A Decentralized “un”-Federal Reserve
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SAN FRANCISCO — February 6, 2021 — Most countries have some form of central bank that exists to stabilize the local currency, interest rates and positively influence the overall financial health of the country in which it exists. Each of these central banks might have a different name and slightly different function from one another. Ukraine’s central bank, for instance, is called the National Bank of Ukraine, and in the United States of America it is referred to as the Federal Reserve. It is this latter entity that is the namesake of our project.
Overview
From the Federal Reserve’s website (https://frbservices.org/), “The Federal Reserve, the central bank of the United States, was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Federal Reserve carries out the nation’s monetary policy guided by the goals set forth in the Federal Reserve Act, namely ‘to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.’ ” Additionally, “The Federal Reserve Financial Services (FRFS) strategic direction focuses on meeting the evolving needs of payment system users for end-to-end payment speed, efficiency and security, while remaining true to our longstanding financial services mission to foster the integrity, efficiency and accessibility of the U.S. payment system.”
And, ironically, this last part of the Fed’s statement is a major reason why unFederalReserve exists. Large banks tend to leverage the Fed to meet cash reserve requirements by borrowing directly from the Fed.
Smaller banks and non-bank lenders either cannot nor will not access the Fed’s capital window directly in times of short-term cash crises. Instead, the smaller players are forced to rely on terms dictated by the larger banks with whom they often have deep rooted relations. This tiered structure is the nature of banking globally, with most if not all financial institutions eventually rolling up to the Fed itself.
The Size of the Problem
To give a sense of scale to the issue in the U.S, alone, please see the graph below and consider that of the 5,000+ commercial banks in the U.S., currently about 30 qualify as Giant (red) and another 115 qualify as Large (yellow). That leaves 4,850+ banks in the green and blue areas each having less than $10bn assets each.
But these small banks are only a fraction of the market that either cannot or will not access the Fed window for capital. In the U.S., alone, there are, according to the Mortgage Banking Association, close to 18,000 non-bank mortgage originators, accountable for 50%+ of all U.S. mortgage originations, by the way. In addition, there are 23,000 payday lenders and 9,000 fintechs as of February 2020. This adds up to trillions of dollars in leant capital at any given time as is a huge driver of economic growth.
These tens of thousands of entities not dealing with the Fed to meet immediate cash needs get their capital from other sources; namely, via line of credit agreements with the larger banks. The challenge arises when real-world payment latency (i.e. the late wire, the holiday closing, etc.) place these smaller entities at risk of violating their debt covenants tied to unrestricted cash. Or, when wires and payments arrive early and there’s no immediate use case for the funds.
What Happens Today
Specifically, the challenge is that bank negotiated lines of credit tend to assume draw periods (or length of time the loan will be outstanding) of 30 to 45 days. The bank that only needs the money for a short time period, say 1 to 3 days, will end up paying egregiously high amounts of interest for a very short term loan. These borrowing rates can approach 1% even under current conditions.
Then there is the opposite scenario. Say you are a small, middle-market lender and have a great relationship with the community and vendors with whom you serve. Should they pay you back in advance of their scheduled payoff date, that excess cash is generally swept into money market accounts paying very little to no interest.
Conclusion
Just like there are billions of unbanked individuals around the world, there are thousands of unFederalReserve’d entities being denied access to cheaper capital or allowed any type of returns on their fallow cash. Let’s work to use the power of blockchain technology to expand markets, make them safer and lower costs of capital for everyone.
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