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For Whom the Cash Flows
by Lee Adler, Wednesday May 11 2005

Most people are operating under the misconception that somehow the Fed hands cash to some amorphous "banking reserves departments" in the nation's banking system every day, and that maybe some of that filters into the markets.

That's not how it works. It's just the opposite in fact.

I refer you to the NY Fed website, which has a wonderful primer on the Fed's Open Market Operations, which is the Fed's means of implementing monetary policy on a day to day basis. Admittedly, you have to read between the lines a bit, but after 17 years of listening to Greenspan's twisted, mumbling, obfuscations and prevarications, we should have all gotten pretty good at that.

Here's the key. The Fed only does business with their 22 Primary Dealers. While some are subsidiaries of bank holding companies, others are not. These firms are all broker dealers trading their own accounts. When the Fed does a repo with them, or does a coupon pass, it is buying directly from or lending to these broker dealers' money market or bond trading desks not obscure "reserves departments" of some big banks. Nope, these are direct transactions with Goldman Sachs, Merrill Lynch, Greenwich Capital, and the rest of the Gang of 22. The liquidity reaches the banking system from the Fed via the trading of securities in the market by these dealers. There is no other way. The cash does not come from the banks to the brokers. It's the other way around.

The other thing that's important to recognize is that these guys are in cahoots with each other and with the Fed. They have a conference call early each morning. They tell the Fed what they want! Again from the NY Fed website, "The Fed's traders discuss with the primary dealers how the day might unfold in the securities market and how the dealers' task of financing their securities positions is progressing." Ladies and gentlemen, I did not make this up. This is a DIRECT QUOTE from the NY Fed's website! The Fed decides what to do based on that conference call, another call to the Treasury Department, and its own aims and concerns, how much cash it will provide to or or withdraw from the markets that day via its dealers. Keep in mind, those billions are multiplied many times over in the hands of the dealers who borrow additional billions for leverage.

The dealers then take the leveraged cash and trade. That's what they do. They are first and foremost trading firms, in business purely and simply to make profits from their trading activities. They are not buying and selling on your behalf, out of the goodness of their hearts. They are trading with you for THEIR OWN ACCOUNTS, in order to make a profit by beating you on the spread between the bid and the ask, or by moving the market against you, not for you!

Furthermore, they can trade whatever they want with the cash that comes from the Fed. Bonds, money market instruments, stocks, options, currencies, futures, derivatives, whatever. Sure, because the cash flows in and out of their bank accounts, it affects the level of bank reserves, but the most direct affect is on trading in the markets. The effect on bank reserves is merely a derivative of that.

The Fed's influence over the markets is not amorphous and indirect through some obscure method of changing the levels of bank reserves. Changes in bank reserve levels are merely a byproduct of the Fed's direct pumping of cash to, or withdrawing cash from, the Fed's Gang of 22 Primary Dealers. If you've ever wondered why the market tends to reverse or reaccelerate around 2:30 to 3:00 every day, now you know. That's when the Fed's repos settle.

Read Lee Adler's reports on the Fed's impact on the markets daily in the Wall Street Examiner Professional Edition. Get instant access to real time insights. Click here for information on how to get started.

posted Wednesday May 11, 08 00 AM ET

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