Money is the nervous system of the world’s socio-economic orders.
For most of us, money sits at the other side of an important equation – that which involves the trade-off of time for anything else. Often, we make this trade-off without too much thought behind what it really means; although probably all of us wouldn’t doubt that we only have limited time, we rarely question what money is.
Indeed, we often reduce money to some type of cash (either physical coins and banknotes) or to our online bank accounts with which we settle transactions (means of payment), put it aside as savings (store of value) and price our services, goods or assets in it (unit of account).
The core purpose of this paper is to show that money is far more complex than this.
Most of the work that you will see below has been done by extremely knowledgeable people with decades of experience in the “field” of money. The structures discussed are complex and changing quickly.
Therefore, in this paper I will only aim to highlight the key pieces of information one needs to collect in order to build a deeper understanding of what the world of money really looks like.
Part 1: The money of the real economy
Money, in day-to-day parlance, it is usually thought of as the cash in your pocket or the digits in your bank or savings account. But this is just one type of money in the real economy.
In a fiat monetary system, each type of money is both an asset and a liability. At the broader macroeconomic leve, money is discussed in terms of monetary aggregates (see table below).
These monetary aggregates typically pool together the currency in circulation (which are a liability of the central bank and an asset of those that hold it), different types of bank deposits (which are a liability of the commercial banks and an asset of those who hold them) and reserves (a.k.a. “bank money” which are a liability of the central bank and an asset of the banks – more on this below).
Example of monetary aggregates from the Bank of England
These monetary aggregates aim to provide you with information about three main things in the economy:
- The level of nominal spending in the economy currently
- The level of nominal spending in the economy in the future
- The impact of monetary policies through the transmission mechanism (aka the banks)
Therefore, in order to get a more complete picture of the above dynamics, it is recommended to pay attention to the broadest monetary aggregate as it will include all the instruments that are money-like within the real economy (i.e. not just the cash and the different types of deposits that can be accesses on demand to purchase goods and services). This is detailed in the paper below.
Most central banks around the world will provide you with information on these aggregates – the most important currencies to follow are the USD, the RMB, the GBP, the JPY and the EURO (these drive financial capital flow internationally). You can see below the frequency with which this information is provided by the G20 central banks.
Coins and banknotes enter in circulation usually through the banking system: the process involves commercial banks drawing down banknotes in exchange for reserves (“bank money”) held at the central bank. Households and businesses then obtain the cash directly through withdrawals. The amount of currency in circulation is, in theory, determined by the demand for it.
However, most of the money in the today’s real economy (i.e. used for savings and transactions by households and companies) are made up of bank deposits.
Banks create money when they make new loans – when you are granted a loan, a deposit is credited to your own bank account and you can use that purchasing power immediately.
There are several factors which limit bank lending including:
- market forces (lending must be a profitable activity)
- risk management (banks have to mitigate the risks that come with additional lending)
- regulatory measures (holding sufficient capital)
- the behaviour of households and companies (demand for new loans may be low or non-existent)
- monetary policy (controlled by the central bank).
While bank lending is usually thought of as a process that is happening in the real economy, in the financial system another monetary transaction takes place: “bank money”, aka reserves that banks maintain by law with the central bank also move in the interbank market.
Bank reserves are provided to banks by the central bank in exchange of other assets. From here we enter the realm of “other money” – the money of the financial system.
As Zoltan Pozsar (Credit Suisse), whose work has been critical in putting this paper together, stated that “for institutional cash pools, money begins where M2”. M2 is a monetary aggregate, broader than M0 and M1 but narrower than M3.
To some extent, this can be seen in the chart below which is a comprehensive map of the USD flows, built by the New York Federal Reserve. It explains how USD-denominated purchasing power (money) moves within a highly complex system. The obvious thing to note is that there are different types of instruments used by different institutions to settle transactions.
We will discuss this chart in more detail over the coming pages – what we will see is that the 2D structure that we see below is really a multi-layered hierarchy.
Part 2: The money of the financial economy
Sophisticated investors (such as asset managers, corporate treasurers, money market funds and foreign exchange reserves pools) use instruments as money which monetary aggregates do not capture (a notable exception from this is the M4 published by the Bank of England which does capture repurchase agreements, i.e. repos).
