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John W. Labuszewski

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Title: John W. Labuszewski


1
Financial Innovation in a Distressed Economy
  • John W. Labuszewski
  • April 2009

2
Disclaimer
The information herein is taken from sources
believed to be reliable. However, it is intended
for purposes of information and education only
and is not guaranteed by CME Group as to
accuracy, completeness, nor any trading result,
and does not constitute trading advice or
constitute a solicitation of the purchase or sale
of any futures, options or other derivatives
products. The Rules and Regulations of CME Group
should be consulted as the authoritative source
on all current contract specifications and
regulations.
3
Outline
  • A Culture of Innovation
  • Whats Changed?
  • Financial Crisis
  • OTC Derivatives Clearing Services
  • CME ClearPort

4
A Culture of Innovation
CME Groups history of innovation
1970s
1990s
2000s
1980s
  • 1st US financial exchange to demutualize
  • 1st US financial exchange to IPO
  • CBOT Common Clearing Link
  • Hosting NYMEX on CME Globex
  • CME / CBOT merger creating CME Group
  • CME / NYMEX merger
  • 1st global electronic trading system in CME
    Globex
  • E-miniTM SP 500 futures
  • 1st successful stock index SP 500?
  • 1st successful cash-settled futures CME
    Eurodollars
  • 1st financial futures CME currency futures
  • 1st interest rate futures contract CBOT GNMA
    CDR futures
  • 1st Treasury futures contract CBOT 30-Yr Bond
    futures

5
A Culture of Innovation
Seven traditional new futures product criteria
  • Price Transparency Volatility?
  • Futures enhance transparency, protects against
    manipulation
  • Volatility produces speculative opportunity and
    need to hedge
  • Ideal market incorporates long-term trends and
    significant intra-day ranges
  • Customer Interest/Product Champion?
  • Survey/assess customer demand
  • Willing market maker is ideal
  • Develop products w/ strategic partners
  • Regulatory Considerations?
  • CME usually operates as a DCM but will consider
    alternative regulatory structure
  • Large, Competitive Cash Market?
  • Market size - outstanding value or turnover
  • Trends in size and turnover of interest
  • Market structure broadly categorized as
    competitive, oligopolistic, monopolistic
  • Many natural buyers and sellers is ideal
  • Homogeneous, Standard Product?
  • Fragmented markets may not achieve critical mass
    of liquidity
  • Consider grade premiums, discounts
  • Futures foster product standards
  • Competitive, Strategic Factors?
  • Experience of other exchanges, OTC competition?
  • Supports an exchange strategic initiative?
  • Lack of Suitable Cross-Hedges?
  • Related products available with high correlation
    for use as cross-hedge?
  • Basis risk, liquidity of competitive market?

6
What has Changed?
  • Changing nature of competitive landscape
  • Demutualization focused exchanges on profit
    motive
  • CME demutualized in 2000 and issued an IPO in
    2002
  • The trend towards for profit is almost
    universal amongst exchanges
  • Commodity Futures Modernization Act (CFMA) of
    2000
  • Allows exchanges to certify non-controversial
    new products .. does not absolve exchanges of
    internal due diligence process but nonetheless
    facilitates speed to market
  • Alternate regulatory environments created DTEF,
    EBOT, Security Futures Products (SFPs)

7
What has Changed?
  • Changing nature of competitive landscape, cont.
  • 3. Electronic trading alters new product paradigm
  • Exchanges exist to allocate access to trading
    process exchanges sold memberships to allocate
    access to physically confined pits electronic
    trading tremendously enhances global distribution
  • Pit traded contracts must immediately attract
    critical mass of outside order flow to support
    locals or perish
  • CME Globex altered new product paradigm,
    extending shelf-life
  • Financial crisis underscores value of centralized
    clearing
  • Counterparty credit risk is major concern CME
    Clearing offers unparalleled financial sureties
  • CME Group historically offered vertically
    integrated execution and clearing services but
    clearing services may be unbundled
  • Building on futures business, CME Group offering
    clearing services in OTC arena

8
Financial Crisis
  • The bubble bursts
  • ARM rates started to rise in 2004 , distressing
    subprime ARM borrowers
  • Mortgage delinquencies and defaults were the
    result
  • 22.2 of subprime ARMs in foreclosure by Dec-08
  • Subprime ARM origination 1.4 trillion in past
    years relative to 30 trillion in
    non-financial consumer debt

9
Financial Crisis
  • The bubble bursts, cont.
  • Housing activity measured by building permits,
    starts and completions peaked by early 2006 then
    collapsed
  • Activity now 1/4th of what it was at peak
  • Slight uptick in Feb-09 may be sign of a bottom?

