UPDATE 3-CME quarterly profit falls on writedowns

* Q3 profit falls 16 percent

* Says little impact on volume from hedge fund contraction

* Working with regulators on CDS clearing proposal (Adds analysts' comments, paragraphs 3,6, 8-9, byline)

By Ros Krasny

CHICAGO, Oct 29 (Reuters) - CME Group Inc (CME.O), parent of the world's largest derivatives exchange, said on Wednesday quarterly profit fell 16 percent as the company wrote down investments and incurred a large tax adjustment.

CME officials said that the exchange has been weathering extreme financial market volatility and a sharp deleveraging in credit markets over the past several months that has hurt trading in interest rates, its biggest product line.

"The declining volume in interest rate products is cyclical. It's not that the products themselves are becoming less useful," Craig Donohue, CME's chief executive, told Reuters in a telephone interview.

Third-quarter earnings on a GAAP basis was $2.81, down from $3.87 a year ago, on income of $169 million versus $202 million, mostly reflecting non-core and merger-related items and a large tax adjustment. Revenue rose by 20 percent to $681 million.

Analysts on average had expected earnings of $3.98 per share and revenues of $650.6 million.

Ed Ditmire, analyst at Fox-Pitt Kelton in New York, said CME's earnings report gave a platform for the company to talk about its initiative in credit default swaps.

CME, in partnership with Citadel Investment Group, the big hedge fund, is one of several groups vying to create a clearing house for the huge over-the-counter credit default swaps market -- a move being pushed by U.S. financial regulators.

Donohue said CME has been working "extensively" with regulators on its proposal, including the New York Federal Reserve Bank, Commodity Futures Trading Commission and Securities and Exchange Commission.

"They think their offering will be different and compelling," Ditmire said. "Otherwise, their core business is much as it has been -- but not as fast-growing."

At a time when some industry watchers expect an implosion of the hedge fund industry, most notably famed investor George Soros who said this week that two-thirds of hedge funds could disappear, CME said it has seen little impact so far.

"A lot of the smaller funds are having difficulties ... but those are not typically our customer base," said Rick Redding, CME's managing director for products and services.

Among the non-core items that hurt CME's earnings were $28 million in writedowns of FXMarketSpace -- a joint venture with Thomson Reuters -- and Swapstream, and also the sale of metals contracts from the former Chicago Board of Trade.

CME also incurred a $48 million revaluation of the firm's deferred tax liabilities.

CME said the average rate per contract at the former Chicago Mercantile Exchange and Chicago Board of Trade rose to 65.9 cents in the quarter from 64.8 cents in the second quarter. The RPC is a key measure of operating margins.

CME earlier reported that average daily futures and options trading volume for the quarter was down 7 percent on the year.

In July, CME completed its purchase of NYMEX, the big New York-based energy and metals exchange, just a year after it swallowed the Chicago Board of Trade.

"We've done $20 billion in mergers. It's important that we digest those (exchanges) and focus on growing their businesses. That's more our focus," Donohue said.

In after-hours activity, CME last traded at $256.54, down 3 percent from Wednesday's close of $265.00. CME shares on Tuesday hit $223.32, the lowest level since June 2005.

(Editing by Leslie Gevirtz)