Gunning For CME's Golden Goose

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FMX Futures Exchange, launched by BGC Group, aims to challenge CME Group's dominance in the Treasury and interest rate futures markets.FMX plans to offer lower prices, advanced technology, and ...

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But the competition could result in a few challenging years for CME.JHVEPhoto US Treasuries are considered one of the safest and most easily traded securities in the world. There is currently roughly $27 trillion in outstanding Treasuries and an average of over $800 billion in par value is traded every day. But that's just the cash Treasury market. Interest rate and Treasury futures are used to trade an average of $4.2 trillion in notional value each day. And virtually all of that futures trading runs through one company - CME Group Inc. (NASDAQ:CME). Treasury and interest rate futures are the most frequently traded contracts on CME's exchange. In 2023, the segment made up over half of the average daily volume and brought in $1.56 billion, representing 28% of company revenues. It's a lucrative, high margin business that has grown significantly in recent years as rising interest rates have caused many companies and market participants to hedge risk. But, for the first time in over a decade, CME is facing competition for its Treasury and interest rate futures exchange. In January 2024, the CFTC (Commodity Futures Trading Commission) granted approval for the FMX Futures Exchange to offer US Treasury and SOFR (Secured Overnight Financing Rate) futures. BGC - Who? FMX was created by BGC Group, Inc. (NASDAQ:BGC), a global brokerage and financial technology company led by Howard Lutnick. Lutnick is also the CEO of Cantor Fitzgerald, a financial services firm that specializes in middle-market investment banking, prime brokerage, and commercial real estate financing. Cantor Fitzgerald became well known in the 1970s by licensing its bond data to Telerate, allowing it to acquire a monopoly on electronic bond quotes. By the 1990s, Cantor Fitzgerald was one of the largest traders of US Treasuries. In 1996, the company began developing an electronic bond trading platform known as eSpeed. Alarmed by eSpeed's potential to dominate bond trading markets, a consortium of banks including Citigroup, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley launched a rival electronic trading platform known as BrokerTec in 2000. Cantor Fitzgerald was devastated by the September 11 attacks, as 658 employees working at the World Trade Center were killed. Lutnick, by sheer luck, survived because he took his son to his first day at kindergarten and was scheduled to come in late to the office. In the years that followed, Cantor Fitzgerald rebuilt and reorganized. In 2004, its voice brokerage business was spun out as BGC Partners. In 2008, BCG Partners merged with eSpeed. ESpeed would later be sold to Nasdaq, Inc. (NDAQ) in 2013 and again sold to Tradeweb Markets Inc. (TW) in 2021. It has since been merged into Tradeweb's Dealerweb platform. Once his non-compete agreement with Nasdaq ended in 2017, Lutnick began building another bond trading platform known as Fenics UST at BGC Partners. Since then, Fenics UST has grown its market share to 28% of the cash Treasury market traded by CLOB (Central Limit Order Book) - this represents roughly 10% of electronically traded Treasury volumes. Fenics UST's growth has mostly come at the expense of BrokerTec, which was acquired by CME in 2018. BGC Partners completed a corporate conversion last year and is now known as BGC Group. With Fenics UST firmly established, Lutnick now hopes to use FMX to challenge CME for control of the Treasury and interest rates futures markets. The Great American Monopoly BGC's attempt to break CME's dominance of the Treasury complex won't be easy. Lutnick calls it \"one of the great monopolies in America.\" This is, in fact, Lutnick's third attempt at launching a Treasury futures exchange. In 1998, Cantor Fitzgerald partnered with NYBOT (New York Board of Trade). CBOT (Chicago Board of Trade) - which controlled the Treasury futures market at the time and would later merge with CME in 2007 - retaliated by attempting to reverse Cantor Fitzgerald's regulatory approval and threatening to launch cotton and coffee futures to compete with those traded on NYBOT exchanges. In 2009, BGC Partners launched ELX Futures in a venture with Citadel Securities and a number of major investment banks. However, it ultimately failed due to a lack of a connection to an established clearinghouse. Lutnick isn't the only one who has tried to launch Treasury futures to compete with CME. In 2000, BrokerTec launched a futures exchange competing with CBOT. However, CBOT refused to allow its clearinghouse to offset margin for collateral held at its rival's exchange and BrokerTec failed to gain meaningful market share. CME eventually acquired BrokerTec through a merger in 2018. In 2003, Eurex attempted the same thing. Having learned from BrokerTec's failure, Eurex was believed to be in discussions with CBOT's clearinghouse to clear its futures contracts. CBOT responded by switching its futures clearing to CME and slashing its transaction fees. Eurex went as far as filing