In this concluding post of my 4 part introduction to Currency exchange in the Better Money System, I'll examine the Role of Primary Dealers. This will expand on my previous reference to Primary Dealers in the Core of Better Money, in which I also outlined the transaction combinations that comprise Open Market Operations.
In part 3 of this series I introduced Exchange Providers and Depository Institutions. A Primary Dealer must be one or the other.
Unlike other participating Financial Institutions that lack Primary Dealer status, a Primary Dealer has special responsibilities and Privileges that require and enable it to serve as a backstop to other providers of Currency exchange services. If regular Exchange Providers or Depository Institutions encounter market conditions that lead to an imbalance in their trading balances that can only be resolved by resort to an external market, a Primary Dealer must stand ready at all times to Make a Market. For this reason, a loss of confidence in AUG that leads to a "run" of Members seeking to dump their AUG in exchange for USD or other conventional money would not cause the exchange rate of AUG to diverge significantly from the gold price. To explain this, let's start by comparing and contrasting a Primary Dealer with a primary dealer as the term is conventionally used in reference to government central banks. [I'll use this upper case/lower case convention to distinguish my defined term from more generic references.]
Similarities
Primary dealers in both government central banking systems and the Better Money System have similarities with respect to:
- Open market operations
Designation as a primary dealer entails a set of privileges and obligations vesting the entity with the ability and responsibility to engage as the counterparty to the Monetary Authority in Open Market Operations ("OMO"). [OMO, while a very useful acronym, is grammatically awkward since it is plural but looks singular – yet associated verbs are not uncommonly conjugated as if it were singular]. We'll take a deeper dive into OMO shortly. For now it suffices to recall that OMO result in an increase or decrease of the overall quantity of Base Money issued and outstanding. In fact with Better Money and all other brands of Real Money that implement a Primary Dealer model, OMO are the only way to increase or decrease the Base Money supply.
- Obligation to Make a Market
Primary dealer obligations include a requirement to Make a Market.
Differences:
- With a government central bank:
- A primary dealer is a specially credentialed securities dealer.
- OMO are initiated by the Monetary Authority and conducted pursuant to its discretionary monetary policy. A primary dealer is obliged to bid to buy, or offer to sell, its pro rata share of whatever it is the Monetary Authority is, respectively, selling or buying.
- With Better Money
- A Primary Dealer is a specially credentialed provider of Currency exchange services.
- Primary Dealers initiate OMO pursuant to their own business requirements as providers of Currency exchange services . The Monetary Authority is obliged to fulfill its end of the bargain, resulting in an increase or decrease of the amount of Base Money in circulation.
What do OMO consist of?
[From here on in this post I'll be using the Fed as my only example of how government central banks do things. The others are similar in terms of the abstract logic but I am more familiar with the processes and nomenclature of the Fed than, say, those of the ECB or BOJ.]
OMO as conducted by the Fed
The Federal Open Market Committee ("FOMC") formulates monetary policy with respect to USD. The principal lever for implementing monetary policy in recent years is OMO.
The Trading Desk of the Federal Reserve Bank of New York ("New York Fed") initiates and executes OMO, both Temporary and Permanent OMO ("POMO"). Temporary OMO is interesting and important—especially now as the Fed undertakes to raise interest rates with tools which include its overnight reverse repurchase agreement facility ("ON RRP", aka "reverse repo")—but beyond the scope of the current discussion.
Permanent OMO means the outright purchase or sale of securities by the Fed using Primary Dealers as its counterparties. Let's examine a POMO purchase and look at how it expands the USD money supply.
A purchase of securities via POMO symmetrically expands the New York Fed's balance sheet. The securities so acquired become assets initially booked at cost basis to the System Open Market Account (SOMA) . These assets are paid for with newly created money, increasing the Fed's Monetary Liabilities by an equal amount.
The New York fed publishes its tentative schedule for outright POMO, distinguishing between the two major categories of its asset portfolio:
- Agency Mortgage-Backed Securities ("Agency MBS") - I defer to Margot Robbie to explain what MBS are in general and their role in modern finance. Prior to the financial crisis of 2008-09, the Fed pretty much held only Treasury securities in the SOMA and the total assets on its consolidated balance sheet amounted to < $1 trillion. Since 2009 the fed has acquired over $1.7 trillion of Agency MBS. Agency MBS held in the SOMA now comprise about 40% of the assets backing USD at the Base Money level. "Agency" refers to MBS guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac.
