CME Stands to Benefit From Rising Interest Rates as Volatility Returns to Its Markets

Business Strategy & Outlook

CME has suffered from little to no revenue growth more recently as all its futures complexes reported lower trading volume in 2021 than in 2019, with the notable exception being its equity futures platform, which remains well above prepandemic levels. The most significant headwind for the company has been the impact that low short-term interest rates has had on its interest rate complex, which is its largest source of revenue. When interest rates are expected to stay low there is less need for interest rate hedging and less incentive for speculation, creating a drag on CME’s trading volume. With interest rates now rising, though, this drag has been removed and the company’s results have improved so far in 2022. After a couple years of meager revenue growth, CME enjoying more favorable market conditions in the near term.

CME has benefited in the past from increased retail interest in equity markets. Equity markets saw a surge in trading volume in 2020, with equity derivative products seeing a larger and more maintained increase. CME’s equity index futures business produced impressive performance as a result. The expected revenue from CME’s equity derivatives to partially normalize over time as retail interest in equity markets fades. That said, the rise of $0 commissions, changes in investor behavior, and the availability of futures on retail brokerage platforms will provide a permanent tailwind to CME’s equity business, so one cannot foresee a full retracement. Additionally, as global commodity markets remain volatile, CME’s energy and agricultural futures to see continued interest. Beyond 2022, CME should see steadier growth in revenue and earnings. CME has a dominant position in many of the contracts that trade in its exchange and is well diversified across multiple product lines. In the long term, the anticipate that the company will continue to benefit from secular growth in the need to hedge commodity, energy, and interest rate exposure. CME also has a history of generating incremental growth through the introduction of new futures contracts, like the micro-E-mini S&P 500 contract and bitcoin futures.

Financial Strengths

CME Group has a strong balance sheet that would serve as a buffer if a market disruption occurs The balance sheet also provides the company with the flexibility needed to invest more capital into organic investments or acquisitions if it chooses to do so. At the end of 2021, the company had equity of $27 billion against $3.4 billion in debt. The company’s balance sheet is managed conservatively, with a targeted EBITDA to debt ratio of 1 time and a firm goal to keep $700 million in cash on hand at any given time. CME is well above this goal, with more than 2.8 billion on hand at the end of 2021, giving it a rock-solid balance sheet. As a clearinghouse, CME is obligated to cover the losses of its clearinghouse members in the event of a default. However, CME’s share of potential losses as a clearinghouse is capped at $250 million and the company’s balance sheet has more than sufficient liquidity to cover the potential credit risk that comes from the firm’s clearinghouse activities. In recent years, CME has returned most of its operating cash flow in the form of dividend payments. The company does this through a combination of a regular quarterly dividend and a special discretionary distribution it typically makes once per year. The company to maintain its regular dividend for the foreseeable future but note that the size of the special dividend can fluctuate from year to year based on the company’s result for the year and what cash it has on hand. Should the company make another major acquisition, like the purchase of NEX, the discretionary portion of CME’s dividend to shrink or be eliminated outright.

Bulls Say

CME has assembled a diverse set of derivative products in interest rates, equities, commodities, metals, and foreign currency. Weakness in one product is often offset by strength in another.

CME has been able drive trading volume growth by successfully introducing new futures contracts, like the micro-E-mini-S&P 500 and Bitcoin futures.

CME stands to be a beneficiary of rising rates as increased volatility drives more trading volume in its interest rate futures contracts.

Company Description

Based in Chicago, CME Group operates exchanges giving investors, suppliers, and businesses the ability to trade futures and derivatives based on interest rates, equity indexes, foreign currencies, energy, metals, and commodities. The CME was founded in 1898 and in 2002 completed its initial public offering. Since then, CME Group has consolidated parts of the industry by merging with crosstown rival, CBOT Holdings in 2007 before acquiring Nymex Holdings in 2008 and NEX in 2018. In addition, the company has a 27% stake in S&P/Dow Jones Indices LLC, making the Chicago Mercantile Exchange the exclusive venue to trade and clear S&P futures contracts. Through CME’s acquisition of NEX in 2018 it has also expanded into cash foreign exchange, fixed income trading, and collateral optimization.

(Source: Morningstar)

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