An interview with CME Group’s CEO Craig Donohue

While the problems wrought by the recession have hammered CME Group Inc.’s stock during the past year, the solutions being put forth to prevent future financial crises are starting to revive the share price.

CME could be the beneficiary of proposed government regulation that would push more trading onto its platforms. But just like the economy, the stock still has a long way to go to regain its former strength.In its trading pits and on its electronic platforms, hedgers and speculators alike are brought together by the CME to trade on the world’s largest futures and derivatives exchange. In late 2008 and early 2009, the global economic crisis drastically reduced CME’s trading volume and eroded its revenues, which it derives from the fees it charges per trade, and led to a decline its stock price.

The Chicago-based company’s stock has fallen 25.6 percent to $335.34 at the close of trade Tuesday from its 52-week high of $450.96 on June 17 and 52.2 percent below its peak of $701.78 on Dec. 12, 2007. The shares reached their 52-week low of $155.06 on Jan. 23.

The average daily volume of trades on CME’s platforms in May fell 14.7 percent compared with the same time period in 2008, with the company’s largest product line, interest rates derivatives, falling 28.7 percent last month from May of last year.

“The crisis has really had an effect on our interest rate products,” CME Chief Executive Officer Craig Donohue said at the annual shareholder meeting on May 13.

At the time, the Federal Reserve Board’s near zero interest rates had quashed volatility but in the last two weeks early signs of economic recovery and inflation fears have brought back interest rate volatility, increasing trading volume in that market 42.2 percent in May compared with April. Overall trading volume for the CME in May was up 16.8 percent from the previous month.

Mark Lane, an analyst with William Blair and Co. LLC, downgraded the stock in April to market perform from outperform. In an interview Tuesday, Lane said a recent spike in Treasury yields and investors willing to take on more risk have boosted trading volume, providing a “sign of light.” However, he said near-term growth remains under significant pressure.

”I think with volume growth, the comparisons will still be tough against last year,” Lane said.

However, Treasury Secretary Timothy Geithner proposed a plan to Congress May 13 that would mandate standardized derivatives contracts trade through regulated clearing houses such as CME. Since Geithner’s proposal was unveiled, shares of CME have rallied, increasing 29.7 percent in three weeks and soaring past the 52-week consensus price target of $245.88 compiled by Bloomberg LP.

“Pressure by the U.S. Treasury to clear trades could play to CME’s advantage,” Ken Worthington, an analyst for J.P. Morgan Chase and Co., said in a recent research note. He has a neutral rating on the stock and a 52-week price target of $280.

The primary benefit for CME under the Treasury’s plan would be increased volume on its over-the-counter platform Clearport, which it acquired when it bought the New York Mercantile Exchange in August.

One of the most high profile of the derivatives markets because of its role in the current financial crisis is the credit default swap market. Under Geithner’s plan, credit default swaps would likely be required to be traded on a regulated exchange like CME’s Clearport. However, despite CME gaining approval from the SEC in March to clear the products, it has yet to start doing so.

“It’s a lack of dealer support that’s keeping them out of that business,” Lane said.

Where the support has gone is to a major competitor to CME: IntercontinentalExchange Inc., which began trading credit default swaps in March. ICE has established a strong position in the market by clearing contracts totaling in excess of $350 billion in notional value, which is the total underlying worth of the contracts, not just the amount traders have paid to purchase the contracts themselves.

“Overall ICE has the advantage at the moment,” said Michael Wong, an analyst for Morningstar Inc., who has a three-out-of-five-star rating on CME’s stock and said its fair value was $236 prior to Geithner’s proposal. “They have more of the support of brokers and traders.”

Despite the attention it receives, CME CEO Donohue said there are bigger fish to fry in the OTC market than credit default swaps.

“Much has been talked about the credit default swaps market, which is currently about a $27 trillion market,” Donohue said. “But I think it’s important to see that the interest rates swaps market dwarfs that with roughly $300 trillion outstanding.”

It’s with the larger interest rate market, which could be pushed onto clearing services if Geithner’s plan is approved, where CME will regain the upper hand on ICE, analysts said.

“CME has a significant competitive advantage going after the interest swap market because it owns the interest rate futures market in the United States,” Lane said in a May 14 research note.

While new government regulations on the financial sector may fuel CME’s growth by increasing its trading volume and profits, for now, the company is trying to raise trading volume by introducing more product lines. Donahue said last year CME introduced 141 new products for Clearport and 100 more products for the OTC platform so far this year.

Shareholder Tully Davia, a retail investor, said he’s confident that CME’s research department will be active in developing new products that will fit both hedgers’ and speculators’ needs and also drive trading volume. He agrees with the company’s aggressive approach to continue rolling out more types of contracts to be traded on CME platforms.

“It’s the old ‘spaghetti against the wall’ approach,” said Davia. “If you list enough stuff, eventually something is going to stick.”