Federal Reserve System is a relatively young, but definitely the most powerful Central Bank in the world.
The main function of FED is regulation of the money supply.
Since the RESERVEUM Analytical Group is actually studying how to develop a protocol for regulating fair and non-inflationary money, we decided to take a closer look at how exactly the FED regulates the money market.
It seems that such a serious financial institution as FED must have a serious mathematical and statistics apparatus for regulating the money supply. But it is actually easier than it may seem at the first sight. The FED only has four main instruments:
- the reserve ratio
- the interest rate
- operations in the open market
- quantitative easing.
Later we will dwell on each of these instruments and will offer you more modern alternatives to these methods that will be used by the RESERVEUM protocol in the future. Meanwhile, let’s come back to the topic of this article and see how it started.
The History of FED.
Starting from the end of the XVIII century, there were several Central Banks and national bank systems created in the USA, but none of these projects could ensure the necessary level of financial stability and effective control. Every new attempt led to a financial crisis, and after a series of such panics at the beginning of the XX century, the time came for a systematic solution of the problem.
The idea to create the Federal Reserve system is believed to belong to senator Nelson W. Aldrich. He created two National Monetary Commissions, one of which studied the monetary system of the USA, and the other one – the banking systems of Europe. From 1908 to 1913, these commissions developed a project of the Federal Reserve System that was launched in December 1913 and continues its work to the modern day.
The organisational structure of the reserve was the main topic of arguments between the Republicans and the Democrats. But the private capital found for creating it made the new institution quite independent from the President and the Government. The FED was created as an independent agency of the US Government; such independent organisations perform government tasks that are outside the Government authority. Neither the President nor the US Congress could take part in the FED activities, their influence was limited to regulatory government acts.
In fact, the FED is free to take decisions, it is financed independently and needs the consent of neither the President nor the Congress. The Federal Reserve System Board is chosen by the President of the USA for a period that is several times longer than the President’s term of office. It includes seven people, including the Head of the Board.
The name itself – the Federal Reserve System, – shows that it is different from a classic Central Bank. In the USA, it is replaced with a whole system of banks: 12 regional federal reserve banks and around 3000 commercial banks. Apart from banks, the system includes the Federal Open Market Committee (FOMC), with the Federal Reserve System Board heading the whole structure.
Unlike traditional Central Banks, the FED’s capital does not belong to the government. The reserve capital is gained by selling the FED stocks. The main stakeholders are banks that make up the system. These stocks enable them to choose the Boards in regional Federal Reserve Banks and get 6% dividends annually.
The concerted work of all the chains in the FED system helps it perform all the functions of a Central Bank: control and regulation of the banking system, loan system, money supply regulation, prices and labour market stability, making financial operations of the country and international levels, and many other things.
FED Functions and Money Market Regulation Methods.
It is hard to outline the main function of the FED, but there is no secret which of them is the weakest chain in the link. This is money supply regulation, or the monetary policy. The imperfection of the mechanisms used by the FED for maintaining the money issuing is the main source of troubles in the US financial system.
The gears that either reduce or increase the money supply in circulation are the reserve ratio the interest rate, the operations in the open market, and the quantitative easing. All these methods are outdated and imperfect and blow up a financial bubble. They can be (and should have been long ago) replaced with a more effective algorithm that would exclude the human factor.
1. The Reserve Ratio
Commercial banks use the acquired funds for giving out loans, but some of these funds should be frozen as a reserve. If the reserve ratio is reduced and banks are allowed to give out more loans, the money supply grows. Growing reserve requirements makes banks save more money as the reserve, so they have less money for giving out loans. Such measures reduce the money supply.
