2007 Annual Report

Q. Is the Chicago Fed's interest in financial market policy motivated by recent market disturbances?

A. The turmoil that has characterized financial markets since August of 2007 certainly illustrates why financial market expertise is vital to the public policy process. But it's important to remember that financial turmoil is hardly a new phenomenon. There have been four major financial crises in the last 28 years-the 1980 crisis involving Mexico's default, the market crash in October of 1987, the liquidity crisis following the Russian default and devaluation in the fall of 1998, and the September 11 terrorist attacks. We've also identified 35 potential market disruptions over the last 25 years that could well have materialized into full-blown crises. Each one had the potential to adversely affect economic activity, with a real impact on people's standard of living. Clearly, it's imperative that we better understand the dynamics of these disruptions to have a better chance of avoiding them-and to mitigate their impact when they do occur.

Q. What is the Fed's role when financial crises occur?

A. The Fed has a critical role. While each crisis may look very different from the preceding crisis, one thing they all have in common is a shortfall of liquidity. In other words, many otherwise sound institutions can't obtain the means to make needed payments. This is where the Fed comes in. The Fed is the ultimate source of liquidity in the economy because the liabilities of the Fed (currency and bank reserves) constitute the key means of payment. So when there is a shortage of liquidity, the Fed is generally called upon as first responder. The Federal Reserve Act of 1913 said one of the key reasons for establishing the Fed was the need for an "elastic currency." This means the Fed is expected to add or withdraw liquidity as needed to facilitate economic activity.

Q. Why is it important for the Chicago Fed to have a Financial Markets Group?

A. There is a contribution to be made by looking at financial market policy issues from a Chicago perspective. Chicago is the second most important center of financial activity in the U.S., behind New York. But Chicago's role in finance is not simply to act as a miniature New York. Rather, Chicago is the global leader in a small but important slice of the financial pie: exchange-traded derivative contracts (mostly futures and options). The total volume of derivative contracts traded on Chicago's exchanges last year vastly exceeded the volumes traded on exchanges in any other global financial center. Most is traded on the Chicago Board Options Exchange and on the exchanges now affiliated with CME Group (a newly formed combination of the Chicago Mercantile Exchange and the Chicago Board of Trade). But there are a number of small and nascent derivatives exchanges based in Chicago that add to the vibrancy of the Chicago financial markets, including the Chicago Climate Exchange (a venue for trading carbon emission permits), OneChicago (a venue for trading single-stock futures), the United States Futures Exchange, the Merchants Exchange, and the Actuarial Exchange.

Q. Are there policy concerns particularly relevant to derivatives exchanges and clearinghouses as opposed to financial activities such as banking or securities trading?

A. Certain characteristics of derivatives trading are particularly noteworthy. For example, derivatives trading and clearing require high-frequency risk and liquidity management to ensure the continued creditworthiness of market participants. They depend on reliable execution of time-critical margin payments on a daily and sometimes twice-daily basis. Much of the trading on these exchanges is done via direct computer-to-computer connections (so called "black box" trading), with trade execution times on the order of microseconds. The liquidity in these markets resides, to a large extent, with relatively small proprietary trading firms whose structure and incentives are very different from the large banks and brokerage houses that dominate securities trading. Given these special characteristics, it is important that financial market policy analysis be informed by a Chicago point of view. The Chicago Fed's Financial Markets Group seeks to provide this perspective.

Q. What does the future hold for the city of Chicago's financial markets?

A. Derivatives markets represent a rapidly growing segment of the financial sector. Over the last eight years, the total value of derivatives contracts outstanding has grown by over 20 percent per year. Each year, it seems that new types of derivative contracts are created and traded. Just look at the phenomenal growth of credit derivatives over the past five years. So Chicago, as the world's center of derivatives exchange activity, is well positioned to benefit from this growth trend. But remember that while Chicago has the lion's share of exchange-traded derivatives activity, this represents only 15 percent of the derivatives market. The remaining 85 percent of derivatives trading is in the over-the-counter market based in New York and London. And the over-the-counter market is looking more and more exchange-like, with high-liquidity, screen-based trading, and even central clearing. So the big question for Chicago is how successfully Chicago's institutions will meet the challenge of an increasingly innovative over-the-counter market. We don't know how all this will play out, but I feel confident that the ultimate winner from this competition will be the U.S. economy.