ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Edgar Glimpses Via Acquire Media NewsEdge) INTRODUCTION Management's Discussion and Analysis of Financial Condition and Results of Operations is organized as follows: • Overview: Includes a discussion of our business structure; current economic and industry-wide trends relevant to our business; our current business strategy; and our primary sources of operating and non-operating revenues and expenditures.
• Critical Accounting Policies: Provides an explanation of accounting policies which may have a significant impact on our financial results and the estimates, assumptions and risks associated with those policies.
• Recent Accounting Pronouncements: Includes an evaluation of recent accounting pronouncements and the potential impact of their future adoption on our financial results.
• Results of Operations: Includes a discussion of our 2010, 2009 and 2008 financial results and any known events or trends which are likely to impact future results.
• Liquidity and Capital Resources: Includes a discussion of our future cash requirements, capital resources, significant planned expenditures and financing arrangements.
On March 23, 2008, CME Group acquired Credit Market Analysis Ltd., a private company incorporated in the United Kingdom, and its wholly-owned subsidiaries (collectively, CMA). On August 22, 2008, NYMEX Holdings, Inc. (NYMEX Holdings) merged with CME Group. On March 18, 2010, Board of Trade of the City of Chicago, Inc. (CBOT) acquired a 90% ownership interest in CME Group Index Services LLC (Index Services), a joint venture with Dow Jones & Company (Dow Jones). The following Management's Discussion and Analysis of Financial Condition and Results of Operations includes the financial results of CMA beginning March 24, 2008, the financial results of the former NYMEX Holdings beginning August 23, 2008 and the financial results of Index Services beginning March 19, 2010.
References in this discussion and analysis to "we" and "our" are to CME Group Inc. (CME Group) and its consolidated subsidiaries, collectively. References to "exchange" are to Chicago Mercantile Exchange Inc. (CME), CBOT and New York Mercantile Exchange, Inc. (NYMEX), collectively.
OVERVIEW Business Structure CME Group, a Delaware stock corporation, is the holding company for CME, CBOT, NYMEX and their respective subsidiaries. The holding company structure is designed to provide strategic and operational flexibility. CME Group's Class A common stock is listed on the NASDAQ Global Select Market (NASDAQ) under the ticker symbol "CME." Our exchange consists of designated contract markets for the trading of futures and options on futures contracts as well as clearing over-the-counter contracts.
Futures contracts and options on futures contracts provide investors with vehicles for protecting against, and potentially profiting from, price changes in financial instruments and physical commodities.
We are a global exchange with customer access available virtually all over the world. Our customers consist of professional traders, financial institutions, individual and institutional investors, major corporations, manufacturers, producers and governments. Customers include both members of the exchange and non-members.
38 -------------------------------------------------------------------------------- Table of Contents We offer our customers the opportunity to trade futures contracts and options on futures contracts on a range of products including those based on interest rates, equities, foreign exchange, agricultural commodities, energy, and metals.
Our products provide a means for hedging, speculating and allocating assets. We identify new products by monitoring economic trends and their impact on the risk management and speculative needs of our existing and prospective customers.
Our major product lines are traded through our electronic trading platform and our open outcry trading floors. These execution facilities offer our customers immediate trade execution and price transparency. In addition, trades can be executed through privately negotiated transactions that are cleared and settled through our clearing house.
Our clearing house clears, settles and guarantees every futures and options contract traded through our exchange, in addition to cleared over-the-counter products, including credit default swaps and interest rate swaps. Our clearing house performance guarantee is an important function of our business. Because of this guarantee, our customers do not need to evaluate the credit of each potential counterparty or limit themselves to a selected set of counterparties.
This flexibility increases the potential liquidity available for each trade.
Additionally, the substitution of our clearing house as the counterparty to every transaction allows our customers to establish a position with one party and then to offset the position with another party. This contract offsetting process provides our customers with flexibility in establishing and adjusting positions and provides for performance bond efficiencies.
To ensure performance of counterparties, we establish and monitor financial requirements of our clearing firms. We also establish minimum performance bond requirements for our exchange-traded products and over-the-counter products. We mark-to-market all open positions at least twice a day and require payment from clearing firms whose positions have lost value and make payments to clearing firms whose positions have gained value. For product offerings within new markets, positions are marked-to-market daily, with the capability to mark-to-market more frequently as market conditions warrant. We maintain a financial safeguard package to be used in the event of default of a clearing firm for our futures, options or cleared over-the-counter credit default swap contracts. In the unlikely event of a payment default by a clearing firm for our futures, options or cleared over-the-counter credit default swap contracts, we would first apply assets of the defaulting clearing firm to satisfy its payment obligation. These assets include the defaulting firm's guaranty fund contributions, performance bonds and any other available assets, such as assets required for membership and any associated trading rights. In addition, we would make a demand for payment pursuant to any applicable guarantee provided to the exchange by the parent company of a clearing firm. Thereafter, if the payment default remains unsatisfied, we would use, in order, CME's surplus funds, guaranty fund contributions of other clearing firms and funds collected through an assessment against solvent clearing firms to satisfy the deficit. Surplus funds represent the amount of CME working capital reduced by an amount necessary to support normal operations and amounts designated by CME for our interest rate swap financial safeguard package.
We maintain a separate financial safeguard package to support our cleared over-the-counter interest rate swap products. This separate interest rate swaps financial safeguard package is independent of our financial safeguard package for our futures, options or cleared over-the-counter credit default swaps and is isolated to clearing firms for our interest rate swap products. This financial safeguard package includes a separate guaranty fund, risk committee and default management procedures. We have also designated an additional $100.0 million of CME working capital to be used in the event of default of one of the clearing firms for interest rate swap contracts after the defaulting clearing firm assets have been applied.
Industry Trends Economic Environment. Despite the recent economic volatility, our customers continue to use our markets as an effective and transparent means to manage risk. Over the last few years, trading activity in our centralized markets has fluctuated due to the ongoing uncertainty in the financial markets, fluctuations in the availability of 39 -------------------------------------------------------------------------------- Table of Contents credit, variations in the amount of assets under management as well as the Federal Reserve Bank's continued zero interest rate policy. We continue to maintain quality products and services which support our customers in any economic environment.
Competitive Environment. We operate in a highly competitive industry and expect competition to continue to intensify, especially after a recent consolidation of exchanges and new entrants to the markets we serve. We encounter competition in all aspects of our business. Competition is influenced by liquidity and transparency of the markets, variability in fee structures, breadth of product offerings including quality of new product development as well as efficient and innovative technology. We now face competition from other futures, securities and securities option exchanges; over-the-counter markets; clearing organizations; consortia formed by our members and large market participants; alternative trade execution facilities; technology firms, including market data distributors and electronic trading system developers; and others.
Regulatory Environment. Our operations as a futures exchange have historically been subject to extensive regulation. In light of widespread difficulties across the economy, particularly acute in the latter half of 2008 and early 2009, there have been many calls for a restructuring of the regulation of financial markets.
In July 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act is a comprehensive banking and financial services reform package that includes significant changes to the oversight of the derivatives markets, both over-the-counter and exchange-traded. While we believe that the new regulations will provide opportunities for our business, the new regulations are subject to extensive rulemaking by various regulators. To the extent the regulatory environment following the implementation of the new legislation and other financial reform regulations is less beneficial for us or our customers, our business, financial condition and operating results could be negatively affected.
Business Strategy Our strategy focuses on leveraging our benchmark products, enhancing our customer relations, expanding our customer base, advancing our clearing and trading technologies, and deriving benefits from our integrated clearing house as well as our scalable infrastructure. We specifically focus our strategy on capitalizing on opportunities created by increased market awareness and acceptance of derivatives, increased price volatility, technological advances and the increasing need for counterparty risk mitigation and clearing services.
This strategy allows us to continue to develop into a more broadly diversified financial exchange that provides trading and clearing solutions across a wide range of products and asset classes. We believe that we can build on our competitive strengths by implementing the following strategies: • Grow our core business through expansion of our existing benchmark product lines and new product offerings as well as improvement of our customer relations in order to cross-sell our products; • Globalize our business by expanding and diversifying our worldwide customer base through strategic investments and relationships with other key exchanges around the world, which allows us to accelerate our market penetration and improve product sales channels; • Provide a comprehensive multi-asset class clearing solution to the over-the-counter market that maximizes operational efficiency, as well as expand our over-the-counter product offerings; and • Establish ourselves as the leading exchange company provider of information products and index services, which would allow us to create additional cross-listing opportunities and new opportunities for index creation. It will also allow us to create opportunities for licensing across the global market as well as expanding market data dissemination services to our global network of clients and exchange partners.
Primary Sources of Revenue Clearing and transaction fees. A majority of our revenue is derived from clearing and transaction fees, which include electronic trading fees, surcharges for privately-negotiated transactions and other volume-related charges for contracts executed through our trading venues. Because clearing and transaction fees are assessed on a 40 -------------------------------------------------------------------------------- Table of Contents per-contract basis, revenues and profitability fluctuate with changes in trading volume. In addition to the industry trends noted earlier, our revenues and trading volume tend to increase during periods of economic and geopolitical uncertainty as our customers seek to manage their exposure to, or speculate on, the market volatility resulting from uncertainty.
