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Edited Transcript of CME earnings conference call or presentation 30-Oct-19 12:30pm GMT

Q3 2019 CME Group Inc Earnings Call

Chicago Nov 1, 2019 (Thomson StreetEvents) -- Edited Transcript of CME Group Inc earnings conference call or presentation Wednesday, October 30, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bryan Thomas Durkin

CME Group Inc. - President

* John C. Peschier

CME Group Inc. - MD of IR

* John W. Pietrowicz

CME Group Inc. - Senior MD & CFO

* Sean P. Tully

CME Group Inc. - Senior MD and Global Head of Financial & OTC Products

* Terrence A. Duffy

CME Group Inc. - Chairman & CEO

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Conference Call Participants

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* Alexander Blostein

Goldman Sachs Group Inc., Research Division - Lead Capital Markets Analyst

* Benjamin Joseph Herbert

Citigroup Inc, Research Division - VP

* Brian Bertram Bedell

Deutsche Bank AG, Research Division - Director in Equity Research

* Christopher Meo Harris

Wells Fargo Securities, LLC, Research Division - Director and Senior Equity Research Analyst

* Daniel Thomas Fannon

Jefferies LLC, Research Division - Senior Equity Research Analyst

* Jeremy Edward Campbell

Barclays Bank PLC, Research Division - Lead Analyst

* Kenneth Brooks Worthington

JP Morgan Chase & Co, Research Division - MD

* Kwun Sum Lau

Oppenheimer & Co. Inc., Research Division - Associate

* Kyle Kenneth Voigt

Keefe, Bruyette, & Woods, Inc., Research Division - Associate

* Michael Roger Carrier

BofA Merrill Lynch, Research Division - Director

* Richard Henry Repetto

Sandler O'Neill + Partners, L.P., Research Division - Principal of Equity Research

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Presentation

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Operator [1]

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Ladies and gentlemen, good day, and welcome to the CME Group Third Quarter 2019 Earnings Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Mr. John Peschier. Please go ahead, sir.

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John C. Peschier, CME Group Inc. - MD of IR [2]

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Good morning, and thank you all for joining us. I'm going to start with the safe harbor language, then I'll turn it over to Terry and John for brief remarks followed by your questions. Statements made on this call and in the other documents on our website that are not historical facts are forward-looking statements.

These statements are not guarantees of future performance. They involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any statements. For a detailed information about factors that may affect our performance can be found in our filings with the SEC, which are on our website. Also on the last page of the earnings release, you will find a reconciliation between GAAP and non-GAAP measures.

With that, I would like to turn the call over to Terry.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [3]

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Thanks, John. And as John said, I want to thank you all for joining us this morning. My comments will be brief so we can get right to your questions. We released our executive commentary this morning, which provided extensive details on the third quarter. In Q3, average daily volume grew to more than 20 million contracts per day, up 30% compared to Q3 last year.

Normally, the number of months of July and August are slow, so we're pleased with the activity this year. We delivered record quarterly average daily volume in metals products, which rose 32%.

Average daily volume in interest rates and equities were each up more than 35%.

Our Options business continues to perform very well. During the third quarter, our options volume reached 4.1 million contracts per day, or up 32%. We drove significant growth from customers based outside the United States.

During the third quarter, volume originating from Asia reached a record level of 1.2 million contracts per day, up 61%.

Volumes from European-based customers increased by 34% versus Q3 last year, and was the third best quarter overall, with records in metals and equities.

Lastly, the activity from Latin America has accelerated. We had 152,000 contracts per day during the quarter, the second-highest in our history.

We continue to deliver successful new product rollouts. Our popular Micro E-mini's ADV grew 35% sequentially from Q2 to Q3. We reached a monthly record in our new SOFR contract in September, with 58,000 contracts traded and a daily record in mid-September of more than 150,000 contracts traded.

New products announced recently include the E-mini S&P ESG futures; U.S. liquefied natural gas export futures; and also, we developed a bilateral pricing agreement between CME and the Shanghai Gold Exchange.

Turning to the next integration. We are pleased with how it is progressing. We have made great progress leveraging the joint sales teams to enable cross selling and to offer the full portfolio of products and services.

We are also beginning to combine the office space around the world, which should assist with generating revenue synergies at a lower cost. We remain laser focused on this very strategic transaction and look forward to keeping you updated on our progress.

With that, let me turn the call over to John to provide you with some additional comments.

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [4]

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Thanks, Terry. It was a tremendous quarter, revenue reached almost $1.28 billion, the highest level we've seen this year, during what is typically a seasonally slow quarter. Terry touched on the strength in our futures and options franchise. We also saw a sequential growth in the NEX business, including EBS, BrokerTec and triReduce.

During the third quarter, our adjusted expenses, excluding license fees, came in at $409 million, up slightly from the prior quarter. We remain highly confident that we will come in between $1.64 billion and $1.65 billion in adjusted expenses for the year, which we reduced by $10 million last quarter.

One final note, earlier this year, proposed federal regulations were released related to the U.S. tax legislation enacted in 2017. These regulations clarified whether a deduction would be available related to foreign customers serviced from our U.S. operations. As a result of these regulations and the nearing completion of our 2018 tax returns, we've revised our income tax calculations for 2018 and 2019 to reflect the new guidance.

We recorded an $89 million tax benefit in the current quarter. Of this, approximately $52 million related to 2018 and was taken out this quarter in adjusted non-GAAP results. The remaining $37 million relates to the first 3 quarters of this year, resulting in an adjusted effective tax rate of 20.5% for the quarter.

Adjusted Q3 diluted EPS, including this entry, was $1.90. We expect the annual 2019 effective tax rate to be approximately 23.5%.

With that short summary, we'd like to open the call for your questions. (Operator Instructions) Thank you.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question will come from Richard Repetto with Sandler O'Neill.

