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2005 Co-Persons of the Year
by: Russell Wasendorf, Sr.
SFO unveils its Co-Persons of the Year. One look at the CME’s stock price today versus three years ago when the IPO was launched, and you’ll know it’s more than just luck. There’s some leadership going on.
When in 2002 Stocks, Futures and Options magazine first launched its “Person of the Year” award, the U.S. had just been through a period in which investor confidence in the market had plummeted to a historic nadir. In the judgment of the magazine’s Person of the Year selection committee at that time, even in the tough years, or perhaps particularly during challenging or changing market periods, there are those who stand above the crowd – individuals who have made a mark on investors or institutions or both…or are about to do so. James Newsome, then chairman of the Commodity Futures Trading Commission (CFTC), was so honored that first year. In subsequent years, Jim Rogers, commodities guru who has capitalized well on that market and made stodgy investors sit up and take notice, and NYSE CEO John Thain, who is meeting the challenge of a changing stock market, received SFO’s award.
Each year as we look across the broader landscape of potential recipients, we keep several things in mind. Have or will this person’s accomplishments long term result in a positive effect for investors, either in their mindset toward trading/investing or in new opportunities that may be offered to them? Does the person represent best of class in what he or she has accomplished? Is the person a solid, consistent contributor in advancing new ideas, even if those ideas go against the status quo? And, naturally, there are a number of intangibles when it comes to getting a feel for the right person at the right time. We suspect that there may perhaps be some years when no one will really stand out, and then there’s the option of making no award in those years. But we had no such dilemma when it came to the year just ending.
In continuing our tradition, albeit a short one, this year, SFO has veered somewhat by naming two individuals who stood out during 2005, not because they led well during a period of market upheaval or change – quite the opposite actually because the world was their oyster as trading volume and profits made the CME bar charts look pretty – but because they exemplified best in class for leading an organization to these amazing heights, for making investors happy as their stock price quickly mounted, and for refusing to rest on their respective laurels.
Chicago Mercantile Exchange is a different exchange than it was even three years ago when the exchange went public and when this year’s SFO honorees, CEO Craig Donohue and Board Chairman Terry Duffy, had yet to sit in their CEO and chairman seats. They had, of course, been part of the hard-slogging exchange executive team that made the decision to put the wheels in motion as the first IPO of a U.S. financial exchange during a decidedly slippery market period.
Has the IPO done well? The answer is an unqualified yes. In a best-case scenario of underpromise and overdeliver, three years ago CME’s stock offering price was set at $35, and as we went to press it was just north of $380 per share – right in line with Google (GOOG) at $390+ . CME is one of just nine U.S. companies with stock trading at greater than $300; unquestionably, this has been the impetus for other exchanges to seek IPO status.
Trading volume at CME is up dramatically from a year ago, and the year before that and so on, in spite of recent lower volatility in several of the exchange’s most fertile markets, so a lot is going right. Average daily trading volume in October alone, the most recent reporting period, was 4.5 million contracts, up nearly 40 percent from the same period a year ago. That’s almost 100 million contracts in a single month, and nearly 75 percent of that was traded electronically.
At this juncture, it’s probably appropriate to add the disclaimer that past performance is not a guarantee of future performance and also that there’s nothing that automatically paves the way for the same kind of meteoric price rise that CME stock has experienced to date. That done, however, we think that Donohue and Duffy deserve credit for leading and motivating progressive thinking that has kept CME moving in the right direction. Realizing the greater need for risk management, an increasing movement from passive to active investment strategies, and growing investor sophistication, they have overseen the addition of new, unique products, services and alliances and have proactively advanced a vision on the way products are delivered to a risk-averse universe.
James Newsome, who took the reins as president of the New York Mercantile Exchange (NYMEX) just more than a year ago after a lengthy stint at the CFTC, says that as a result of their leadership, “the CME is held in a light that makes all of the other exchanges envious.” Adds Newsome, “Overarching everything, they just simply have made very, very good business decisions on behalf of the exchange.”
