One of the biggest difficulties for markets last year was the Federal Reserve's aggressive policy of hiking the fed funds rate. After holding interest rates at close to 0% in 2020 and 2021, rates rose at a rapid clip last year. While this meant tough sledding for the stock and bond markets, not all stocks were negatively affected by this increase in rates.
CME Group (CME -0.62%) is the biggest operator of derivatives exchanges, and the Fed's moves helped it put together a record year for trading volumes. Is the stock a buy at these levels?
CME Group operates major derivatives exchanges
CME Group operates numerous derivatives exchanges, including the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX), and the Commodity Exchange (COMEX). These exchanges trade interest rate products, stock index futures and options, foreign exchange products, commodities, cryptocurrencies, and numerous other products. CME Group earns revenue from trading and clearing fees and selling trading data to third parties like Reuters and Bloomberg.
Interest rate products are CME Group's biggest business. Interest rate products account for 30% of CME Group's revenue and include the Secured Overnight Financing Rate (SOFR), which is replacing the London Interbank Offered Rate (LIBOR). Interest rate futures also include Eurodollar futures and Treasury futures and options. These products help institutions lock in borrowing and lending rates. For example, if an institution wanted to borrow funds in six months and lock in the rate, it could use CME Group's interest rate products to hedge the risk of rates increasing.
Low interest rates hurt CME Group in 2020 and 2021
During the pandemic, CME Group struggled with low volumes in its interest rate products. This was due to the Fed's policy of pushing interest rates as low as possible in order to stimulate the economy. The problem is that interest rates generally cannot fall below 0%, especially in the short-term money markets. Since nobody was willing to bet on a theoretical impossibility (rates going negative), people who wanted to bet that rates would increase were unable to find the "other side" of the trade. This caused average daily volumes to fall in these products.
In 2022, the Federal Reserve began raising interest rates, which eliminated this problem. It translated to the best year in CME Group's history with average daily volumes of 23.3 million contracts -- a 19% increase compared to 2021. The transition from LIBOR to SOFR began with a bid-rigging scandal about 10 years ago. The SOFR contract is meant to be based on actual trading and not on broker bids, which may or may not be honored and can be manipulated. LIBOR is slated to be phased out in June of this year, and SOFR will take its place. During 2022, trading volumes in SOFR products increased eightfold.
Interest rate products were not the only area that saw increased trading volumes. Equity indices saw a substantial 39% increase in average daily volumes as investors bet on E-mini, E-micro, S&P 500 dividend products, and other equity-linked products. Other products including energy futures and options as well as foreign exchange saw increased trading as well.
CME is not cheap but it has a competitive moat
CME Group is trading at 22.4 times expected 2023 earnings per share. This is on the high side given its growth, but CME has a competitive moat that would be extremely hard for a competitor to replicate. Investors trade products based on both commission costs and liquidity, and that liquidity is hard to independently create. Growth will come from launching additional products, which is a slow process.
CME Group has a dividend yield of 2.4%, which isn't likely to tempt an income investor, but the stock will continue to be a mature grower with limited competition. Investors who want to sleep at night might find that combination attractive.