an antitrust case against CBOT for predatory pricing. It eventually admitted defeat in 2005. In 2011, NYSE Euronext - which is now a part of Intercontinental Exchange, Inc. (ICE) - launched Treasury futures on its Liffe platform. It had secured an agreement with the DTCC (Depository Trust and Clearing Corporation) to offset margin requirements for futures contracts with collateral held for cash Treasuries, allowing traders to improve capital efficiency. CME responded by offering cross-margining between Eurodollars and Treasury bond futures. CBOT and CME have been defending their hold on the Treasury and interest rate futures markets for decades. History is filled with many attempts to create a viable alternative. So far, all have failed. Does FMX stand a chance? FMX Selling Points Price Traders complain of frequent price increases and rising data costs associated with trading at CME. However, given the company's monopoly on Treasury and interest rate futures, there's little they can do other than pay up. For what it's worth, CME's reported average rate per contract on interest rate futures has actually been fairly steady around $0.50 for the past decade. Traders have been shelling out more money though, simply due to higher trade volumes: CME Press Releases Though FMX hasn't published a fee schedule yet, it is likely to undercut CME on pricing with no membership requirements. CME could respond to this with price cuts of its own, but that could lead to a price war that would destroy margins. Technology FMX, by virtue of being newly created, utilizes the latest technology. It claims to have the fastest matching engine for cash Treasuries. This is likely one reason it has been able to gain market share against CME BrokerTec, which has seen its revenues drop from $192M in 2019 to $152M in 2023 along with a 35% drop in average daily volumes. FMX's futures exchange will utilize similar technology and will be co-located with Fenics UST servers, providing ultra-low latency to reduce legging risk when trading futures vs cash basis. CME, on the other hand, continues to run separate exchanges cobbled together from its many acquisitions. In particular, Treasury futures are still traded on CBOT while SOFR futures are on CME and cash Treasuries are on BrokerTec. Another consideration is that CME's exchanges were built on technology that is decades old. To its credit, CME did announce in 2021 that it had partnered with Google Cloud to undertake a digital transformation. However, that is expected to play out over a decade. Initially, CME planned to migrate its data and clearing services to the cloud, and it deemed the data portion of that process complete last year. However, it will likely take significantly longer to move all of its markets to the cloud. Thus in the short to medium term, FMX is likely to have a technology advantage. Aside from simply faster trade execution, FMX plans to help traders save money by offering lower tick sizes to reduce bid-ask spread. For example, the widely traded 10Y Treasury futures have a face value of $100,000 and a minimum tick size of ½ of 1/32 of 1% of par. That works out to $15.625 as the minimum between ticks. CME Source: CME FMX plans to cut the minimum tick size in half, to ¼ of 1/32 of 1% of par, allowing trades in increments of $7.8125. Allowing better prices helps traders save much more money per transaction compared to lowering exchange fees. CME could respond by similarly reducing tick sizes. This could result in a race to the bottom, though it's unclear whether or not CME would face a technology limitation if the required precision gets too high. Cross-Margining A common factor contributing to previous failures to compete against CME has been the issue of clearing and cross-margining allowing improved capital efficiency. To address this, FMX has partnered with LCH (London Clearing House), a subsidiary of the London Stock Exchange Group plc (OTCPK:LNSTY). LCH is the dominant clearinghouse for interest rate swaps with a 73% market share. As swaps are also derivatives of Treasuries, they can be used for one-pot margining, offering up to 97% savings on futures collateral. FMX claims that the partnership with LCH offers the maximum capital efficiency for SOFR futures while matching or beating CME efficiency for Treasury futures. Ironically, CME has preemptively responded by pulling the same move NYSE Euronext did a decade ago - partnering with DTCC to offer cross-margining with cash Treasuries. This is expected to allow savings of up to 80%. Though it may seem like the FMX-LCH partnership has the advantage here, this is somewhat negated by the need to post collateral for trading on FMX in the first place. Traders currently at the CME will have to consider whether it's worth the time and money to move to FMX to take advantage of the enhanced margin efficiency, better trade execution, and lower prices. Initially, this is likely to appeal only to the subset that already holds collateral for swaps at LCH and is willing to make a clean break from CME for interest rate futures trading. That's a tough sell, as CME is a one-stop shop that also offers contracts on equities and commodities. But, the market for interest rate swaps is considerably larger than that of cash Treasuries. LCH