- US Treasury securities - You need to use the search feature since the only listed POMO involving Treasury securities since QE3 ended 10/27/2014 was 2/23/2016 (as of my last search 3/12/2016).
The Federal Reserve System's consolidated balance sheet provides a top level view, published weekly, where the newly acquired assets comprise part of "Securities held outright" under the heading "Reserve Bank credit".
The corresponding liability that is incremented (i.e. with OMO in which assets are acquired and Base Money is created) is "Reserve balances with Federal Reserve Banks". (Audited financial statements of the individual Federal Reserve Banks are also available).
As for the newly created money comprising this increment of "Reserve balances with Federal Reserve Banks", it becomes:
- a deposit liability of the New York Fed, constituting
- money (an asset) in the primary dealer's bank's account at the New York Fed, offsetting
- the primary dealer's bank's new deposit liability, which constitutes
- money in the primary dealer's bank account.
So to summarize:
- The primary dealer sells assets (securities) and receives assets (money). Its balance sheet changes a little to reflect this change in the composition of its assets but the transaction has negligible effect on its overall size.
- However, the balance sheets of the primary dealer's bank and that bank's bank (the New York Fed) both increase, expanding the supply of both Broad Money and Base Money respectively.
Measures of the USD Broad Money supply (M1, M2 and MZM) all include physical cash/coin in general circulation, a subset of Base Money. These Broad Money aggregates, however, all exclude the other components of Base Money: vault cash held by banks, and, reserve balances held by commercial banks in Federal Reserve banks. These latter components both comprise forms of bank reserves, assets that offset an equal dollar amount of deposits on the liability side of commercial banks' balance sheets. So in order to avoid double counting, all three Broad Money aggregates increase with a securities purchase via OMO, but this reflects the increase of commercial bank deposits rather than the expansion of the balance sheet of the New York Fed. That expansion is only captured in the Base Money figures.
I don't know about you, but for me, not coming from an accounting background, it took me years to really own a deep intuitive grasp of these layers of liability that are so integral to monetary systems and banking. I suspect it is tricky for many people. In a later post I plan to drill down on the concept of bankers' banks – the way banks are organized in hierarchical layers. It is a critical concept for understanding the historical process that resulted in government central banks as they currently exist.
OMO in the Better Money System
OMO with the Better Money System isn't as complicated, partly because there aren't multiple layers. No bank is obligatorily involved.
As noted in part 2 of this series, increases or decreases in aggregate demand for AUG feed back through exchange markets to Primary Dealers. Facing an imbalance of orders from customers, including other providers of exchange services, a Primary Dealer may determine that the lowest cost means of adjusting (replenishing or drawing down) its own AUG trading balances is OMO requiring the Issuer to either increase or decrease the Base Money supply. Figures 7 and 8 from my pending patent application lay out the nuts and bolts of these processes.
Bailment and Issuance process
Figure 7 shows a system (700) by which new quantities of the gold-Backed Base Money may be created and distributed into circulation on/within the Settlement Platform. The process begins external to the Settlement Platform (708) when Primary Dealer (701) makes a Bailment (702) (or otherwise surrenders possession and ownership) of gold bullion (703) to the Allocated Storage holdings (704) of the Trust which serve as reserves. Upon receipt of the bullion, the Repository (705) sends notification (706) to the Issuer (707). Assets having been secured, issuance of new Base Money of the gold-Backed Monetary Liabilities may proceed within the closed universe of the Settlement Platform (708). On the authority of the Issuer (707), an Issuance Spend (710) is made from Mint Account (709) to Comptroller Account (711). A Distribution Spend (712) is then made to the Account (713) of the Primary Dealer (701) that had bailed in bullion (703).
