The Repo Market

The over-the-counter repo market is now one of the largest and most active sectors in the US money market. Repos are widely used for investing surplus funds short term, or for borrowing short term against collateral. Dealers in securities use repos to manage their liquidity, finance their inventories, and speculate in various ways. The Fed uses repos to manage the aggregate reserves of the banking system. What are Repos? Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often Treasury securities. On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds. Although legally a sequential pair of sales, in effect a repo is a short-term interest-bearing loan against collateral. The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of any duration but are most commonly overnight loans. Repos for longer than overnight are known as term repos. There are also open repos that can be terminated by either side on a days notice. In common parlance, the seller of securities does a repo and the lender of funds does a reverse. Because money is the more liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value, usually by 2 to 5 percent depending on maturity. The overnight repo rate normally runs slightly below the Fed funds rate for two reasons: First a repo transaction is a secured loan, whereas the sale of Fed funds is an unsecured loan. Second, many who can invest in repos cannot sell Fed funds. Even though the return is modest, overnight lending in the repo market offers several advantages to investors. By rolling overnight repos, they can keep surplus funds invested without losing liquidity or incurring price risk. They also incur very little credit risk because the collateral is always high grade paper. Repos are not for Small Investors The largest users of repos and reverses are the dealers in government securities. As of June 2008 there were 20 primary dealers recognized by the Fed, which means they were authorized to bid on newly-issued Treasury securities for resale in the market. Primary dealers must be wellcapitalized, and often deal in hundred million dollar chunks. In addition there are several hundred dealers who buy and sell Treasury securities in the secondary market and do repos and reverses in at least one million dollar chunks. The balance sheet of a government securities dealer is highly leveraged, with assets typically 50 to 100 times its own capital. To finance the inventory, there is a need to obtain repo money in large amounts on a continuing basis. Big suppliers of repo money are money funds, large corporations, state and local governments, and foreign central banks. Generally the alternative of

investing in securities that mature in a few months is not attractive by comparison. Even 3month Treasury bills normally yield less than overnight repos. Clearing Banks and Dealer Loans A securities dealer must have an account at a clearing bank to settle his trades. For example, suppose ABC company has $20 million to invest short term. After negotiating the terms with the dealer, ABC has its bank wire $20 million to the clearing bank. On receipt, the clearing bank recovers the funds it loaned the dealer to acquire the securities being sold, plus interest due on the loan. It then transfers the sold securities to a special custodial account in the name of ABC. Since government securities exist as book entries on a computer, this is a trivial operation. The next morning the dealer repurchases the securities from ABC, pays the overnight interest on the repo, and regains possession of the securities. Assuming a 5% repo rate, the interest due on the $20 million overnight loan would be $2,777.78, which is based on a 360-day year. If both parties agree, the repo could be rolled over instead of paid off, thus providing another day of funds for the dealer and another day of interest for ABC. If the dealer is short on funds needed to repurchase the securities, the clearing bank will advance them with little or no interest if repaid the same day. Otherwise the bank will charge the dealer interest on the loan and hold the securities as collateral until payment is made. Since dealer loans typically run at least 25 basis points above the Fed funds rate, dealers try to finance as much as they can by borrowing through repos. By rolling over repos day by day, the dealer can finance most of his inventory without resorting to dealer loans. It is sometimes advantageous to repo for a longer period, using a term repo to minimize transaction costs. Clearing banks charge a fee for executing dealer transactions. They prefer not to issue large dealer loans because it ties up the banks own reserves at little profit. In truth, there is not enough capacity in all of the clearing banks in New York to provide dealer loans sufficient to cover the financing needs of the large securities dealers. Matched Books in Repos A dealer who holds a large position in securities takes a risk in the value of his portfolio from changes in interest rates. Position plays are where the largest profits can be made. However many dealers now run a nearly matched book to minimize market risk. This involves creating offsetting positions in repos and reverses by reversing in securities and at the same time hanging out identical securities with repos. The dealer earns a profit from the bid-ask spread. Profits can be improved by mismatching maturities between the asset and liability side, but at increasing risk. As dealers move from simply using repos to finance their positions to using them in running matched books, they become de facto financial intermediaries. In borrowing funds at one rate and relending them at a higher rate, a dealer is operating like a finance company, doing for-profit intermediation.