Putting everything together may create the impression that all money is equal (even if the various components of monetary aggregates are usually weighted based on their use in transactions) – in reality, money is a hierarchical structure.
The risk in holding this perspective of a homogenous monetary world is that it does not allow you to see the distinction and connection between the real economy and the financial economy.
The hierarchical structure of money was popularised by the incredible work of Professor Perry Mehrling, built upon by Zoltan’s analysis and further enhanced by the in-depth research into global liquidity of Michael Howell from CrossBorder Capital.
“Money is usually defined from a functional perspective as a “unit of account, store of value and medium of exchange.” However, this definition does not take into account the quintessential attribute of money — that money always trades at par on demand — and the institutional arrangements that underpin this attribute.” – Zoltan Pozsar, 2014 (bolding is my own).
In analysing the financial economy, we will focus on the US as it is by far the most complex and the biggest “money market”.
There are four key institutions involved in issuing USD-money for sophisticated investors and three categories of participants in the USD money markets.
The “money makers”
Pozsar (2014) identified the following institutions that are “money makers”: Central banks issue reserves; Banks issue deposits; Dealers issue repos; Money market funds (MMFs) issue constant NAV shares (CNAV shares). Each of these types of money are claims which are backed by either public or private assets.
Money claims backed by public assets include:
- currency and reserves (issued by the central bank) are backed by assets such as US Treasury securities, agency debt and RMBSs
- government repos (issued by dealers) are liabilities of the dealers’ government bond trading desks collateralised by various public assets
- and CNAV shares issued by government-only MMFs are backed by Treasury bills and other public short-term assets.
Money claims backed by private assets include:
- deposits (issued by banks) are backed by loans to the private sector
- private repos (issued by dealers) are liabilities of dealers’ credit desks collateralised by private assets such as corporate bonds, ABSs and private-label RMBSs
- and CNAV shares issued by prime funds backed by private bills like commercial paper (this is one area of money markets which was drastically affected by the coming into force of Basel III in 2015).
All of the above are money. These instruments have one thing in common – they “promise” to trade at par and on demand. What this means in practice is that they can be converted into cash whenever and without loss to the par value (i.e. $1 of any of these instruments is equal to $1 of cash).
Unlike the money found in the real economy, these claims differ in their functionality, in the sense of whether they can used to settle transactions. As Pozsar explained, payments between dealers and money funds, as well as between all other actors in the economy, are settled in bank [demand] deposits and flows between banks are settled with reserves in the interbank market and the central bank.
Here we note the first important aspect of the money hierarchy: banks form the backbone of the payment system and facilitate payments of all entities lower in the hierarchy.
However, overnight repos and CNAV shares are different because they cannot be used for settlement purposes even if they are still regarded as money.These are overnight claims, but there are also money which are claims with a maturity longer than overnight but less than one year. All of them can be traded for a demand deposit at par on demand.
Another way of putting it: repos and CNAV shares are convertible into cash in the form of demand deposits which can be used for settlement purposes. Therefore, from the perspective of those that hold these instruments, they are money.
Pozsar classifies these as “money-like-claims” that offer par at maturity but not on demand. These instruments include negotiable time deposits issued by banks, term repos issued by dealers, US Treasury bills and notes maturing within one year.
“Money-like-claims” are not all equal in their “money-like” quality: those that are closer to maturity are more “money-like” than those further from maturity. Additionally, they differ in the strength of their promise of par on demand and par at maturity across the world. This means that money is really on a spectrum rather than in static forms.
With the exception of central banks, all other institutions that engage in money creation have to hold money assets which are money liabilities of institutions higher up the hierarchy. In practice, this gives money and money-like-claims different liquidity and credit risk profiles.
This determines the ease with which any of these “money makers” can access funding liquidity (especially in times or crisis) and closely related, which of these money carry more credit risk (when capital is scarce, credit risk increases).
From a balance sheet perspective, below is a macro-level overview of how the hierarchy of money looks like.
The above chart gives us a clearer picture of the balance sheet of the key “money makers” within the USD system. Each currency will have its own money matrix, as Pozsar calls it.
One thing to note is that the above figure is mostly a picture of the onshore USD system. There is also the offshore USD system which we need to factor in (see the map made by the New York Federal Reserve above).
Following the Global Financial Crisis of 2007-2009, the Federal Reserve has put in place a number of mechanisms to provide USD funding to offshore entities that needed it.