Redemption and De-Issuance process
Figure 8 shows a system (800) by which quantities of the gold-Backed Base Money are removed from circulation and extinguished and gold bullion is released from reserves. The process begins within the closed universe of the Settlement Platform (801) with a Redemption Spend (803) from the Account (802) of a Primary Dealer (813) to the Comptroller Account (804). A De-issuance Spend (805) is then made from Comptroller Account (804) to Mint Account (806) resulting in a decrease in the amount of the gold-Backed Base Money in circulation. Monetary Liabilities having decreased, a corresponding quantity of gold bullion may be released from reserves. Upon confirming receipt of the De-Issuance Spend (805), the Issuer (807) sends a Delivery Order (808) to the Repository (809) specifying a particular bar or bars of gold bullion (812) to release from the holdings of he Trust (810). In certain preferred embodiments, the Delivery Order (808) must also be authorized by the escrow agent (not shown). Upon successful authentication of the Delivery Order (808), the Repository (809) makes a delivery (811) of gold bullion (812) in accordance with instructions from the Primary Dealer (813).
Why does Better Money implement a Primary Dealer system?
Let's say you have some AUG but decide you'd rather have physical gold in your own possession. With the way Better Money works, you would use your AUG as money and go buy whatever it is you want, whether it is gold or other goods/services. If the seller doesn't take AUG yet, you might need an intermediate step, exchanging your AUG for some brand of money the seller does accept and then using that to pay him/her.
Since AUG is 100% Backed by gold, why can't you simply Redeem your AUG directly with the Issuer? Or more broadly, why can't all Holders of AUG initiate OMO?
To explain why not, let's look at the exact analogy with USD. Suppose you have some USD but decide you'd rather have some US Treasury securities, MBS or gold. The Fed has mega-oodles of all those types of assets which they hold as eligible collateral backing their direct USD Monetary Liabilities (USD Base Money). But if you could somehow approach them and request to swap/redeem some of your USD for some of these assets they'd probably suggest you take a hike (i.e. go find someone in the business of buying and selling stuff like that).
The reasons for this in both the Federal Reserve and the Better Money systems are practical.
Let’s again start with the Fed, examining its rationale for maintaining a primary dealer logic and the requirements they impose. These are delineated in its operating policy Administration of Relationships with Primary Dealers. In general, the Fed’s use of a primary dealer system enables transaction efficiency and reduces counterparty risk. It is easier to assure that a select group of counterparties has the expertise and wherewithal to handle the large transaction volumes OMO entail. To become a primary dealer to the New York Fed an institution must:
- commit to offer reasonably competitive bids at every US Treasury auction of securities,
- have capital sufficient to withstand trading and portfolio losses,
- have staff well versed in the ins and outs of FedTrade and other arcane trading and payment platforms.
With Better Money, reduction of counterparty risk is also a concern. If someone were to mail in their gold coin collection it would be hard to determine whether the gold was even genuine. But there is also another very practical consideration. Just as a primary dealer in the Fed system must know its way around Treasury securities (and MBS), a Primary Dealer in the Better Money system must be able to maintain relationships with bullion dealers capable of:
- dealing in Good Delivery gold bullion, and,
- making/taking delivery to/from the Repositories in which the gold reserves Backing Better Money are held in Allocated Storage.
The all-inclusive alternative of allowing each system participant to surrender gold to the trust holding AUG Base Money reserves would simply never fly. No treasury grade Repository (or reputable trustee) will accept bullion from external sources and of undocumented provenance and warrant that it is actually holding gold. Just as with OMO with the Fed, in which the bonds move from account to account on the Fedwire Securities Service, the process by which additional gold augments the reserves underlying AUG Base Money (or delivery in the opposite circumstance) typically entails moving bullion bars a few feet intra-vault from one allocated stack to another.
Similarly, provision of liquidity is important to both systems. With government primary dealers, capitalization and credit-worthiness is of over-arching importance. With Better Money, this is less of an issue because the Primary Dealer cannot enter into OMO unless it has either:
- already acquired Good Delivery gold and surrendered it to the trust holding AUG Base Money reserves in accordance with System rules, or,
- made a Redemption Spend which, because of the Strict Debit Rule, means reversal due to payer default is impossible.
Nevertheless, as Market Maker of last resort, a Primary Dealer in the Better Money system must be able to handle larger Exchange Orders—for instance from Members that are themselves wholesale providers of exchange—and fulfill them in a timely manner. This requires maintenance of adequate trading balances and adherence to best practices designed to minimize the risk of default.
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