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Richard Henry Repetto, Sandler O'Neill + Partners, L.P., Research Division - Principal of Equity Research [2]

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I guess -- everybody's asking about the volume picture, and I know not to focus on short -- what do you call it, short-term things. But the volumes have across asset classes have dropped over the last 2.5 weeks, so I guess any insight there.

But I guess more importantly, is the longer-term picture. If interest rates are so much of the -- drive so much of the complex and the transaction revenue, what -- how would you talk -- think about the outlook for the interest rate volume, the interest rate transaction revenue in a low rate environment going forward as well?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [3]

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Well, Richard, I think a lot of us would like to kind of jump in a little bit and give you snippets of what we think, but we've got to be careful because as you know, it's very hard for us to predict the future volumes or what they may or may not be.

That being said, when you look at the volumes across, especially, the last period that you referenced, the last couple of weeks, they have been down significantly in the ETFs and the cash markets and the equities, all across the board you've seen a tightening of volumes going on. So it's not just CME. And then when it comes to interest rates, you look at all the -- we're a 90% service economy in the United States, 10% manufacturing roughly.

And there a lot of different borrowing cost at different levels that I think people continually need to manage that risk. And regardless of what the Fed funds rate or the borrowing rate is by the Fed, there's a lot of people that don't give that, and we're going to continually to look to have people manage risk throughout the curve.

So I still think that there is uncertainty as it relates to what those rates are going to be, and I think that the business has -- we're set up in a very good position to capture additional volatility. There's no question, and it's undeniable that it has slowed down. It'll be interesting to see what the Chairman Powell says coming up. So I'll ask Sean to comment more, but I would not try to base a 12-month period on a 2-week cycle.

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Sean P. Tully, CME Group Inc. - Senior MD and Global Head of Financial & OTC Products [4]

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Yes. Rich, this is Sean jumping in. So for the last 2 weeks, certainly the volumes have been lower than they have been for the previous couple of months. But really not surprised, relative to the ebb and flow of economic information and markets.

If you go back a month or so ago, the probability of tightening at the Fed meeting, which is occurring this week, was less than 50% -- sorry, easing, excuse me. The probability of easing was less than 50%.

If you look at the probability today, it's running around 94%. So the market has gone from a highly uncertain situation relative the FOMC meeting, excuse me, to a certain situation, at least from a market standpoint. When you do that, when you remove the uncertainty, then the marketplace volumes tend to fall, which is the volatility tends to fall because marketplace has come to a conclusion.

So I think that, that's a part of the drag in terms of the last couple of weeks. But that's the ebb and flow. No doubt, there will be high levels of uncertainty at FOMC meetings that are upcoming later this year as well as into next year. It's just a short-term event. In terms of the volumes themselves as well, if you look at our volumes, Terry indicated, if you look at the large ETFs in equities, for example, comparable to our products, they're down much more in terms of volumes than our products, they're running down around 50%, ours are down substantially less than that.

We continuously look at making sure that our products are the most attractive of any products available in the marketplace and that market participants come to us for managing their risk. So we're continuously, as you know, focused on adjusting our products in order to make them more attractive as well as innovating new products.

For example, you'll recall, we lowered the minimum price increments in our 2-year futures in January of this year, and those volumes are up substantially relative to the rest of the marketplace now versus where they were a year ago. Sorry, 2-year future is running at around 16% of our overall volumes of our treasury futures, whereas previously, they were running at more like 12.7%.

So an additional 150,000 contracts coming out of the 2-year notes on the back of that. We've also seen outside growth, for example, in our 10-year -- Ultra 10 Year futures, which you know, are new just couple of years ago, recently doing 267,000 contracts a day.

I'm very excited about SOFR. You've heard in terms of innovation our talk about SOFR. In the month of September, the SOFR futures, as Terry mentioned earlier, had a record day of 152,000 contracts in a single day. Putting that in perspective, that's $670 billion notional equivalent.

It's an enormous day for the repo market. The fact that there is volatility in the repo market, repo triggers now coming to CME to manage their risk. Recall that we only launched that product in May of the previous year. We now have more than $1.7 trillion in open interest in that product.

So we're continuously innovating. In terms of the Micro E-minis, Terry mentioned that earlier on the call, we're currently at 565,000 contracts, ADV more than 50,000 contracts trading -- sorry, more than 50,000 accounts trading.

So huge growth in the contract. A huge number of new participants trading it. The average trade on that, I will also mention, is 2.65 contracts. So far smaller than the E-minis. And so very additive to our product.

So whether it's the SOFR futures, whether it's adjusting existing contracts, whether it's the Micro E-minis, we're continuously looking on making sure that we've got the absolute, most-innovative, most-attractive products possible for our clients, and we look to grow our complex in any interest rate environment or any market environment.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [5]

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And Rich, let me just add one more thing, because I think there's a bit of confusion sometimes when people look at rates. Our business is not driven off of making money off of money. We have a very small part of our business that does that, unlike some other businesses.

Our business is to manage risk for a whole host of interest rate fluctuations that have to come to our marketplace to mitigate that. So I think when we look at rates at historical low levels, that affects people who are trying to make money off of money versus what we do for a living.

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Operator [6]

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Our next question comes from Dan Fannon with Jefferies.

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Daniel Thomas Fannon, Jefferies LLC, Research Division - Senior Equity Research Analyst [7]

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Terry, you mentioned the next integration and the potential, kind of, the meetings and potential revenue synergy opportunity. I guess could you be specific about kind of what's happening and the success you're having or meetings and progress. I think at the start it was around some of the intermediary in the banks in Europe and Asia. So I guess if could be some more tangible, kind of, comments around what the progress you're having would be helpful.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [8]

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Yes. Dan, that's a great question. I'm going to ask Bryan to chime in on this to talk a little bit more about because he's been leading this effort along with John. So Bryan, maybe you can chime in a little bit?

