Does cash still count? Electronic payments in their many forms are a ubiquitous part of our culture and the U.S. economy. Many of us have our paychecks automatically deposited in our bank accounts. We use online bill payment services and frequently shop at our favorite virtual storefronts. Businesses increasingly use electronic payment methods—taking advantage of cost and efficiency gains to contribute to their bottom lines. With this commonplace use of electronic money, you might assume that paper payments are shrinking, and perhaps the predictions of a cashless society, which have persisted since the 1960s, will come true. While it is clear check usage is declining, at this point, it certainly isn’t clear for the other form of paper payments—cash.

Because cash transactions are anonymous, that is, they aren’t tracked through the banking system, measuring how often cash payments are made is difficult. However, the total amount of money in circulation can be measured precisely to determine whether

currency is growing or shrinking. And growing it is! Over the past three decades, the value of U.S. currency in circulation has grown dramatically—from $93.4 billion in 1977 to $783.2 billion in 20061. The number of pieces of currency in circulation also has increased during this time—from 7.5 billion to 26.4 billion.

Cash certainly counts to the Federal Reserve. The twelve Federal Reserve Banks play a major role in the distribution of U.S. currency. In fact, currency is a liability of the Reserve Banks and, as such, is a significant component of Reserve Bank balance sheets. Reserve Banks supply commercial banks, savings banks, and credit unions (collectively known as "depository institutions”) with the currency they in turn provide to their customers. Reserve Banks also accept deposits of unneeded and/or worn currency from depository institutions and remove unfit and counterfeit notes from circulation.

This is a big business for the Reserve Banks. From Sunday night until Friday evening, Reserve Bank cash offices keep the money flowing—receiving, counting, and processing currency from and paying out currency to depository institutions. Federal Reserve Bank offices provide cash services directly to over half of the banks, savings banks, and credit unions in the United States and indirectly to the remainder that contract with correspondent banks using Reserve Bank cash services. Altogether in 2006, the Reserve Banks received and processed 38 billion notes, destroyed 7 billion worn notes, and paid out 39 billion new and fit notes at an operating cost of $319 million, not counting the $600 million incurred by the Bureau of Engraving and Printing to print new notes.

Like any large business, the opportunities and challenges associated with providing cost-effective, high-quality cash services are significant, particularly in today’s rapidly changing business environment. As the headquarters for the national Cash Product Office for the Reserve Banks’ cash business line, the Federal Reserve Bank of San Francisco plays a leading role setting the strategic agenda and collaborating with all of the Reserve Banks to address these challenges and leverage opportunities.

The value of U.S. currency in circulation has
increased steadily through the decades

Source: U.S. Treasury

Cradle to Grave: The Life of U.S. Currency
The life of a new Federal Reserve note begins when the Reserve Banks work with the Board of Governors to determine the demand for new currency and submit their annual print order to the U.S. Treasury’s Bureau of Engraving and Printing (BEP). The order is an estimate of the amount of currency the public will demand in the upcoming year and reflects estimated changes in currency usage and destruction rates of unfit currency. The Reserve Banks pay for the cost of printing and transporting new currency from the BEP printing facilities in Washington, D.C., and Fort Worth, Texas. Over the last decade, these printing facilities combined turned out a little more than 99 billion new notes.

Printing the notes involves a series of passes using three separate printing processes. An offset press is used to print the subtle background colors on the front and back of the notes—red and tan for the $10 note, peach and green for the $20 note, and blue and red for the $50 note. The intaglio press follows to create U.S. currency’s artful design and distinct look and feel of engraved images, icons, and scroll work. Once dry, notes that meet an examiner’s inspection standards are ready for the final process using typographic printing to create the Federal Reserve District seal and its corresponding number and the Treasury seal and serial numbers.

Newly printed notes are cut, bundled, and shipped to Reserve Banks for distribution. Upon arrival, they are officially “Federal Reserve notes,” although the notes do not become a liability on Reserve Banks’ balance sheets until they are distributed to depository institutions for circulation. Notes typically do not stay in circulation for long. In fact, usually they make several return visits to Reserve Banks before they are ultimately destroyed. When depository institutions receive more currency from their customers than they need on hand, often they want to convert this non-interest-earning asset into balances in their Federal Reserve accounts. Reserve balances can be invested in interest-earning instruments such as a fed funds loan to another institution or a U.S. Treasury security. Reserve Banks use these currency deposits to fill orders from other depository institutions for additional currency to meet their customers’ demand. In this way, Reserve Banks act as an intermediary between depository institutions to balance currency needs within a region and across the country.

Each time Reserve Banks receive currency from a depository institution, they run the currency through high-speed processing machines that count the notes, identify possible counterfeits, and determine if notes are suitable for recirculation. Worn notes that are unfit for recirculation are automatically shredded, giving new meaning to President Harry Truman’s famous statement, “The buck stops here.”

