This post describes the nitty gritty of what happens when the Fed purchases Treasuries. I will go into detail on the balance sheet implications for each participant, which will vary depending on whether the market participant is a bank or a non-bank. The bank/non-bank distinction matters because non-banks do not have Fed accounts and thus cannot hold reserves.

The Fed only does QE trades through Primary Dealers, who generally are not banks (they are broker-dealers) and do not have Fed accounts. (The exception is few U.S. branches of foreign banks who house their broker-dealer business in the bank entity, which do have reserve accounts). In practice, Primary Dealers tend to bank with custodian banks like Bank of New York Mellon, who specialize in collateral management services.

But the focus should not be the primary dealers as they are merely conduits. The newly created reserves ultimately end up in the account of whoever sold the Primary Dealer the Treasuries. If the seller is a Bank, then it will end up in the Bank’s Fed account. If the seller is a non-bank, it will end up in the Fed account of the bank that the Non-Bank banks with. The bank’s new reserve asset will be balanced against new bank deposit liabilities owed to the Non-Bank.

Below I walk through four scenarios of QE sales: Non-Bank Investor to Non-Bank Primary Dealer, Bank Investors to Bank Primary Dealer, Bank Investor to Non-Bank Primary Dealer, and Non-Bank Investor to Bank Primary Dealer. This should offer insight into the plumbing of QE.

Non-Bank Sells Treasuries to Non-Bank Primary Dealers

In this common scenario the non-bank Primary Dealer buys Treasuries from a Non-Bank (could be a corporation, hedge fund, mutual fund, another dealer etc.). The Primary Dealer borrows money from a money market fund via the repo market to make the purchase. The Treasury purchased is immediately pledged as collateral for the money market fund’s repo loan. The Primary Dealer will repay the repo loan using the proceeds it receives from selling the Treasury to the Fed.

Note that none of these entities have reserve accounts. The QE reserve impact happens behind the scenes when the commercial banks that the participants have accounts with settle payments with each other. Recall, reserves are basically a special type of money used for transactions between commercial banks.  Reserves will move from the money market fund’s bank to the Non-Bank’s Bank, via the Primary Dealer’s Bank.

The Primary Dealer then sells the Treasury to the Fed, and repays the repo loan to the money market fund.

At the end of the day, there are $100 more reserves in the banking system. They end up in the Fed account of the non-Bank’s bank. The Non-Bank itself essentially exchanges Treasuries for bank deposits.

Bank Sells Treasuries to Bank Primary Dealers

In this scenario a Bank sells Treasuries to a Primary Dealer who is also a Bank, who then sells it to the Fed. Because all entities have Fed accounts, all transactions are settled in reserves. (The Primary Dealer can also fund the transaction using a repo loan, but for simplicity I construct the example assuming it has enough reserves to not need funding.)

Bank Sells to Non-Bank Primary Dealer

In this scenario things are bit more complicated because one participant has a reserve account, while others do not. At the end of the day the Fed increases its balance sheet, and the Bank Seller swaps Treasuries for reserves.

The Primary Dealer intermediates this by buying the Treasuries with funding from a repo loan and then sells the Treasuries to the Fed. Behind the scenes, the Primary Dealer’s Bank receives reserves from the Money Market Fund’s Bank, then sends them to the Bank Seller. Then the Primary Dealer’s bank receives reserves from the Fed when the Primary Dealer sells the Treasuries to the Fed. And finally, the Primary Dealer’s bank sends reserves to the Money Market Fund’s bank when the Primary Dealer repays the repo loan.  Note all these transactions take place within a day.

Non-Bank Sells to Bank Primary Dealer

In this example a Non-Bank sells Treasuries to a Primary Dealer who is also a bank. The Non-Bank cannot hold reserves, so the Treasuries are sold for bank deposits, which are created by the Non-Bank’s bank. The Non-Bank’s bank holds the reserves, while increasing its bank deposit liabilities to the Non-Bank. The Bank Primary Dealer funds the purchase with a repo loan from a money market fund.