Thoughts on capturing legal risks in interest rates … – Alton Drew

What I’m reading today: A Lawyer’s Perspective on U.S. Payment System Evolution and Money in the Digital Age. Source: Board of Governors of the Federal Reserve System.

In 2022, the Board of Governors of the Federal Reserve System published a paper authored by Jess Cheng and Joseph Torregrossa discussing the legal underpinnings of the payment system in the United States and thoughts on how digital assets could be incorporated into the current payments system. In part, the authors concluded that:

“[T]he U.S. payment system is composed of a growing multiplicity of issuers of money and payment arrangements. Diversity and responsible innovation in the payment system traditionally have served consumer and business needs well, enabling competition and reflecting market preferences for holding and using different forms of money for different types of transactions. Though complex, the system is able to function smoothly and safely largely because of the Federal Reserve’s role as a network hub that supports efficient interoperation of the system’s component parts and because of the unique stability of settlement on the Federal Reserve’s balance sheet. From a legal perspective, although different legal bases underpin different arrangements, U.S. payments law as a whole (commercial law, the regulatory regime, and the supervisory framework) aims to provide certainty and predictability that “one dollar” has a singular meaning in whatever form it takes.”

Reading the article from a perspective of risk to contract making, I asked myself two questions. One, what does the ready ability of a Federal Reserve note as a medium of exchange for goods and services based on the full faith and credit of the United States actually mean? This question came to mind when the authors discussed how the legal concept of a federal reserve note translated to the economic functions of money. Today, we can’t redeem a federal reserve note for gold or silver. U.S. legal tender is only redeemable in the form of a dollar or another federal reserve note. According to the authors, a federal reserve note is readily able to be exchanged for goods and services because it is an obligation of the United States and backed by the full faith and credit of the US government.

I thought this conclusion was a bit round about. A more direct translation from law to economy is that the dollar can be exchanged for goods and services because the government provides an economy that generates a myriad of goods and services such that individuals here and abroad are willing to sell their labor, goods, and services in order to earn US dollars and buy into a diverse and productive American market.

The second question I had as I read the article was, are interest rates accounting for the risks that occur when liabilities (claims of customers on their bank deposits) outweigh the value of bank assets?

The authors discussed the payments system where in a nutshell the Federal Reserve acts as a hub between multiple payment systems embodied in commercial banks. JP Morgan’s bank customers can move money between themselves where the bank reduces a payor’s account by x amount of cash and increases the payee’s account by x amount of cash.

Since a bank customer’s account represents a contractual claim on their deposit with a bank, it means that when a bank reduces the amount of cash in a customer’s account, the liability the bank has to that customer is also reduced and vice versa. When the cash in a customer’s account is increased, the bank’s liability to that customer is increased as well.

Now insert the Federal Reserve in the mix. JP Morgan and Wells Fargo have master accounts at the Federal Reserve where these accounts are used to help move money between customers of both banks. When a customer of JP Morgan’s payment system wants to move money to a customer of Wells Fargo’s payment system, the Federal Reserve reduces its liability to JP Morgan by reducing the bank’s federal reserve master account by the amount of its customer’s payment and increases the liability to Wells Fargo when the Federal Reserve increases the amount in Wells Fargo’s federal reserve master account.

I see risks where assets held by banks that back these liabilities, for example, loans to customers or the source of cash on deposit, are faulty. We got a major glimpse of this in 2023 when a number of banks failed as a result of increases in interest rates driving down the value of assets held by banks. Since monetary policy is the use of interest rate strategy to manage the supply of money, should we, at a minimum, expect a legal framework that requires an accounting for potential risks short of government interfering in the actual making of interest rates?

Alton Drew

28 March 2025

The Data …

Foreign exchange per the Board of Governors of the Federal Reserve System.

EUR/USD=1.0806

GBP/USD=1.2896

USD/JPY=148.9800

Administered rates per the Board of Governors of the Federal Reserve System.

Discount Window: 4.50%

Effective Federal Funds Rate: 4.33%

Interest on Reserve Balances: 4.40%

Overnight Reverse Repurchase Facility Rate:4.25%

Reference Rates per the Federal Reserve Bank of New York.

Effective Federal Funds Rate:4.33%
Overnight Bank Funding Rate: 4.33%
Secured Overnight Financing Rate:4.36%
Broad General Collateral Rate:4.34%
Tri-Party General Collateral Rate:4.34%

Foreign exchange per the Eastern Caribbean Central Bank.

USD/XCD=2.70

GBP/XCD=3.49529

EUR/XCD=2.90939

CAD/XCD=1.88488

JPY/XCD=0.01793

KWD/XCD=8.75557

AED/XCD=0.73509

CNH/XCD=0.37176

Administered rates per the Eastern Caribbean Central Bank.

ECCB Discount Rate: 3.0%

ECCB Call Rate: 2.4%

ECCB Fixed Deposit Rate (one month): 2.8%

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DISCLAIMER: I am not a financial adviser. These blog posts are for educational purposes only. Investing of any kind involves risk. Your investment and other financial decisions are solely your responsibility. It is imperative that you conduct your own research and seek professional advice as necessary. I am merely sharing my opinions.

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