Both just fortysomething, Duffy and Donohue, native Chicagoans, are part of the exchange’s rich tapestry of leadership, and they are mindful of the fact that the people who came before them – those with eagle-like vision – laid the foundations for success that they are now helping to expand. They are not aiming for perfection, fully realizing that not all strategies will hit pay dirt immediately; without the ability to be wrong sometimes, the exchange loses its ability to take calculated risks.
“Clearly, these guys have been visionaries in the futures and futures clearing business and on how to run a for-profit exchange,” said Gary Cohn, co-head of Goldman Sachs’ Fixed Income, Currencies and Commodities (FICC) and Equities divisions. “They’ve leveraged their knowledge of the industry into a really great business model. That can only happen if they’ve gone through enormous personal sacrifice to get that done.”
We couldn’t have said it better.
RW: Both of you probably realize that we’ll be at the anniversary of your IPO when this issue comes out. So this will not only be a tribute to the two of you as SFO “Co-Persons of the Year,” but also coincidentally will mark the third year anniversary of your IPO. One of the things that is particularly interesting as far as the IPO is concerned is that you were fighting some odds when it debuted during perhaps one of the most challenging periods in recent IPO history. Many felt that the CME was ill advised to push forward. In fact, the Wall Street Journal back then stated, “Despite recent signs of life, the IPO market is likely to emerge from its Thanksgiving hiatus with little more than a whimper.” So, a very big step for the CME. And, of course, you brought it out on Pearl Harbor Day, December 7. What led you to go ahead with it?
TD: That period in history for our country was a very difficult one; it was literally less than a year after September 11 that we made a decision to go forward with the IPO. But we looked at the bigger picture and thought it was appropriate to move forward. We weren’t going to worry about what the pundits and the economists had to say about the economy. We found the reasons why it was right to do things and fulfilled promises that we had made to the membership on the direction this company needed to head. And we had a different product – one that nobody else in the U.S. had gone to market with before. So we moved forward very deliberately and told our story appropriately in our own timeframe. I think investors took it to heart.
CD: Part of our decision was that we thought we were going to be a particularly high-quality offering at a time when there wasn’t necessarily a lot of that in the market. What we had was a very unique, hundred-year-old, very well-established business with, at that point, a couple of years of truly demonstrably significant growth.
RW: That brings up another issue. You had just demutualized, which meant that you went from a membership structure to preparing for a for-profit corporation. Was there consternation among your previous members and current shareholders who may have created a strong voice at that time as well?
TD: I think any time you have change, there’s uncertainty or apprehension, but our direction was clear. We knew that we needed to make some changes, and one of the things we talked about a lot was becoming a public company. I think we did a good job of educating and communicating with our membership on the pros and cons of becoming a public company, so I don’t think it was any great surprise. And generally the membership embraced the idea. But, sure, there definitely was some apprehension – and there probably is still some today from people who sold out prior to us becoming public, who say they never should have done it because maybe they’d still have their floor model exactly the way it was in 1992. Of course, that would never be true in today’s world, but there will always be people who believe that.
RW: It would seem that the only people who would be upset at the moment are those people who are no longer holding stock in CME. There really are very few good, recent comparisons between the performance of your stock and anyone else’s. It’s quite similar to the price pattern the S&P had from 1982-83 until ’92 with a little bit of a dip in the middle. Of course, we’re talking a three-year span versus a ten-year span, which also leads me to believe that there’s a lot more that could happen positively for CME that could propel its stock higher. You know that some people are comparing CME to Google, a technology company. CME does about three-quarters of its business within a technologically electronic arena. How do you rate the parallels?
TD: The only thing I might say, to lighten up a second, is that when people make comparisons between CME and Google, they are referencing chart formations and nothing more than that. There are a lot of similarities to that chart formation, but as far as pure business comparisons, nobody’s ever given me any other fundamentals that represent Google and CME.
RW: Certainly Google’s had some spectacular growth based on their innovation; so has CME. I don’t know if there’s another exchange that better exemplifies the advantages of being innovative and of being as fast on its feet than CME.