While volume has the most significant impact on our clearing and transaction fees revenue, there are four other factors that also influence this source of revenues: • rate structure; • product mix; • trading venue; and • the percentage of trades executed by customers who are members compared with non-member customers.
Rate structure. Customers benefit from volume discounts and limits on fees as part of our effort to increase liquidity in certain products. We offer various incentive programs to promote trading in various products and geographic locations. We may periodically change fees, volume discounts, limits on fees and member discounts, perhaps significantly, based on our review of operations and the business environment. For example, we have an incentive program in place to provide fee incentives to international trading firms that trade our products electronically.
Product mix. We offer trading of futures and options on futures contracts on a wide-ranging set of products based on interest rates, equities, foreign exchange, agricultural commodities, energy and metals. Rates are varied by product in order to optimize revenue on existing products and to encourage trading volume upon introduction of new products.
Trading venue. Our exchange is an international marketplace that brings together buyers and sellers mainly through our electronic trading platform as well as through open outcry trading on our trading floors and privately negotiated transactions. Any customer who is guaranteed by a clearing firm and who agrees to be bound by our exchange rules is able to obtain direct access to our electronic platform. Open outcry trading is conducted exclusively by our members, who may execute trades on behalf of customers or for themselves.
Typically, customers executing trades through our electronic platform are charged fees for using the platform in addition to the fees assessed on all transactions executed on our exchange. Customers entering into privately negotiated transactions also incur additional charges beyond the fees assessed on all transactions. Privately negotiated transactions include block trades, which are large transactions that are executed between selected parties off the public auction market on CME Globex or the trading floor.
Member/non-member mix. Generally, member customers are charged lower fees than our non-member customers. Holding all other factors constant, revenue decreases if the percentage of trades executed by members increases, and increases if the percentage of non-member trades increases.
Other sources. Revenue is also derived from other sources including market data and information services, access and communication fees and various services related to our exchange and building operations.
Market data and information services. We receive market data and information services revenue from the dissemination of our market data to subscribers.
Subscribers can obtain access to our market data services either directly or through third-party distributors.
Our service offerings include access to real-time, delayed and end-of-day quotation, trade and summary market data for our products and other data sources. Users of our basic service receive real-time quotes and pay a flat monthly fee for each screen, or device, displaying our market data.
Alternatively, customers can subscribe to market data provided on a limited group of products. The fee for this service is also a flat rate per month.
41-------------------------------------------------------------------------------- Table of Contents Pricing for our market data services is based on the value of the service provided, our cost structure for the service and the price of comparable services offered by our competitors. Increases or decreases in our market data and information services revenue are influenced by changes in our price structure for existing market data offerings, introduction of new market data services and changes in the number of devices in use. General economic factors that affect the financial services industry, which constitutes our primary customer base, also influence revenue from our market data services.
On March 18, 2010, CBOT and Dow Jones entered into an agreement to form Index Services. Index Services was formed through the contribution of CBOT's market data business and Dow Jones' index business. Index Services generates market data and information services revenue through licensing of its trademark indexes as well as through calculation and distribution of its market data.
Access and communication fees. Access and communication fees are the connectivity charges to customers of the CME Globex platform to our market data vendors and to direct market data customers as well as charges to members and clearing firms that utilize our various telecommunications networks and communications services, including our co-location initiatives. Access fee revenue varies depending on the type of connection provided to customers.
Revenue from communication fees is dependent on open outcry trading, as a significant portion relates to telecommunications on our trading floors.
Other revenues. Other revenues include rent charged to third party tenants as well as ancillary charges for utilities, parking and miscellaneous services provided to tenants. We maintain three commercial buildings in Chicago's central business district. We rent retail and office space to third party tenants, including exchange customers. We also maintain office space in New York City that is rented to third party tenants, including exchange customers. All tenants pay market rates for rent. Revenues related to our real estate operations are generally affected by market rental rates, lease renewals and business conditions in the financial services industry in which most of our tenants operate.
To further diversify the range of services we offer, we have entered into processing and development agreements with other exchanges and service organizations. Prior to our merger with NYMEX Holdings in August 2008, we collected fees from NYMEX for listing energy and metal futures products on the CME Globex platform. In 2010, we entered into an agreement with BM&FBOVESPA S.A (BM&FBOVESPA) to develop a new multi-asset class electronic trading platform for their customers. We recognize revenue under this agreement as services are provided and when developed technology is delivered.
Additionally, other revenues include fees for administrating our Interest Earnings Facility (IEF) program, trade order routing, and various services to members and clearing firms. We offer clearing firms the opportunity to invest cash performance bonds in our various IEF offerings. These clearing firms receive interest income, and we receive a fee based on total funds on deposit.
In addition, other revenues include trading gains and losses generated by GFX Corporation (GFX), our wholly-owned subsidiary that trades foreign exchange futures contracts to enhance liquidity in our electronic markets for these products.
Primary Expenses The majority of our expenses do not vary directly with changes in our trading volume. Licensing and other fee agreements expense and the majority of our employee bonuses do vary directly with trading volume.
Compensation and benefits. Compensation and benefits expense is our most significant expense and includes employee wages, bonuses, stock-based compensation, benefits and employer taxes. Changes in this expense are driven by fluctuations in the number of employees, increases in wages as a result of inflation or labor market conditions, changes in rates for employer taxes and other cost increases affecting benefit plans. In addition, this expense is affected by the composition of our work force. The expense associated with our bonus and stock-based compensation plans can also have a significant impact on this expense category and may vary from year to year.
42-------------------------------------------------------------------------------- Table of Contents The bonus component of our compensation and benefits expense is based on our financial performance. Under the performance criteria of our annual incentive plans, the bonus funded under the plans is based on achieving certain financial performance targets established by the compensation committee of our board of directors. The compensation committee may adjust the target level of performance for material, unplanned revenue, expense or capital expenditures to meet intermediate to long-term growth opportunities.
Stock-based compensation is a non-cash expense related to stock options, restricted stock and performance share grants. Stock-based compensation varies depending on the quantity and fair value of awards granted. The fair value of options is derived using the Black-Scholes model with assumptions about our dividend yield, the expected volatility of our stock price based on an analysis of implied and historical volatility, the risk-free interest rate and the expected life of the options granted. The fair value of other awards is based on the share price on the date of the grant.
Amortization of purchased intangibles. This expense primarily includes amortization of intangible assets obtained in our mergers with CBOT Holdings and NYMEX Holdings as well as other asset and business acquisitions. Intangible assets subject to amortization consist primarily of customer relationships, licensing agreements, and lease-related intangible assets.
Depreciation and amortization. Depreciation and amortization expense results from the depreciation of long-lived assets purchased, as well as the amortization of purchased and internally developed software.
Other expenses. We incur additional ongoing expenses for communications, technology support services and various other activities necessary to support our operations.
• Communications expense includes costs for network connections to our electronic trading platform and some market data customers; telecommunications costs of our exchange; and fees paid for access to external market data. This expense may be impacted by growth in electronic trading, our capacity requirements and changes in the number of telecommunications hubs and connections which allow customers outside the United States access to our electronic trading platform directly.
• Technology support services consist of costs related to maintenance of the hardware and software required to support our technology. Our technology support services costs are driven by system capacity, functionality and redundancy requirements.
• Professional fees and outside services expense includes costs of consulting services provided for major strategic and technology initiatives as well as legal and accounting fees. This expense may fluctuate as a result of changes in services required to complete initiatives and legal proceedings.
• Occupancy and building operations expense consists of costs related to leased and owned property including rent, maintenance, real estate taxes, utilities and other related costs. We have significant operations located in Chicago and New York City with smaller offices in located throughout Europe, North and South America, the Middle East and Asia. Additionally, we have trading facilities in Chicago and New York City as well as data centers in various U.S. locations.
• Licensing and other fee agreements expense includes license fees paid as a result of trading volume in equity index products, and royalty and broker rebates on metals and energy products, subsequent to the merger with NYMEX Holdings. This expense fluctuates with changes in equity index product volume as well as CME ClearPort volumes and fee structure changes in the agreements.
• Restructuring expense includes transitional employees' severance, retention bonuses and associated payroll taxes as well as outplacement costs and post-employment healthcare subsidies resulting from our mergers with CBOT Holdings in July 2007 and with NYMEX Holdings in August 2008.
• Other expenses include marketing-related as well as general and administrative costs. Marketing, advertising and public relations expense includes media, print and other advertising costs, as well as costs associated with our product promotion. Other expenses also include litigation and customer settlements as well as impairment of operational assets.
43 -------------------------------------------------------------------------------- Table of Contents Non-Operating Income and Expenses Income and expenses incurred through activities outside of our core operations are considered non-operating. These activities include investments in debt and equity securities for operational and strategic purposes, financing activities and our securities lending program.
