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.
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