currently has over $120 trillion in outstanding USD overnight index swaps. That's a lot more money and market participants that would be potentially interested in improved cross-margining at FMX. In comparison, there is about $27 trillion in cash Treasuries currently outstanding. Though that is growing quickly due to the government issuing more debt, 70 to 80% of the Treasury market is currently uncleared. According to the SEC, in 2017 just 13% of cash Treasury transactions passed through central counterparty clearing (i.e., DTCC). That means there's a considerably smaller pool of money that would potentially benefit from the CME-DTCC cross-margining program. However, recent developments could also considerably change the cash Treasury clearing landscape… Another Wrinkle to Iron Out In December 2023, the SEC issued a new rule that would force the majority of cash Treasury transactions to flow through covered clearing agencies. Implementation will begin in 2025 and the rule will go into full effect in 2026. Currently, DTCC controls the only covered clearing agency for Treasuries. The new rule means that a lot more transaction volume is likely to flow through the DTCC in the coming years. However, CME has applied to start a Treasury clearing business. LCH and ICE have also indicated interest in launching Treasury clearing services as well. CME's application is particularly interesting because it could potentially put them in the awkward position of directly competing with DTCC even as they are partnered on cross-margining. According to CEO Terence Duffy, CME was \"obligated\" to file an application for Treasury clearing and that \"if it's not necessary because a better offering comes out of DTCC with the efficiencies for the clients, we will stay with DTCC.\" Needless to say, as the incumbent DTCC has the advantage in clearing cash Treasuries. But if it fails to step up to the challenge of handling significantly higher trading volumes, cash Treasury clearing could end up in a free-for-all among several major exchange operators. Assuming DTCC comes out on top, the increased volume could reinforce CME's hold on futures through the cross-margining program. However, analysis from BNY Mellon suggests that the new rule could also result in a reduction in high frequency trading which could reduce liquidity and widen bid-ask spreads. That could potentially push traders toward exchanges with better execution like Fenics UST or increase volume in derivatives such as swaps cleared by LCH. What's the Financial Impact? BGC is launching the FMX exchange with a consortium of the biggest investment banks and moneymakers. The list includes Bank of America, Barclays, Citi, Goldman Sachs, JP Morgan, Morgan Stanley, Wells Fargo, Citadel, Jump Trading, and Tower Research Capital. These partners have invested in a 25.75% stake in FMX and are incentivized to bring trading volume to the exchange - their stake jumps to 36% if targets are met. As such, I think the base case scenario is that FMX should be able to obtain at least 10% market share in Treasury and interest rate futures. A simplistic approach would be to take the annual revenue from CME's interest rate segment (~$1.56B) and divide it by 10, yielding $156 million. However, we do have additional information that can refine the calculations. CME's fee schedule for interest rate futures shows a price of $0.19 per side for futures traded on Globex (so $0.38 per contract). Higher prices apply to non-members. CME Source: CME FMX will need to match or beat these prices to attract traders. Additionally, high volume traders like the banks that are partnered with FMX benefit from volume discounts on CME of up to $0.06 per side. CME Source: CME This means that the price to beat would be $0.19-$0.06 = $0.13 per side or $0.26 per contract. FMX would likely have to price contracts at $0.20-$0.25 to attract traders. Under those assumptions, the base case revenue for FMX would be considerably lower, at $60M - $75M. However, according to Lutnick, in the first year or so the futures business is not expected to bring in significant revenue, because FMX will \"initially charge very low to no price\" so that traders can easily connect and test out the platform. If we assume that CME will initially be losing 10% of interest rate volumes from large traders at a discounted rate of $0.30 per contract, the impact will be a loss of $90M. That translates to a negligible 1.6% of annual revenues, well within normal fluctuations due to changes in trading activity. Author What if FMX is able to steal 25% market share? I think that the chances of this occurring are small, but reasonable with a probability of 20-30%. In order to achieve this, FMX will have to convince a significant number of small or mid-sized traders to make the switch. These traders are less likely to meet the thresholds for volume discounts, so the average rate per contract would likely be higher. For this upside case, an estimated volume of 3M contracts per day at $0.30 per contract would bring in $225M in annual revenue. If we assume that CME is losing this volume at a higher rate per contract than FMX is gaining them, say $0.40 per contract, then the impact would be a $300M loss in revenues. That works out to a more substantial 