Eurodollars

Many foreign banks as well as foreign branches of U.S. banks accept deposits of U.S. dollars and grant the depositor an account denominated in dollars. Those dollars are called Eurodollars. As we will see, they exist under quite different constraints from domestic dollars. While Eurodollar banking got its start in Europe, such banking is now active in major financial centers around the world. Importance of Eurodollars Today the Eurodollar market is the international capital market of the world. It includes U.S. corporations funding foreign operations, foreign corporations funding foreign or domestic operations, and foreign governments funding investment projects or general balance-of-payment deficits. Overseas branches of a U.S. bank are treated as an integral part of the parent bank. In its published statements the parent bank consolidates the assets and liabilities of all branches, domestic and overseas, and it has just one account at the Fed, held by the head office. However each overseas branch keeps its own books for day-to-day operations. An Example Suppose the AAA Corporation draws a check for five million dollars on Citibank, its New York bank, and deposits it at a London Eurodollar bank. The result is that the ownership of five million U.S. dollars has passed from AAA to the London bank in exchange for a Eurodollar time deposit. The London bank now holds a deposit at Citibank balanced by a liability, the time deposit credited to AAA. Since that money earns no interest at Citibank, the London bank will use the funds to make a loan, say to the BBB Corporation which banks at Wells Fargo. Citibank will then show a decrease of five million dollars on deposit at the Fed and a decrease in liability of that amount to the London bank. Wells Fargo will gain that deposit at the Fed and an equal liability as a deposit for BBB. The London bank will record a loan of five million dollars to BBB balanced by a time deposit owed to AAA. Eurodollars Never Leave the U.S. Regardless of where they are deposited, London, Bahrain, or Singapore, and regardless of who owns them, Americans or foreigners, Eurodollars never leave the U.S. Note that throughout both transactions there was no change in banking system reserves at the Fed, and the $5 million remained on deposit at a U.S. bank. A somewhat more involved analysis would show this to be true even if the Eurodollars had been lent to a foreign corporation.

In this example, the London eurobank is acting as a financial intermediary in U.S. dollars. It is doing much the same as any U.S. non-bank intermediary, like a finance company or a pension fund. Unlike domestic U.S. banks, Eurobanks cannot create money in U.S. dollars through the act of lending. Their lending only transfers ownership of deposits at U.S. banks. Eurobanking Practices Banking ground rules in the Euromarket differ sharply from those in the U.S. domestic arena. One important distinction is in the character of their liabilities. In the Euromarket, all deposits with the exception of call money have a fixed maturity that may range from one day to five years. Also, interest is paid on all deposits, the rate being determined by market conditions. For U.S. banks, another important distinction between their domestic and Euro operations is that no reserve requirements and no FDIC premiums are imposed against their Eurodollar deposits. Thus they can invest every Eurodeposit they receive. The Euromarket operates outside the control of any central bank. Eurobank Investments Banks accepting Eurodollar deposits use the dollars to make two sorts of investments, loans and interbank placements. All such placements, like other Eurodeposits, have fixed maturities and bear interest. The rate at which banks in London offer Eurodollars in the placement market is referred to as the London interbank offered rate, LIBOR for short. The usual practice is to price loans at LIBOR plus a spread. Some term loans are priced for the life of the loan, but far more often they are priced on a rollover basis. This means that every three or six months, the loan is re-priced at the prevailing LIBOR for 3- or 6-month money plus the agreed-upon spread. Source of Eurodollar Funds The funds that form the basis for the Eurodollar market are provided by a wide range of depositors: large corporations (domestic, foreign, multinational), central banks and other government bodies, supranational institutions such as the Bank for International Settlements, and wealthy individuals. Most of the funds come in the form of time deposits with fixed maturities. The Eurobanks also receive a certain amount of call money. A call account can be a same-day value account, a 2-day notice, or a 7-day notice account. The going rate for call money closely tracks the overnight Eurodollar rate, which in turn is tied by active arbitrage to the U.S. Fed funds rate. The main attraction of a call deposit is liquidity. Time deposits pay more, but a penalty is incurred if such a deposit is withdrawn before maturity.

