The Federal Reserve System and the BIS

As with all my articles, I offer no warranty express or implied on the accuracy of what I write. Opinions expressed are my own opinions alone, and anybody proposing to take any sort of commercial action on the basis of anything in these articles must do their own due diligence exercise. What follows is a personal view.

I think that the Federal Reserve System, popularly known as the Fed, is one of the most extraordinary financial institutions in the world. Consider: although created by an Act of the United States Congress in 1913, it is owned by stockholders. It reports to Congress, but it's controlling body, the Board of Governors, is appointed by the President of the United States and confirmed by the Senate. It is the chief fiscal policy making body of the United States, but it is autonomous and separate from the Treasury and thereby from Government. It's Governors are very independent - their appointments are long and staggered while that of the President is short, and so they are not overly influenced by the President of the day. I think the Fed truly acts in the best interests of the United States economy.

Within the United States it acts through a system of regional Reserve Systems, the most important probably being the New York Fed. Like all central banks, these regional Feds act as lenders of last resort within their regions, and can fall back on the US Fed in time of need. They fix regional discount rates subject to US Fed approval, and given a competent Fed Chairman like the present incumbent the remarkable Alan Greenspan, the whole system works very well.

The Fed however has no authority outside the United States, even though a large quantity of US currency is more or less permanently resident outside, [ the so-called Eurodollar pool ]; but it does have a great deal of influence. The subject of these articles - Private Placement Programs or HYIP's - are not permitted inside the United States. So we need to understand how the Fed's international influence is exercised.

It seems to me that there are three main methods involved. The first is based on the fact that the supply of US$'s, and thereby the size of the Eurodollar pool, is controlled by the Fed. At present they are doing their best to attract these Eurodollars back to the USA, through such mechanisms as the Rule 144a exemptions dealt with in our article No.3 last week. The other method is by the use of its influence as the major shareholder in the Bank for International Settlements ("BIS"). The BIS has its headquarters in Basel in Switzerland. The Fed is its largest shareholder. Others include the Bank of England, Bank of France, The Central Bank of Belgium, Central Bank of Germany, Central Bank of Japan, J.P. Morgan, The National Bank of New York, First National Bank of Chicago, the central banks of Sweden, Romania, Poland the Netherlands and Switzerland. The function of the BIS is to act as the Central Bank of the world's central banks.

The third, and the most relevant to our articles, is the control of the Fed over off ledger trading in bank instruments denominated in US$'s. Each trade or programme of trades must have the approval of the Fed, normally granted through the London offices. That is why most trade contracts are signed by banks in their London premises. The developments which led to the beginning of off ledger trading started in 1978 when the Federal Government of the United States was faced with what in commercial terms would be regarded as bankruptcy. The New York banking community was owed over half a trillion dollars by the Federal Government, a debt which required servicing at the rate of a billion dollars a week just to keep the government working - a sum which could only be raised through additional borrowing. The classic Debt Trap. However there was an additional problem which impacted directly on the Fed - the commercial banks were beginning to run out of foreign currency.

The Fed was thus faced with a dilemma - it could simply print more money and live with the resultant inflation spiral, or it could try to bring back into the domestic economy some of the Eurodollar pool - and in 1978 the pool was exceptionally large due to the oil crisis of the '70's and the resultant stockpile of Eurodollars in the hands of the oil producing countries. It has been estimated that by 1978 they had between them more than the entire debt of the US Federal Government, mostly banked with non US banks.

The decision was taken to create a climate which would encourage offshore Eurodollar holders to bring back into onshore circulation. We have looked at Rule 144a and the trade in unregistered securities elsewhere. But in addition, the Note Issuance Facility was born. Under this arrangement, banks are permitted to act as marketing agents for their own debt paper, and trade in Medium Term Notes (MTN's) exploded. MTN's are normally issued in denominations of $100 million, either with 10 year redemption dates and 7.5% coupons, one year and 8% coupons, or zero rated one year notes. They are issued at discounts dictated by the markets and the coupons, and on-sold at a lesser discount, thereby creating the profit which is central to the Private Placement trade; BUT they can only be issued against the existence of a Reserved Account full of an equivalent sum of US Dollars. The restrictions on investment in these areas which we have covered in previous articles insure that these reserved accounts are created primarily with Eurodollars.

I have tried here to show the relevance of the Fed to Private Placement Programs, and to sketch the historical background to the present position. As ever, if any reader can correct, or amplify, anything I have written, I would be delighted. I have emphasized elsewhere that the purpose of this Newsletter and of our website is to examine this extraordinary trade and to separate the fact from the fiction. So far the contribution from readers has been minimal, but I live in hope!


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