CME Faces Risk of Slower Growth

CHICAGO (AP) -- CME Group Inc. could see trading growth slow as financial institutions that are facing mounting subprime and other credit-related losses curtail their activity in certain derivatives.

Thus far, the world's largest derivatives exchange has benefitted from the global credit crunch, which was largely triggered by an avalanche of failed subprime mortgages. Financial markets remain highly uncertain about the outlook for the U.S. economy and have been roiled with volatility, factors that have generated increased trading volumes at CME, which translates into higher revenue.

Across its product line, CME Group's trading volume in the fourth quarter through last Friday was up 33 percent from the same time a year ago.

But industry observers have expressed concern about a possible drop in trading volumes given the likelihood of a slowing in mortgage originations over the next year and a possible de-leveraging by hedge funds. With a tightening of credit standards leading to fewer mortgage originations, CME could see a reduction in trading volume in Treasury futures, one of the exchange's larger product groups that is commonly traded by mortgage servicers to hedge against changes in yields.

Nonetheless, analysts and market participants are confident that CME can weather the storm, noting that the exchange should continue to benefit from volatility on the short-end of the yield curve as the Federal Reserve remains active and as participants aim to diminish counterparty risk. Additionally, analysts are optimistic the largest hedge funds, which are among the biggest players at CME, will emerge unscathed from the current credit market turmoil.

Banks, proprietary trading groups, and hedge funds typically look for places to find liquidity during times of turmoil, such as the current credit crunch, said Rick Redding, CME Group's managing director of products and services. "That tends to be a period when the exchange model shines," said Redding.

Treasury futures, which are tied to expectations for 2, 5, and 10-year cash Treasury notes, and 30-year Treasury bonds, are one piece of CME's interest rate complex that includes the shorter-end of the yield curve, specifically federal-funds and Eurodollar futures. Interest rate futures account for about 60 percent of CME Group's total trading volume so far this year, with Treasurys accounting for less than 30 percent of the total.

There will "definitely (be) a moderation in volume in the 10-year," given less mortgage issuance, said Donald Fandetti, equity analyst at Citigroup, but that should be offset by volatility on the short-end of the curve.

In particular, debate about the course of Federal Reserve policy on short-term interest rates could help recoup volume. The Fed has cut the key short-term rate in recent months and market participants expect further cuts at upcoming meetings of the Federal Open Market Committee. However, some Fed policy makers have recently signaled that the easing cycle might be over, creating some uncertainty among investors.

CME also stands to retain existing mortgage business, which is "going to remain quite large," said Stephen Stanley, chief economist for RBS Greenwich Capital.

"Even when (mortgage servicers) are not underwriting new business, they have to hedge the duration of their existing mortgage portfolio," he added.