Understanding Fed Held Reserves

 Why the Fed Must Treat Its Securities at Face Value: The Hidden Logic of a Par-Based System

The Federal Reserve System operates at the core of the U.S. monetary architecture, yet it's frequently misunderstood—even by professionals—when it comes to how it values the assets it holds. In particular, there's growing confusion around the use of amortized cost in the Fed's accounting, and how that relates to its actual operations involving Treasury securities, reserves, and reverse repos.

This post unpacks why the Fed must treat its securities at face value operationally, even though it uses amortized cost for internal accounting—and why any deviation would introduce fatal mismatches into the reserve system.

---

1. Reserves Are Backed by Fed Assets at Face Value

Reserves are not just digital entries—they are claims on the Fed's balance sheet, backed by real assets. These claims are designed to be fungible and transferable across the banking system on a 1:1 basis, with no pricing variability.

To support this, the Federal Reserve holds collateral—mostly U.S. Treasuries—at face value. This ensures that each $1 in reserves is backed by $1 in Fed-held assets, preserving legal parity and systemic integrity.

Crucially, there is a 1:1 relationship between reserves and Federal Reserve Notes (legal tender). The same assets that back reserves at face value also serve as collateral for the issuance of currency. This creates a unified monetary base, with a consistent valuation anchor: face value of Fed-held assets.

---

2. Amortized Cost Creates Irreconcilable Pricing Mismatches

If the Fed were to treat its holdings at amortized cost in operational terms (not just in reporting), it would introduce unavoidable inconsistencies:

• Buying a bond at $95 (discount) would back only $95 in reserves

• Buying a bond at $105 (premium) would back $105 in reserves

Yet interbank transactions always assume reserves are worth $1 per $1, not subject to market drift. Any attempt to back reserves with fluctuating asset valuations destroys the par foundation of the system.

---

3. Interbank Payments Require a Closed, Par-Based System

The Fed facilitates interbank settlement through reserves, and these reserves are:

• Uniform in value

• Cleared at par

• Backed by assets valued at face

There is no room for market-based variability in the reserve system. If Bank A's $1 in reserves isn't worth the same as Bank B's, the system loses coherence. That’s why market value and amortized cost are accounting fictions in this domain.

---

4. The Role of Reverse Repos Reinforces the Face-Value Logic

The Fed's reverse repo (RRP) facility allows it to drain reserves by lending securities temporarily. These transactions are:

• Structured around face-value exchanges

• Compensated with interest to maintain parity

If amortized cost mattered here, it would introduce pricing arbitrage, misalignments in reserve value, and disruptions in monetary control. Instead, the Fed ensures all reserve movements retain a 1:1 asset backing at face value.

---

5. Why Face Value Is Operational, Amortized Cost Is Optical

The key distinction is this:

• Face value governs operations (reserve creation, collateral, RRP)

• Amortized cost governs internal reporting (yield smoothing, P&L, disclosures)

So-called "unrealized losses" are meaningless to the system's function, because the Fed does not mark its assets to market for reserve-backing purposes. When a bond matures, it pays out at face. Period.

---

Conclusion: Only Face Value Preserves Systemic Parity

The Fed's role is not to profit on bond trades. Its securities are not investments—they are tools. And to function as monetary instruments, they must retain their face value discipline throughout their lifecycle.

Face value keeps the reserve system coherent. Amortized cost is just an internal lens.

When commentators fret about "unrealized losses" or the Fed's "insolvency," they are mistaking accounting optics for operational mechanics. The real machinery of the Fed runs on par, and always has.

---

 The Fed’s Passive Machinery: Unmasking the Fiction of Money Creation

The Federal Reserve’s balance sheet is often portrayed as the heart of the U.S. economy, a powerful tool for steering credit, controlling inflation, and shaping fiscal policy. But this narrative is a myth, rooted in a 19th-century fiction that bank deposit accounts are money. In reality, the Fed’s balance sheet is a passive machinery, a record-keeping device constrained by the banking system’s needs, disconnected from private credit creation, and unable to directly influence inflation or government spending. This post exposes the truth: banks create debt, not money; dollars (legal tender) are the real money; and the system hides that banks lack the dollars to back the deposits we treat as cash.

The Fed’s Balance Sheet: A Passive Ledger, Not a Control Panel

The Fed’s balance sheet, valued at $7.2 trillion (May 2025), holds assets like U.S. Treasuries ($4.6 trillion) and mortgage-backed securities ($2.2 trillion), backing liabilities such as bank reserves ($3.1 trillion) and Federal Reserve notes (~$2.3 trillion). Mainstream narratives suggest the Fed uses this to “create money” or “tighten liquidity.” But the reality is different:

• Assets are stuck: The Fed can’t sell its assets without disrupting interbank liquidity. Reserves, claims to these assets, are essential for banks to settle transactions (via Fedwire, ~$1 quadrillion annually). Selling assets drains reserves, risking crises like the 2019 repo spike when reserves fell to ~$1.4 trillion.
• Liabilities are untouchable: Reserves and notes (legal tender, per 12 USC 411) support the banking system’s operations. Reducing them threatens stability, as banks rely on reserves for settlements and notes for cash demand.
• Passive role: The Fed reacts to banks’ needs, not the other way around. Banks’ demand for reserves and notes dictates the balance sheet’s size, making it a record-keeping device for reserves, notes, and Treasury interactions (e.g., Treasury General Account, ~$0.7 trillion).

The Fed isn’t pulling levers; it’s maintaining the plumbing of a system driven by banks.

