CME CME Group Inc

By Alexander Osipovich 

The clock is ticking on a huge futures market where nearly $3 trillion changes hands on an average day.

Eurodollar futures, which let traders bet on moves in short-term interest rates, are poised for the biggest shake-up since they were introduced on the Chicago Mercantile Exchange in 1981.

The reason: the looming end of the London interbank offered rate, the interest-rate benchmark that was at the center of a manipulation scandal earlier this decade. Libor's future is unclear after the end of 2021, when regulators have called for its replacement. That is forcing the exchange's owner, CME Group Inc., to overhaul Eurodollar futures, which track Libor.

The transition will affect a variety of firms that use Eurodollar futures. These include hedge funds that use them to speculate on Federal Reserve policy changes and banks that use them to protect themselves against interest-rate hikes when they lend money.

The contracts are known as "Eurodollar" futures because they were initially tied to the interest rate paid on dollar deposits outside the U.S., particularly in Europe. Price swings are based on what the market perceives the future value of Libor to be. That allows the futures to be used to either bet on, or hedge against, moves in the benchmark rate.

Now, navigating the end of Libor is critical for CME Group, which sees far more trading activity in Eurodollars than in markets such as oil or wheat futures.

CME doesn't break down revenue by individual products, but it has made billions of dollars from Eurodollars over the years. Of the $3.7 billion in revenue that CME collected in the first three quarters of 2019, about 11%, or about $415 million, came from Eurodollar futures and options, according to estimates by research firm Equity Research Desk.

CME hopes to keep that business alive by transforming its Eurodollar futures into similar contracts tied to the Secured Overnight Financing Rate, or SOFR -- the new benchmark interest rate that Fed officials are pushing as a replacement for Libor.

Under CME's proposed plan, a formal declaration that Libor is dead would trigger the automatic conversion of all Eurodollar futures outstanding into SOFR futures, with a price adjustment to account for differences between the two contracts. CME floated details of its plan in a video posted on its website last week.

The shift may be bumpy. Trading activity has been thin in SOFR futures, which were launched on CME last year, and the market is largely untested.

There are also concerns about the underlying benchmark. SOFR is based on borrowing rates for overnight repurchase agreements, or repos, an obscure part of the financial system where banks and other Wall Street firms raise short-term funding. In September, a bout of repo-market volatility briefly caused SOFR to jump to a record 5.25%, about 3 percentage points above its usual range.

The episode raised doubts about the new benchmark and rattled the Fed's efforts to get companies to adopt SOFR, which had already been going slowly.

Some CME traders think uncertainty over the transition has fueled a slowdown in the Eurodollar market. The total number of Eurodollar futures outstanding, a measure called open interest, fell 16% in October from a year ago. It has hovered around 12 million since mid-September, the last time a quarterly Eurodollar contract expired. Typically, open interest drops when one of the quarterly contracts expires in March, June, September or December, before climbing again over the next quarter.

"It feels like the end has pretty much started if you look at how much open interest has poured out of Eurodollar futures," said Ryan Carlson, an independent futures trader who has traded the contract since 2002.

Other traders disagree, saying the slowdown was more likely caused by the Fed's decision to hold interest rates steady after three rate cuts this year. A CME spokeswoman said: "Our Eurodollar futures and options are deeply liquid."

Rivals have spotted an opportunity to grab business from CME, which enjoys a near-monopoly on U.S. interest-rate futures. CME's largest competitor, Intercontinental Exchange Inc., known as ICE, has its own SOFR futures contract. And CME's crosstown rival, Cboe Global Markets Inc., offers a fledgling futures market on Ameribor, an alternative to Libor based on lending between smaller U.S. banks.

"Everyone wants to get a piece of CME's trophy product," said Steve Beitler, chief executive of brokerage TJM Investments.

CME has listed the shift to post-Libor futures and options as a risk to its business. "There is no guarantee that a transition to such contracts would be successful and would replace the revenue we derive from our Eurodollar contracts if the trading volume were to decline or discontinue altogether," CME said in a regulatory filing in February.

So far, CME is keeping ahead of its rivals. Just over 1 million SOFR futures contracts changed hands at CME last month, compared with about 127,000 at ICE, according to data from FIA, an industry group. Meanwhile, Cboe data show 2,680 of its Ameribor futures contracts were traded in October.

CME has overcome threats to its Eurodollar franchise before. In the 2000s it beat an effort by a Swiss-German rival, Eurex, to enter the U.S. interest-rate futures market. It also successfully moved Eurodollars from an old-fashioned trading floor -- which was nearly the size of a football field, with more than 1,500 traders and clerks -- to the largely electronic market that exists today.

Still, CME faces a high-wire act in disentangling its Eurodollar business from Libor, market veterans say.

"It's a tricky situation for CME," said Neal Wolkoff, a former executive at the New York Mercantile Exchange, which was purchased by CME in 2008. "It's an incredibly important market, not just for CME, but for the financial world."

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Write to Alexander Osipovich at alexander.osipovich@dowjones.com

(END) Dow Jones Newswires

November 21, 2019 08:14 ET (13:14 GMT)

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