• Investment income represents income generated by short-term investment of excess cash, clearing firms' cash performance bonds and guaranty fund contributions; income and net realized gains and losses from our marketable securities; gains and losses on trading securities in our non-qualified deferred compensation plans and dividend income from our strategic investments. Investment income is influenced by the availability of funds generated by operations, market interest rates and changes in the levels of cash performance bonds deposited by clearing firms.
• We use derivative financial instruments for the purpose of hedging exposures to fluctuations in interest rates and foreign currency exchange rates. Any ineffective or excluded portion of our hedges is recognized in earnings immediately.
• CME's securities lending program has been suspended since November 2008.
NYMEX's securities lending program was terminated in June 2009. Under the securities lending program, we lend a portion of the securities that clearing firms deposit with us and we receive collateral in the form of cash in return. The cash is invested in bank money market mutual funds, overnight repurchase agreements, corporate debt securities or other asset-back securities to generate interest income. The balance of securities on deposit fluctuates as a result of changes in the clearing firms' open positions and how clearing firms elect to satisfy their performance bond requirements. Securities lending interest expense represents the payment to the borrower of the security for the cash retained during the duration of the lending transaction. Net interest income from securities lending is impacted by changes in short-term interest rates and the level of demand for the securities on deposit.
• Interest and other borrowing costs are associated with various short-term and long-term funding facilities. We maintain a commercial paper program with various financial institutions. In 2008, we issued short-term and long-term debt in conjunction with our merger with NYMEX Holdings. In early 2009, we refinanced part of the debt that was previously issued for the NYMEX Holdings merger. In conjunction with its formation, Index Services issued long-term debt in March 2010. Our debt is effectively fixed rate debt, but some debt-related costs fluctuate with the funding needs of our business.
• Income related to our guarantee of exercise right privileges (ERPs) was a result of our merger with CBOT Holdings. Under the terms of the merger agreement, eligible holders of Chicago Board Options Exchange (CBOE) ERPs could elect to sell us their ERP for $250,000 per privilege. Eligible holders that did not elect to sell their ERPs were entitled to a maximum guaranteed payment of $250,000 from us upon resolution of the lawsuit between CBOT and CBOE. This income represented the change in estimated fair value of our guarantee during the period, which was based in part on the expected outcome of the litigation. This litigation was resolved in December 2009.
• Equity in net losses of unconsolidated subsidiaries includes income and losses from our investments in Dubai Mercantile Exchange (DME), Green Exchange Holdings, LLC, Bursa Malaysia Derivatives Berhad (Bursa Derivatives), OneChicago LLC (OneChicago) and FXMarketSpace Limited (FXMS).
CRITICAL ACCOUNTING POLICIES The notes to our consolidated financial statements include disclosure of our significant accounting policies. In establishing these policies within the framework of accounting principles generally accepted in the United States, management must make certain assessments, estimates and choices that will result in the application of these principles in a manner that appropriately reflects our financial condition and results of operations. Critical accounting policies are those policies that we believe present the most complex or subjective measurements and have the most potential to affect our financial position and operating results. While all decisions regarding 44-------------------------------------------------------------------------------- Table of Contents accounting policies are important, there are certain accounting policies that we consider to be critical. These critical policies, which are presented in detail in the notes to our consolidated financial statements, relate to valuation of financial instruments, goodwill and intangible assets, derivative instruments, revenue recognition, income taxes, and internal use software costs.
Valuation of financial instruments. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, or an exit price. A hierarchy exists for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from independent sources. Unobservable inputs are inputs that reflect our assumptions about the assumptions that market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.
We have categorized financial instruments measured at fair value into a three-level classification hierarchy. Classification is based on the reliability of inputs as follows: • Level 1-Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. Assets and liabilities carried at level 1 fair value generally include U.S. Treasury and Government agency securities, equity securities listed in active markets, and investments in publicly traded mutual funds with quoted market prices.
• Level 2-Inputs are either directly or indirectly observable and corroborated by market data or are based on quoted prices in markets that are not active. Assets and liabilities carried at level 2 fair value generally include municipal bonds, corporate debt and certain derivatives.
• Level 3-Inputs are unobservable and reflect management's best estimate of what market participants would use in pricing the asset or liability.
Generally assets and liabilities at fair value utilizing level 3 inputs include certain other assets and liabilities with inputs that require management's judgment.
For further discussion regarding the fair value of financial assets and liabilities, see note 24 in the notes to the consolidated financial statements.
Goodwill and intangible assets. We review goodwill and intangible assets with indefinite lives for impairment on an annual basis and whenever events or circumstances indicate that the carrying value may not be recoverable. Goodwill is assessed for impairment using a two-step test. In the first step, the fair value of each reporting unit is compared to its carrying amount. If the fair value of the reporting unit exceeds the carrying amount, no impairment exists and we are not required to perform further testing. If the carrying amount exceeds its fair value, the second step must be performed to determine the implied fair value of the reporting unit's goodwill. If the carrying value of the reporting unit's goodwill exceeds its implied fair value, then an impairment loss is recorded in an amount equal to that excess. Determining the fair value of a reporting unit involves the use of significant estimates and assumptions.
Valuation techniques we use to measure fair value include the market approach and the income approach. The market approach encompasses comparable data sets within our peer group, and the income approach includes discounted cash flow measurements using a market discount rate. Our valuation techniques could yield variable results based on changes in assumptions such as the discount rate and long-term growth rate and forecasted revenue and expense. Our annual impairment analysis indicated a fair value for CMA that was below its book value as a result of adverse economic conditions. Accordingly, in June 2010, a $19.8 million impairment loss was charged against earnings.
Indefinite-lived intangible assets are assessed for impairment by comparing their fair values to their carrying values. If the carrying value of an indefinite-lived intangible asset exceeds its fair value, an impairment loss is recognized equal to the difference. The estimate of the fair value of all intangible assets is generally determined on the basis of discounted future cash flows. In estimating the fair value, management must make assumptions 45-------------------------------------------------------------------------------- Table of Contents and projections regarding such items as the discount rate, long-term growth rate, forecasted revenue and expenses, and other factors. Such assumptions are subject to change as a result of changing economic and competitive conditions.
Intangible assets subject to amortization are also evaluated for impairment when indicated by a change in economic or operational circumstances. The impairment testing requires management to first compare the book value of the amortizing asset to undiscounted cash flows. If the book value exceeds the undiscounted cash flows, management is then required to estimate the fair value of the assets and record an impairment loss for the excess of the carrying value over the fair value.
Derivative investments. We use derivative financial instruments for the purpose of hedging exposures to fluctuations in interest rates and foreign currency exchange rates. Derivatives are recorded at fair value in the consolidated balance sheets. Changes in our derivatives' fair values are recognized in earnings unless the instruments are accounted for as hedges. For a derivative designated as a fair value hedge, any gain or loss on the derivative is recognized in earnings in the period of change, to the extent the hedge is effective, together with the offsetting gain or loss on the hedged item attributable to the risk being hedged. We record the effective portions of our derivative financial instruments that are designated as cash flow hedges in accumulated other comprehensive income (loss) in the accompanying consolidated balance sheets. When the hedged item affects earnings, the gain or loss included in accumulated other comprehensive income (loss) is transferred to the same line in the consolidated statements of income as the hedged item. Any ineffective or excluded portion of a hedge is recognized in earnings immediately. Any realized gains and losses from effective hedges are classified in the consolidated statements of income consistent with the accounting treatment of the items being hedged.
Revenue recognition. Over 75% of our revenue is derived from the clearing and transaction fees we assess on each contract executed through our trading venues and cleared through our clearing house. Clearing and transaction fees are recognized as revenue when a buy and sell order are matched and when the trade is cleared. On occasion, the customer's exchange trading privileges may not be properly entered by the clearing firm and incorrect fees are charged for the transactions in the affected accounts. When this information is corrected within the time period allowed by the exchange, a fee adjustment is provided to the clearing firm. An accrual is established for estimated fee adjustments to reflect corrections to customer exchange trading privileges. The accrual is based on the historical pattern of adjustments processed as well as specific adjustment requests. Occasionally market data customers will pay for services in a lump sum payment. When these circumstances occur, revenue is recognized as services are provided.
Income taxes. Calculation of the income tax provision includes an estimate of the income taxes that will be paid for the current year as well as an estimate of income tax liabilities or benefits deferred into future years. Deferred tax assets are reviewed to determine if they will be realized in future periods. To the extent it is determined that some deferred tax assets may not be fully realized, the assets are reduced to their realizable value by a valuation allowance. The calculation of our tax provision involves uncertainty in the application of complex tax regulations. We recognize potential liabilities for anticipated tax audit issues in the United States and other applicable tax jurisdictions using a more-likely-than-not recognition threshold based on the technical merits of the tax position taken or expected to be taken. If payment of these amounts varies from our estimate, our income tax provision would be reduced or increased at the time that determination is made. This determination may not be known for several years. Past tax audits have not resulted in tax adjustments that would result in a material change to the income tax provision in the year the audit was completed. The effective tax rate, defined as the income tax provision as a percentage of income before income taxes, will vary from year to year based on changes in tax jurisdictions, tax rates and regulations. In addition, the effective tax rate will vary with changes to income that are not subject to income tax, such as municipal interest income, and changes in expenses or losses that are not deductible, such as the utilization of foreign net operating losses.
