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My understanding is when the fed buys a bond from a bank they use bank reserves (bank reserves are swapped for a bond). How does the transaction differ when a non bank (ex hedge fund) is involved?

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When the Fed buys a bond as part of a Quantitative easing program, they execute with Primary Dealers through a website interface. Hedge funds do not execute directly with the Fed, although they could execute with a Primary dealer who executes with the Fed.

When the Fed executes with a primary dealer, it credits the account of the primary dealer using newly created funds. The dealer deposits the fund in a bank account, which increases bank reserves in the system.

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Roughly speaking, say the central bank wishes to purchase £10 billion worth of bonds from non bank NB. NB will have an account with a bank B. The central bank cannot transfer reserves directly to NB so instead they give the reserves to B and instruct B to create £10 billion of demand deposits in NB's account.

As you can see, and contrary to the belief of many commentators, QE creates inside money in the very first instance and does not require a bank to do any new lending to convert the reserves to inside money.

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Federal Reserve Financial Accounts Guide - All Tables

https://www.federalreserve.gov/apps/fof/FOFTables.aspx

These are also known as the Flow of Funds statistics kept by the Federal Reserve. The Fed assets and liabilities currently appear in Table L.109 Monetary Authority. The bank sector assets and liabilities currently appear in Table L.110 Private Depository Institutions. Reserves are a liability in the Monetary Authority table with matching financial asset in the Private Depository Institutions. Since non-bank units in the Flow of Funds sectors do not transact in Reserves the commercial banks or so-called depository institutions must clear payments between Fed and non-banks when Fed transacts with non-banks.

Coupled Charts of Accounts:

Reserves are liabilities of the Fed or central bank.

Reserves are financial assets of the commercial bank sector.

Deposits are liabilities of the commercial bank sector.

Deposits are financial assets of the non-bank sector.

Marketable securities are financial assets.

Accounting Rules:

Assets increase by a debit and decrease by a credit.

Liabilities and equity decrease by a debit and increase by a credit.

When Fed purchases a security from a non-bank there are three sectors which keep records using double-entry accounting customs.

  1. Fed debits security assets for an increase and credits reserves due to the payment clearing bank(s) for an increase.

  2. The clearing bank(s) debit reserves for an increase and credit deposits due to the security seller for an increase.

  3. The non-bank security seller debits deposits (cash) for an increase and credits marketable securities for a decrease.

Note the Fed and aggregate bank balance sheets expand and the non-bank sector only recognizes a swap of assets of securities for cash.

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