Exchange of the year/exchange innovation of the year: CME Group

Risk Awards 2019: FX Link, SOFR futures and Nex acquisition headline banner year for Chicago bourse

Derek Sammann and Sean Tully

For most derivatives exchanges, the ability to navigate sudden volatility bursts constituted success in 2018. For CME Group, it was a year for reimagining the role of the world’s largest derivatives trading venue against a changing regulatory backdrop.

In November 2018, the Chicago bourse completed a $5.5 billion acquisition of the UK’s Nex Group. The move combines two giants of futures, cash and over-the-counter trading and could be pivotal in CME’s quest to dominate US rates and foreign exchange markets.

Big ideas may have been brewing in the background, but they did not distract. The statistics alone tell a compelling story. The bourse trades whopping $1 quadrillion a year across all investable asset classes and new records were set in May 2018, when daily contract volume surpassed 50 million for the first time. Five out of six product lines racked up double-digit year-on-year volume growth in the first half of 2018, with metals and forex up 27% and 18% respectively.

Behind the numbers, CME’s banner year is a testament to its consultative approach with clients, responding to feedback with targeted products that address acute pain points.

FX Link is a prime example. In 2017 CME Group met a group of proprietary trading firms in Chicago to discuss their biggest concerns. The clear consensus was margin, capital and costs, particularly when it came to trading the arbitrage between forex spot and futures markets.

Futures commission merchants (FCMs) and prime brokers typically end up holding large balance sheet positions to help clients trading the basis between OTC forex spot and listed quarterly futures. After verifying the extent of the problem with bank clients, CME got to work creating a liquid basis market.

Eighteen months later, FX Link was born. A bridge between listed forex futures and the OTC cash market, it allows firms to trade spot as a basis to listed contracts. Two months after its March 25 launch, more than $1 billion notional had been traded.

“The means by which we can provide the market a more seamless way to do something that they are already doing in a less efficient way is a win for the customers, and it is a mechanism that customers are already accustomed to,” says Derek Sammann, CME’s global head of commodities and options products.

Similarly, new futures on the secured overnight financing rate (SOFR) – the preferred replacement for US Libor – also followed extensive industry consultation. One-month and three-month contracts were launched on May 7, only a month after the New York Federal Reserve began publishing the rate. At CME, the launch was preceded by three years of intensive talks with regulators and customers. The exchange group was an active member of the Alternative Reference Rates Committee (ARRC), the Fed-convened group tasked with selecting and transitioning to the new rate.

We fundamentally rethought and repositioned how we go about product development

Derek Sammann, CME

Product development at CME didn’t always happen this way. According to Sammann, the exchange has fundamentally changed its “spaghetti against the wall” approach of a decade ago, when 10 different products would be released with the hope that a few might actually work out.

“We fundamentally rethought and repositioned how we go about product development, by starting with the client and trying to work with groups of clients to help us develop the best specified product serving the broadest possible need in the most capital- and operationally efficient way possible.” says Sammann. “We are launching far fewer products with much greater degree of success because the market validation, the client validation, the product specification development have been done.”

Clients appreciate the collaborative approach. A clearing head at one FCM says CME constantly has its ear to the ground on issues and obstacles customers face. Competitors may do the same, but CME’s willingness to meet and work with its clients on problems they face sets it apart from other bourses, he adds.

“They are attuned to the marketplace. They take good direction from FCMs like us and our risk team. We meet regularly with them,” says the clearing head.

Regulatory change features high on the list of challenges for which clients turn to the exchange. Topping the agenda is uncleared margin rules for OTC derivatives, including forex swaps. Sean Tully, global head of financial and OTC products at CME, says he has the chart of the rules and their implementation dates – in waves out to 2020 – hanging on a wall in his office and “lives and breathes it every day”.

Regulation breeds innovation

FX Link is just one example of how the exchange is innovating around those new compliance requirements. “It creates a cleared, standardised, listed, lower-cost alternative to FX swaps,” Tully says.

One non-bank market-maker describes FX Link as an important bridge between two markets that are heavily related but not fungible. Large pools of liquidity, particularly from systematic funds, are tied to futures markets. As the largest futures exchange, CME represents around 70% of forex futures liquidity and an estimated one-third of the overall forex market. Without a bridge, such liquidity is not accessible by cash traders.

“FX Link is essentially the cost to convert between cash and futures,” the market-maker says. “All of a sudden cash traders have got a nice triangulation with all the liquidity that sits in CME. For core participants like ourselves, it means access to a deeper spot-equivalent primary market – all of a sudden we have a third more liquidity than when you could only trade pure spot FX.”

Although viewed primarily as an interbank product, it could deliver second-order benefits for all market participants.

“As liquidity is deeper, bid-offer spreads become tighter. Because the FX market is so competitive, it [the benefit] ends up being passed on to the consumer, so that’s the real benefit for end-clients,” says the market-maker.

FX Link is just one part of a wider quest for margin efficiency savings in forex markets and comes a year after CME launched forex monthly futures – a listed alternative to OTC forex forwards. Combined, the two products already account for more than 2% of contract volume at the exchange’s 45-year old forex franchise.

“To launch two new products that almost immediately are giving you 2.4% of your business is a very impressive result,” says CME’s Tully.

The bourse’s extensive industry dialogue was most evident in its SOFR futures launch. In addition to its work with the ARRC, CME conducted more than 100 face-to-face client meetings on contract design, starting at least a year before launch.

We offer the inter-commodity spreads to make it the single most liquid, most efficient execution and the lowest-total-cost execution that you can get anywhere because of the liquidity

Sean Tully, CME

“It was that outreach to the clients where they actually designed the product, and we delivered what they asked for,” says Tully.

To turn that vision into reality, the exchange offered inter-commodity spreads, which allow clients to trade SOFR against Fed fund futures and Eurodollar futures.

“We offer the inter-commodity spreads to make it the single most liquid, most efficient execution and the lowest-total-cost execution that you can get anywhere because of the liquidity,” says Tully.

Huge open interest in Eurodollar and Fed fund futures also offers clients trading the new contracts “enormous” margin offsets, Tully says. Margin savings can be as high as 85% when SOFR futures are considered against open positions in Eurodollar and Fed fund futures, he notes.

More than 100,000 SOFR contracts had traded just two months into launch. Growth is impressive; open interest across the two contracts stood at over 50,000 in October, more than 50% higher than the previous month. Average daily volume for October was more than 8,000 contracts, a 74% increase over the previous month.

In energy markets, where a stellar year was buoyed by 14% growth in WTI Crude Oil futures, CME addressed rapid market structure changes.

The exchange entered talks with Cheniere Energy, a leader in the liquefaction and export of US liquefied natural gas (LNG), on plans for a physically delivered LNG contract on Cheniere’s Sabine Pass terminal on the US Gulf Coast. Those plans are the culmination of a two-year dialogue with LNG participants, starting with producers and consumers.

Increased extraction from US shale fields has created demand for the development of new multi-billion dollar facilities where fracked gas is liquefied, before being shipped to Europe and Asia. While there is a tight correlation with the original fracked gas, there is not yet a price point for gas that is liquefied and put on ships at US port facilities.

With its 80% market share in Henry Hub gas contracts, the heartbeat of the US gas industry, CME spied an opportunity. Although there is no fixed timetable for the LNG futures launch, demand for risk management tools is growing, with additional facilities due to come on line in the next two years.