Internal use software costs. Certain costs for employees and consultants that are incurred in connection with work on development or implementation of software for our internal use are capitalized. Costs capitalized are for application development or implementation for software projects that will result in significant new functionality 46-------------------------------------------------------------------------------- Table of Contents and that are generally expected to cost in excess of $0.5 million. The amount capitalized is determined based on the time spent by the individuals completing the eligible software-related activity and the compensation and benefits or consulting fees incurred for these activities. Projects are monitored during the development cycle to assure that they continue to meet the capitalization criteria and that the project will be completed and placed in service as intended. Any previously capitalized costs are expensed at the time a decision is made to abandon a software project. Completed internal use software projects, as well as work-in-progress projects, are included as part of property in the consolidated balance sheets. Once complete, the accumulated costs for a particular software project are amortized over the anticipated life of the software, generally three years. Costs capitalized for internal use software will vary from year to year based on our technology-related business requirements.
RESULTS OF OPERATIONS 2010 Financial Highlights The comparability of our operating results for the periods presented is significantly impacted by our merger with NYMEX Holdings in August 2008 as well as the creation of Index Services in March 2010. In the discussion and analysis that follows, we have quantified the incremental revenue or expense resulting from the NYMEX transaction wherever such amounts were material and identifiable.
While identified amounts may provide indications of general trends, the analysis cannot completely address the effects attributable to integration efforts.
The following summarizes significant changes in our financial performance for the years presented.
Year-over-Year Change (dollars in millions, except per share data) 2010 2009 2008 2010-2009 2009-2008 Total revenues $ 3,003.7 $ 2,612.8 $ 2,561.0 15 % 2 % Total expenses 1,172.6 1,023.7 978.8 15 5 Operating margin 61 % 61 % 62 % Non-operating income (expense) $ (109.2 ) $ (151.6 ) $ (334.2 ) (28 ) (55 ) Effective tax rate 45 % 43 % 43 % Net income attributable to CME Group $ 951.4 $ 825.8 $ 715.5 15 15 Diluted earnings per common share attributable to CME Group 14.31 12.41 12.13 15 2 Cash flows from operating activities 1,356.4 1,083.1 1,197.2 25 (10 ) • The increase in revenues from 2008 to 2010 was attributable to an increase in contract volume as well as an increase in market data and information services revenue, due in part to our merger with NYMEX Holdings in August 2008.
• From 2008 to 2010, higher compensation and benefits, amortization of purchased intangibles as well as professional fees and outside services contributed to an increase in expenses, due in part to our merger with NYMEX Holdings in August 2008.
• We experienced a decrease in non-operating income (expense) from 2008 to 2010 due to an impairment charge on our investment in BM&FBOVESPA of $274.5 million in 2008 as well as aggregate impairment charges of $46.0 million related to IMAREX ASA (IMAREX) and DME in 2009. This decrease in expense was partially offset by an increase in interest expense and other borrowing costs from 2008 to 2010 due to an increase in average debt outstanding resulting from our merger with NYMEX Holdings in August 2008.
• The effective tax rate increased in 2010 compared with 2009 due to a $51.2 million charge to record the impact of our new combined state and local tax rate on our existing deferred tax liabilities. Our state and local tax rate increased due to revised state apportionment estimates resulting from annual state tax filings. The 2009 effective tax rate remained consistent with 2008. An additional valuation allowance related to unrealized capital losses increased the effective tax rate in 2009. However, this increase was offset by the favorable impact of a New York City tax law change in 2009.
• Cash flows from operations are strongly correlated with trading volume.
47 -------------------------------------------------------------------------------- Table of Contents Revenues Year-over-Year Change (dollars in millions) 2010 2009 2008 2010-2009 2009-2008 Clearing and transaction fees $ 2,486.3 $ 2,161.9 $ 2,115.4 15 % 2 % Market data and information services 395.1 331.1 279.5 19 18 Access and communication fees 45.4 45.6 43.6 - 4 Other 76.9 74.2 122.5 4 (39 ) Total Revenues $ 3,003.7 $ 2,612.8 $ 2,561.0 15 2 Clearing and Transaction Fees The following table summarizes our total contract volume, revenue and average rate per contract. Total contract volume includes contracts that are traded on our exchange and cleared through our clearing house. Contract volume also includes cleared-only CME ClearPort contracts. Volume is measured in round turns, which is considered a completed transaction which involves a purchase and an offsetting sale of a contract. Average rate per contract is determined by dividing total clearing and transaction fee revenue by total contract volume.
All amounts exclude our TRAKRS, HuRLO, Swapstream, credit default swaps and interest rate swaps.
Year-over-Year Change 2010 2009 2008 2010-2009 2009-2008Total volume (in millions) 3,078.1 2,584.9 2,978.5 19 % (13 )% Clearing and transaction fees (in millions) $ 2,486.3 $ 2,161.7 $ 2,114.7 15 2 Average rate per contract 0.808 0.836 0.710 (3 ) 18 We estimate the following increases (decreases) in clearing and transaction fees based on change in total volume and change in average rate per contract.
Year-over-Year Change (in millions) 2010-2009 2009-2008Increase (decrease) due to change in total volume $ 398.5 $ (329.1 ) Increase (decrease) due to change in average rate per contract (73.9 ) 376.1 Net increase in clearing and transaction fees $ 324.6 $ 47.0 Average rate per contract is impacted by our rate structure, which includes volume-based incentives; product mix; trading venue; and the percentage of volume executed by customers who are members compared with non-member customers.
Due to the relationship between average rate per contract and volume, the change in revenues attributable to changes in each is only an approximation.
48-------------------------------------------------------------------------------- Table of Contents Contract Volume The following table summarizes average daily contract volume. NYMEX product and CME ClearPort services volume in 2008 have been calculated for the period from August 23 through December 31, 2008.
Year-over-Year Change (amounts in thousands) 2010 2009 2008 2010-2009 2009-2008 Average Daily Volume by Product Line: Interest rate 5,449 4,260 6,085 28 % (30 )% Equity 2,907 2,916 3,663 - (20 ) Foreign exchange 919 624 623 47 - Agricultural commodity 914 741 848 23 (13 ) Energy 1,662 1,492 1,348 11 11 Metal 316 225 208 40 8 Aggregate average daily volume 12,167 10,258 12,775 19 (20 ) Average Daily Volume by Venue: Electronic 10,120 8,290 10,180 22 (19 ) Open outcry 1,402 1,310 1,943 7 (33 ) Privately negotiated 198 164 208 21 (21 ) Total exchange-traded volume 11,720 9,764 12,331 20 (21 ) Total CME ClearPort 447 494 444 (10 ) 11 Aggregate average daily volume 12,167 10,258 12,775 19 (20 ) Electronic Volume as a Percentage of Average Daily Volume 83 % 81 % 80 % Interest Rate Products The following table summarizes average daily volume for our key interest rate products.
Year-over-Year Change (amounts in thousands) 2010 2009 2008 2010-2009 2009-2008 Eurodollar futures 2,020 1,736 2,360 16 % (26 )% Eurodollar options 726 639 903 14 (29 ) U.S. Treasury futures and options: 10-Year 1,380 913 1,239 51 (26 ) 5-Year 546 410 715 33 (43 ) 30-Year 388 292 427 33 (32 ) 2-Year 274 201 323 37 (38 ) The increase in overall interest rate product volume in 2010 when compared with 2009 was attributable to the overall improvement in the economic environment in 2010 following the credit crisis. Specifically, in the second half of 2010, a continuing zero interest rate policy in the United States and the Federal Reserve's announcement that it will buy additional U.S. Treasury securities to stimulate the economy led to changing expectations about interest rates as well as increased market participants' use of these products. The change in expectations contributed to an increase in volume for longer-term U.S. Treasury products which was only partially offset by slower growth in volume for short-term Eurodollar products.
We believe that the increase in overall Eurodollar products volume in 2010, when compared with 2009, resulted from uncertainty surrounding the London Interbank Offered Rate (LIBOR) due to the European credit crisis throughout early 2010. In addition, changing expectations about the Federal Reserve's monetary policy led to increased volume for longer-dated Eurodollar products.
In 2010, when compared with 2009, we believe that the increase in U.S. Treasury note futures and options volume was attributable to the additional U.S. Treasury note issuance by the U.S. government as well as rising 49-------------------------------------------------------------------------------- Table of Contents intermediate and long-term interest rates. In early 2010, we introduced the Ultra U.S. Treasury bond contract, which generated an average of 31,000 contracts per day since launch.
We believe that the decrease in Eurodollar products volume in 2009 when compared with 2008 was attributable to the zero interest rate policy and increased risk aversion by market participants following the credit crisis within the United States. We believe this reduced certain customers' ability or need to assume and maintain positions during 2009.
We believe that the overall decline in U.S. Treasury note futures and options volume in 2009 when compared with 2008 was attributable to the credit crisis within the United States, which resulted in reduced corporate debt issuances, reduced mortgage issuances and refinancing activity, a slowdown in the U.S.
