CME Group owns the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, and the Commodity Exchange, making it the world’s leading futures and options exchange operator. Its three largest futures and options categories are 1) interest rates, where it possesses 95% market share in U.S. interest rate futures trading;[1] 2) equity indexes, where, largely because of its 27% ownership stake in S&P Dow Jones Indices,[2] it has exclusive licenses to issue futures contracts on the S&P 500, Russell 2000, and Nasdaq indexes; and 3) energy, where it has a dominant position in WTI oil futures trading. The company benefits from two network effects. The first occurs at the exchanges themselves, which are global, two-sided networks that connect buyers and sellers of futures and options contracts and provide them with unrivaled liquidity. This two-sided network effect is further strengthened by the nature of the futures contracts traded on the exchanges. For most assets, traders have no restrictions on where they can buy and sell them. For instance, if a trader buys Microsoft stock on the NASDAQ, he or she can subsequently sell it on any number of exchanges or on increasingly popular alternative trading systems (ATS) such as dark pools and electronic communication networks (ECN). In fact, ATS platforms have become so popular that, as of April 2019, traders chose to execute nearly 39% of all their U.S. stock trades on them.[3] Futures contracts are different. Futures contracts opened on one exchange cannot be closed at another exchange, making it much harder for competitors to successfully develop alternative sources of liquidity for futures buyers and sellers.
CME Group also owns the clearinghouse that validates and finalizes all the futures transactions that occur on its exchange, further enhancing its competitive position through a second, overlapping network effect. Clearinghouses, which serve as third-party intermediaries to ensure that both buyers and sellers honor their contractual obligations, benefit from network effects due to something called position netting. Position netting occurs when a customer places two or more trades through the same clearinghouse and these trades either fully or partially offset each other. When this situation occurs, the clearinghouse requires the customer to put up only enough money to cover the net position, which allows the customer to earn the same dollar return on its trades but with less capital invested than if the positions weren’t netted, raising the customer’s return on investment. For example, if a trader bought $100 worth of Microsoft stock that posted at one clearinghouse and sold $90 short that posted at another clearinghouse and each clearinghouse required the trader to post an amount equal to 100% of the capital at risk, then he or she would have to post $190. However, if the trader bought $100 of Microsoft and sold short $90 dollars of Microsoft through the same clearinghouse, he or she would only be required to post $10 dollars as collateral. As you can see, this netting effect creates a huge incentive for customers to use as few clearinghouses as possible. Importantly, the fact that CME Group owns both the exchanges and their clearinghouse is a huge advantage that is relatively uncommon. For instance, most stock and bond transactions in the United States are cleared through the Depository Trust & Clearing Corporation, a private company jointly owned by its member banks and brokers, making it easier for alternative sources of liquidity to crop up and steal market share from the stock exchanges like the NYSE and Nasdaq.
Lastly, we believe CME operates in an attractive industry. The capital markets have historically grown faster than GDP over time, and we believe this trend will continue in the future because of the nature of economic development. In the early stages of development, governments and banks typically provide most of the funding for businesses and consumers. However, as economies develop, governments gradually allow more international investment and the countries’ citizens and businesses also build up excess wealth that they can use for investment, seeding the early formation of capital markets. As these capital markets develop, they eventually become more distributed and efficient investor networks than the banks, and, therefore, cheaper and more reliable sources of capital for businesses and governments.
In summary, we believe the combination of the unrivaled liquidity of CME’s futures exchanges, the nature of futures contracts where they must be opened and closed on the same exchange, and the reinforcing network effects of clearinghouse position netting make it highly likely that CME Group will continue to earn attractive returns on capital by serving as a mission-critical and hard-to-disrupt toll collector on the global capital markets.
To read a more detailed description on CME as discussed in a prior investment letter, click here.
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[1] See https://www.morningstar.com/company-reports/1212435-cme-has-benefited-from-higher-interest-rates-as-volatility-returns-to-its-markets?listing=0P00000187
[2] See https://www.sec.gov/ix?doc=/Archives/edgar/data/1156375/000115637523000020/cme-20221231.htm.
[3] See https://www.wsj.com/articles/dark-pools-draw-more-trading-amid-low-volatility-11556886916.