Cboe Outlook Revised To Stable On Strong Performance And Liquidity Improvements At EuroCCP; 'A-' Rating Affirmed

Stocks and Financial Services Press Releases Wednesday September 30, 2020 16:49
Bangkok--30 Sep--S and P Global Ratings

NEW YORK Sept. 29, 2020--S&P Global Ratings said today it revised its outlook on Cboe Global Markets to stable from negative. At the same time, we affirmed our 'A-' long-term issuer credit rating and senior unsecured ratings on Cboe.

We revised the outlook to stable because two developments at Cboe, when taken together, support its resilience. First, we had identified its acquisition of EuroCCP as a source of risk, not least because EuroCCP's efforts to bolster its liquidity resources amid a severe clearing member default were a work in progress. While we see EuroCCP as relatively weaker than a majority of the clearinghouses we rate, it has made significant progress on liquidity. Second, Cboe has demonstrated robust business performance and sustained low leverage.

Cboe reported record trading volumes in the first two quarters of the year amid heightened volatility in the pandemic and a surge in retail engagement in the U.S. Net revenues increased 16.5% in the first two quarters--better than most U.S. peers owing to booming average daily trading volumes in single-name equity options and U.S. cash equity (up 54.7% and 66.7%, respectively, compared with the same period last year).

Profitability (as measured by EBITDA margin) improved to record levels. Although we believe the EBITDA margin (close to 70% at the end of June 2020) could decline slightly next year as average daily trading volumes normalize, we expect Cboe's profitability to remain above peers.

We expect the company to continue benefiting from the full realization of cost synergies linked to the Bats acquisition ($85 million on a run-rate basis) and the switch to zero commission by most U.S. retail discount brokers (beginning in November 2019) that benefits retail trading.

That said, we still see the dependence on the flagship products (VIX futures and options and S&P 500 options) and the low proportion of annuity-based revenues versus peers as relative weaknesses for Cboe's business. However, a recent string of promising business initiatives could address these relative weaknesses over time:

The creation of the new Information Solutions business line (comprising three of the recent acquisitions, Hanweck, Trade Alert, and FT Options), which should improve the proportion of annuity-like revenues.
The launch of some successful new products such as futures on the iBoxx iShares $ High Yield Corporate Bond Index and the listing of options on ESG indices.

The plan to launch an offering in pan-European equity derivatives, starting with equity index options in first-half 2021. Although U.S. and EU cash equity markets have comparable size, the EU equity options market is much smaller than the U.S market and largely fragmented across different trading venues. Cboe plans to attract liquidity and to expand the size of the market overall with the launch of a single trading platform and by offering margin diversification benefits at EuroCCP. We do not factor in any substantial upside from this project over our two-year rating horizon given the time it takes to build and displace liquidity, in our view.

Despite larger share repurchases than in prior years ($219 million in the first two quarters of 2020 versus $168 million for full-year 2019), dividend increases by 17% in the third quarter of 2020, and several acquisitions this year, we expect leverage to remain at a low 1.2x at the end of 2020, thanks to strong cash-flow generation.

EuroCCP's margin models performed very well during the very high volatility in March and April. For the 12 months ended March 31, 2020, the CCP achieved coverage of 99.78% in practice, against a targeted coverage of 99.7%. Preliminary data indicates a 100% coverage level in April 2020. Moreover, at EUR16.8 million, the largest hypothetical loss not covered by margins (had a clearing member defaulted one day during the period, and given the changes in stock prices that occurred that 3-day period) represented less than 10% of the size of the default fund that day. This shows that the CCP would have had more than ample resources within the waterfall to absorb clearing losses associated with the default of any clearing member.

Following its acquisition on July 1, EuroCCP has strengthened its liquidity framework in our view, with the combination of a new EUR1.5 billion committed line of credit and the implementation of two new liquidity tools:

Under the new Settlement Prefunding Requirement (SPR), the CCP could suspend novation on "long" OTC equity transactions by the largest two clearing members unless these members pre-fund the long positions that are supposed to settle two days later. The suspension of novation would reduce liquidity needs in a stress scenario where the two clearing members default jointly ("cover 2"), whereas pre-funding would increase liquidity resources.

The new Settlement Exposure Add-On (SEA) works like a dedicated default fund for liquidity risk, contributed to by the largest five clearing members up to a current cap of EUR1 billion (in aggregate). The SEA mechanism can only be activated to the extent that the CCP still exhibits a shortfall of liquid sources over liquidity uses in a "cover 2" stress after the SPR mechanism has been used.

We believe that the new liquidity framework provides the CCP with enough liquidity to cope with the joint default of the largest two clearing members, in most circumstances. Given the interoperability agreements between EuroCCP, LCH, and SIX x-clear, EuroCCP is also potentially exposed to the default of these other clearinghouses.

By design of the SPR and SEA mechanisms, EuroCCP would have enough liquidity to meet liquidity needs in a stress scenario where the largest interoperable CCP defaults, if none of the clearing members default that day. However, the default of a CCP is likely to be caused (or to cause itself) the default of one large clearing member. We estimate that in such a stress scenario, EuroCCP could, in theory, exhibit a shortfall of liquidity resources in some instances. This, coupled with its higher margin concentration than most peers and the lack of central bank access to monetize non-cash collateral, constitutes a relative weakness in our view compared with the majority of the clearinghouses we rate.

The stable outlook reflects our assumption that leverage will remain below 1.75x on a sustained basis. We expect that the new liquidity tools at EuroCCP will provide the clearinghouse with sufficient liquidity resources in a stress scenario whereby the largest two clearing members default jointly. We also expect that the switch to a value at risk-based margining model by the end of this year (provided it gets regulatory approval) will not weaken financial safeguards at EuroCCP overall.

We could lower the rating if:
The concentration in the flagship products increases;
Leverage exceeds 1.75x following a series of acquisitions or aggressive financial policies; or
Concentration at EuroCCP increases from already high levels or financial safeguards at the CCP unexpectedly weaken.
An upgrade is a remote scenario at this stage, given Cboe's dependence on flagship products and on transaction-based revenues.

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