Some of these include FX swap line (through which USD are lent against collateral in the form of foreign currency) and, more recently, the FIMA Repo Facility which provides USD liquidity to offshore entities against their holdings of US Treasury securities.
Additionally, you have the US branches of non-US banks located in New York which borrow USDs and then lend them internationally. Most of this lending is done through the repo and FX swap markets.
The participants in “money markets”
Pozsar (2016) highlights that there are three categories of participants and nine balance sheets which are involved in these types of “financial money”.
The monetary authority is the central bank that issues and sets the price of base money. Then we have the money dealers. These are market makers across different money markets – sovereign, secured and unsecured, both onshore and offshore. They include: The US Treasury, the Federal Home Loan Banks (FHLBs), primary dealers and money market funds.
Finally, we have public and private “cash pools”. In the public cash pools group we have FX reserve managers and cash that needs to be managed at international institutions such as the IMF; in the private cash pools category we have hedge funds, asset managers and the cash balances of corporations (corporate treasurers).
In the image above, you will note different maturities – these are the spectrum of tenors of liabilities issued by each of these USD money market participants.
Money dealers sit in between the monetary authority and cash pools – they are the link between the two.
Before the financial crisis of 2007-2009, money dealers used to lend mostly to each other but Basel III changed that and now they borrow from cash pools (at a rate x) and lend it to the Fed (at a spread above rate x). The exception here is the US Treasury which holds assets (cash) at the Fed (in the Treasury General Account on the central bank’s liabilities side) and receives zero interest on it, making this a negative carry trade. However, the Treasury needs to keep a certain amount of funding liquidity to protect itself against a debt ceiling crisis.
The hierarchy of money markets is displayed below.
Let’s work our way through this image from left to right on both sides of each balance sheet. On the Y axis above we have % of various interest rates.
The Federal Reserve
As mentioned earlier, in the current monetary system someone’s money is someone else’s liability – as Basel III shifted the focus of USD money markets towards the Fed, the central bank is the one that sets the price of these liabilities with a range of interest rates (the squares on the vertical line above the L side of its balance sheet).
The red square (on zero) is for the US Treasury and the FHLBs which have deposit accounts at the Fed. However, the latter also has access to the Fed’s o/n RRP (overnight Reverse Repo facility) which sits above the red square and it is coloured in dark blue – and so do money funds.
Above it, we have the rate of interest paid on the foreign repo pool (the mustard full square) and this is available to public cash pools.
The highest paying interest rate in money markets is the IOR (light blue square), which is what banks get on their [excess] reserves held at the central bank.
These reserves are the most liquid asset for banks and an important factor in their portfolios of high quality liquid assets (HQLAs). Therefore, reserves are lent only at a spread above the IOR and when the banks are in a position to do so. The blue square which is empty is called the “shadow” IOR and it accounts for a surcharge at the FDIC (Federal Deposit Insurance Corporation).
The Money Dealers
The Treasury, on the asset side, has the account with the Federal Reserve on which it receives nothing. On the liability side, the Treasury taps the money market with 1, 3, 6 and 12-months bills. These are the various shades of green diamonds: the shortest maturity is the darkest diamond and the longest maturity is the lightest diamond (sitting above the IOR).
Depending on their maturity profile, these liabilities are assets for private and public cash pools, money funds, US banks and foreign banks (with US branches). Note that banks only tap Treasury bills when they yield above the IOR, which are usually the 12 months ones.
The Federal Home Loan Banks also hold cash with the Fed in order to comply with regulatory guidelines from FHFA (Federal Housing Finance Agency). They can lend at the o/n RRP rate and at the o/n effective fed funds (FF) rate (the yellow circle above the FHBLs’ A). These are on the asset side of their balance sheet.
On the liability side, they issue agency discount notes of 1 week and 1, 3 and 6-months maturities. These are the triangles of various shades of orange or brown (the darkest is the 1 week note and the lightest is the 6 months one). These liabilities are assets for money funds and private cash pools.
Turning towards US banks and New York branches of foreign banks, on the asset side they have their HQLA portfolios against money market liabilities that are maturing in 30 days or less. HQLAs tap both money markets and bond markets.
