic flex options process. Given that the OTC community or the dealers have been wanting to go on exchange with some of this stuff, have you guys considered launching a SEF that would take advantage of that technology?

William Brodsky

It's a great question. I think in one of our comments, whether it was a quarterly or we've been public at one of the conferences, we're certainly watching the definitions first of swap dealers in considering building a SEF, whether or not that is an interest to pursue here at CBOE. I think like the rest of the industry, unfortunately, today the answers we're still waiting for definition and clarity on the regulation, even though July has come and gone as the target date. So certainly, we'll never rule that out. It's definitely on our radar. And the process here at CBOE and our technology is to consider SEF and the systems behind operating a SEF as well as, of course, the legal and regulatory hurdles. We will be looking at that and making further comments as definitions come out of the rule making and out of D.C.

Operator

I'm showing no further questions in queue at this time. I would now like to turn the call back over to Ms. Koopman for any further remarks.

Debbie Koopman

Thanks to everybody for joining us today. If you have any questions, feel free to give me a call.

Operator

Ladies and gentlemen, thank you for your participation. That concludes the conference. You may disconnect, and have a wonderful day.

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