From studying the shadow banking system we can see how different types of institutions essentially use different classes of assets and mechanisms as money.
This is discussed in a paper by Zoltan Pulzar, who refers to it as a kind of “hierarchy of money”.
What I’ve found is that you can classify the system into four different kinds of institutions. You have central banks, commercial banks, dealer banks, and money market funds. Each of these institutions “issue”, for want of a better word, a different type or kind of money.
Money Ranked By Its Proximity To Government
Each type of money is backed by a different asset.
Central banks issue reserves and small and large commercial banks issue deposits. Some banks (dealer banks) also issue repos, and money market funds issue net asset value shares.
These are all ranked with respect to their proximity to the government. There is a bottom-up structure to this, with the central banks at the top issuing reserves followed by the regular banks issuing deposits with reserves as the underlying asset.
If you rank these institutions by their proximity to the government, then the structure as shown below:
Money Claims Backed by Public Assets
The dealer banks sell short-term secured loans also known as repurchase agreements (repos), agreeing to repurchase the security at a higher price in the future. These securities then serve as collateral. The money market funds do a similar thing.
So, depending on where in the system the money originates, there are either public assets or private assets backing the transactions. Public assets would be US treasury bills or notes, or agency debt which is backed by the government. Examples of this are Fannie Mae and Freddie Mac mortgage-backed securities.
The commercial banks then have residential mortgage-backed securities (MBSs) which are a form of public asset part. The private asset side has dollar-denominated bills or commercial paper. And there are asset-backed securities that are backed by private assets and loans issued globally throughout the system.
The government repos are essentially liabilities of dealer banks, where their government bond trading desks issue them. The net asset value (NAV) shares from the money market funds are backed by T-bills and other short-term assets.
You then have currency and reserves, which are liabilities of the central bank and these are typically backed by the treasury’s agency debt and the RMBs mentioned above.
Money Claims Backed By Private Assets
The private assets or deposits at commercial banks are their liabilities that are backed by loans.
Whenever a commercial bank issues a loan, they give one a deposit that’s backed by the loan that is taken out.
The loan is therefore the asset and the deposits are their (the commercial bank’s) liability.
You can also have private repos which are liabilities of the dealer bank’s credit trading facility. This is where they transform credit in a way. These are typically collateralized by corporate bonds, asset-backed securities, and private label RMBs.
What I’ve noticed is that you can have public RMBs as well as private label ones with lots of nuances in so far as the different types of securities and different, specific types of issuance.
Next, we have the constant NAV shares of prime funds, backed by private bills. These would be commercial paper and other similar financial instruments.
Money Defined
All these claims promise to pay at par on demand, which is how Pulzar defines money in his discussion paper.
Money is not just the unit of account, medium of exchange, and store value. Money is defined as a contract where the terms promise to pay at par value on demand.
This then leads to the next part of the settlement discussion.
Settlement of Money
If you buy an item from a business, that business then gives you goods. You pay with money, typically with your debit card. This transaction is settled with demand deposits between your checking account and your bank’s account.
The exception to this is when commercial banks settle via their reserves with the central bank.
However, in the shadow banking system, parties such as money market funds that don’t have reserves with the Federal Reserve bank, or any other reserve bank for that matter, make use of reverse repo facilities at the Fed in a more nuanced structure.
Instruments such as overnight repos and NAV shares, cannot be used for settlement but they can be traded for demand deposits at par on demand fairly easily. So, they are convertible almost instantaneously into payment system money or, in other words, demand deposits.
Money-Like Claims
Money claims in general are just claims on some form of value. Money-like claims are used similarly but they are not the same thing.
Money-like claims are defined as money claims with a maturity longer than overnight but for a period of less than one year.
An example would be US treasury bills or notes with less than one year left to maturity. They are offered at par at maturity. You will therefore have to wait for a year before the bill or note matures and you receive the money in your account. It is then not on demand, as you have to wait to receive the proceeds of the bill or note.
The closer you get to maturity, the more that claim becomes money. You’re factoring in risk, whether it’s interest rate risk or maturity risk, on the time left until maturity. It is for this reason that the pricing risk diminishes as you get closer to the maturity date.
The essence of the argument is that money-like claims pricing is a spectrum where the instrument becomes more like money as the duration to maturity decreases and less like money as the duration increases.
Another factor in deciding money-like claims is that different types of instruments can be breakable at penalty.
What this means is that you can invest funds in a negotiable term deposit such as a certificate of deposit (CD) for example, and withdraw it early. The penalty is that when you break it, you don’t get them at the par value you would have received if you’d waited the full term for the CD to mature.
The breakable penalty is then the fee that you are charged for not keeping your funds invested for the full term of the contract.
What it comes down to is that the various institutions play on different fields. The banks can’t deal in the realm of reserves. They can only deal in the demand deposit function. The demand deposits are the backbone of the entire financial system.
The central banks deal with reserves and settlements between the banks. These structures then branch out and therefore use different financial instruments like money, which creates the hierarchy of money.
In effect, the hierarchy of money is made up of different types of structure and uses different methods to effect payment. Each institution has a different option in terms of government backstops, both directly and indirectly, which provide stability and trust within the system.
For more on the Monetary System:
https://jamesdforsythe.com/category/monetary-system/
For more on the shadow banking system: (YouTube)
Reference:
Zoltan Pozsar, “Shadow Banking: The Money View”, Office of Financial Research Working Paper, 14-04 (2014)