On the liability side, banks tap the unsecured money markets – the circles on the vertical lines above the Ls. These include the o/n effective FF rate and the overnight bank funding rate or OBFR (the yellow circle with the blue line – the blue line is the OBFR rate), Eurodollar operating deposits (the light grey circle just below the IOR), non-operating deposits (black circle) and commercial paper (CP) which is the darker shade of grey overlapping the FF/OBFR circle.
You can see in the chart above that these liabilities are assets for money funds and private cash pools. They tap secured markets via repos and FX swaps.
Primary dealers fund exclusively in secured markets – in the o/n tri-party repo market (the empty blue square). They could not historically access the Fed’s discount window (i.e. they cannot be backstopped by the monetary authority, unlike banks). The discount window operates at a penalty rate over IOR and is there for banks to borrow from the Fed in times of financial stress1.
However, during the recent pandemic, this has changed and primary dealers have access to Fed funding via the Primary Dealer Credit Facility (PDCF) at a 0.25% interest rate (or the rate that is equal to the discount window for banks)2.
The o/n tri-party repo market is a market where money market funds and private cash pools lend cash (o/n or longer) against collateral. On the asset side, primary dealers lend to other primary dealers, to dealers that are not primary dealers and to hedge funds and total return funds.
On the chart above, these are the orange minus sign (o/n bilateral repo for interdealer lending to other primary dealers), the orange square (o/n GCF repo rate for interdealer lending to non-primary dealers) and the orange plus sing (o/n bilateral repo rate for lending to customers, i.e. hedge funds etc.), indicating the spread differentials that these entities can get funding from primary dealers.
Finally, money funds do not issue debt to fund themselves (unlike all of the above money dealers). They issue equity – CNAV shares (the empty black circle on the liability side of money funds). This black empty circle represents the yield that cash pools earn on the money funds shares.
On the asset side, money funds have access to a range of both secured and unsecured of assets: government money funds hold primarily guaranteed and secured paper and prime funds hold mostly unsecured paper. They also have access to the o/n RRP with the Fed.
As mentioned above, there are two types of cash pools: private and public. Private ones have access to every instrument above except for the liabilities of the Fed, fed funds and GCF repo. This further illustrates the hierarchy of money markets (and thus of money). Public cash pools have access to the same instruments as the private cash pools, plus the foreign repo pool at the Fed.
A simplified version of the above slide can be seen below. However, it only shows the shortest tenor for each money dealer.
The hierarchy of onshore interest rates for money markets is as follows:
- Ceiling: IOR
- o/n bilateral rate + GFC repo rate (dealer-to-customer)
- o/n GFC repo rate (dealer-to-dealer)
- o/n GFC repo rate – o/n bilateral rate (dealer-to-dealer)
- OBFR (anchor for offshore USD swap rates)
- o/n tri-party Treasury repo rate
- Floor: o/n RRP
Note that this hierarchy is not set in stone – you need to monitor these rates to see if they change and then find out why.
We also need to talk about the hierarchy of the offshore USD market.
One of its important components is the FX swap market – this is a highly complex system and I will only offer an overview of its structure based on Pozsar’s work (Pozsar calls the FX swap market the “Outer Rim”).
As you can see, there are 4 levels of intermediation in the FX swap market.
Level 1 involves dealers that run matched FX swap books and link lenders of US dollars with borrowers of US dollars. However, because matched books are usually not a reality, some players need to step in and clear the markets – these are the foreign banks (Level 2). When markets are under more serious pressure, then the US banks (Level 3) comes into play. US banks have access to more stable funding than foreign banks and therefore, they can help clear markets – at a higher price than foreign banks do and even at a higher price than the dealers.
Finally, Level 4 of intermediation involves the Federal Reserve, the ultimate lender of US dollars. One thing to note is that things can change fast in this market, shifting the importance of each of these players.
How things have changed SINCE the pandemic
Below are some of the key changes that have been put in place by the Federal Reserve to shore up the onshore and offshore USD markets.
On a collateralised basis for the onshore market:
- The Discount Window was lowered and now lends to banks at 0.25% against collateral.
- The Primary Dealer Credit Facility which lends to primary dealers against collateral at the rate of the discount window.
- The Repo Facility that lends to primary dealers at the IOR against US Treasury collateral.
On a collateralised basis for the offshore market:
- The FIMA Repo Facility that lends to foreign central banks and other international institutions at 0.25% spread above the IOR against Treasuries.