Treasury cash market trading as well as the Federal Reserve Bank's purchase of U.S. Treasury securities. The decline in 2009 when compared with 2008 was also attributable to the zero interest rate policy, which we believe reduced market participants' need to hedge interest rate risk.
Equity Products The following table summarizes average daily volume for our key equity futures and options products.
Year-over-Year Change (amounts in thousands) 2010 2009 2008 2010-2009 2009-2008 E-mini S&P 500 2,300 2,284 2,597 1 % (12 )% E-mini NASDAQ 100 317 311 432 2 (28 ) Russell (volume through September 19, 2008) - - 261 - (100 ) In 2010 when compared with 2009, growth in equity products volume was relatively flat. We believe an improved economic outlook leading to increased investment in the equities market contributed to an increase in volume in 2010. This increase was offset by a decrease in volume attributable to a decline in average volatility for equity products, as measured by the CBOE Volatility Index, in 2010 when compared with 2009.
We believe that equity product volume decreased in 2009 when compared with 2008 due to the decline in volatility, as measured by the CBOE Volatility Index.
Average volatility decreased starting in the beginning of 2009 through the end of 2009. In addition, the decline in volume was attributable to the termination of our license to list Russell-based contracts.
Foreign Exchange Products The following table summarizes average daily volume for our key foreign exchange futures and options products.
Year-over-Year Change (amounts in thousands) 2010 2009 2008 2010-2009 2009-2008 Euro 367 225 223 63 % 1 % Japanese yen 131 93 133 41 (30 ) British pound 124 100 83 24 21 Australian dollar 105 68 45 55 50 Canadian dollar 91 63 46 43 36 We believe that the increase in volume in 2010, when compared with 2009, was attributable to the weakening of the Euro and British pound compared with the U.S. dollar. Uncertainty surrounding the Euro following the European credit crisis contributed to increased volatility, which led to increased trading volume for the Euro products in 2010 when compared with 2009. We also believe that the strengthening of the Yen compared with the U.S. dollar contributed to an increase in volume. In addition, our cross-selling efforts to market participants in other asset classes as well as increased global sales presence contributed to growth in volume.
50-------------------------------------------------------------------------------- Table of Contents In 2009 when compared with 2008, we believe that the convergence of interest rates towards zero between the European, United States and Japanese markets led to flat volume for our Euro products and a decline in volume for our Japanese yen products. The increase in volume for the British pound, Australian dollar and Canadian dollar products was attributable to a divergence between interest rates in the United States and interest rates in the British, Australian and Canadian markets.
Agricultural Commodity Products The following table summarizes average daily volume for our key agricultural commodity futures and options products.
Year-over-Year Change (amounts in thousands) 2010 2009 2008 2010-2009 2009-2008 Basic corn 358 259 320 38 % (19 )% Basic soybean 186 180 183 3 (1 ) Basic wheat 109 85 91 29 (7 ) We believe that the increase in average daily volume for our commodity products in 2010 when compared with 2009 was attributable to increased volatility associated with changes in global supply attributable to global weather events.
In addition, increased demand for protein in emerging markets has increased demand for feedgrains.
In 2009 when compared with 2008, we believe a decrease in commodity price volatility and decreased demand for commodities products as a result of the credit crisis within the United States caused the overall decline in volume for commodities products. We believe the credit crisis reduced certain customers' ability or need to assume and maintain positions.
Energy Products The following table summarizes average daily volume for our key energy futures and options products.
Year-over-Year Change (amounts in thousands) 2010 2009 2008 2010-2009 2009-2008 Crude oil 853 712 738 20 % (4 )% Natural gas 489 478 519 2 (8 ) Refined products 244 194 175 26 11 Power 73 105 7 (31 ) n.m.
n.m. not meaningful In 2010 when compared with 2009, we believe that the growth in volume was attributable to an improved economic outlook as well as increased liquidity within the energy futures market. We believe crude oil contract volume increased at a higher rate than natural gas contract volume due to an increase in volume generated from customers outside the United States as well as increased volatility in the crude oil market.
We believe the increase in average daily volume in 2009 when compared with 2008 was due to market participants seeking to mitigate counterparty risk on their over-the-counter exposures through central counter party clearing. The table above includes volume for the period prior to our merger with NYMEX in 2008.
Metal Products We believe that the increase in metal product volume in 2010 was attributable to increased investment in precious metals as an asset class during periods of uncertainty in interest rates and foreign exchange. In 2010 when compared with 2009, gold contract volume increased by 31% to an average of 0.2 million contracts per day.
51 -------------------------------------------------------------------------------- Table of Contents In 2009 when compared with 2008, we believe metal products volume decreased, including the period prior to our merger, due to lower price volatility and decreased demand for metal products as a result of the credit crisis within the United States. In 2009 when compared with 2008, average daily volume for gold contract volume decreased by 6% to 0.2 million contracts per day.
Average Rate per Contract The average rate per contract decreased in 2010 when compared with the same period in 2009 due to an increase in member trading volume, which increased faster than non-member trading in 2010. In general, members receive lower rates compared with non-members. In addition, the average rate per contract decreased due to a lower portion of equity and energy products as a percentage of total volume compared with interest rate products. As a percentage of volume, equity products volume decreased by 4% and energy product volume decreased by 1% while interest rate product volume increased by 3%. Equity and energy products have higher fees compared with interest rate products.
In 2009 when compared with 2008, the average rate per contract increased due to the inclusion of a full year of volume from NYMEX products and CME ClearPort services, which had an average rate per contract of $1.512 and $2.051, respectively, in 2009. Additionally, the average rate per contract increased due to a lower portion of interest rate products as a percentage of total volume compared with equity products, which have a higher rate per contract. As a percentage of CME and CBOT volume, equity products volume increased by 2% in 2009, while interest rate products volume decreased by 4% when compared with 2008.
Concentration of Revenue We bill a substantial portion of our clearing and transaction fees to our clearing firms. The majority of clearing and transaction fees received from clearing firms represent charges for trades executed and cleared on behalf of their customers. One firm represented 13% and one firm represented 12% of our clearing and transaction fees revenue in 2010. One firm represented 13% and one firm represented 11% of our clearing and transaction fees revenue in 2009. One firm represented 12% and one firm represented 10% of our clearing and transaction fees revenue in 2008. Should a clearing firm withdraw, we believe that the customer portion of the firm's trading activity would likely transfer to another clearing firm of the exchange. Therefore, we do not believe we are exposed to significant risk from the loss of revenue received from a particular clearing firm.
Other Sources of Revenue The increase in market data and information services revenue was principally due to market data and licensing revenue from Index Services, which began March 19, 2010. An increase in the basic device monthly fee in 2010 also contributed to an increase in revenues in 2010.
Revenue generated from NYMEX increased by $59.2 million in 2009 when compared with 2008. In addition, revenues increased in 2009 when compared with 2008 due to additional revenue generated from CMA as well as an increase in data feed surcharges and vendor licensing fees.
Year-over-year increases in screen counts generated by business combinations were partially offset by an overall decrease in screen counts for existing customers. Decreases in screen counts were due to cost-cutting initiatives at customer firms. The table below includes screen counts for CME, CBOT and NYMEX.
Year-over-Year Change(dollars in millions, except monthly fee per device) 2010 2009 2008 2010-2009 2009-2008 Average estimated monthly basic device screen count 384,000 411,000 343,000 (27,000 ) 68,000 Basic device monthly fee per device $ 61 $ 55 $ 55 $ 6 $ - Estimated increase in revenues Due to an increase in monthly fee per device 27.7 - Due to an increase (decrease) in screen counts $ (17.5 ) $ 45.0 52 -------------------------------------------------------------------------------- Table of Contents The two largest resellers of our market data represented approximately 45%, 55% and 56% of our market data and information services revenue in 2010, 2009 and 2008, respectively. Despite this concentration, we consider exposure to significant risk of revenue loss to be minimal. In the event that one of these vendors no longer subscribes to our market data, we believe the majority of that vendor's customers would likely subscribe to our market data through another reseller. Additionally, several of our largest institutional customers that utilize services from our two largest resellers report usage and remit payment of their fees directly to us.
Other revenues increased in 2010 when compared with 2009 due to $10.7 million of revenue generated from our agreement with BM&FBOVESPA to develop a new multi-asset class electronic trading platform and incremental processing services revenue generated from various strategic relationships. This was partially offset by a $6.3 million decline in trading revenues generated by GFX Corporation (GFX) resulting from lower trading activity and narrower trading margins.
Other revenues decreased in 2009 compared with 2008 due to a decline in processing services revenue of $53.6 million. In 2008, we recognized processing services revenues from our trade matching agreement with NYMEX, which was terminated in August 2008 upon our merger with NYMEX. The decrease in revenues was partially offset by rental income and other building-related revenue generated from our building in New York City, which was acquired as part of our merger with NYMEX Holdings in August 2008.