CD: We definitely think of ourselves as a financial technology company, since technology has become such a huge part of what we are and how we provide value to customers. That’s a whole different way of thinking about ourselves than was true five years ago when we very much thought of ourselves as an exchange only. I think part of the commonality, if there is any, between us and a Google or a company like that is that electronic trading and distribution gives us the potential to reach clients in all parts of the world at all times of the day in much the same way that the Internet has made Google and Yahoo! very valuable companies. A lot of our growth has been because we can reach more people around the clock and because we’re doing a better job of marketing the products on a global basis. Beyond that, I don’t know that there are any fundamental comparisons, but in that broad sense I think there’s something there.
RW: I still think very few investors realize that the CME introduced the first financial market of any futures exchange – currencies – and was the first exchange to be successful in stock index futures. And the percentage of business CME conducts in the short-term interest rate market via Eurodollars is enormous. Those are some innovations, among others, that historically have fared very well for you. What do you see for the future? What kinds of things can you imagine in your wildest dreams?
CD: Maybe before we get to that part of it, you correctly pointed out the history of innovation, and that’s very clearly been a part of the culture of the organization. Terry and I talk about this often. We’re fortunate that there were a lot of really smart, visionary people before us who made a lot of very good decisions that have allowed us to continue to build on that success over the last two to three years. We’re trying to make sure that this remains part of the DNA of the company.
RW: The CME has been known to take a lot of risks that panned out.
CD: Yes, that’s definitely true. We want to continue to be market leaders and calculated risk-takers. We know that some of our ideas won’t work, but we think that’s ok, too. Recently, we’ve been very successful with weather derivatives. We’re trying auction markets on leading economic indicators. We’ve announced that in 2006 we’re going to introduce market real estate index futures, and there are a couple of interesting aspects to that.
RW: Well for one, it represents an enormous asset size.
CD: Yes, the real estate market is actually larger than the equity market. And if you read the literature, you’ll see there’s a fair amount of opinion about over-valued real estate in the U.S. and how to protect against the risk of loss associated with that. So we’re continuing to look at new and novel ways to take existing applications for risk transfer and find new extensions of them – just like in the ‘70s when CME expanded from agricultural commodities to foreign exchange and then in the ‘80s to intangible instruments like interest rates and stock indexes. Now we’re thinking that there may be other applications that don’t relate to financial instruments, but instead relate to market risks that create financial risk. Thinking that way is something we have to constantly perpetuate.
RW: From what you’re saying, real estate index futures could have great potential in a couple of different senses, given the size and influence of that market. When we think about the longest stock bull market in history, the S&P bottomed back in 1981-1982 and started a very long track higher. Then the market tended to bubble a couple years ago, but maybe there’s still a continuation of this stock market rally to come. But here’s the point: Some people attribute the stock market rally to the fact that institutions didn’t need to sell their stock to protect themselves in a down market because they had stock index futures as a hedge. The potential for a real estate futures market is that it could offset risk in that sector. Rather than thinking that the real estate bubble is about to burst, maybe we’ll have a way to perpetuate that bull market. We’ve seen that happen a number of times. There might be a deterrent effect. Some of the analogies are stretching things, but many people believe the reason we’ve never had an atomic war is because everybody has the weapons, and that becomes a deterrent. If we really have a way to hedge the risk, then maybe that in itself protects the market. Even people that don’t use S&P futures, for instance, have benefited from institutions that do use them.
CD: There’s no way to empirically demonstrate that linkage, but we definitely believe that we’ve increased investor confidence in the stock market and reduced volatility. You can transfer these risks; if you couldn’t, people would be moving out of the market based on what’s happening at any given moment in time. Instead, they have the ability to take a very long-term approach of wanting that equity market exposure but not the temporary variances that cause them problems – without a mutual fund manager or an index fund manager.
RW: On a totally different topic, does anything feel different at CME since it’s become a publicly traded firm?