- The USD swap lines that lend to foreign central banks against collateral (foreign currency) at a rate of OIS plus a spread of 025%.
These are facilities through which the Fed provides funding versus collateral. The o/n RRP facility and the foreign RRP facility are also collateralised but in this case is the Federal Reserve that provides the collateral – just to highlight this.
The above measures flatten the hierarchical structure – all USD money markets are linked to the Fed now.
Additionally, the Federal Reserve has provide support to parts of the USD money markets that are exposed to unsecured funding, namely:
- The Commercial Paper Funding Facility through which the central bank backstops the commercial paper market by lending at a higher rate than the price of collateralised facilities
- The Money Market Mutual Fund Liquidity Facility which provides prime money funds with the ability to borrow from the Fed at a rate of the Discount Window plus a spread.
These are the ones related to money markets (short-term lending of money – of all the types discussed above). The Fed also put in place a number of other facilities aimed to backstop certain parts of the economy, capital markets and financial markets:
- The PPPLF which is intended to facilitate lending by eligible borrowers to small businesses under the Paycheck Protection Program of the CARES Act. The eligible borrowers (depository institutions and credit unions) borrow from this Facility and lend against PPP loans guaranteed by the Small Business Administration to American SMEs.
- The Municipal Liquidity Facility which backstops the municipal credit market.
- The Main Street New Loan Facility which complements the PPLF in its efforts to lend to SMEs.
- The Primary Market Corporate Credit Facility that provides liquidity to the primary corporate debt market. The maturities of these debt securities can be up to 4 years.
- The Secondary Market Corporate Credit Facility that backstops the secondary corporate debt market. The maturities of these securities can be up to 5 years.
why does this all matter?
Firstly, being aware that there is a real economy and a financial one with potentially different incentives changes how we see the world around us: these two economies are very interconnected.
As we’ve seen above, banks are the backbone of the payment system for the real economy and play a massive role in the financial economy too – we can all see changes in the real economy (e.g. unemployment goes up or down, demand for jeans goes up or down, CPI goes up or down) but the financial economy is usually veiled.
In times of “normality” and peace this hidden world is not of interest to most of us. But in times of turmoil it suddenly becomes our focus – these cash pools that lend their excess cash to various money dealers need it back when funding liquidity is tight. Or, banks that have drilled into their HQLA to earn some extra spread may need to rebuild their HQLA portfolios and look to get back what they lent in the money markets.
These actions put pressure on prices of money (the interest rate structure seen above) which result in even more funding stress that spills in the real economy – if these “money-like” instruments do not uphold their promise of delivering $1 for $1 (trade at par and on demand or at par on maturity) then their role as means of settlement breaks down.
Put it in English, if a corporate treasure cannot recover each dollar it lent into the money markets when the company needs to pay for its costs then these costs are cut (less investments, higher unemployment, lower dividends and so on).
Secondly, the fragility of this system comes to mind. The financial world is built on flows of numbers that go through these balance sheets. I let your imagination do the job in answering: what can go wrong with all of this interconnectivity in the financial system, when with just the stroke of a pen laws can be change and these structures upset?
Thirdly, monitoring money markets is key for understanding one of the most powerful driver of asset prices – liquidity. There are various definitions of liquidity which basically divide the concept into market liquidity (depth) and funding liquidity (balance sheet capacity).
In reality, these two notions are tightly linked. Two of the best sources that will help you understand how important liquidity is for financial (and real) economy are this paper from BIS and this website created by CrossBorder Capital. For now, it is sufficient to say that money markets are part of a much bigger “flow of funds” structure.
Thank you for reading.
Global Money Notes No. 30, Credit Suisse (2020)
Global Money Notes No. 29, Credit Suisse (2020)
Global Money Notes No.10, Credit Suisse (2017)
Global Money Notes No. 9, Credit Suisse (2017)
Money Markets after QE and Basel III, Credit Suisse (2016)
Understanding the Central Bank balance sheet, Bank of England (2015)
Shadow Banking: The Money View, OFR (2014)
How money is created, Bank of England
Money creation in the modern economy, Bank of England (2014)
- See: Interest Rate Control Is More Complicated Than You Thought
- Note: the discount window should always sit above the IOR but in recent times the whole interest rate corridor has been lowered to help deal with the pandemic’s impact on financial markets and economic activity.