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Bryan Thomas Durkin, CME Group Inc. - President [9]

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Thank you, Terry. We're not skipping a beat since our last chat on our last earnings call in terms of integrating the businesses. I think a very formidable part of this is the sales effort.

So you heard Terry allude to earlier how we really integrated our sales teams. We're speaking with one voice as we're able to go out and engage with our client base and help them drive solutions to meet their risk management needs across both the cash, the futures, as well as the optimization services that we offer and that's resonating very strongly.

What's very exciting for us is the introduction into some other quadrants within the banking community, particularly in the regional banking sector, which is an area that we've not quite have the engagement on the core futures side of the business and that's offering up more opportunities, again, across our entire portfolio. So we're very excited about how the sales efforts have come together, and how we're able to cohesively represent the offerings that we have.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [10]

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John?

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [11]

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Yes. Thank you, Terry. Dan, it's interesting, we had a call just yesterday with the sales team, to give you kind of a tangible example. TriResolve, which is working on providing our clients help in terms of the initial margin calculations that they're going to have to do. About 300 come due this current year and followed by the following year with about 700 more clients, that'd be 2020 and 2021.

We are -- they were educating all the entire sales team about what this offering is, so that our entire sales force then can help sell that product to all of our clients. So really, it's being able to sit down and talk about the entire suite of services.

As Terry mentioned, we're about managing risk, and we're able to then sit down and offer them, whether it's on the futures side, providing risk management through the clearing house, or whether it's on the cash side, offering risk management on the -- with our optimization business. So it's really -- it's kind of interesting as a great example in terms of being on the call and having them walk through this campaign that we're working on across the entire sales force. Sean?

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Sean P. Tully, CME Group Inc. - Senior MD and Global Head of Financial & OTC Products [12]

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Yes. Maybe one specific example will be helpful. So SOFR. I talked briefly earlier and Terry talked briefly earlier about our great success in terms of SOFR futures. 58,000 contracts a day in the month of September, about 50,000 contracts a day so far this month. If you think about the BrokerTec business, they do $260 billion worth of U.S. repo every day.

So our BrokerTec repo team is on the phone with those repo desks literally every day. Those are the same traders who needed to hedge their risk in SOFR during the month of September. So it was very easy to have that BrokerTec team, who has the largest of U.S. repo business that exists, talk to their clients and sell them into our SOFR futures, which are now, I think, a very significant success.

If you look at the SOFR futures today, during the month of September, we ran at around 83% of the average daily volume, and we're currently running 93% or 94% of the open interest of the marketplace. So it's a clear opportunity, where we're already getting those opportunities in the synergies.

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Operator [13]

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Our next question comes from Ben Herbert with Citi.

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Benjamin Joseph Herbert, Citigroup Inc, Research Division - VP [14]

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I was just hoping you could touch on the non-U. S. volume strength in the quarter, and kind of help us think through organic efforts to expand the client customer base versus just overall macro and geopolitical uncertainty.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [15]

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Ben, thank you for that question. I'll ask Bryan to again address that as he does head up the international business. Bryan?

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Bryan Thomas Durkin, CME Group Inc. - President [16]

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As we noted, this is one of our top quarters in terms of producing activity, volume and revenues out of international. Our international activity grew by 40%. We're generating from this past quarter $5.3 million contracts of our total volume. EMEA represented about a 34% increase of $3.8 million a day. And Asia, which we're very excited about, $1.2 million, their activity was up about 61%.

As I've mentioned in past visits with all of you, we've really charted our focus on our country planning so that we can more deeply penetrate the activities across the quadrants within each of these regions, and it's definitely resonating with the marketplace. I can break it down by product within financials, equities, commodities, where that activity is coming up.

And so through those sales efforts, as we've indicated, having the boots on the ground, being able to offer the broad array of asset classes, we're continuing to see great growth coming out of all of these regions, new clients coming into our existing products.

One of the major drivers for the last quarter was our interest rates. And so when we talk about our 2-year treasury complex, for example, there's different segments that are driving that growth coming out of Europe versus coming out of Asia. And that goes to the efficacy, again, of the sophistication of our sales team being able to reach out to those very specific segments and bringing them in to these markets.

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [17]

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And just talk a little bit about the international growth as it relates to the tax deduction that we're taking. Really, the -- it's another benefit to the strategy we have of growing globally. Our ability to take this tax deduction really is because we've chosen to service our foreign clients from the United States.

So the extent that we're continuing to grow globally, and as Bryan indicated that, that growth is faster outside the U.S. than within the U.S., we're able to take advantage of this tax deduction. So it's another benefit to growing globally.

And also, we're able to -- as we grow globally, we're able to utilize our systems 24 hours a day and provide our clients better and better liquidity 24 hours a day. So it really -- it's able to leverage all the infrastructure that we have and really allow us to create that liquidity. So when an event happens, any day time, day or night, we're the place to manage that risk.

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Operator [18]

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Our next question comes from Brian Bedell with Deutsche Bank.

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Brian Bertram Bedell, Deutsche Bank AG, Research Division - Director in Equity Research [19]

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If I may, I'm going to link in the combination of the sales forces question with some organic growth initiative that you've got. And the question is, your outlook of the potential for improving volumes from things like the FASB rules on NBS hedging, traction with your portfolio, or I guess, how the portfolio margining savings are resonating with clients, and also the international traction.

So linking that together with the combination of sales force, can you, sort of, potentially see, sort of, an elevated improvement in volumes from those initiatives combined with the now combination of the 2 sales forces?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [20]

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Thanks, Brian. Let me turn that to Sean and then Bryan can add in a little bit. Sean, why don't you go ahead and start?