Lender of Last Resort Two questions arise regarding the liquidity of the Euromarket: Who lends if the supply of Eurodollars dries up? Who lends if the solvency of a major bank in the Euromarket is threatened? The dollars don't disappear, but its possible that holders of Eurodollar deposits could move them back to banks in New York. Thus Eurobanks could face a liquidity crisis. To protect against any such risk, many have negotiated standby lines with U.S. banks. In addtion, central banks have concluded that each looks after its own. Thus the Fed is the appropriate lender to a U.S. banker whether its troubles arise from its New York or London operations. Other central banks are expected to stand behind their own domestic banks both at home and abroad.

Foreign Exchange
Payment involving the transfer of bank deposits from the buyers account to the sellers account is very simple if both buyer and seller share the same bank. The process is only a little more complex when they have different banks if both banks are part of the same clearing system. If the two banks are in different clearing systems, payment is substantially more complex. A Case of Different Clearing Systems Consider a U.S. importer who buys a shipment of Swiss watches. Assume the exporter requires payment in francs to his account at a Swiss bank, which of course is in a different clearing system. Normally the importer will go to the foreign exchange desk of his own bank and pay the dollars required to buy the francs as a deposit in a Swiss bank. The details of this transaction are handled by his own bank. A check can then be drawn on the Swiss bank in payment to the exporter. When the exporter deposits the check in his Swiss bank, it will clear in the normal fashion through the Swiss banking system. Where does the U.S. bank get the Swiss francs to sell to the importer? If the bank is large enough and does business in foreign exchange, it may maintain a deposit of its own at a Swiss bank. If not, it can buy the francs in the interbank market in foreign currencies where the ownership of deposits in different currencies is traded. Small banks may need the services of a correspondent bank that has trading facilities. Use of a Forward Contract If the importers payment is not due for say three months, he can buy a forward contract with his bank for delivery of francs at that time. This locks in the dollar price and thus protects him against changes in the exchange rate before actual payment is required. If the amount were large enough, the bank would hedge its own risk with a currency swap in the foreign exchange market. A currency swap consists of two simultaneous transactions. In this example, one would be the purchase of francs for dollars for immediate delivery in the spot market. The other would be a contract in the forward market allowing the bank to sell francs for dollars at an agreed upon price three months hence. At that time the francs would be delivered as required. The currency swap locks in the exchange rate and thus protects the bank. The bank makes its profit as a markup in the forward contract bought by the importer.

The Foreign Exchange Market Because so much of world trade is conducted directly in US dollars, foreign exchange between non-U.S. currencies usually involves conversion into and out of U.S. dollars. The foreign exchange market is an international market, active around the clock. London has by far the largest market, followed by New York, Tokyo, and Singapore. Large banks and security dealers maintain trading rooms where they post on computer screens around the world their bid and ask prices for currencies relative to the U.S. dollar. Quotes are offered for both the spot market and the forward market. Foreign exchange trading has grown rapidly since 1971. That is the year Nixon ended gold backing for the U.S. dollar in international payments, thus leaving the exchange rates of the worlds currencies to float at market prices. The volatility of those rates has increased dramatically since the mid-1970s, creating investment risk as well as opportunities for speculative gain. Foreign exchange trading in support of commerce is now just the tip of the iceberg, probably less than 5% of the total.

