The new CME Group (NYSE:CME) demonstrates the power of the exchange model for investors. The merger of the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) took effect on July 13, and this is the last quarter for which results for each exchange will be reported separately.
In the second quarter of 2007, CME flaunted a 61% operating margin, while CBOT flashed a 56% margin. Both figures exclude merger-related costs, and strikingly, both were recorded before any expected merger benefits. If the merger goes as planned, the exchanges will jointly save $150 million per year, mainly by consolidating technologies and trading floors, while reaping $75 million in revenue synergies.
The exchange model explains the rich operating margins. Once a trading platform is in place, the marginal cost of each additional trade is minimal, pumping a large chunk of the revenue per contract traded directly to the bottom line. Keeping revenue per contract steady while spinning up trading volumes yields rich results. And even if revenue per contract declines, results will stay good as long as volume increases outpace those shortfalls.
The CME Group results show this model in action. At CME, the average daily trading volume was 6.4 million contracts for the first half of 2007, up 19% from the same period in 2006. The average rate per contract was $0.624 for the second quarter of 2007, compared with $0.632 in the second quarter of 2006. These factors drove CME's results for the second quarter of 2007, with a 17% revenue increase to $329 million and an 15% rise in net income to $126 million.
CBOT had an even better Q2. The exchange achieved record trading volume of 256 million contracts, a 23% increase year over year. The average rate per contract was $0.662 for the quarter, compared with $0.564 in the second quarter of 2006.
But there are potential crimps on this gushing cash faucet, most notably the "M" word: monopoly. As Skadden Arps cheerfully points out in a press release regarding its client, the CME, the new group has an 85% share of the U.S. futures trading market.
Howard Lutnick, chairman and CEO of Cantor Fitzgerald, recently commented in the Financial Times: "[CME/CBOT] is certainly a monopoly. There is only one euro-dollar contract, there is only one US Treasury contract."
In addition, the CME is entirely focused on the United States -- specifically, Chicago. Craig Donohue, the chief executive of the CME group, recognizes this, discussing potential expansion in Europe, Asia, and South America. Finally, CME's desire to compete in over-the-counter derivative markets with initiatives such as Swapstream brings the company into conflict with some of its own investment-bank customers, including Morgan Stanley (NYSE:MS) and Merrill Lynch (NYSE:MER).
However, the exchange's margins remain plenty plump for now, and they stand to swell even further once its merger settles out.
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Fool contributor John Finneran advises, trains, and writes on increasing the financial value of technology, especially business cases. He owns stock in Merrill Lynch, but does not own any of the other shares mentioned. The Fool's disclosure policy is anything but derivative.