Expenses Year-over-Year Change (dollars in millions) 2010 2009 2008 2010-2009 2009-2008 Compensation and benefits $ 432.1 $ 351.0 $ 317.6 23 % 11 % Communications 40.6 47.0 52.3 (14 ) (10 ) Technology support services 50.5 46.2 59.6 9 (23 ) Professional fees and outside services 117.5 85.1 71.9 38 18 Amortization of purchased intangibles 128.1 125.1 98.7 2 27 Depreciation and amortization 129.9 126.3 137.3 3 (8 ) Occupancy and building operations 74.9 76.3 71.4 (2 ) 7 Licensing and other fee agreements 82.6 89.2 70.3 (7 ) 27 Restructuring (0.6 ) 5.3 4.8 (111 ) 11 Other 117.0 72.2 94.9 62 (24 ) Total Expenses $ 1,172.6 $ 1,023.7 $ 978.8 15 5 2010 Compared With 2009 Operating expenses increased by $148.9 million in 2010 when compared with 2009.
The following table shows the estimated impact of key factors resulting in the increase in operating expenses.
Year- Change as a Over-Year Percentage of (dollars in millions) Change 2009 Expenses Salaries, benefits and employer taxes $ 42.7 4 % Bonus expense 32.7 3 CMA goodwill and trade name impairment 20.5 2 Marketing and travel expense 15.9 2 Professional fees related to Index Services 14.7 2 Other expenses, net 22.4 2 Total $ 148.9 15 % 53 -------------------------------------------------------------------------------- Table of Contents The rise in salaries, benefits and employer taxes was attributable to an increase in average headcount due to Index Services as well as salary increases and rising healthcare costs.
Our improved performance relative to our 2010 cash earnings target compared with 2009 relative to our 2009 cash earnings target led to the increase in our bonus expense.
Impairment charges on goodwill and trade name related to our CMA operations in the second quarter of 2010 led to an increase in expenses in 2010.
Global expansion and establishment of strategic partnerships contributed to an increase in marketing and travel expenses in 2010.
The increase in expenses in 2010 was also due to professional fee expenses incurred for Index Services. This increase included $10.3 million of professional and legal fees incurred for the formation of Index Services.
2009 Compared With 2008 In 2009, operating expenses increased by $44.9 million when compared with 2008.
The following table shows the estimated impact of key factors resulting in the increase (decrease) in operating expenses.
Year- Change as a Over-Year Percentage of (dollars in millions) Change 2008 Expenses Amortization of NYMEX purchased intangibles $ 30.1 3 % Salaries, benefits and employer taxes 28.1 3 Broker rebates 25.7 3 Legal fees associated with strategic initiatives 6.7 1 Marketing and travel expense (9.0 ) (1 ) Swapstream goodwill impairment (11.9 ) (1 ) Maintenance and support costs for e-CBOT (28.2 ) (3 ) Other expenses, net 3.4 - Total $ 44.9 5 % Amortization of purchased intangibles increased in 2009 due to our merger with NYMEX Holdings, which was completed in August 2008.
An increase in average headcount as a result of our merger with NYMEX Holdings in 2008 contributed to the rise in salaries, benefits and employer taxes subsequent to our merger with NYMEX Holdings in August 2008.
Licensing and other fee agreements increased in 2009 due to an increase in broker rebates on NYMEX products.
Legal fees incurred to support various strategic initiatives, including our efforts to provide clearing services for credit default swaps and other over-the-counter products, led to growth in expenses in 2009 when compared with 2008.
Marketing and travel expenses decreased in 2009 due to the company's expense reduction efforts in 2009.
Impairment charges recognized in 2008 on goodwill related to our Swapstream operations led to a decrease in this expense in 2009.
A decrease in depreciation, maintenance and support for our CBOT metal products on e-CBOT, CBOT's legacy electronic trading platform, led to a decrease in expenses in 2009.
54 -------------------------------------------------------------------------------- Table of Contents Non-Operating Income (Expense) Year-over-Year Change (dollars in millions) 2010 2009 2008 2010-2009 2009-2008 Investment income $ 42.3 $ 28.5 $ 45.5 48 % (37 )% Impairment of long-term investments (2.2 ) (46.0 ) (274.5 ) (95 ) (83 ) Gains (losses) on derivative investments (2.6 ) - (8.1 ) n.m (100 ) Securities lending interest income - 2.8 38.3 (100 ) (93 ) Securities lending interest and other costs - (0.1 ) (51.7 ) (100 ) (100 ) Interest and other borrowing costs (140.3 ) (133.9 ) (56.5 ) 5 137 Guarantee of exercise rights privileges - 4.3 12.8 (100 ) (66 ) Equity in net losses of unconsolidated subsidiaries (6.4 ) (6.8 ) (31.5 ) (6 ) (79 ) Other income (expense) - (0.4 ) (8.5 ) (100 ) (95 ) Total Non-Operating $ (109.2 ) $ (151.6 ) $ (334.2 ) (28 ) (55 ) n.m not meaningful Investment Income.The increase in investment income in 2010 when compared with 2009 was attributable to a $16.0 million increase in dividend income from our investments in BM&FBOVESPA, TMX Group Inc. and Bolsa Mexicana de Valores, S.A.B.
de C.V., and a $3.7 million gain resulting from the sale of various equity and debt securities. The increase was partially offset by a $4.8 million decrease in interest income as a result of lower average investment balances and lower average interest rates.
In 2009, investment income declined when compared with 2008 due to decreases in market interest rates resulting from rate reductions by the Federal Open Market Committee throughout 2008. The decline due to interest rates was partially offset by an increase in the invested portion of clearing firms' cash from performance bonds and guaranty fund contributions. In addition, we recognized $4.5 million in gains on our marketable securities related to our non-qualified deferred compensation plan in 2009 compared with losses of $8.2 million in 2008.
Gains and losses from these securities are offset by an equal amount of compensation and benefits expense.
Impairment of Long-Term Investments. In 2010, we determined that our investment in OneChicago was impaired based on its historical financial performance and other factors. As a result, we recognized an impairment charge of $2.2 million.
At December 31, 2009 we determined our investment in DME was impaired due to the excess of our carrying value over our investment's estimated fair value. As a result, we recognized an impairment charge of $23.6 million. In 2009, we also determined that our investment in IMAREX ASA (IMAREX) was impaired due to an extended and significant decline in the market price of its stock. As a result, we recognized an impairment charge of $22.4 million in 2009. In 2008, we determined that our investment in BM&FBOVESPA S.A. (BM&FBOVESPA) was impaired due to an extended and significant decline in the market price of its stock. As a result, we recognized an impairment loss of $274.5 million.
Gains (Losses) on Derivative Investments. In the fourth quarter of 2010, we recognized an $8.6 million loss due to ineffectiveness on the interest rate swap contract used to hedge interest rate risk on our term loan. Both the swap contract and the term loan were originally scheduled to expire in August 2011.
In December 2010, we approved a plan to refinance the term loan in January 2011 resulting in ineffectiveness of the hedge.
In March 2010, we recognized a $6.0 million gain on derivative investments as a result of a settlement from the Lehman Brothers Holdings Inc. (Lehman) bankruptcy proceedings. The settlement related to an unsecured claim against Lehman as counterparty to an over-the-counter put option contract we purchased to hedge our risk of changes in the fair value of BM&FBOVESPA stock resulting from foreign currency exchange rate fluctuations between the U.S. dollar and the Brazilian real. The net gain (loss) on derivative investments recognized in 2008 was due to the loss on the put option contract resulting from weakening of the U.S. dollar compared with the Brazilian real until its termination in 2008.
55-------------------------------------------------------------------------------- Table of Contents Securities Lending Income (Expense). During 2009 and 2010, CME's securities lending program remained suspended as high volatility in the credit markets and extreme demand for U.S. Treasury securities continued. Suspension of the program resulted in a decrease in net securities lending interest from 2008 to 2010. We expect the securities lending program to remain suspended throughout 2011.
Interest and Other Borrowing Costs. In 2010 when compared with 2009, interest expense increased due to the issuance of $612.5 million of 4.40% fixed rate notes due 2018. This resulted in an increase in average effective yield and total cost of borrowing. However, average debt balances have decreased in 2010 due to the reduction in overall debt levels throughout the year. The increase in expense was also attributable to a full year of interest expense recognized on the 5.75% fixed rate notes issued in February 2009.
The increases in interest and other borrowing costs in 2009 when compared with 2008 were due to higher average debt levels outstanding, which were the result of debt issued in August 2008 in conjunction with the NYMEX Holdings merger.
These borrowings consisted of commercial paper and short- and long-term notes.
In February 2009, we terminated our revolving bridge facility. The increase in interest and other borrowing costs in 2009 was also attributable to the $7.6 million of debt issuance costs recognized for the bridge facility during 2009, including $4.6 million of accelerated costs resulting from the facility's termination.
Effective January 11, 2011, we terminated our $1.4 billion senior credit facility, including the $420.5 million term loan and entered into a new $1.0 billion multi-currency revolving senior credit facility, which matures in January 2014. We expect interest expense to decrease by $2.6 million in 2011 due to the refinancing of the senior credit facility.