Algorithmic analogue of the reserve ratio in the RESERVEUM protocol: We believe that this instrument is outdated, it harms the money market and directly boosts inflation. In the RESERVEUM protocol, it is impossible to issue non-supplied tokens, all tokens at the moment of their creation are supplied with any currency allowed within the protocol at the 1:1 ratio according to the rate at the moment of the issuing
2. The Interest Rate
Another way of increasing and reducing the money supply with the help of the loans system is changing the interest rate. The interest rate is the percentage rate of the loans given out from the FED to private banks. If the rate is lowered, banks take more loans to give out more loans to their clients. The lower is the rate from the FED, the more loans are given out and so the money supply grows. The higher is the rate, the more profitable it becomes to keep money in the bank deposits, which leads to a lower money supply in circulation.
The algorithmic analogue of the interest rate in the RESERVEUM protocol: The reserve norm for creating a new Reserveum token will constantly grow over time. However, the growth rate will constantly be regulated depending on the proportion of newly created tokens to the tokens that users returned to the system in exchange for the reserve. You can find out more about this process in our article the Anatomy of Stablecoins
3. Operations in the open market;
It means that the Federal Reserve System buys and sells government notes and treasury bills. To grow the money supply, the FED buys the bonds from holders, to reduce – sells them. These operations are extremely important for the economy, so important that there was created a special Federal Open Market Committee as a part of the FED. Every paper of the government notes influences the whole financial cycle. Selling the notes reduces the supply in the intra-bank loan market and affects the rate that banks use for giving out loans to each other; meanwhile, the reserve amounts grow and the money supply shrinks.
The algorithmic analogue for the operations in the open market in the RESERVEUM protocol: The Reserveum protocol administration will charge a small commission for creating new tokens, a so-called seigniorage. A part of this seigniorage will be used to maintain the token rate stability.
4. Quantitative Easing
Quantitative easing, or QE, is an instrument to grow the money supply; it is believed to be an emergency option, but in reality, it is used alarmingly frequently. When people say that the FED started the printing this is what they mean. QE is an extra emission of both cash and non-cash money. In fact, paper money in the USA amount to only 10% of all the money supply, and issuing them is not a big deal. The blowing up of a financial bubble happens to new tranches of quantitative easing, that are in fact buying government bonds for non-cash money, or “money made of air” – just the digits in bills and documents.
The algorithmic analogue of the quantitative easing in the RESERVEUM protocol: The money supply will be regulated by the market itself, in other words, by the Reserveum token holders. The volume of tokens in circulation is not pre-defined. The tokens will be created constantly as long as there are people who want to initiate the mining of new tokens in return for locking the equivalent reserve. There will also be a constant opposite process – Redeeming tokens. So tokens will be burnt in exchange for returning the reserve if holders don’t want to use their tokens anymore. The number of tokens in circulation will always be perfect for the current state of the market.
The FED’s Main Problem
In fact, the main problem of the existing financial system is the unlimited power of the banking system to use the money for creating profit. Money is not just used for business, buying and saving, when it ends up in banks, it turns into consumer loans, commercial, intra-bank loans, it is used for buying bonds, as the reserve, and as a result, it brings the banks profits that exceed the original amount by scores. 90% of the money supply is just notes in banking documents, and this money never existed, what is worse, it is considered to be a part of the money supply, so it has a direct influence on the inflation growth.
When the money supply in the economy grows it is believed to be a well-being boost, and the market reacts with higher prices. But in fact, the average consumers’ income is not growing because the money supply only grows inside the banking system. All this leads to higher prices on consumer products, while the people’s purchasing power falls, in other words, people get poorer. They pay for the inflation from their wallets, while the FED continues boosting the fictional money machine.
More than a hundred years ago, the FED was created to limit the power of commercial banks and bring order to the monetary system, but the mechanism is extremely outdated. The modern economy needs more updated instruments for money management. One of the best solutions today can be the “algorithmic FED”. This is a protocol written as an open code that would control the money issuing not in a centralised manner, but by the decision of the currency users.
In other words, such a protocol could replace the existing banking system by conducting all the necessary functions but without misuse of other people’s money and artificial blowing up of the money supply.
Learn more about the protocol Reserveum.