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Sean P. Tully, CME Group Inc. - Senior MD and Global Head of Financial & OTC Products [21]

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Yes. If you look at insurance companies overall, there has been increased usage of our treasury bond futures in particular over the last couple of years. And as you know, we've seen great growth in our treasury futures complex, and as well, our treasury options complex.

In addition to that, in terms of the portfolio margining, we are very excited about the significant increase in uptake over the last year. In October, we reached a new all-time record. In terms of portfolio margining, saving market participants $5.7 billion worth of margins. That's helped us to lead to very strong growth as well in our OTC clearing. If you look at our OTC clearing volumes, for example, this year, overall, total volumes across all currencies and all products are running at about $136 billion a day, up 29% from last year.

So a very significant increase. And again, with a very large set of participants -- increased number of participants taking greater advantage of portfolio margining.

On the portfolio margining front as well, we've recently announced that we are enhancing our portfolio margining efficiencies. We will be doing that in the month of November. In terms of that, that will make it even more efficient than it is today to trade Eurodollar futures as a spread -- excuse me, to U.S. dollar interest rate swaps.

So we continuously enhance all of our services. We've enhanced the efficiencies on OTC clearing. It is showing through as much greater growth, and it takes time for participants to sometimes take advantage of all of the new products and services, all of the new enhancements that we create. But over time, they do and that's an example of where they are.

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Bryan Thomas Durkin, CME Group Inc. - President [22]

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I'll just comment from the international perspective. Capital efficiency is of paramount importance to our user community, particularly, on the banking sector as well as the buy side.

Our activities throughout EMEA and Asia, particularly, looking at the interest rate quadrant, we've seen tremendous growth coming out of the banking sector as well as hedge funds. A lot of this is being driven out of Singapore, Japan and Australia.

The same thing holds true in terms of on the EMEA side. So throughout Europe, we've seen triple-digit growth coming out of the hedge fund community in our rates and almost triple-digit growth coming out of the banks. That's being driven out of the U.K., some areas of the Czech Republic.

Something very interesting, you've heard me talk about the country planning and highlighting the Netherlands and Switzerland, those areas right now are #2 and #3 in terms of our drivers of growth coming out of EMEA. And again, that's driven out of the interest rate sector.

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Operator [23]

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Our next question comes from Michael Carrier with Bank of America.

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Michael Roger Carrier, BofA Merrill Lynch, Research Division - Director [24]

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John, just given some of the near-term volume concerns, you had, obviously, a solid quarter. Maybe you can just give us an update on how you're thinking about expenses in the near term? Maybe areas of more flexibility if some of the weakness continues, and then any investment needs on the horizon?

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [25]

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Thanks, Mike. I think as we always talked about, there's a couple of line items that really kind of fluctuate based on business performance. One of them is, obviously, our bonus. Our bonus fluctuates based on the business performance, and then our license fees, you really are about -- 3 quarters of our license fees are attributable to the equity complex, so sustained downturns in business performance and in the equities will impact our expenses.

As I said when we had this call in April, when we had a bit of a slow period at that point, this is not a lever that we want to pull prematurely. So there's always ebbs and flows as we've talked about on this call in terms of volume. So we want to be very careful that we don't squeeze too tightly and impact future growth. So we're always very focused on managing the business extremely efficiently, so we are always very careful with every dollar we spend, but we don't want to impact future growth by prematurely squeezing it even harder.

In terms of our go-forward investment, we're constantly investing in the business. We're investing right now in the build out of Globex to migrate from the legacy NEX infrastructure into our Globex infrastructure. So we are right now having a double carrying cost as we build out the test environment, build out the capacity and capabilities in Globex, while running a production system for NEX. And then once that ultimately is completed, then we'll be able to decommission the legacy NEX infrastructure.

So we're constantly investing in the business, we're investing in providing our customers the best experience. As move BrokerTec and EBS onto Globex, we can capture some of the revenue synergies that we've been talking about, and also make sure that we're constantly giving our clients the very best trading and risk management experience.

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Operator [26]

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Our next question comes from Kyle Voigt with KBW.

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Kyle Kenneth Voigt, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [27]

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Maybe just one on this joint recommendation that was written by some large banks and asset managers last week with respect to CCP management standards. And one of the suggestions that was in the paper was around skin in the game, it feels like a topic that comes up every couple of years here. But the paper suggested, I think, CCPs should put up 20% of the default fund, I know that number keeps fluctuating around.

But can you just talk about the regulators and thinking about this topic, and whether or not you think that the regulators have appetite or like, how far up on their priority list would be really seeing some new CCP management standards going forward?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [28]

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Thanks, Kyle. It's Terry. I'll comment a little bit and I'll ask Sunil and maybe Bryan to comment as well. We are -- we were a little surprised, obviously, to see that paper drop the way it did. There's a lot of things in there that we've been discussing for a number of years, going back probably to 2011, 2012.

There were a couple of new issues in there that we had never heard from the signatories about this before, especially on the skin-in-the-game percentages the way they put it in 2 different levels. As you know, CME has skin in the game and Sunil can explain it better than I, but we are first in the waterfall.

One of the things about skin in the game, you have to be very, very careful from -- we believe that people who introduced risk to the system should be putting in the money for the system. We are here to manage the risk. We don't introduce the risk. And so those that are bring the most to risk, you know, should be putting in money for the default fund.

We don't want to have smaller participants that are trying to hedge their crops and do other business throughout the world production be -- given to a situation where they could get hurt, because they're the smaller participants and the bigger ones introduce too much risk to the system but don't want to put the money up.

So that's a bit of a concern for us. So it's also a bit of a moral hazard, for a lack of a better term. When you are the first line of defense with a large number, people could look at you as a moral hazard, knowing that full well that you are the first line of defense under default as a CCP. We don't think that is good for risk management practices. So we don't subscribe to that.