Banks Create Debt, Not Money

Textbooks claim banks “create money” when they lend, but this is a misnomer. When a bank issues a $100,000 loan, it creates a $100,000 deposit—a liability, a promise to pay dollars, not dollars themselves. These deposits (~$17 trillion of M2 ~$21 trillion) are counted as money because they’re accepted for payments, taxes, and debts. But they’re debt, a bank IOU, not money in the true sense.

• Dollars are money: Only Federal Reserve notes (~$2.3 trillion), legal tender per 31 USC 5103, are true money, issued by the Fed and collateralized by assets (per 12 USC 411). Deposits are bank-created debt, not dollars.
• Endogenous money: Banks lend based on demand and capital, not reserves ($3.1 trillion), creating deposits endogenously. Loan growth ($12 trillion, C&I loans up ~2% YoY) drives M2, not Fed actions, disconnecting the balance sheet from credit creation.

The 19th-century fiction that “deposits are money” (e.g., legal acceptance of checks, 1848’s Foley v. Hill) conflates bank debt with dollars, obscuring the system’s structure.

The System Hides Banks’ Lack of Dollars

The banking system is designed to make deposits feel like dollars, but banks hold shockingly few actual dollars to back them:

• Vault cash reality: Banks operate on vault cash ($0.2 trillion), the physical notes in branches and ATMs, not the total currency in circulation ($2.3 trillion, much of it abroad). This covers just 1.2% of deposits ($17 trillion).
• Dollar scarcity: If depositors demanded cash, banks couldn’t deliver—notes ($2.3 trillion) and reserves ($3.1 trillion, convertible to notes) cover ~18% of deposits. A bank run would expose this gap, as seen in historical crises (e.g., 1930s, 2008).
• Systemic facade: Digital payments (~80% of transactions, 2024 Fed data), Visa-like networks, and Fedwire (transferring reserve claims, ~$1 quadrillion annually) make deposits seem like dollars. The Fed ensures banks can access notes or settle claims, hiding the shortfall.

The system’s plumbing—Fedwire as a mechanism transferring claims to assets (like Visa for deposits)—sustains the illusion that banks have the dollars they don’t.

Quantitative Tightening: A Monetary Mirage

Quantitative tightening (QT), the Fed’s attempt to shrink its balance sheet (~$1.2 trillion reduction since 2022), is often sold as a way to “pull liquidity” from the economy. But it’s a fiction:

• No impact on deposits: QT, via roll-offs ($60 billion/month, Treasuries and MBS maturing), primarily reduces the Treasury General Account ($0.7 trillion), not reserves (~$3.1 trillion) or deposits (M2 stable at ~$21 trillion). Deposits, bank debt, persist unless borrowers default or banks fail.
• Limited reserve effect: Roll-offs don’t directly drain reserves, unlike open market operation (OMO) sales. Even OMO’s reserve reductions don’t destroy deposits, as banks lend endogenously.
• No economic control: QT can’t steer credit (loan-driven) or inflation (e.g., 2021–22 spikes from supply/fiscal factors), as the balance sheet doesn’t touch deposits, the economy’s lifeblood.

QT’s failure to shrink M2 shows the Fed’s balance sheet is disconnected from the real economy, a passive ledger, not a policy tool.

No Constraint on Government Spending

Pundits claim the Fed’s balance sheet limits government spending, but this is false. When the government spends, it creates deposits (bank debt) by issuing Treasuries or drawing on the TGA. The Fed accommodates this:

• Treasury operations: The Fed buys Treasuries ($4.6 trillion held) or manages the TGA ($0.7 trillion), ensuring liquidity for fiscal policy.
• No dollar limit: Spending creates deposits, not reliant on physical dollars (~$2.3 trillion). The deposit-as-money fiction enables this, as banks absorb government debt as new deposits.

The balance sheet reacts to fiscal needs, not constrains them, debunking deficit hawk myths.

The 19th-Century Fiction at the Core

The modern monetary system rests on a 19th-century fiction: bank deposit accounts are money. Legal and economic shifts (e.g., 1848’s Foley v. Hill, check acceptance) equated bank debt (deposits) with dollars, creating a system where:

• Banks dominate: They create deposits (~$17 trillion) through lending, not Fed-controlled dollars.
• Fed as backstop: The balance sheet ($7.2 trillion) provides reserves ($3.1 trillion, claims to assets) and notes (~$2.3 trillion) to make deposits function as dollars, but it’s passive, per banks’ discretion.
• Illusion persists: The system hides banks’ dollar scarcity (vault cash ~$0.2 trillion vs. deposits ~$17 trillion), with Fedwire and Visa-like systems transferring claims, not dollars.

This fiction locks the Fed into a reactive role, supporting a debt-based economy it can’t control.

Conclusion: A Passive Machinery, Not a Mastermind

The Fed’s balance sheet isn’t a tool for steering the economy—it’s a passive machinery, a ledger tracking reserves ($3.1 trillion), notes ($2.3 trillion), and Treasury interactions to sustain the illusion that bank deposits (~$17 trillion) are dollars. Banks create debt, not money, and the system hides their lack of dollars (vault cash ~$0.2 trillion). QT is a fiction, unable to shrink deposits; credit and inflation are driven by banks and external factors, not the Fed; and government spending faces no balance sheet limit. Rooted in a 19th-century fiction, the monetary system thrives on a lie: deposits aren’t dollars, but we treat them as such. It’s time to see the Fed for what it is—a record-keeper, not a ruler.