Year-over-Year Change (dollars in millions) 2010 2009 2008 2010-2009 2009-2008 Weighted average borrowings outstanding $ 2,668.1 $ 2,841.8 $ 1,296.1 $ (173.7 ) $ 1,545.7 Weighted average effective yield 4.96 % 4.23 % 3.58 % 0.73 % 0.65 % Total cost of borrowing 5.24 4.76 4.30 0.48 0.46 Total cost of borrowing includes interest, commitment fees, discount accretion and debt issuance costs.
Guarantee of Exercise Rights Privileges. In December 2009, final approval of the settlement of the ERPs associated with our CBOT Holdings merger occurred and we reduced our liability associated with our guarantee of the ERPs to zero, which resulted in a gain in 2009. Following the resolution of the lawsuit, we also adjusted the value of the 159 ERPs that we held to the expected settlement value, which also contributed to the gain in 2009. We recognized a gain in 2008 due to a reassessment of possible outcomes of the litigation.
Equity in Net Losses of Unconsolidated Subsidiaries. The termination of our investment in FXMS, our joint venture with Thomas Reuters Group PLC (Reuters), in the fourth quarter of 2008 contributed to the decrease in losses in 2009 when compared with 2008. In 2008, we recognized losses from our investment in FXMS of $26.5 million including a $15.9 million write off of our recorded investment in FXMS and our portion of the remaining capital needed to wind down operations.
Income Tax Provision The following table summarizes the effective tax rate for the periods presented: Year-over-Year Change 2010 2009 2008 2010-2009 2009-2008 Year ended December 31 44.7 % 42.6 % 42.7 % 2.1 % (0.1 )% 56 -------------------------------------------------------------------------------- Table of Contents The increase in the effective tax rate in 2010 when compared with 2009 was attributable to a $51.2 million charge to record the impact of our new combined state and local tax rate on our existing deferred tax liabilities. The state and local tax rate increased due to revised state apportionment estimates resulting from annual state tax filings. The increase in the effective tax rate was also due to the impairment of CMA's goodwill and trade name in the second quarter of 2010 which was not deductible.
In 2009, the rate increased as a result of an additional valuation allowance of $64.4 million related to unrealized capital losses. The increase was offset by a decrease resulting from a $38.9 million reduction in net deferred tax liabilities related to a New York City tax law change enacted in 2009. In 2008, the rate reflected a $48.3 million charge to record the impact of our new combined state and local tax rate on our existing net deferred tax liabilities, partially offset by a first quarter 2008 Illinois tax law change that resulted in a $38.6 million reduction in net deferred tax liabilities.
LIQUIDITY AND CAPITAL RESOURCES Cash Requirements. Until we began our commercial paper program in mid-2007, we historically met our funding requirements with cash generated by our ongoing operations. While our cost structure is fixed in the short term, our sources of operating cash are dependent on trading volume levels. We believe that our existing cash, cash equivalents and marketable securities and cash generated from operations will be sufficient to cover our working capital needs, capital expenditures, and other commitments. However, it is possible that we may need to raise additional funds to finance our activities through issuances of commercial paper, future public debt offerings or by borrowing money from financial institutions.
Cash will also be required for operating leases and non-cancelable purchase obligations as well as other obligations reflected as long-term liabilities in our consolidated balance sheet at December 31, 2010. These were as follows: Other Operating Purchase Long-Term (in millions) Leases Obligations Liabilities Total(1) Year 2011 $ 22.5 $ 10.4 $ 36.8 $ 69.7 2012-2013 43.7 6.5 - 50.2 2014-2015 41.1 0.4 - 41.5 Thereafter 142.5 - - 142.5 Total $ 249.8 $ 17.3 $ 36.8 $ 303.9 (1) Gross unrecognized income tax liabilities, including interest and penalties, of $71.9 million for uncertain tax positions are not included in the table due to uncertainty about the date of their settlement.
Operating leases include rent payments for office space in Chicago and other smaller offices in the United States and in various foreign countries. The operating lease for our headquarters in Chicago expires in November 2022. Annual minimum rental payments under this lease range from $8.5 million to $13.6 million. We also maintain an operating lease for additional office space in Chicago, which expires in November 2023. Annual minimum rental payments under this lease range from $3.9 million to $6.2 million.
Purchase obligations include minimum payments due under agreements to purchase software licenses, hardware and maintenance as well as telecommunication services. Other long-term liabilities include primarily funding obligations for pension and other post-retirement benefit plans.
Future capital expenditures for technology are anticipated as we continue to support our growth through investment in increased system capacity and performance and through technological initiatives on our electronic 57-------------------------------------------------------------------------------- Table of Contents trading platform. Each year capital expenditures are incurred for improvements to and expansion of our offices, remote data centers, telecommunications capabilities and other operating equipment. In 2011, we expect capital expenditures to total approximately $180 million. We continue to monitor our capital needs and may revise our forecasted expenditures as necessary in the future.
We intend to continue to pay a regular quarterly dividend to our shareholders.
The decision to pay a dividend, however, remains within the discretion of our board of directors and may be affected by various factors, including our earnings, financial condition, capital requirements, levels of indebtedness and other considerations our board of directors deems relevant as well as our debt instruments as discussed below. CME Group and its subsidiaries are also required to comply with restrictions contained in the general corporation laws of its state of incorporation which could also limit its (or their) ability to declare and pay dividends. In 2010, our quarterly dividend remained at $1.15 per share.
On January 5, 2011, our board approved a change in our annual dividend policy to increase the target from approximately 30% of the prior year's cash earnings to approximately 35% of the prior year's cash earnings. On February 23, 2011, the board of directors declared a regular quarterly dividend of $1.40 per share payable on March 25, to shareholders of record on March 10. Assuming no changes in the number of shares outstanding, the first quarter dividend payment will total approximately $93.6 million.
Sources and Uses of Cash. The following is a summary of cash provided by (used by) operating, investing and financing activities.
Year-over-Year Change (dollars in millions) 2010 2009 2008 2010-2009 2009-2008 Net cash provided by operating activities $ 1,356.4 $ 1,083.1 $ 1,197.2 25 % (10 )% Net cash provided by (used in) investing activities (108.4 ) 544.8 (3,749.1 ) (120 ) 115 Net cash provided by (used in) financing activities (653.4 ) (1,665.2 ) 2,004.5 61 (183 ) Operating activities The increase in net cash provided by operating activities in 2010 when compared with 2009 was due to higher trading volumes and increased profitability. In 2010, net cash provided by operating activities was $404.3 million higher than net income. This increase was primarily the result of depreciation and amortization expense of $129.9 million and amortization of purchased intangibles of $128.1 million. An increase in accrued expenses also contributed to the overall increase.
Net cash provided by operating activities decreased in 2009 when compared with 2008 due to decreased profitability excluding impairment charges. In 2009, net cash provided by operating activities was $257.3 million higher than net income.
This increase was due primarily to $126.3 million of depreciation and amortization and $125.1 million of amortization of purchased intangibles.
Investing activities The termination of the NYMEX securities lending program in 2009 as well as the decrease in proceeds from marketable securities, net of purchases, of $278.2 million, contributed to the increase in cash used for investing in 2010 when compared with 2009.
The increase in cash in 2009 when compared with 2008 was due primarily to cash paid to shareholders in our merger with NYMEX Holdings in 2008 of $2.8 billion, net of cash received, and a payment of $612.0 million for the termination of certain NYMEX membership rights in conjunction with the merger. The increase in cash was also due to a $315.8 million net decrease in NYMEX securities lending program investments and a $382.4 million increase in proceeds from maturities of marketable securities, net of purchases in 2009.
58-------------------------------------------------------------------------------- Table of Contents Financing activities The decrease in cash used in 2010 relative to 2009 was attributable to a decrease in commercial paper repayments, net of proceeds, proceeds from our share issuance to BM&FBOVESPA as well as the termination of the NYMEX securities lending program in 2009. The decrease was partially offset by the distribution to Dow Jones of $607.5 million related to Index Services as well as an increase in share repurchases of $548.3 million. Share repurchases increased in an effort to offset most of the dilution associated with the issuance of shares to BM&FBOVESPA.
The increase in cash used in 2009 relative to 2008 was due to new issuances of debt of $2.9 billion in 2008 in conjunction with our merger with NYMEX Holdings compared with net debt reductions of $900.1 million in 2009.
Debt Instruments. The following table summarizes our debt outstanding as of December 31, 2010: (in millions) Par Value Term loan due 2011, interest equal to 3-month LIBOR plus 1.00%(1) $ 420.5 Fixed rate notes due August 2013, interest equal to 5.40% 750.0 Fixed rate notes due February 2014, interest equal to 5.75% 750.0 Fixed rate notes due March 2018, interest equal to 4.40%(2) 612.5 (1) In September 2008, the company entered into an interest rate swap agreement that modified the variable interest obligation associated with this loan so that the interest payable effectively became fixed at a rate of 4.72% beginning with the interest accrued after October 22, 2008. The interest rate swap agreement was terminated on January 11, 2011 when the loan was repaid.
