Yesterday was the Chicago Mercantile Exchange Group’s (NASDAQ:CME) annual meeting. I didn’t attend, but listened to a bit of it while it was live streamed through its website. CME has a lot of great things going for it, but it has a lot of issues too. I think the stock is probably fairly priced right now.
At this annual meeting, I was only concerned with one issue. It was the issue of B shares. Some of my fellow former board members and I wrote about it at Futures Magazine. It was very concerning to me for a variety of reasons that were ticked off in the article. One that really bugged me was that in floor traded futures, your word was your bond. Thankfully, the issue didn’t pass.
When CME demutualized, it made a bond with the membership. The proposal we put to the membership in 2000 passed with 99% of the vote. It is imperative to note that nowhere in the proposal did it say, “B directors have to be former floor traders." Nowhere were there requirements for length of membership, or family lineage. It didn’t ban electronic or HFT traders from assuming a spot on the board. In fact, there are current members on the CME board that have an interest in HFT firms.
The B directorship at the CME is the most democratically elected Fortune 500 board membership. It’s the most democratically elected membership of any corporation on the face of the earth. Let me list the requirements:
- Own, lease or have a B membership assigned to you. If it’s assigned, then you don’t have any out of pocket expense.
- Appear before the B nominating committee. If not nominated, get 100 signatures on a petition and you are on the ballot.
- Campaign and if the votes add up in your favor, you win and have a seat on the board.
That’s it. This year, the B-3 share (IOM membership) had four candidates for one spot. Elections are competitive. That is our tradition. We talk that talk and walk that walk.
Currently, every B share director happens to have been a former floor trader or broker. But, look at the rest of the board. From the Executive Chairman on down, 13 of the 18 board members are former floor personnel. They were traders, brokers, or ran a desk. There isn’t one whit of difference between them and the B directors.
If one were to look at the entire population of people that own a B share, or could be assigned a B share by their firm, there are multiples of qualified people from all parts of the industry. If we open it up to the universe of people that could lease a B share, the pool is exponential.
CME said at the meeting that the issue wasn’t dead. They would bring it back in a different form. I go back to the top of this piece. Your word is your bond. A promise is a promise. I know some B shareholders that would never part with their B share at any price because they value the fee break too much. Others like the income they receive from leasing it out, but at some point it’s advantageous for CME to find a way to end the B share.
Why do I think that? CME is largely an interest rate market. They have diversified streams of income, but interest rates from short term to long term are the real drivers of volume. When the Fed finally decides to go off 0% interest rates, the volume explosion in contracts from T-Bonds to Eurodollars will be massive on an electronic platform. Having a better fee structure will allow CME to extract more profit. A better fee structure will help CME “futurize” OTC trading. The exchange will convert 30% margin trades to 57% margin trades.
Here would be my advice to CME management. If the B share is that much of an impediment to Board business, there is one way to get rid of it. Pay just like they did when they bought the CBOT and NYMEX. However, in this case it will cost them more.
The best solution would be a stock swap. Swap As for Bs in a 3-2-1 manner like we had with the old PMT. In the stock swap, B shareholders would give up ALL rights. The old memberships would be extinguished, and so would leases, and fee structures. My guess is that the dilution would be less than 4% of the outstanding A shares. CME could open up floor access for a fee-and contracts would no longer be restricted by membership class.
CME could put a lock up on the shares if they wanted. That would allow them time to figure out the kind of deposits they would want for clearing the exchange. They could also rethink clearing qualifications and might be able to open up their clearing platform to different kinds of entities-creating more competition in the brokerage space.
A shareholder might shudder at the dilution, but I assure you. Several years ago I did a discounted cash flow analysis of buying the memberships with cash, and then adjusting fees based on volume. The net present value was slightly higher than the cash outlay. CME would have paid for the deal in five years. Traditionally, these kinds of deals are analyzed with a ten year time horizon. At that time, B shares were significantly more expensive than they are today. The deal is a no brainer. CME has probably bought back more stock over the years than it would cost them to do a deal.
The only thing standing in the way is stubbornness. Stubbornness on the part of CME management because they think they are being extorted to buy an asset they shouldn’t have to pay for. Stubbornness on the part of members who tend to over value their memberships. It seems to me the time is right to think out of the box on a deal so that when the economy takes off, CME is better positioned to take full advantage of it.