There were some other provisions in there. One, on new products that I found very disturbing. I think when you look at new products if -- there's not a new product that came to this exchange without some kind of 0 in front of it. We create liquidity, we nurture it, we build it. We risk management quite differently. So I was surprised to see some of the rhetoric that came out in that paper associated with that.

The last thing that I'll comment on is, as it relates to a vote that the participants would have seen if they want to participate once the default happens. We are very concerned because of their positions that they could have in the market and then having a vote associated with it. We think that can be definitely an inherent conflict of interest for the other participants, which I referenced earlier.

Your other question was, do the regulators have an appetite to address this? It's not for me to speak for the regulators. You have to talk to them to decide what their appetite is. I have been in communication, as has Bryan, and other members of my team, working with the commission, explaining the issues that I just explained to you or otherwise I wouldn't have said them to you right now on this call.

So I have discussed everything I have said to you with the regulators and our concerns associated thereof. And I think they're very well aware of them. That's all I can say. I cannot speak for the regulators.

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Operator [29]

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Our next question comes from Alex Blostein with Goldman Sachs.

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Alexander Blostein, Goldman Sachs Group Inc., Research Division - Lead Capital Markets Analyst [30]

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Question for you guys around the equity futures business. Definitely strong traction from some of the new product. Can you talk a little bit about when the incentives are set to expire here? And as we sort of think about the more normalized capture rates in these buckets, again, kind of holding maybe the mix of volume constant, kind of where should the capture rate for equity franchise -- what should that, sort of, look like once these, sort of, fee waivers go away?

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [31]

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Sure. Thanks, Alex. This is John, then I'll toss it on over to Sean. We've been very, very pleased with the performance of the micros far exceeded our expectations.

In Q2, we had about 8% of the total trading volume was -- in our equity complex, was related to the micros, that increased to about 16% this quarter. So what does that mean in terms of the rate per contract? In net debt we had about a $0.05 downward pressure on our rate per contract related to the micros in the second quarter, about a $0.10 impact this quarter.

But the good -- the positive thing is that this is all additive to our revenue. We don't think that there is any cannibalization of our business. So this is really kind of new revenue for us. So very, very pleased with the performance. Sean?

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Sean P. Tully, CME Group Inc. - Senior MD and Global Head of Financial & OTC Products [32]

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Yes. The only thing I would add is that we did have a very aggressive incentive program initially and that is waning off. And the incentives will be a bit lower starting next month, even lower than this month, but only a bit lower. So -- but we will keep some incentives in place in order to retain the very strong liquidity.

So you're seeing probably now and you'll see in the next quarter, something more like the RPC or the net RPC that we expect in that product. Another thing to remind you of in terms of the cannibalization or, again, we believe that it's not cannibalization. The 50,000 accounts, as I said earlier, trading the product, the average rate is 2.65 contracts. So much smaller than an E-mini.

Recall that the micros are 1/10 the size. So the average trade is about 25% of the an E-mini. So that tells you that this is additional. In addition to that, on the pricing, just as a reminder, for members, it's $0.04 a contract. So an E-mini equivalent, that's $0.40 versus a rack rate for a member in our E-mini is $0.35, so a nice premium.

In addition to that, for nonmembers, our E-minis trade at $1.18 per contract, whereas these are $0.20. So multiplied by 10, that's $2. So they're also priced at a significant premium on a risk-adjusted basis.

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [33]

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Yes. Alex, this is John. So just to give you an idea, the average RPC for the E-minis has gone from about $0.05 to about $0.08 currently -- Micros, I'm sorry, not the minis, so micros.

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Operator [34]

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Our next question comes from Ken Worthington from JP Morgan.

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Kenneth Brooks Worthington, JP Morgan Chase & Co, Research Division - MD [35]

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There was a Wall Street Journal article out this morning with regard to Eurodollars in data. Does -- the quoting size issue highlighted impact all asset classes, or was this just a Eurodollar phenomenon? And does the data phenomenon have any impact on volumes? If so, which direction, I couldn't quite tell. And if you could, could you take a guess on magnitude?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [36]

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Yes. Ken, thanks. Seems like we're answering a lot of questions from the press these days, and their articles they're written of. Bryan, why don't you go head and address the Eurodollar?

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Bryan Thomas Durkin, CME Group Inc. - President [37]

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I'll address the messaging program and policy perspective in terms of, you had asked if we have programs in place to address how our users utilize the technology and the access into our Globex platform. We do have a messaging policy that applies to all of our product complexes and it's calibrated based upon how these markets trade. We are very sophisticated in terms of our understanding of messaging and messaging ratios to transactions. And so it's a very transparent policy that we've had in place.

We did see a dynamic occur over the course of the last few weeks in terms of messaging increasing significantly. We've got on top of that, we addressed our policy, we had introduced an enhancement to the policy, dealing with excessive messaging. And that has addressed the conduct that we have seen. So we're pleased with the actions that we've undertaken to ensure that behavior that's coming in, messaging that's coming into our system and our infrastructure is appropriate for the overall marketplace in general.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [38]

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Ken, thank you for your question, and I think Bryan summed it up very, very well. I couldn't add much more to that but I can't underscore enough that the policy change that we have made, including our market red division, is very important. We've talked with the participants in the marketplace, we've addressed these issues. They understand our concerns. It doesn't benefit anybody by people trying to circumvent with the messaging traffic.

So I think that we're in a much better place than we were before. I don't believe our procedures or policies in the past were flawed. I just think that you need to amend these things once in a while, and that's exactly what we did. So I think that's what the article was reflecting. So hopefully that answers your question.

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Operator [39]

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Our next question comes from Jeremy Campbell with Barclays.