10
Financial Crisis
  • The bubble bursts, cont.
  • Housing peaked in mid 2008
  • Peak-to-valley decline from Jun-06 thru Jan-08
    -30.2 measured by SP/Case-Shiller 10-City Index
  • Coastal cities experienced brunt of decline Las
    Vegas -46.2, Miami -42.8, San Francisco
    -43.0
  • Central northeast cities did better Denver
    -12.3, Boston -15.3, New York -16.0,
    Chicago -21.7

11
Financial Crisis
  • Cascading losses
  • Problem originated in subprime mortgage sector
    including MBS, CDO and SIV structures
  • But firms liquidated other, more liquid assets to
    raise capital
  • Liquidation and deleveraging accelerating across
    all capital and commodity markets
  • Domestic equity markets off 40 or 11 trillion
    in 2008 with volatility spiking to 85
  • Commodity markets not immune either as crude oil
    fell from mid-08 highs of 150 to lt40 by early
    2008 as demand weakened

12
OTC Derivatives Clearing Services
  • Challenges faced by OTC traders
  • OTC derivatives facilitate confident lending and
    investment but faces major problems
  • Dealers access to capital constrained
  • Counterparty credit risk heightened for buy- and
    sell-sides bid/offer spreads may widen,
    particularly as trades are unwound
  • Need for independent pricing sources
  • Customer protection has become a key issue
  • Operational efficiencies loom large
  • Must cope with potentially greater regulatory
    scrutiny
  • THUS value of centralized counterparty clearing
    has increased

13
OTC Derivatives Clearing Services
  • Benefits of centralized counterparty clearing
  • Automated bookkeeping services ensure timely
    accurate confirmations
  • Mark-to-market (MTM) prevents accrual of
    unrealized losses
  • Capital efficiencies thru cross-margining
  • CME Group has most diversified product line
    interest rates, equities, currencies, energy,
    metals, ag products
  • Financial sureties including
  • Separation of trading and credit counterparty
    functions
  • Customer protections thru segregation of customer
    funds and positions from bank or broker
  • Backed by 8 billion financial safeguards system

14
OTC Derivatives Clearing Services
  • Our response
  • CME Group hopes to address challenges by
    providing
  • Responsible credit management services
  • Capital efficiencies thru cross-margining vs.
    broad range of products
  • Unbundling execution and clearing services
  • Classic exchange model bundles electronic trade
    execution with clearing
  • OTC-style, bi-lateral execution may be paired
    with futures-style, multi-lateral clearing model,
    allowing customers to enjoy value-added
    information flows and trade concepts that dealers
    often provide
  • Also permits OTC traders to benefit from
    financial sureties and capital efficiencies
    associated with central counterparty clearing
  • Extending CME ClearPort to address these issues

15
CME ClearPort
  • CME ClearPort
  • Established model
  • CME ClearPort operating successfully since early
    2000s in energy markets
  • ClearPort volumes increasing in wake of financial
    crisis
  • We seek to extend model to other product lines

16
CME ClearPort
  • What is CME ClearPort?
  • What it is not
  • Historically applied in energy markets but
    model may be applied to interest rates, credit,
    currencies, ag products and more
  • Should not be thought of as execution platform or
    just clearing
  • It is a process
  • A gateway or conduit that allows OTC executed
    contracts to be submitted to CME Clearing House
    for processing and clearing
  • Highly flexible and will imply somewhat different
    services in context of different asset classes
  • Unifying feature
  • Couples OTC-style, bi-lateral execution with
    futures-style, multi-lateral clearing services
    CME ClearPort is conduit or mechanism to couple
    these 2 functions

17
Financial Innovation in a Distressed Economy
  • John W. Labuszewski
  • April 2009
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