Financial Innovation in a Distressed Economy

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 • What’s Changed? • Financial Crisis • OTC Derivatives Clearing Services • CME ClearPort

4. A Culture of Innovation CME Group’s history of innovation 1970s 1980s 1990s 2000s • 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 S&P 500 futures • 1st successful stock index … S&P 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. 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) What has Changed?

7. 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 What has Changed?

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 ~1/4thof 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 S&P/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 <$40 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