Direct vs Indirect Lending

The financial system offers two different ways to lend: (1) direct lending through financial markets, and (2) indirect lending through financial intermediaries, such as banks, finance companies, and mutual funds. Direct Lending Direct lending involves the transfer of funds from the ultimate lender to the ultimate borrower, most often through a third party. An example is a private party purchasing the securities issued by a firm. The securities are usually sold to the public through an underwriter, someone who purchases them from the issuer with the intention of reselling them at a profit. The underwriter negotiates the terms of the contract with the borrower and appoints a trustee, typically a commercial bank, to monitor compliance. Because of the costs involved, the issue of securities makes sense for the borrower only when the amount to be raised is substantial. If the security is a bond issue, the borrower is obligated to return the principal at maturity and to pay interest during the period of the loan. If the securities are equities, the borrower has no obligation to return the principal, but is expected to pay dividends. What if the lender needs his money back immediately? The only solution is to sell the security in the secondary market. However a secondary market will exist only if someone has created it. Secondary Markets There are two types of secondary markets, dealers and brokers. Dealers stand ready to buy or sell from their own inventory at quoted prices, profiting by the markup in those prices. Brokers simply bring buyers and sellers together but do not buy or sell securities. Their profit is normally a commission on the resulting sale. The existence of a good secondary market is of benefit to borrowers as well as lenders. It makes the loans more liquid and therefore more attractive to lenders. A more attractive loan lowers the cost to the borrower. Indirect Lending Indirect lending is lending by the ultimate lender to a financial intermediary who pools the funds of many lenders in order to re-lend at a markup over the cost of the funds. The ultimate borrowers are normally unknown to the ultimate lenders. A lender faces less risk in indirect lending because, as a specialist in the field, the intermediary normally has a well-established credit standing. Of course, lower risk usually means less gain for the lender. Indirect lending generally offers lower cost to the ultimate borrower for small or short-term loans. Most borrowers lack sufficient credit standing to borrow directly. Borrowers who do have that option may find it cheaper, especially for large sums. In fact it may not even be

possible to borrow large sums indirectly through intermediaries. The capacity of the direct financial markets is much larger than that of even the largest intermediaries. Comparison of Risks The two types of lenders face different problems with borrowers in financial difficulty. With direct lending, rescheduling a loan is problematic because the relationship is generally at arms length and legalistic. The risks are often unknown to the lender. With indirect lending, the intermediary is usually in a much better position to know whether the problem is permanent or temporary. As the sole lender, the intermediary can alter the terms without having to obtain the agreement of others.

Understanding Government Debt

"Our nation's wealth is being drained drop by drop because our government continues to mount record deficits. The security of our country depends on the fiscal integrity of our government, and we're throwing it away." Senator Warren Rudman. Warnings like this are commonplace today. The assumption is that the Federal government has limited financial resources and at some point will be unable to service its growing debt, in short that it will become bankrupt. Responsible fiscal policy is viewed as requiring a balanced budget. Individuals and firms can indeed borrow their way into bankruptcy. There is no such danger for the government when it borrows in the same currency that it creates. In a fiat money system the government has just as much money at its disposal under a budget deficit as with a budget surplus. When we adopted a monetary base of intrinsically worthless paper money in the mid-20th century, we created a new paradigm that is still widely misunderstood. The imperatives are quite different from those of the earlier gold-based system. The key to maintaining the purchasing power of money is to control the price of credit. That means controlling the cost to banks of acquiring the reserves they need to cover their depositors' transactions. The Fed has the primary responsibility, but the Treasury plays an indispensable role.