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Jeremy Edward Campbell, Barclays Bank PLC, Research Division - Lead Analyst [40]

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And thanks for the color earlier around Rich's question about the absolute level of rates and the rates to the volumes. But I'm also getting some more specific questions from accounts about the impact of the Fed's open market bond purchases on OI and volumes in the rates business.

Now I know that the recent kind of quasi QE has been named at more stabilized than the repo market, and there's been -- there was, obviously, a lot going on 7 to 10 years ago during the initial runs of QE from a regulatory and macro context as well.

So Terry and Sean, you talked earlier about risk management in the rates business. But at the current level of QE, or if we get like an escalation of QE in the next couple of years, how should we, one, think about the need for risk management in a QE-driven lower rate vol world? Two, maybe what the impact could be on OI and volumes?

And I guess, three, if there is any parallels we can draw by looking at what CME's kind of prior experience was during prior QE cycles?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [41]

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That's great question, Jeremy. I'm going to turn to Sean, that I'll jump in when he's done.

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Sean P. Tully, CME Group Inc. - Senior MD and Global Head of Financial & OTC Products [42]

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Yes. So thank you, Jeremy. In terms of the Fed's most recent activity, its purchase of T-Bills as well as its entrance into the repo market, clearly, that is in order to stabilize the amount of liquidity available for overnight borrowing and lending, relative to the jump that the Federal Reserve -- the marketplace experienced in September.

So the Federal Reserve, if you'll recall prior to the financial crisis, was very active on a daily basis in the repo market in order to make sure that it had the right level of reserves in order to target the Fed funds' rate.

If you look at all of these recent actions in terms of Federal Reserve entering the overnight repo, the term repo and the purchase of T-Bills, this is also so they can target the overnight rate. That's that's not changing and it really does not impact the longer part of the curve. It doesn't impact anything but their ability to target the overnight rate.

If you think about it with the advent of the financial crisis and the huge quantitative easing that they did during the financial crisis, they grew their balance sheet tremendously and a lot of uncertainty from the Federal Reserve on how to get that overnight rate into the time zone that they want it.

So these are additional tools that they're using just to make sure that, that overnight rate is about where they want it. It doesn't change the volatility in the FOMC in terms of changing their target rate. It doesn't change that whatsoever, which is really what a lot of our products go to.

So I don't see it having a big impact. In terms of previous experience, if you look at, yes, from the very early part of the financial crisis and the early part of Zero Interest Rate Policy, our volumes were challenged, no question, probably from '09 to '12, relative to the implosion of bank balance sheets, for example.

However, if you look at our experience since 2012, even during Zero Interest Rate Policy, we grew our interest rate business tremendously. And I think I can underline tremendously. If you look at today, for example, we're running in these -- statistically, you've heard me talk about it on earnings call for last few years.

Back in 2012, we were running about 45% of the average daily volume of the U.S. Treasury cash market in terms of our treasury futures. Today, I'm happy to say, we're a new all-time record of 121% in terms of our treasury futures relative to the cash treasury bond market.

So we've shown, right, that we can continue to grow. We grew our open interest, we grew the number of large open interest holders, we grew our volumes relative to the underlying cash market throughout zero.

And again, I think I said earlier, my job -- and I know Derek feels the same way, our jobs are to grow our complexes in any market environment through innovation and making our products more attractive.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [43]

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I'll just add a little bit. I think Sean summed it up very, very well. But I think when we look back at '08, '09 and '10, when we were creating and Sean and his team were creating new products to mitigate risk and rates, a lot of people said, what are you doing? Everybody else thought the geopolitical fundamental factors in the marketplace, they waited for that to change for their business to grow.

That's not what we did. So even during all the quantitative easing and these rates going to historic lows, we grew the business, as Sean pointed out, with all the new products he introduced.

So I'm quite confident that with the trillions of dollars of exposure that's out there and a whole host of different durations associated with lending today, that we have to continue to innovate, and that's exactly what we did the last 10 years, to give the numbers that Sean just raised a moment ago. So that's the way I look at the next several years.

We'll continue to look at what the needs of the market are to mitigate their risk, no matter what the price of the Fed lending rate will be, because we know there's trillions of dollars out there that needs to be managed. So I'm quite optimistic about that business. Thank you.

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Operator [44]

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Our next question comes from Owen Lau with Oppenheimer.

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Kwun Sum Lau, Oppenheimer & Co. Inc., Research Division - Associate [45]

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So you announced the divestitures of some businesses like NEX Exchange, NEX Treasury. And so could you please size the revenue and expense impact of those business for us? And do we have any timing of the sale or are you still in the process to look for buyers?

And additionally, you also expect to realize $30 million expense synergy this year, up $5 million, but maintaining the run rate at $50 million. What was driving that acceleration of the expense synergies' realization?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [46]

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Sure. Thanks, Owen. I'll let John go ahead and address that.

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [47]

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Yes. Thanks, Owen. Let's talk about kind of the businesses that we've acted on. ENSO closed at the beginning of the October. NEX Exchange and NEX Treasury, we anticipate closing in the fourth quarter, and then we have [IMM], which is a platform in Italy that we are winding down.

So when we look at the forecast for 2020, the impact on revenue was about $15 million. The impact on direct cost were about $25 million. So those are at a forecasted loss of around $10 million. So those are -- those we've all -- we've acted on all of those businesses.

But with regard to the synergies, we did increase our -- the amount that we realized in terms of synergies this year. And really, it's a function of the great work that the management team has done in terms of managing the integration. We were able to make some of the office moves faster than we had originally anticipated, which allowed us to capture some of those synergies earlier than we anticipated.

So we actually realized more synergies this year, and we're well on track for achieving the $50 million run rate synergies by the end of this year. And that's net of, as I mentioned previously, we do have a double carry in terms of infrastructures, where we have the next legacy infrastructure as well as the Globex infrastructure running in parallel in anticipation of that migration of BrokerTec and EBS.