TD: To be honest, not a whole lot feels different. I think what is noticeable to me is how quickly CME can make decisions to benefit its shareholders. Obviously that’s key for us. We also don’t have 212 committees like we had as a mutual organization. We have 11 board-level committees that basically are involved in the organization. The processes are much more streamlined than what they once were, but at the same time I think we’ve struck a good balance by tapping into the resources we have available to us from our membership and from customers throughout the world.
RW: Let’s talk about CME trading volume. Most recently, you’re averaging 4.5 million contracts traded per day, up 40 percent from a year ago. On a notional basis, what would that translate to daily?
TD: A little less than a trillion-and-a-half dollars a day. Eurodollars trade roughly a trillion dollars a day by themselves.
CD: It may even be higher than that because we were $463 trillion last year, and we’ll be significantly in excess of that this year.
RW: You trade ten percent of the gross domestic product of the United States each day.
CD: Right. Not bad. (laughs)
RW: According to your most recent news release, 74 percent of your volume is electronic, which of course means that 25 percent of your business is still traded in the pit. It seems that with each announcement, the amount of electronic trading continues to creep up. Has floor trading become a mere accommodation to your members?
CD: No. I have a couple of points to make on that. If you look at our options market, it’s clearly very different in terms of being able to easily facilitate electronic trading and liquidity than in the underlying futures markets – in part because they’re inherently less liquid. We trade something like 60,000 different options instruments with different maturities and strike prices, and we’re still in the very early stages of bringing electronic trading to that arena – the point being that we have to demonstrate the capability to effectively handle that business electronically. We went from being three percent electronic in options in January to being roughly 10 percent electronic in options today. Obviously, until we have more liquidity electronically, the customers probably will want to trade those products on the trading floor. We’re talking about a million contracts a day. A million contracts a day is a hundred thousand more than we traded on a daily basis in 2000 – huge business. We need to facilitate that business, and the best way for us to facilitate that business is still on the floor. With time, we think we’ll be successful in increasing the percentage of electronic trade. That’s number one.
RW: What’s the second point?
CD: Number two is that we talked to institutional investors who are active in the S&P market, who still, for different kinds of activities in the market, like using the floor for certain benefits they think are valuable to them. There isn’t a black and white, homogeneous kind of answer with respect to preferences and viewpoints on electronic trading markets and products, and market mechanisms are not all the same.
TD: And as long as there is still some liquidity on the floor that is of benefit to the end user, it frees them up to let someone else work the order for them. It lets them go on and do other business.
RW: Speaking of other business, are you going to merge with the Board of Trade?
TD: It’s always been part of our strategy not to comment on potential or non-potential mergers and acquisitions.
RW: Didn’t expect you to, although now that the Board of Trade has gone public and has a publicly traded price, you both know what you are worth, which is a pretty good position to start out with when there are opportunities for mergers. What I really wanted to talk about in this regard is that one of the things that has become pretty common practice here in Chicago is that any challenges that you face, you often face with your friends on Jackson Boulevard. When the stronghold of Chicago futures business was challenged with a very direct challenge from Eurex, it seemed that the two of you shouldered that fight together – maybe not entirely in a conscious sense – but you did cooperate to hold your own against foreign competition. You are partners with the Chicago Board of Trade when it comes to OneChicago, your clearing house clears trades for the CBOT, you have common clearing members – a number of common threads. There are many examples of your exchanges working together, whether against foreign competition or in the halls of Congress or at City Hall.
CD: I would say it a little differently in the sense that each of us is facing largely different, but similar competitive challenges. Eurex by its own declaration was very much at that time focused on the Treasury product line and not really focused on us directly – not that we didn’t think that ultimately they might be – but at that time the CBOT was their focus. We faced competition coming from Euronext Liffe aimed at our Eurodollar market. Though we are separate entities with separate issues and decision-making processes, CME and CBOT did find common ground in thinking about how to really position ourselves successfully in terms of our customers’ needs – for example, the whole idea of common clearing and providing for a way to make the business more efficient in a way that enhanced each of our value propositions.
RW: Terry, did you want to expand on that?