The National Cash Product Office
In coordinating the Federal Reserve’s vast cash services business, the Cash Product Office is involved in every aspect of the life cycle of a Federal Reserve note. Staff from the San Francisco Reserve Bank’s Los Angeles, San Francisco, and Seattle offices direct the activities of the Product Office. Additionally, staff in the Richmond and Cleveland Reserve Banks perform substantial automation work. In keeping with the Product Office’s strong commitment to collaborative leadership and reliance on the deep business knowledge that resides throughout the Federal Reserve System, all major Product Office initiatives involve key staff from other Reserve Banks.

Cash Product Office Staff: San Francisco
Cash Product Office staff in San Francisco (left to right) Nancy Leon, Carla Kitchin, Mark Peralta, Stephen Lai, Barbara Bennett, Louise Willard, Roxana Tsougarakis, Chad Harper, Jaclyn Hodges, and Jeff Collins provide strategic direction to the Federal Reserve’s national cash services business. In this capacity, they and their counterparts in Los Angeles guide policy and product development, capacity planning, and inventory management for the Reserve Banks. Not pictured: Kevin Fleming, Leslie Goff, Sy-Dang Tran

The Cash Product Office’s four major responsibilities are very similar to those involved in managing any product. Staff conduct strategic planning and market research around the central bank’s currency distribution role. They develop programs and procedures for the operational aspects of the Fed’s cash business, and they provide the technology support and development for the automated cash infrastructure. Finally, as the Federal Reserve’s primary point of contact on cash distribution matters, they communicate with external constituencies such as large depository institutions, vendors, the press, and other central banks.

All four of these responsibilities tie directly to the Federal Reserve’s fundamental goals that were laid out when the Federal Reserve Act of 1913 authorized the issuance of Federal Reserve notes. These goals include ensuring that cash is readily available when and where it is needed, especially during times of crisis, and that the public is confident that currency supplied by banks and merchants is genuine and readily usable in subsequent transactions. Underlying everything is the commitment to good stewardship, namely, that the resources spent to print, process, store, and distribute cash to the domestic and international public are minimized for society as a whole.

Cash Product Office: Los Angeles
Left to Right: Rosalinda Bernardino, Mochael Valente, Shawna Gale, Marla Borowski, Phillip B. Johnson, Olympia LaPoint, Juan Rodriquez, Phuong Luu

Evolving Markets and Models

While the Fed’s fundamental goals regarding U.S. currency remain the same, clearly, much has changed since the 1920s when the Federal Reserve’s cash services footprint first was established. The country’s major population and commerce centers have expanded from the Northeast and the Midwest to include the South and the West. Within the past ten years, legislative changes and new technologies have enabled the Fed’s largest depository institution customers to offer nationwide banking services, while using more centralized business models. Additionally, with changing patterns in the use of cash and innovative technologies, large depository institutions are using increasingly sophisticated models to manage their own cash inventories and provide cash to their customers across the country.

The changes within the Federal Reserve have been dramatic as well. Historically each Reserve Bank and Branch provided a full range of services to local depository institutions. Now, a number of services, particularly check services, have evolved into centralized functions, which are intended to improve efficiency and market alignment. In cash services, new buildings have been built and new, high-speed processing equipment has been introduced since the 1920s. The Phoenix Cash Processing facility built in the San Francisco Reserve’s District in 2001 is the most recently constructed site.

Central Business Administration Function
Within the CPO, Central Business Administration Function (CBAF) staff such as (left to right) Amy Burr, Ken Green, Carolyn Pitts, Sam Koeritz, Kathy Sigman, David Huang, and William Riley provide the technology and development support for the Federal Reserve’s cash operations. The CBAF team develops and supports the complex suite of systems that tracks, inventories, and accounts for Federal Reserve notes during their life cycles, among other responsibilities. The team is based in the San Francisco, Richmond, and Cleveland Reserve Banks.

In 2006, the Cash Product Office spearheaded several major initiatives to align the Federal Reserve’s cash services with the evolving market. The initiatives that follow are setting the stage for better use of resources, improved productivity, and more effective working relationships with customers and other business partners.

Aligning the Cash Footprint: Infrastructure
The year 2006 marked the culmination of a multiyear review of the Federal Reserve’s cash processing and distribution points, resulting in a new, supplemental distribution model, called a “cash depot,” to address changing market realities. Several factors provided the impetus for this review including the growing cost, complexity, and economies of scale of currency processing equipment and the increased overhead expenses associated with higher post-9/11 security costs.

Staff from the San Francisco, Kansas City, Atlanta, Richmond, New York, Minneapolis, and Dallas Reserve Banks conducted the review. The review concluded that new cash delivery models (in addition to the traditional collocation of currency processing and distribution at each Federal Reserve site) were not only feasible but also consistent with good stewardship of the public’s resources. Specifically, Reserve Bank Branch markets that lack the volume to support large-scale currency processing operations could be converted to the depot service model as long as the depot is no more than five hours driving distance from the closest Reserve Bank Branch where processing takes place.