Government Money We can think of "government money as existing in two forms: the monetary base issued by the Fed, and securities issued by the Treasury. Base money represents immediate purchasing power, while Treasury securities represent future purchasing power. Treasury securities necessarily pay interest to compensate owners for the delay in purchasing power. The private sector runs mainly on bank money created by banks when they lend to the public. Banks must hold enough reserves of base money to cover their depositors' transactions. The amount they must hold varies with the net amount of borrowing, which in turn depends on the interest rate. Since the Fed controls the interest rate, it is ultimately up to the Fed to limit the demand for bank money to what the public can absorb without undue inflationary pressure. Treasury Operations The Treasury deposits its receipts from taxes and the sale of its securities into accounts at commercial banks, known as Treasury Tax and Loan (TT&L) accounts. It spends out of its account at the Fed, and replenishes that account with transfers from its TT&L accounts. To minimize variations in aggregate reserves of commercial banks, the Treasury targets a constant balance in its Fed account. Thus for all practical purposes, the Treasury spends out of its commercial bank accounts. If Treasury outflows consistently exceeded inflows, the money supply would steadily increase and create unacceptable inflationary pressures. Therefore the Treasury recaptures all of its spending on average. It does so with taxes and the net sale of securities when there is a shortfall in tax revenues. In effect the Treasury pays for its deficit spending by issuing securities rather than base money. That means deficit spending has no net effect on the immediate purchasing power of the private sector. Tax or Borrow? The choice between government taxing and borrowing, i.e. fiscal policy, is entirely at the discretion of Congress. That choice has economic consequences which can be either good or bad. Unfortunately fiscal policy is often governed by the belief that deficit spending is ipso facto bad. The real economic consequences are seldom considered in that decision. Deficits represent no financial risk to either the government or the public. All too often the focus has been on irrelevant accounting issues. Indeed attempts to balance the budget can easily be counterproductive, especially during recessions. Conversely when the economy is sluggish or in recession, deficit spending helps support aggregate demand needed for recovery. Rolling Over Government Debt Nothing about government debt requires that it be paid off. Of course individual securities must be redeemed as they mature, but the Treasury can roll over its maturing debt indefinitely. Rolling

over means selling new securities to pay for the redemption of maturing securities. This involves no new tax revenues. Treasury securities offer a risk-free, interest-earning alternative to base money spent into circulation by the government. If the private sector has more non-interest-earning base money in the aggregate than it wishes to hold, its only alternative is to buy Treasury securities. Since the Treasury can pay whatever interest rate the market demands, there will always be willing buyers of its securities. Net financial wealth of the private sector Treasury securities are valuable assets for the holders. They can readily be sold for money or pledged as collateral for loans. Together with the monetary base created by the Fed, they comprise the net financial wealth of the private sector. By contrast, bank lending cannot change the net financial wealth of the private sector because bank credit is matched by an equal amount of borrower debt. The value of Treasury securities to the private sector as a whole is in the principal, not in the interest payments they shed. The interest payments are matched by tax revenues, and are therefore a wash in the aggregate. Some fear that as the national debt grows it will create an ever increasing inflation rate. That fear is not supported by the historical record. The debt/GDP ratio reached an all-time high at the end of World War II, yet the inflation rate during the next two decades averaged only 2%. In the following decade the debt/GDP ratio fell to a long-term low, while the inflation rate averaged about 8%. If there is an upper limit to the debt in terms of its effect on the inflation rate, it has yet to be experienced.

Recycling Money
This article traces money flows within the U.S. We deal with two types of money, base money and bank money, and focus on how they move between the public, the banks, the Fed, and the Treasury. The public comprises firms and households, which are the producing and consuming sectors of the economy. Banks comprise the depositories which provide payment services as well as financial intermediation for the public. Base Money The monetary base is the definitive money of the nation. It exists in two forms (1) notes and coins issued by the Fed, and (2) deposits of banks at the Fed. Both are referred to here as base money, and are interchangeable on demand. The Fed has sole authority for issuing base money. It does so by purchasing Treasury securities for its own portfolio, and crediting the seller's bank with a deposit at the Fed. This is known as monetizing the debt. Conversely when the Fed sells securities, that amount of base money vanishes. Although base money is not a claim on any Fed assets, it is carried as a liability on the Fed's balance sheet, backed by the financial assets it has purchased. Normally, the Fed only acquires Treasury securities because of their liquidity and credit-worthiness. However to deal with the 2008 financial crisis, the Fed expanded the list of eligible securities significantly. In the past, the Fed issued only non-interest-earning liabilities. As of October 2008, it has authority to pay interest on the excess reserves it holds on deposit for banks. That interest rate is currently set at 0.25%, but will no doubt be increased as the economy recovers and the interbank lending rate is returned to more normal levels. Bank Money and Bank Reserves Banks issue credit when they accept deposits and when they create new deposits to fund loans. A bank checking deposit represents a promise to deliver base money on demand. Since bank deposits can be easily transferred by check or electronic means, they serve as a medium of exchange, and therefore as money. A banks reserves comprise its vault cash plus its deposit at the Fed, known as Fed funds. Any payment involving the transfer of deposits between banks requires an equal transfer of Fed funds between the respective banks. When one writes a personal check to make a purchase, the bank's account at the Fed is debited to cover the check. That means a bank must have reserves of base money in order to do business. In the special case when the check is deposited in the same bank on which it is drawn, only a transfer of deposits within the bank is involved. Bank reserves comprise a small fraction of the monetary base, but they play a key role. The Fed adds or drains reserves as required to balance the supply and demand at its target Fed funds rate. Aggregate reserves increase when the Fed buys Treasury securities from the public and decrease

