a brief primer on dollars

2021.09.16 | stablecoins and the near future of crypto series

This post will introduce some basic concepts around types of money and money aggregates, the mechanics of the federal reserve and fractional banking. If you’re already familiar with these, you can skip to the next post on eurodollars themselves.

central bank reserves, monetary base and the Fed

We are all familiar with physical flat, fiat money - US dollar bills. The world runs on the Dollar. And in a lot of ways, this is the only type of “real” money that exists because it’s the only type of (US government) money one can truly spend. However, there is another monetary cousin of the greenback that is vital for understanding eurodollars and that is the central bank reserve. I’ll refer to them as cbr’s for short.

What are central bank reserves? The best starting point to answer that question is to understand what they’re not: money. They’re not money because they can’t really be spent. They can’t really be spent because they exist in and never leave one place: the Federal Reserve’s digital ledgers; a database, essentially. And they can only be held by those who have an account at the Federal Reserve. Individuals cannot have accounts at the Federal Reserve; only banks can - commercial banks and the central banks of other countries, along with the US government itself - which has its own account there. To “hold” cbr’s simply means that there is a line in the Federal Reserve’s digital ledger database with your name on it that has some number next to it - the amount of cbr’s that you “hold”. That’s it.

“Withdrawing” a cbr means one of two things: either the Fed moves some of your imaginary cbr’s “out” of your account and “into” the account of someone else with an account at the Fed or the Fed drives a truck over with some physical dollar bills and debits your account. What does the Fed do with the cbr’s if it’s debited them from your account? Does it credit those cbr’s to the Fed’s own account? Nope. It just magically makes them disappear. Literally just reduces the value stored in that line of the database. That seems crazy. And it kind of is. Welcome to central banking.

Step back and think about this: every single electronic “dollar” that exists, every single electronic dollar payment that happens “anywhere” in the world does so in a single place: the Fed’s digital ledger database.

If Zimbabwe Guaranty Bank pays Swiss Commercial Bank $1M, what actually happens is that ZGB asks the Fed to shuffle $1M of cbr’s that are “held” in ZGB’s account (ZGB’s line of the database) at the Fed to SCB’s account at the Fed (SCB’s line of the database).

If I want to pay you $50, the same thing happens: My bank asks the Fed to take $50 of cbr’s from its account at the Fed and shuffle it over to your bank’s account at the Fed. Your bank then just changes a line in their database and poof, you’ve got $50 digital dollars. If you want to convert that to physical currency (aka physical flat, fiat money), you go to the atm and pull it out of there. In the background, the bank is “withdrawing” some cbr’s on your behalf as described above. But you don’t get cbr’s, you get dollars.

money aggregates: mb / m0

Money aggregates are just estimates about how much of a “type” of money actually exists. They’re generally made by the Fed but others make them as well.

These estimates summarize two different “types” of money, roughly: central bank money and commercial bank money.

Central bank money is what you can think of as “real” money. It is generally considered to include central bank reserves and physical currency.

Commercial bank money is money that is “created” by commercial banks. This is largely comprised of deposits. This money that is created by commercial banks all represent claims on central bank money.

The central bank can directly control how much central bank money there is because it owns the cbr digital ledger and the dollar printing presses (technically the Bureau of Engraving and Printing owns the presses but, you get the idea). And it can indirectly control commercial bank money with things like capital requirements. Capital requirements, more or less, are simply limiting how much commercial bank money a commercial bank can create with respect to how much “real” central bank money it holds.

MB and M0 are slightly different measures of central bank money. M1 - M3 and MZM represent the amount of central bank money plus various types of commercial bank money.

The common trait across all of these aggregates is that, either directly or indirectly, the Fed has some measure of control over them via setting the Federal Funds Rate, capital requirements etc. Eurodollars, on the other hand, sit outside of this hierarchy and also outside of the Fed’s control (mostly). And this is a key thing to remember. Eurodollars are “dollars” the Fed can’t really control. We’ll come back to this. But hold this thought in your mind as you read on.

This chart illustrates the cumulative nature of each of these measures visually ⁴ :

credit money and fractional banking

Let’s talk a bit more about money creation. People frequently mention that the Fed “creates” money. As you saw above, this is totally true. It can simply decide that it has $1T worth of cbr’s to give out by typing 1,000,000,000,000 into a database. That’s what “printing money” really is. It then just moves some of that into the accounts of the commercial banks or foreign central banks who have accounts at the Fed and the money is now “in the economy”.

However, the Fed isn’t the only one that can create money. Banks can also create money. But they don’t create “real” money. They create credit money. Or, what we referred to above as “commercial bank money”. Here’s how that works:

USAA is a federally chartered US bank. That means it has an account at the Fed and it’s allowed to “make” credit money. It makes credit money through, well, credit. Said differently, it makes credit money by making loans.