TD: The clearing agreement was something that benefited our mutual clients and now our mutual shareholders. It’s been a good agreement and one of the things we were shoulder to shoulder on, especially when the competition wanted to come into this country. We were all for competition, but wanted to make sure it was on the same regulatory landscape under which we were operating. So we went to Washington to make certain we weren’t going to run into a regulatory arbitrage that would put us at a disadvantage in this country. We definitely both shared in that common interest.
RW: Let’s talk about OneChicago, the single stock futures exchange in which you have a stake. I know that single stock futures haven’t gathered as much traction as many had hoped it might, but it has continued to grow steadily. Is that something you should have taken on yourself as an exchange, rather than partnering with other exchanges?
CD: The feeling is that we are still better off in partnership with the CBOE and the Board of Trade in doing that. It’s a tough, uphill battle even with all of us working together to make it successful. I don’t think in retrospect that we would have done anything different, but who knows, we could speculate forever. We are now starting to see some positive development of liquidity in the market, though. Average daily volumes obviously are up significantly from what they were, as is open interest, but it’s still in the very early stages. I think it’s a more promising end indication that these markets might have some chance of success. Obviously, recently finally getting to a break-even basis is positive, as well, so that’s important for us as a public company.
RW: There are some futures markets that have seemed to make so much sense and yet failed. And there are cycles of up and down interest in various products. At one time, currency futures were the big dogs, then forex trading through the Interbank market became the big dog, but currency futures have made a nice resurgence. Maybe with recent events, we should be rethinking that whole issue of regulated versus non-regulated. That brings us to one of the most important things that you and other exchanges provide best along side centralized price discovery, transparency and price dissemination – and that is safeguards. With the recent collapse of Refco and the problems that occurred there, the unregulated part of the business collapsed due to alleged fraudulent practices, while the futures part remained pretty much intact. The day after these events unfolded, CME was able to reassure the futures trading public that their funds were secure, that safeguards were in place, and that futures customers would not have to fear for their funds. Let’s talk just briefly about this, but please, in less than 2,500 words if possible.
TD: The system of safeguards in the futures business is totally unique, and we think it’s fundamentally better than any that exist in any other market sector, whether that’s securities markets or the over-the-counter. First of all, we have a twice-daily mark-to-market system, so of course, there is no accumulation of losses as one’s exposures in the market changes; you have to continue to make variation payments throughout the day. That is unique in that it keeps reducing risk continuously in the whole system. Nobody has done that or replicated what we’ve done. Second, we have access at any given time to more than $40 billion of high-quality, extremely liquid collateral to rely on in the event of a situation involving market stress or financial distress of a clearing member firm. We have a mutualized structure, so in the event that a clearing member encounters some difficulty in meeting its obligations to the clearing house, we mutualize the risk. We look to the other clearing member firms to make sure the system is working and is liquid and that as a clearing house we can continue to meet obligations of public users of the market.
RW: What about the aspect of an exchange like the CME being a self-regulatory organization and having the ability to step in at any given time to take emergency action for those firms it oversees?
TD: Yes, if we are uncomfortable with a clearing member’s capital position or financial wherewithal, we can require additional capital to provide certainty that they will meet their obligations to the clearing house. If they can’t meet that request, we can order them to liquidate their positions. And if they don’t do that, we have the ability to liquidate their positions ourselves. If we are concerned and want to facilitate the transfer of accounts from one clearing member firm to another, we can do that. The system has been well honed over time as we’ve had different events of market stress over the last 20 years, including the 1987 market crash, the failure of Barings Bank, Long-Term Capital Management, and Drexel Burnham Lambert.
RW: I think that the importance of segregated funds, in light of what has happened, is even more on people’s minds.