So really, as Terry indicated in his prepared remarks, we're very, very pleased with the way the integration has been going and really excited about kind of the future of our business with NEX.

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Operator [48]

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Our next question comes from Chris Harris with Wells Fargo.

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Christopher Meo Harris, Wells Fargo Securities, LLC, Research Division - Director and Senior Equity Research Analyst [49]

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Can you talk a little bit about your expectations for the next-gen EBS platform? And then how is this platform different from Globex?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [50]

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Why don't we have Sean and Bryan discuss that real quick. Sean?

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Sean P. Tully, CME Group Inc. - Senior MD and Global Head of Financial & OTC Products [51]

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Sure, very briefly. In September, we did announce that we will be launching over the next 18 months, we'll be migrating clients from the current EBS direct platform to, what we call, EBS QDM 2.0. The primary differences are much, much faster speed, and much greater bandwidth.

So these platforms are direct trading platforms between counterparties. And so the faster speed, the greater bandwidth gives a much more efficient trading at a much lower latency, which is very attractive to market participants.

The other thing I'll remind you, ENSO, again, that's a rollout over 18 months, it's going to take time. At the moment, participants are consuming the data over the platform, they're not actually transacting, and they're doing that in order to test the performance of the system before it is used for actual trading. And the performance result so far very pleasing relative to both their and our expectations.

The other thing on that platform that we have that you should be well aware of is the analytics that allow customers to continuously revise the way they execute their trades and to optimize it for lower costs. So we're very excited about the enhancements that we are making to the EBS technology, as well as the other technologies that we are -- that we've inherited from the NEX businesses. Bryan?

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Bryan Thomas Durkin, CME Group Inc. - President [52]

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A major value driver of all of this is moving all of these markets on to Globex without a doubt and engaging with our client base and the most active users of EBS. There's a great deal of enthusiasm in the migration to the Globex platform. I think it's fair to say that the EBS platform was due for some substantial upgrades prior to our acquisition.

And so the ability now to have the benefit of infrastructure that they're already used to, being able to migrate now these markets onto that platform and as we're doing it, we're enhancing functional attributes that they needed and wanted for some time.

We're also reducing the complexity in terms of how order messaging comes into the platform and how those orders are received by the matching engine. So it's very important for us to be actively engaged with the client base as we're going through this integration process. The feedback that we're getting so far is extremely positive.

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Operator [53]

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Our next question comes from Brian Bedell with Deutsche Bank.

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Brian Bertram Bedell, Deutsche Bank AG, Research Division - Director in Equity Research [54]

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One clarification on the tax rate, John. Is that 23.5%, is that a good run rate to consider also for 2020?

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [55]

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Great, great question, Brian. It's a function of what we think the business is going to be looking like in 2020. But really the tax benefit that we're getting this quarter, we anticipate that continuing until 2025, where it gets -- decreases by about a 1/3.

So we're anticipating a tax benefit of between $45 million and $50 million per year, obviously, subject to any potential tax law changes, subject to the finalization of the regulations, which we don't anticipate changing.

So this benefit that we're getting in terms of servicing our international customers outside of the U.S., from within the U.S., is an ongoing benefit for us. And we'll provide the effective tax rate guidance going into our fourth quarter call in February.

So very, very, very pleased with our international growth and international expansion. Our strategy of growing globally, again, has benefited through our tax situation.

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Brian Bertram Bedell, Deutsche Bank AG, Research Division - Director in Equity Research [56]

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Okay. That's helpful. And then maybe if I could just zero in on one aspect of my first question and that was just the -- you guy's view or maybe Sean could comment on this, on the FASB hedge accounting rules. And I think Bryan you mentioned regional banks are now -- you've been able to penetrate the regional bank community a little bit better with the combined sales force.

So just thinking about what banks may do in particular now that the hedge accounting has been relaxed, which I think allows MBS hedging -- more MBS hedging, if I'm right on that?

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [57]

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Yes. Certainly, the action that the FASB has taken has really made it certainly much more easier and efficient from a financial reporting perspective to -- for utilization of our products.

I think, really, this is really, I think, more on the margins than it is a kind of a major driver of activity, because at the end of the day, it's really the economic impacts that people are concerned about rather than the financial reporting, which does have some impact, but I think it's more on the margins. I don't know, Sean, do you...

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Sean P. Tully, CME Group Inc. - Senior MD and Global Head of Financial & OTC Products [58]

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John, I don't think I have much to add to that. I mean in addition to that, Brian, we wouldn't be able to track what impact that's having very closely. Probably, again, a small positive marginal benefit.

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Operator [59]

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Our next question comes from Kyle Voigt with KBW.

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Kyle Kenneth Voigt, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [60]

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Just curious if you could give us an update on the net investment income line, just the total cash collateral, like average in the quarter and your basis point fee you're generating on that and then if we get another cut from the Fed today, just how the net fee rate will likely move going forward?

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [61]

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Yes. Great. I'm glad you asked because I've been studying this. So anyway, Kyle, so taking a look at the nonoperating portion of our section of our income statement, you could see that it's gone up about $5 million, and really it's a function of a couple -- of primarily 2 things. One is, we did have a sequential increase of about $2 million related to cash on deposit at the clearing house, and that was partially offset by lower returns that we got on those balances. And the balance has increased about on average -- the average balance has increased about $3.8 billion.

So it went from about, on average, $25.6 billion in the second quarter to about $29 billion, $29.5 million in the third quarter. The amount of return we got went from about 34 basis points to 32 basis points from Q2 to Q3. So in total, it was a sequential increase of about $2 million.

We did have a change in our -- in the amount that we charge for noncash collateral, which is in the other income section of our -- I'm sorry, the other revenue section of our income statement. And that increased sequentially about $10 million. So that's not in the other income section, but other revenue.