when it sells Treasury securities. The public also affects aggregate reserves when it deposits or withdraws cash from banks, causing the Fed to rebalance reserves to compensate for changes in aggregate vault cash. When the Fed needs to adjust banking system reserves, it deals with a group of financial institutions known as primary dealers comprising banks and securities dealers. It does not concern itself with individual banks needing reserves. Banks short of reserves have to borrow them in the money market or in the Fed funds market from those long on reserves. They can also borrow from the Fed, but only at a penalty rate above the Fed funds target rate. The Transaction Money Supply The Fed has defined a measure of the transaction money supply and named it M1. It consists of (1) cash in circulation, (2) travelers checks, and (3) demand deposits at commercial banks, but not the deposits of other banks, the US government, and foreign central banks. Note that the money supply comprises only liabilities of the Fed and the banking system. Reserves are bank assets, and not a part of the money supply. Although cash is the ultimate form of money, by dollar volume it plays a minor role in the economy. Cash and travelers checks are used mainly as portable money in retail purchases. The largest volume of transactions by far involves the transfer of bank deposits, i.e. bank money. M1 reflects the demand for liquidity (immediate spending power) by the private sector. The demand increases with inflation and varies with economic conditions. For example, during recessions both firms and households spend less, so they usually move some of their demand deposits into interest-earning savings vehicles like T-bills and CDs. Of the many factors that influence M1, the most significant is the demand for Federal Reserve notes which has been steadily growing. Most of that demand comes from overseas, but the increasing immigrant population in the US is also an important factor. As more notes are withdrawn from banks, the Fed must buy more Treasury securities from the public to prevent a drain on banking system reserves. This effect is seen most clearly in the steady growth of Treasury securities in the Fed's portfolio. Treasury Operations The Treasury deposits its receipts from taxes and the sale of its securities in commercial bank accounts, known as Treasury Tax and Loan (TT&L) accounts. Like ordinary bank accounts, TT&L accounts are bank money but are not a part of M1 because they are owned by the government. The Treasury writes checks against its account at the Fed. That injects base money into the banking system, which increases aggregate banking system reserves. However it simultaneously transfers funds from its TT&L accounts to replenish its Fed account, which reduces banking system reserves. By targeting a constant balance in its Fed account, it minimizes disturbances in the aggregate reserves of the banking system, and thereby facilitates the Feds control of the Fed

fund rate. For all practical purposes, the Treasury pays its bills out of its commercial bank accounts. The Treasury has no use for funds in its TT&L accounts in excess of its near-term payment obligations. On average it matches inflows against outflows by selling or redeeming its securities as required. In effect, the public pays for those securities with funds received from government deficit spending itself. Thus, except for short-term transients, neither budget deficits nor budget surpluses affect the money supply.

