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.
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Outline

• A Culture of Innovation
• Whats Changed?
• Financial Crisis
• OTC Derivatives Clearing Services
• CME ClearPort

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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

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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?

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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)

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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

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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

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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

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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

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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

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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

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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

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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

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Financial Innovation in a Distressed Economy

• John W. Labuszewski
• April 2009