The other main driver of the nonoperating section of our income statement is lower interest expense. That's down about $2.3 million, and that's really a function of lower balances, lower debt balances we've been focused on paying down our debt. So those are 2 main drivers in the other nonoperating income section of our income statement.

I do want to point out, we did have a reclass from investment income of about $3 million to equity and -- equity earnings and nonconsolidated -- or unconsolidated subsidiaries. And that is really related to legacy NEX investments. So that will now be recorded in equity earnings and unconsolidated subsidiaries. So those were the main drivers.

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Kyle Kenneth Voigt, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [62]

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That's great. I could just ask one more just on the balance sheet. I think you have about $400 million of CP outstanding right now, if I'm calculating that correctly. Do you anticipate paying down that commercial paper completely by the end of the year or maybe just timing there? I'm just trying to get a sense of how much of your cash flow would be available for the annual variable dividend this year?

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John W. Pietrowicz, CME Group Inc. - Senior MD & CFO [63]

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Yes. Sure. We don't give out guidance on that. So just to kind of walk down our capital structure. We had about $1.3 billion cash on hand. We're comfortable with the $700 million minimum cash balance. We're comfortable at that level.

We have $1.3 billion cash on hand. We've got $3.9 billion in total debt, of which, we have $435 million in commercial paper. And we're currently sitting at 1.2x debt to EBITDA. So we paid down about $1.5 million in debt since the first of the year.

In terms of when you look at modeling the fourth quarter, generally, we do have one of our larger cash bills. Obviously, it's subject to business performance in the fourth quarter. We don't have pension funding as we prefunded that in 2017. So if you look at historical cash trends, we usually have a pension funding, but like I said, we mentioned -- we prefunded that in 2017. So we will not have one in 2019.

We anticipate lower than historical tax payments as a result of the tax change. So that will have a fairly significant impact in terms of the cash flows in the fourth quarter, which will be a benefit in terms of cash generation in the fourth quarter. We do have a bond interest payment in the fourth quarter and AP tends to be higher in Q4, and we also have a dividend in December.

So those are some kind of puts and takes to help in terms of modeling the cash flow in the fourth quarter. In terms of the actual pay down of the commercial paper, we're not giving any guidance on that.

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Operator [64]

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Our next question comes from Richard Repetto with Sandler O'Neill.

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Richard Henry Repetto, Sandler O'Neill + Partners, L.P., Research Division - Principal of Equity Research [65]

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Just one quick last follow-up. The retail e-brokers went to 0 commissions on the equity and ETF trades. And I know the futures trades, there's still a premium. I guess, in retail, I think has been a good part of your volume, and you had mentioned that before. I think it was 10% or somewhere around there.

But anyway, do you expect to see any impact? I know you offer some, what do you call, benefits to futures trading that retailers, you can't get on equities as well. So how do you see the balance then -- that -- the 0 commission impacting your -- the retail side of your business?

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [66]

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Thanks, Rich. I'll let Bryan touch on that and then I'll give a comment.

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Bryan Thomas Durkin, CME Group Inc. - President [67]

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Thanks, Rich. Our retail partners continue to look to us for products, education, sales and our marketing efforts to help them grow and expand their client opportunities. We've developed some very strong partnerships in this regard over the last several years. And it's been very fortuitous in terms of a growing segment, as you well know, of business for us.

They look to us for: one, liquidity in the products that we offer, the margin efficiency and leverage offered in our futures versus the other alternatives. And then our 24/7 global access to our liquidity. That, in concert with the education efforts that we've undertaken with them, has allowed us to help them grow their user base significantly in terms of focusing them towards certain asset classes and products.

Through these efforts, particularly, through Julie Winkler's sales team and her marketing efforts, we've been very dedicated to our retail growth efforts. We've been successful in generating over 90,000 new retail futures traders in this year alone.

And just to break that down a little bit, our retail average daily volume today is about 734,000 contracts in Q3, which is up 34%. And out of this, we're very excited to say, 49% growth coming out of EMEA and 26% of this is coming out of Asia.

When you look at the product innovation perspective, we rely heavily on this group as well in terms of addressing their increased demand, for example, for the Micro E-minis and the efforts that have come out of that. It's one of our most successful products launches, as Sean and Terry have outlined.

And on the education front, we continue to work very collaboratively in providing education and marketing efforts to grow that knowledge base of our products. And our most recent success area has been an area of consistent focus for the last 2 years is in options. Our options growth from this community has been tremendous.

So when you take a look at the total cost of trade from a perspective, given all of the above that I've just outlined, we're very confident in our retail clients and our partner firms and that they'll continue to look to our offerings.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [68]

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And Rich, just to add. I think Bryan summed it up quite well. But if you look at what some of the biggest retail brokers are saying that use our products today, they are saying they're with some of their most valued clients that they have today.

I think that that's an important statement that they're making, that's not us making, it's them making it. I don't want to reference it in case they don't want me to say their name. But at the same time, I don't want -- I would not want to see retail brokers trying to push people into derivatives or futures that don't have a good understanding of them. That's not what we're all about. When we talk about retail, we talk about sophisticated participants. And I think that's a lot what these discount brokers have.

So we'll continue the educational process, working with the retail brokers into our product line, but at the same time, because their business model may have shifted a little bit on 0 commissions, we don't want to just push them into our markets that they're not accustomed to.

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Operator [69]

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At this time, we have no further questions. So I will turn it back to management for closing comments.

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Terrence A. Duffy, CME Group Inc. - Chairman & CEO [70]

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We want to thank you all very much. We look forward to talking to you over the next several weeks, and then we'll see you in next quarter, several months, I should say. Thank you.

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Operator [71]

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Thank you, ladies and gentlemen. That concludes the CME Group Third Quarter 2019 Earnings Call. You may disconnect your phone lines, and thank you for joining us this morning.