Chapter 02 · How money really works

The two dollars you don't know about

6 min

You are joining a course midway

This chapter builds on the ones before it. You can read it now, but it will not count towards your progress until the earlier chapters are done.

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Nicolas just wired €200,000 to buy his house. Except not a single banknote made the trip from one bank to the other. And yet, Ms. Smith did receive the money. How does that work?

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Nicolas is a happy man: his bank just lent him €200,000 to buy his main home. That money won't sit in Nicolas's account for long: he's using it to pay the seller, Ms. Smith. So what happens if Ms. Smith banks somewhere else?

So what happens if Ms. Smith banks somewhere else?

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This is where interbank clearing comes in. Wait, don't go! I'll walk you through it, nice and simple.

Before we go any further, you need to grasp one thing: there are two kinds of money, and they never flow through the same pipe:

The two kinds of money: the one you use, and the one reserved for banks

When we pay for groceries, gas, a bit of shopping, or grab some crypto just in case you never know…

The notes in your wallet are part of it. But the big chunk is the reserves: the money commercial banks use among themselves to settle what they owe each other.

We'll see in a moment how they use this M0 money to settle the net debts left over from all the day's M2 transactions.

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Now picture millions of M2 transfers flying between banks every single day.

At regular intervals (say, at the end of the day), banks tally up everything they owe one another: that's the clearing⁠(opens in a new tab). Then they settle only the net difference (the balance) in M0 money: that's the settlement⁠(opens in a new tab). That, right there, is interbank clearing.

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Sounds abstract? Good. Let's get our hands dirty once again!

The clearing mechanism for the Nicolas-Ms. Smith transaction

Back to our two characters, Nicolas and Ms. Smith.
Here we go: Nicolas wires €200,000 to Ms. Smith's bank account. If you've been following, this transaction is M2 money. Perfect.

End of the day rolls around, time to settle up: Nicolas's bank owes €200,000 to Ms. Smith's bank. Which money gets used? Exactly, M0 money!

We've simplified: just one transaction today. In real life it's millions of transfers, all netted, and only the net balance changes hands. But the mechanism is exactly the same.

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Now let's look at the full balance sheet of Nicolas's bank - this time with everything we set aside in : the M0 reserves, the debt owed to the Central Bank, the equity. Notice the €200,000 M0 debt on the liabilities side.

Click below to see how the bank taps its M0 reserves to clear that debt during settlement.

NICOLAS'S BANK BALANCE SHEET

ASSETS	LIABILITIES
€500,000,000 (all claims on customers, including that of Nicolas)	€440,000,000 (all customer deposits, except Nicolas who transferred his money to Ms. Smith)
€10,000,000 (M0 Reserves)	€200,000 (M0 debt to Ms. Smith's bank)
	€20,000,000 (debt to the Central Bank)
	€49,800,000 (equity)

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You've just scratched off another layer most people never even suspect is there. And trust me, it's going to matter for what comes next: .