While the stock exchanges like Nasdaq and Intercontinental Exchange reported record numbers in the second quarter, CME Group (CME 1.37%) reported a drop in revenues. It turns out that the steps taken to support the economy by the Federal Reserve have worked against CME, largely because much of its business is in interest-rate products. This was an issue I talked about pre-earnings. So what actually happened?
CME Group is the world's largest derivatives exchange, encompassing the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, and the Commodities Exchange. The company makes its money from clearing services (which is ensuring the buyer has the money, the seller has the securities, and then completing the sale) and transaction fees. CME also sells its pricing data to users.
Investors primarily use derivatives for hedging purposes, or risk management. One of CME Group's most important products is interest-rate derivatives, which let all sorts of users from banks to insurance companies to general corporations hedge their interest-rate risk. In the second quarter of 2020, CME Group reported a 7% drop in revenue, which was primarily driven by a 50% sequential decline in interest-rate derivatives trading. Average daily volume for interest rate products was 6.9 million. In the first quarter, it was 13.8 million, and a year ago it was 11.6 million.
What caused the drop in interest-rate derivatives demand? A collapse in volatility in the bond market. Here is what happened.
An unprecedented intervention in the financial markets
In March and April, the Federal Reserve intervened in the markets by pushing the benchmark federal funds rate to a range of 0% to 0.25% and purchasing a massive amount of government debt in order to drive down longer-term interest rates to support the economy. These actions served to drive volatility in the bond market down to eight-year lows.
It is hard to overstate just how big the Fed's footprint has been in the bond market over the past three months. Before the 2008 crisis, the Fed typically held just under $1 trillion in assets on its balance sheet. In the immediate aftermath of the 2008-2009 financial crisis, the Fed began buying Treasuries and mortgage-backed securities (this was called quantitative easing). By 2014, the Fed held $4.5 trillion in assets. The Fed let some of the assets run off, and by February, it held $4.1 trillion.
It now holds $7 trillion. This increase ($2.9 trillion) is almost as much as the Fed's holdings increased ($3.5 trillion) from 2009 through 2015. Five years' worth of purchases over the course of four months. That is astounding.
The collapse in volatility saps demand for interest rate hedging
The net result of the Fed's buying has been a collapse in bond market volatility. This means the day-to-day movement in prices has been reduced to almost nothing, which is exactly what you would expect to see when a player comes in and overwhelms everyone else in the market. With interest rates close to zero, there is no reason to hedge against a further decline.
The Fed can't push the fed funds rate below zero, as that would wreak havoc with the internal plumbing of the bond markets. With the Fed also signaling that interest rates will stick at these levels for the next couple of years, investor demand for short-term hedging products dried up. Hedging isn't free, and many businesses will choose to not pay for it.
That said, the company did raise a great point: The sheer amount of Treasury issuance will increase demand for hedging activity down the road. On the earnings conference call, Sean Tully, global head of financial and OTC products, explained why this lull in volatility might be short-lived.
If you look at the unprecedented deficit this year estimated at 3.7 trillion, now estimated potentially 2 trillion of deficit next year, you're going to see the highest debt to GDP ratios the U.S. government seen certainly since World War II and possibly ever, you are going to see the highest level of debt in the U.S. ever. ... The growth in coupon securities, the growth in debt and deficits once the Federal Reserve reduces its intervention in the market and once the pandemic recedes, the needs for hedging, the needs for our products are being much, much larger I think than ever before in history. So, yes, July is very low volatility. However, the unprecedented debts and deficits and issuance of coupon securities means that the risk that is going to need to be managed on a go-forward basis is going to be much larger than ever.
Obviously, the Fed's actions will be driven by the COVID-19 crisis. If the disease slowly fades into the background or a vaccine is developed, the Fed will probably try and extricate itself from the markets. That will be the trigger for investors to begin hedging against an increase in rates. If Tully's predictions of increased future demand for interest rate products plays out, CME Group should return to normal revenue growth. If it doesn't we will have to wait for the Fed to start thinking about hiking rates. In the meantime, the company will continue to develop new products, especially ethical, social, and governance (ESG) indices. This will drive growth as we await a return to normal bond market volatility.