Managing Treasury Flow of Funds

The U.S. Treasury receipts from taxes and the sale of securities now total well over $2,500 billion a year. Almost all of that comes out of the bank deposits of taxpayers. Banks must cover those payments with their own reserves on deposit at the Fed, but bank balances at the Fed total less than $25 billion. How can banks manage such a large flow of funds on so little reserves? Treasury Tax and Loan Program The answer is that the Treasury spends on average as much as it receives. Its spending replenishes banking system reserves about as fast as they are used. However there can be significant short-term imbalances between inflows and outflows. Banks would be in trouble if the Treasury made no provision for those imbalances. That is the principal purpose of the Treasury Tax and Loan (TT&L) program. All tax payments by individuals and businesses go into Treasury accounts at depository institutions called TT&L accounts. Government spending, however, is paid out of the Treasury account at the Federal Reserve. The Treasury must therefore replenish its Fed account with frequent transfers from its TT&L accounts. Payments deposited in TT&L accounts cause a transfer of reserves within the banking system but do not change the total. However when TT&L deposits are moved to the Treasury's account at the Fed, banking system, reserves decrease accordingly. By targeting a constant balance in its Fed account, nominally $6 billion, the Treasury helps to maintain the reserves of the banking

system at a nearly constant level. This is key to enabling the Fed to maintain control of the Fed funds rate, its primary monetary policy tool. The Role of Depository Institutions A depository institution can participate in the TT&L program in any of three ways: as a collector, retainer, or investor institution. Collector institutions act as tax collection conduits. They accept tax payments from businesses, and transfer the payments to Treasury accounts at district Federal Reserve Banks. A retainer institution also accepts tax payments, but retains the payments in an interest-bearing "Main Account" until called for by the Treasury. If the Main Account balance exceeds the institution's balance limit or if it exceeds the collateral value of assets pledged by the institution, the rest is transferred promptly to a Treasury account at the district Federal Reserve Bank. An investor institution does everything a retainer institution does, and also accepts discretionary investments from the Treasury. Direct investments are credited to the institutions Main Account, and must be collateralized. They pay interest to the Treasury at the weekly average overnight federal funds rate, less 25 basis points. Tax Collection Methods from Businesses The taxes paid by businesses consist mainly of witholdings of personal income taxes, corporate income taxes, and social security contributions. The Treasury now uses two mechanisms to collect these taxes: The Paper Tax System (PATAX), and the Electronic Federal Tax Payment System (EFTPS). In the PATAX system, a business makes federal tax payments by preparing a federal tax deposit coupon and delivers the coupon and the check to its depository institution. Upon receipt, the institution debits the customer's checking account and credits an interest-free Treasury tax collection account. The depository institution must pledge collateral to cover any balances that exceed its insurance coverage. The following day, the balance in the account is transferred to a Federal Reserve bank if the institution is a collector institution, otherwise to the Main Account in the same institution. A business enrolled in the EFTPS makes a tax payment by authorizing, by telephone or computer, withdrawal of the payment from its account at a participating depository institution on a specified future date. On the payment date, the funds are transmitted to a Treasury account at a Federal Reserve Bank via an automated clearinghouse (ACH) transfer. If the participating institution is a retainer or investor institution with sufficient free collateral and room under its balance limit to accept additional funds, the payment is immediately routed back to the institution's Main Account. EFTPS was first required for large business taxpayers in the fall of 1996. Subsequently it became mandatory for any business making more than $200,000 in aggregate annual tax payments.

Stabilizing Treasury Balances at the Fed In July 2000, the Treasury and the Fed implemented the Treasury Investment Program (TIP), a major revamping of the TT&L infrastructure that centralized at the FRB St. Louis many of the functions previously carried out by the individual Federal Reserve Banks. The consolidated functions include tracking Main Account balances, monitoring collateral, and investing and calling Treasury balances. TIP now allows Treasury cash managers to monitor many fund transfers on a nearly real-time basis and thus reduce the errors in maintaining the Treasury balance at the Fed. This in turn reduces the amount of open market operations the Fed must conduct to hold the interbank lending rate (Fed funds rate) on target.