Let’s say USAA has 1 million cbr’s in its account at the Fed. And “using” those $1M cbr’s, it decides it wants to make $10M of loans. Here’s how it makes a loan. Just like the Fed, it simply goes into it’s database and types in 1,000,000 on ten different lines of the database (10 loans of $1M made to 10 different accounts). In that instant, $1M of m0 has been used to “create” $10M of loans aka “credit money”. M0 is unchanged. But M1 grows by $10M. This is money that you could turn around and withraw immediately. This 10 x 1 ratio is the implicit (and simplified) capital ratio of the bank. By limiting this ratio, the Fed can limit how much M1 banks create and thus turn up/down the “heat” of the economy.

This process is what fractional banking really is. Making way more money in loans aka credit money aka commercial bank money than one has real money aka m0 aka monetary base aka mB. It does this based off of the key bet that it won’t have to pay all of that credit money out at once.

The amount of credit money made is of course a big driver (but not the only one) of the bank’s revenue and profits. If a bank can keep accumulating “real money”, then it can keep creating more credit money while still maintaining the capital ratio requirements set by the Fed and other regulatory bodies. Importantly, over time, what banks were allowed to count as “real money” in this ratio evolved. And that evolution in what could be defined as “real money” fueled the growth in demands for eurodollars. More on this later.

If something out in the real world happens and everyone suddenly wants their money at once, then the bank essentially loses it’s bet and a bank run occurs. This is what happened in the great depression and in It’s A Wonderful Life and it’s why FDIC now exists - to give banks a lifeline to get extra “real” money (m0 / mB) when everyone wants to pull out their money at once and the bank’s measely $1M of “real” money is not nearly enough to cover all of those withdrawals.

It’s easy to forget about this now thanks to FDIC. In fact, I think it’s a testament to the effectiveness of FDIC that in our times, we don’t really worry about bank runs. Banks do occasionally get something right…

the fed’s tools: discount window, federal funds

Now that you have a more mechanical, rather than just theoretical, notion of fractional banking, let’s talk in more detail about how the Fed attempts to influence those money aggregates.

Recall from above that on any given day, a number of people, in a relatively unpredictable way, might want to withdraw or transfer money from their bank accounts. They can withdraw money digitally, meaning the bank is sending cbr’s out of its Fed account to some other Fed account on behalf of some customer. Or they can withdraw money physically, meaning the customer pulls out physical cash from an atm. At the same time, a number of people might be receiving / depositing money into their accounts digitally or physically as well.

A couple things to note about this process.

First let’s talk about the frequency of these transfers of digital cbr’s between Fed accounts. The Fed, to save everyone a lot of work, doesn’t actually transfer cbr’s for each transfer request. It’d result in an extremely large number of database transactions. Instead, it keeps track of the requests and then at some interval (let’s say every 24 hrs to keep it simple) tallies up the requests, nets them out and then makes a single transfer for the net amount. This process is part of the reason why you have to wait a few days for an ACH transfer to clear. It’s also part of the reason why it’s possible to spend more than what you have in your checking account (aka overdraft your account). As of a couple years ago, I was told by an inside source that some of this nightly settlement process is still facilitated by emailing csv’s around, if you can believe that. That’s right up there with the US using floppy disks to store nuclear launch codes until 2019.

So you can see now that there is this cadence of sorts to how money flows. Every night, all the tallies are netted, money changes hands, the daily ledgers are cleared and things start fresh in the morning. I’m abstracting a lot of details but that’s the idea on a conceptual level.

Now, if a commercial bank needs to transfer more cbr’s than it actually has in its account at the Fed or it simply doesn’t want to transfer out such a large percentage of the cbr’s it owns, what does it do? Simple - it takes out a loan. From who? Well, traditionally, the Fed itself or other banks. Both can just lend the bank cbr’s for a short period of time. In theory, it won’t be long before they have a day where there is a net inflow of cbr’s and they can repay that loan.

And this is where the discount window and federal funds rate come in. The discount rate is the rate charged at the metaphorical discount “window” which is where a bank can “go” to get a loan from the Fed itself. The federal funds rate is the rate at which a commercial bank will lend another bank some “federal funds” (aka central bank reserves) for a loan. The loans come from different sources (the Fed or a commercial bank) but they serve the same purpose - to help cover the amount of cbr’s that a bank’s account holders want to withdraw on a given day.

The short term nature and daily cadences of these loans and settlement processes is why they call the market for these loans the “overnight market”. Very often, the loan is paid back the next day. So, you’re taking out an overnight’ish loan.

You also hear folks talk about “wholesale money”. That stems from the sheer size of these loans. Just like you might buy 6 cases of pistachios at a time wholesale at Costco, banks take huge loans of cbr’s via overnight markets to make sure they can cover these daily transfers.

up next

In this post, you got a quick primer on the guts of the US financial system. In the next post we’ll build off of these concepts to define what eurodollars are.