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The Path to Profit The CME Sets Out on the Road to Demutualisation

Following last month’s overwhelming approval by members to demutualise the 102-year-old Chicago Mercantile Exchange (CME), the exchange is now preparing for its new for-profit approach, which will streamline governance and convert its memberships into shares with trading rights in CME products and pure equity in the exchange.

 A week after the 6 June vote, which garnered an unprecedented 98.3% approval, the Commodity Futures Trading Commission (CFTC) approved the Merc’s rule changes to become a for-profit corporation. The revisions principally concern governance of the institution when it transforms from a membership-owned, not-for-profit entity and the separation of ownership of shares from trading privileges.

The transaction was also subject to the approval by the P-M-T Limited Partnership, which operates the exchange’s Globex2 electronic trading system, to have the exchange purchase the assets of the partnership. More than 84% of the eligible P-M-T units voted in favour of the plan. Upon consummation of the transaction and purchase of the assets by the exchange, the P-M-T Limited Partnership will be dissolved.

The final hurdle rests with the Internal Revenue Service, which is considering a ruling regarding the tax consequences of the action (ie, that memberships would be converted into shares on a tax-free basis). Once that ruling is received, all that will remain is the final preparation and filing of various corporate documents.

The CME will convert into a for-profit corporation, the new ‘Chicago Mercantile Exchange Inc.’, in several steps. The current Illinois-based not-for-profit corporation will be merged, first into a new Delaware non-stock corporation and immediately thereafter, into a stockholder-owned, for-profit Delaware corporation. A final step involves a recapitalisation in which the Class A shares (representing equity rights) and several series of Class B shares (giving current members in the various trading divisions equity and trading rights) will be issued.

’The deregulation we are undergoing in the US will allow us to offer products and services that we couldn’t previously provide,’ says CME chairman Scott Gordon. ‘As the lines have begun to blur between exchange traded derivatives and OTC derivatives, we at the CME want to be the premier global marketplace for much more than just futures and options.’

The New Model <?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />

The move to become a for-profit company comes as the exchange faces one of its most trying times. As competition from banks, other exchanges and ECNs has increased, many critics have questioned whether or not the traditional exchange model is dead. In answer to these mounting challenges, in November 1998 the Merc outlined a five-point strategy to strengthen its products, technology and alliances with other members of the financial services industry as part of the demutualisation process.

Last year, the exchange announced the formation of two major alliances ‘ the Globex Alliance and its strategic partnership with the London International Financial Futures & Options Exchange (Liffe).

The Globex Alliance includes the CME, the Paris BourseSBFSA, Singapore Exchange Derivatives Trading Ltd (formerly SIMEX, the Singapore International Monetary Exchange), Canada’s Montreal Exchange, Brazil’s BM&F (the Bolsa de Mercadorias & Futuros), and most recently Spain’s MEFF. Members will be able to access the products of each exchange through a single screen. This connectivity is due out later this summer, with full connectivity expected by year-end. The alliance provides members of each exchange with direct access to each other’s electronically traded products, along with cross margining of positions, in order to reduce the capital requirements of customers and members. The Globex2 trading engine is currently being upgraded to improve its speed and functionality, notes Gordon.

In a second alliance, the CME entered into a strategic partnership with Liffe last year, which gives CME members direct access to Liffe products traded over LiffeConnect, while Liffe members will have access to CME products traded on Globex2. The exchanges plan to eventually connect the two electronic systems so their customers can trade the products of both exchanges. Cross margining of the exchange’s interest rate products ‘ including the CME’s Eurodollar and Liffe’s Euribor ‘ was initiated 31 March as the world’s first such programme across international borders. The programme is collectively saving member firms approximately $8.5 million a day.

The CME’s Clearing House developed Span, a risk-based margining system that is now used by 30 exchanges to measure Value at Risk (VAR). ‘This is part of our cross-margining service, which gives our customers the benefit of margin reduction, because there is far less risk in the system. Through our alliances, investors get the benefit of cross margining, which means capital efficiency and global access,’ notes Gordon. ‘Our clients need us to continue to have a flawless clearing house, because a centralised clearing house is an important aspect in keeping their costs down.’

The Drivers 

Gordon says that the recently created president and CEO position, which was taken up by James McNulty earlier this year, is key to addressing the user side of the market. Since joining, McNulty has created a nine-member management team, which is responsible for overseeing each major facet of the CME’s business.

’What we’re seeing in the exchange arena is similar to what we’ve seen in the banking, airline and telecommunications industries,’ says McNulty. ‘There are three major drivers affecting the business model: globalisation, technology and deregulation. Globalisation means you can achieve economies of scale within a single global platform. The CME addressed this early on with the Globex Alliance. Meanwhile, deregulation allows higher levels of competition and fosters innovation. We have seen deregulation’s impact in other businesses, and now we’re beginning to see it in the futures industry. But technology is the most important of all, because it not only helps speed these processes, but it also brings down the costs of globalisation. The rapid speed with which people have adopted the Internet has caused major dislocations, because it changes the way people conduct business and opens up new markets.’

McNulty says the CME is focusing its future efforts on three main arenas ‘ retail and institutional investors and the B2B marketplace. The retail sector, which Gordon says is surprisingly sophisticated, is providing the largest growth area for the exchange. The CME has tapped this customer base via its simplified and smaller sized e-mini contracts, which launched in mid-1997, and are now available electronically on a 24-hour basis. The e-mini S&P contract became the second largest contract (behind the CME’s flagship Eurodollar contract ‘the world’s most actively traded futures contract), for the first time during May; and in June, it returned to its consistent position of being the exchange’s third largest contract. The CME hopes to capitalise on the popularity of these contracts by launching similarly sized contracts (which are about a fifth of the size of the traditional contracts) into other sectors. To this end, the exchange will launch a Fortune e-50 contract, traded exclusively electronically, this fall.

’The low cost of access provides a great opportunity to train large numbers of investors in these products,’ says McNulty. ‘This group has a great hunger to democratise the market. At the same time that we launch the Fortune e-50 contract, we will release a new version of our Web site, which will provide online education where investors can learn to use these products effectively.’

On the institutional side, McNulty says investors are asking for new ways to create capital efficiencies and client services, so the exchange will be developing contracts specifically for this sector later in the year.

In the B2B arena, the CME has set-up a B2B team under Satish Nandapurkar who is responsible for developing a new line of e-business and business-to-business opportunities for the exchange. ‘I see three different B2B models emerging,’ says McNulty. ‘The first is a collaboration with some verticals (co-branding) in which you list a suite of products on an exchange, thereby getting the liquidity and clearing of a futures exchange. The second falls under service agreements ‘ providing clearing services such as our Clearing 21 facility. Thirdly, new companies will provide all sorts of services via a horizontal infrastructure to vertical exchanges.’

The Right Balance 

’We don’t have a monopoly or unique niche in products or services, because technology and deregulation mean that many more participants can get into this space,’ says Gordon. ‘We’re in a service business, and unless we offer the right mix, our customers will go to those that do. So we must continue to challenge the traditional methods of doing business.’

’As we become a demutualised, shareholder company, it’s important to have the right framework in place for decision making,’ adds McNulty. ‘It’s not just about being user friendly, you have to be intensely client focused.’

Profit & Loss

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