TD: Of course. And a regulatory system that provides for segregation of customer funds as well as special bankruptcy protections that are designed to protect customers in the event of their clearing member firms’ insolvency or bankruptcy again is unique in terms of how it works in the futures industry. The customer is protected fully – not just partially – because their funds are fully segregated; in other words, they can’t be commingled with the other assets of the firm, but are instead held in specially identified accounts – with no right of offset. So if an insolvent clearing member firm, for example, had obligations to a bank for financing, the bank could not dip into those customer segregated funds. It’s very rare to have special provisions of the bankruptcy code designed to protect a customer against its own clearing member firm under those circumstances.
RW: So, what about SIPC? Just to clarify the unique nature of futures protection versus securities, what would have been the case if it was a securities broker-dealer account and the securities broker-dealer became insolvent?
TD: There is no segregation. Yes, there is SIPC insurance, but it only protects the customer up to $100,000 in cash or $500,000 in total account value. So, obviously, in the case of futures, with a million-dollar account that’s entirely segregated, the customer is more fully protected than would be the case on the securities side. That really speaks positively for our industry.
RW: Has it been a challenge to explain what has happened with Refco against a backdrop of Refco having such a huge futures presence?
CD: Not to you and your readers, but a lot of people do not have a clear understanding of the situation. One of the things we have tried to do on this issue is differentiate between what appears to have happened with Refco, which really has to do with disclosure issues and securities law issues – issues that relate to what some people think is a defrauding of investors of Refco, Inc. – and now what has happened in relationship to futures account holders or trading in the futures markets, which has been the bright side of the story. We tried to draw that distinction because it is a complicated world, and unfamiliar issues tend to blur in people’s minds.
RW: We touched on several elements as you looked into the future a little earlier, but I feel that we got onto another topic before you could finish your thoughts.
CD: We are very focused on continuing to try to stimulate growth in all of our different product lines, and we have a nice mix of products and customers. We already discussed electronic trading of options, but one thing we haven’t emphasized enough is the huge growth opportunity we see in foreign exchange. Not just because of recent events, by the way, but at this point fundamentally because of the way we see the foreign exchange market evolving. Clearly, it plays to our strengths of a centralized, transparent, technologically efficient market with a central kind of party clearing solution; this is increasingly valuable to the buy side, but the efficiencies we can create should also be valuable to the sell side. Volume seems to be reflecting the recognition of these efficiencies; CME FX average daily volume was up more than 50 percent from last year through October – electronically traded FX was up 73 percent. And global growth, not just in Europe, but ultimately in Asia, as well, is on our radar screen.
RW: I don’t know if you noticed as I did one of the things that occurred right after 9/11 was one particular business that had a huge spurt in business activity. That was the home security business like burglar alarms. It sparked a thought that if people suddenly are much more acutely aware of risk, then certainly the futures industry has to be coming into its own. It’s an enormous benefit to be able to manage risk in a number of markets.
CD: It’s funny that you make that comment because we are working with Professor Schiller from Yale University, and he has developed these real estate indexes, but he’s also written a book that you might like – Risk in the 21st Century. The central thesis of the book is that we are at a point now where we can take risk management from Wall Street to Wal-Mart. Hence, real estate index futures – which are actually one of his more conventional ideas – but he also has some really interesting ideas about risk transfer having to do with national security and individual career advancement. As odd as it may sound, there’s a whole chapter on how you can actually transfer the risk of your future success or failure as a professional. He has some very interesting ideas. It’s very much what you are talking about.
RW: I’ll have to visit the bookstore, and give that one a try. Well, on that note, I want to thank you for taking this time to talk about a number of important issues, and most certainly congratulate you both and the dedicated and talented staff you lead for your achievements on behalf of CME. You both deserve SFO’s Person of the Year award for 2005. And, you know, there is nothing like the success of a ten-fold increase in your stock price over just three years to draw the attention to good leadership and a very, very strong company.
TD: We’ve been very blessed to have a cohesive working team, and I think team really is the apt word here. I am a huge White Sox fan, and one of the things that is mentioned most often to exemplify this team is “There is no ‘I’ in Team.” I think that is a lot of what CME is about.
CD: There are a number of really good leaders that comprise the success of CME. We just get to be the visible part of that.
RW: It’s good leadership that lets other leaders lead. Thanks again to you both.