(2) In March 2010, we completed an unregistered offering of fixed rate notes due 2018. Net proceeds from the offering were used to fund a distribution to Dow Jones in conjunction with our investment in Index Services. In February 2010, we entered into a forward-starting interest rate swap agreement that modified the interest obligation associated with these notes so that the interest payable on the notes effectively became fixed at a rate of 4.46% beginning with the interest accrued after March 18, 2010.
We maintained a $1.4 billion senior credit facility with various financial institutions, including the $420.5 million term loan and a $945.5 million revolving credit facility. The senior credit facility was terminated on January 11, 2011. Any commercial paper outstanding was backed by the revolving credit facility. Under our senior credit facility, we were required to maintain a consolidated net worth of at least $12.1 billion.
Effective January 11, 2011, we entered into a new $1.0 billion multi-currency revolving senior credit facility with various financial institutions. The proceeds from the revolving senior credit facility can be used for general corporate purposes, which includes providing liquidity for our clearing house.
As long as we are not in default under the new senior credit facility, we have the option to increase the facility from time to time by an aggregate amount of up to $1.8 billion with the consent of the agent and lenders providing the additional funds. The new senior credit facility matures in January 2014 and is voluntarily prepayable from time to time without premium or penalty. Under our new credit facility, we are required to remain in compliance with a consolidated net worth test, as defined as our consolidated shareholders' equity as of September 30, 2010, giving effect to share repurchases made and special dividends paid during the term of the agreement (and in no event greater than $2.0 billion in aggregate), multiplied by 0.65.
We maintain a 364-day fully secured, committed line of credit with a consortium of domestic and international banks to be used in certain situations by our clearing house. We may use the proceeds to provide temporary liquidity in the unlikely event of a clearing firm default, in the event of a liquidity constraint or default by a depositary (custodian for our collateral), or in the event of a temporary disruption with the domestic payments system that would delay payment of settlement variation between us and our clearing firms.
Clearing firm guaranty fund contributions received in the form of U.S. Treasury securities, Government agency securities or 59-------------------------------------------------------------------------------- Table of Contents money market mutual fund as well as the performance bond assets of a defaulting firm can be used to collateralize the facility. The line of credit provides for borrowings of up to $1.0 billion. At December 31, 2010, guaranty fund collateral available was $2.2 billion. We have the option to request an increase in the line from $1.0 billion to $2.0 billion. In addition to the 364-day fully secured, committed line of credit, we also have the option to use the new $1.0 billion multi-currency revolving senior credit facility to provide liquidity for our clearing house in the unlikely event of default.
In addition, our 364-day fully secured, committed revolving line of credit contains a requirement that CME remain in compliance with a consolidated tangible net worth test, defined as CME consolidated shareholder's equity less intangible assets (as defined in the agreement), of not less than $125.0 million. In the event that CME elects to increase the facility, the minimum consolidated tangible net worth test would increase ratably up to $187.5 million.
The indentures governing our floating and fixed rate notes, our 364-day fully secured, committed revolving line of credit for $1.0 billion and our $1.0 billion multi-currency revolving senior credit facility do not contain specific covenants that restrict the ability to pay dividends. These documents, however, do contain other customary financial and operating covenants that place restrictions on the operations of the company, which could indirectly affect the ability to pay dividends.
At December 31, 2010, we have excess borrowing capacity for general corporate purposes of approximately $945.5 million.
As of December 31, 2010, we were in compliance with the various covenant requirements of all our debt facilities.
CME Group, as a holding company, has no operations of its own. Instead, it relies on dividends declared and paid to it by its subsidiaries in order to provide a portion of the funds which it uses to pay dividends to its shareholders.
To satisfy our performance bond obligation with Singapore Exchange Limited, we may pledge CME-owned U.S. Treasury securities in lieu of, or in combination with, irrevocable letters of credit. At December 31, 2010, the letters of credit totaled $83.0 million. CME also guarantees a $5.0 million standby letter of credit for GFX. The beneficiary of this letter of credit is the clearing firm that is used by GFX to execute and maintain its futures position. The letter of credit would be utilized in the event that GFX defaults in meeting performance bond requirements to its clearing firm.
The following table summarizes our credit ratings as of December 31, 2010: Short-Term Long-Term Rating Agency Debt Rating Debt Rating Outlook Standard & Poor's A1+ AA Stable Moody's Investors Service P1 Aa3 Stable Given our ability to pay down debt levels and refinance existing debt facilities if necessary, we expect to maintain an investment grade rating. If our ratings are downgraded due to a change in control which results in a downgrade below investment grade, we are required to make an offer to repurchase our fixed and floating rate notes at a price equal to 101% of the principal amount, plus accrued and unpaid interest.
Off-Balance Sheet Arrangements. As of December 31, 2010, we did not have any significant off-balance sheet arrangements as defined by the regulations of the Securities and Exchange Commission.
Liquidity and Cash Management. Cash and cash equivalents totaled $855.2 million at December 31, 2010 and $260.6 million at December 31, 2009. The balance retained in cash and cash equivalents is a function of 60-------------------------------------------------------------------------------- Table of Contents anticipated or possible short-term cash needs, prevailing interest rates, our investment policy and alternative investment choices. A majority of our cash and cash equivalents balance is invested in money market mutual funds that invest only in U.S. Treasury securities or U.S. government agency securities. Our exposure to risk is minimal given the nature of the investments.
Our practice is to have our pension plan 100% funded at each year end on a projected benefit obligation basis, while also satisfying any minimum required contribution and obtaining the maximum tax deduction. Based on our actuarial projections, we estimate that a $14.1 million contribution in 2011 will allow us to meet our funding goal. However, the amount of the actual contribution is contingent on the actual rate of return on our plan assets during 2011 and the December 31, 2011 discount rate.
Net current deferred tax assets of $18.3 million and $23.8 million are included in other current assets at December 31, 2010 and 2009, respectively. Total net current deferred tax assets include unrealized losses, stock-based compensation and accrued expenses.
Net long-term deferred tax liabilities were $7.8 billion and $7.6 billion at December 31, 2010 and 2009, respectively. Net deferred tax liabilities are principally the result of purchase accounting for intangible assets in our various mergers including CBOT Holdings and NYMEX Holdings.
We have a long-term deferred tax asset of $145.7 million included within our domestic long-term deferred tax liability. This deferred tax asset is for an unrealized capital loss incurred in Brazil related to our investment in BM&FBOVESPA. As of December 31, 2010, we do not believe that we currently meet the more-likely-than-not threshold that would allow us to fully realize the value of the unrealized capital loss. As a result, a partial valuation allowance of $64.4 million has been provided for the amount of the unrealized capital loss that exceeds potential capital gains that could be used to offset the capital loss in future periods. We also have a long-term deferred tax asset related to Brazilian taxes of $125.3 million for an unrealized capital loss incurred in Brazil related to our investment in BM&FBOVESPA. A full valuation allowance of $125.3 million has been provided because we do not believe that we currently meet the more-likely-than-not threshold that would allow us to realize the value of the unrealized capital loss in Brazil in the future. Valuation allowances of $49.4 million have also been provided for additional unrealized capital losses on various other investments.
Net long-term deferred tax assets also include a $19.3 million deferred tax asset for foreign net operating losses related to Swapstream. Our assessment at December 31, 2010 was that we did not currently meet the more-likely-than-not threshold that would allow us to realize the value of acquired and accumulated foreign net operating losses in the future. As a result, the $19.3 million deferred tax assets arising from these net operating losses have been fully reserved.
Each clearing firm is required to deposit and maintain specified performance bond collateral. Performance bond requirements are determined by parameters established by the risk management department of the clearing house and may fluctuate over time. We accept a variety of collateral to satisfy performance bond requirements. Cash performance bonds and guaranty fund contributions are included in our consolidated balance sheets. Clearing firm deposits, other than those retained in the form of cash, are not included in our consolidated balance sheets. The balances in cash performance bonds and guaranty fund contributions may fluctuate significantly over time.
Cash performance bonds and guaranty fund contributions consisted of the following at December 31: (in millions) 2010 2009 Cash performance bonds $ 3,717.0 $ 5,834.6 Cash guaranty fund contributions 231.8 102.6 Cross-margin arrangements 79.7 10.6 Performance collateral for delivery 10.0 34.1 Total $ 4,038.5 $ 5,981.9 61 -------------------------------------------------------------------------------- Table of Contents We are required under the Commodity Exchange Act to segregate cash and securities deposited by clearing firms on behalf of their customers. In addition, we are required to segregate all funds and securities deposited by clearing firms from exchange operating funds and marketable securities. As with cash performance bonds and guaranty fund contributions, these balances may fluctuate over time due to investment choices available to clearing firms and any change in total deposits required. The fair value of securities and IEF funds on deposit consisted of the following at December 31: (in millions) 2010 2009 Performance bonds $ 82,867.7 $ 70,511.5 Guaranty fund contributions 2,828.3 2,652.2 Cross-margin arrangements 196.8 220.5 Performance collateral for delivery 2.1 2.6 Total $ 85,894.9 $ 73,386.8 The performance bond collateral and the guaranty fund contributions include collateral for clearing firms for the futures, options and cleared over-the-counter credit default swaps as well as cleared over-the-counter interest rate swaps.
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