5.4% of revenues. In a blue sky scenario where FMX is able to take half of the interest rate futures market at $0.40 per contract, it could rake in $600M in revenue. If FMX is able to exceed CME's market share, it is possible it may quickly win the rest as well. Exchange-type businesses tend to be winners take most (or all) as evidenced by CME's long-running monopoly. Traders are attracted to exchanges with the most liquidity and the most market participants as that helps them obtain the best prices and execution. This network effect becomes self-reinforcing. Buy, Hold, Sell? In the base case scenario where FMX obtains 10% market share, the impact will be low for both CME and BGC. As mentioned previously, it would equate to just 1.6% of revenues for CME. BGC's primary brokerage business brings in $2B annually, so an additional $60M would be just a 3% boost. Even then, it likely wouldn't make a significant contribution to the bottom line - exchange-type businesses have stable fixed costs and margins increase as transaction volumes rise. If FMX doesn't achieve much scale, the exchange will operate near breakeven or at a loss. Even if profits are made, a significant chuck will be attributed to BGC's partners' equity stake. In the upside scenario, FMX could boost BGC's revenues by more than 10%. That's significant, but not game-changing. More significantly, this is not something that will happen overnight. According to Lutnick, FMX is likely to take at least 3 years to ramp up - in the first year, it will focus on establishing connections with traders; in the second, it will ensure transactions are occurring smoothly; and in the third, it would begin competing with CME for volume. Recall that BGC took 6 years to achieve a 28% market share with Fenics UST. While FMX will have a jump start with its high volume partners, it will still take time to produce results. In the near term, BGC's fortunes will depend more on market volatility and trading activity through its brokerage business. Increased government debt issuance and geopolitical tensions impacting commodity and energy prices are drivers that could increase commissions. BGC is also slowly transitioning away from voice brokerage and focusing more on its electronic platforms. Even though the FMX futures exchange is not expected to bring in much money on its own, it could accelerate growth in BGC's foreign exchange segment and Fenics UST cash Treasury business. Fenics UST has already been gaining market share against CME's BrokerTec and FMX could increase awareness and interest in this platform. FAST Graphs At 9x forward earnings, BGC trades at an undemanding multiple. However, that is in line with its closest comparable peer StoneX Group Inc. (SNEX). Retail brokerages such as The Charles Schwab Corporation (SCHW) and Interactive Brokers Group, Inc. (IBKR) trade at 22x and 18x respectively. Exchanges such as Nasdaq, ICE, and CME all trade at around 22x. There is a chance that the market rerates BGC to a higher multiple, but that is likely contingent on it showing that FMX is a viable exchange and that it is making progress in the transition away from voice brokerage. As for CME, while FMX is unlikely to pose a major financial threat in the near term, it does enhance the risk of the market rerating the stock to a lower valuation, particularly if CME is seen as losing market share. Due to its high dependence on transactional and clearing fees which make up over 80% of revenue, CME is more vulnerable to reductions in trade volume. In contrast, other exchange peers like ICE and Nasdaq have achieved 52% and 60% recurring revenues respectively through a focus on technology and data services. Analysts are already questioning if the interest rate franchise is at peak earnings if the Fed moves to cut rates later this year. However, CME is sufficiently diversified such that volatility in equity and commodities markets can make up for lower trading in rates. A bigger concern may be whether or not CME feels threatened enough to actively compete with FMX. In the past, the exchange has drastically cut transaction fees to drive rivals out of business. With FMX expected to offer futures at low to no cost, CME may be forced to give traders discounts and incentives to keep them on its exchange. The company could also attempt to accelerate investment in its digital transformation to enhance its technology. Both options could be a drag on earnings. FAST Graphs At 22x earnings, CME trades below its historical average multiple of 27x. However, the company is likely entering into a period of lower growth and increased competition. While its regular quarterly dividend is not at risk with a 47% payout ratio, CME has traditionally paid out nearly all of its earnings through annual special dividends. These are likely to be reduced if the company feels the need to invest more in defending its business from competitors. If history is a guide, the odds of FMX succeeding in breaking CME's monopoly on Treasury and interest rate futures are low. But, the competition could result in a few challenging years for CME and its shareholders. FMX Futures is expected to launch in September 2024.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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