With a cash depot, depository institutions still deposit currency and pick up orders in their local Branch city, but do so at a secure collection point operated by a third party transportation company acting as the agent for the Federal Reserve. The third party, generally an armored carrier, transports deposits to the servicing Reserve Bank office which counts deposits and prepares orders. The third party then transports orders from the servicing Reserve Branch back to the secure collection point for payout to the depository institution. The Federal Reserve pays for the transportation between the depot and the servicing Reserve Bank.

This distribution model eliminated costly overhead and achieved economies of scale without shifting the burden for long-distance transportation costs to depository institutions. Since the initiative was launched, six Reserve Branches have converted to the depot model: Little Rock, served by Memphis; Louisville, served by Cincinnati; Buffalo, served by Cleveland; Portland, served by Seattle; Oklahoma City, served by Dallas; and Birmingham, served by Atlanta. The Omaha Branch is slated to convert to the depot model once Kansas City, its servicing site, completes its new building in the first half of 2008.

With the country’s changing demographics, the review team also analyzed whether any new markets warranted a Federal Reserve cash presence, either in the form of a depot or a full-fledged facility. Given the well-established private sector transportation solutions coupled with uncertainty over future domestic cash volume trends, the team concluded that expansions were not advisable at this time.

Currency Technology Office
Currency Technology Office (CTO) staff members (left to right) Diana Joyner and Elva Wilhite oversee the installation of one of the upgraded high-speed cash processing machines in the San Francisco Reserve Bank’s vault. As one of the technical arms of the Cash Product Office, the CTO, which is based at the Richmond Reserve Bank, focuses on the automation of physical currency handling, the high-speed processing environment, and financial and administrative support for System-level currency processing. The group also provides agency support to the Bureau of Engraving and Printing and the Secret Service.

Increasing Productivity: High-Speed Cash Processing
The Federal Reserve owns 133 high-speed cash processing machines that count notes and detect worn and counterfeit currency. Each machine can process about 700,000 pieces of currency per nine-hour shift, and many of the machines run two shifts per day. In 2006, the Reserve Banks processed approximately 38 billion pieces of currency on these machines! Like any good business, the Fed continually assesses how it can improve productivity and reduce processing costs. For the past two years, engineers at the Richmond Reserve Bank worked with the machine’s manufacturer to increase the currency processing throughput. The first refurbished machine is slated for production in 2007, with the remainder set for production by 2009. Early indicators suggest the upgraded machines will increase the throughput rate by 8 to 10 percent or more.

Getting the Incentives Right: Currency Recirculation
Historically, the Federal Reserve has provided its currency processing service to depository institutions at no charge. To prevent overuse of this free service, the Federal Reserve has a long-standing administrative policy that discourages depository institutions from depositing and ordering fit currency of the same denomination within a period of five business days. This practice of churning currency, whereby institutions deposit and order fit currency within the same business week rather than holding it, is known as “cross-shipping” within the Federal Reserve. The process is inefficient because it requires unnecessary handling, processing, and round-trip transportation. In 2006, processing cross-shipped currency cost the Reserve Banks approximately $27 million.

Despite the administrative policy, depository institutions have strong incentives to cross-ship. They receive fit, clean currency for payout to customers without having to sort it themselves. More importantly, excess cash sent to the Federal Reserve is credited to their reserve account balances that can be invested, unlike non-interest-earning cash kept on hand in bank vaults. Given these reasons, it isn’t surprising that the cross-shipping policy was ineffective, and as a result, the Federal Reserve, and by extension the public, incurred unnecessary currency processing and storage costs.

After consultation with the Reserve Banks, the Board of Governors, and the banking industry, the Cash Product Office proposed a more market oriented set of incentives. The revised policy, which was approved by the Board of Governors and published in early 2006, has two key components. First, institutions will be allowed to cross-ship currency but will be required to pay a fee that essentially equals the Federal Reserve’s cost to process and store cross-shipped currency. This approach accounts for the true societal cost of processing cross-shipped currency, while preserving this service as an option if it’s the most efficient solution for the depository institution.

With payments to and receipts from depository institutions rising,
Reserve Banks are processing more cash

Source: Federal Reserve Cash Product Office

The second component, a Custodial Inventory program, allows qualifying depository institutions to convert a portion of the cash balances held in their vaults into reserve account balances that earn interest. Through this program, qualifying institutions can recoup the interest they would have lost from holding cash receipts for a few days rather than sending the cash to their local Reserve Bank. To qualify for the Custodial Inventory program, depository institutions undergo a safety and soundness review, a site inspection and consistency review, and procedural training, among other requirements.

Together, the fee and Custodial Inventory programs are referred to as the “Recirculation Policy.” The Custodial Inventory program was implemented in July 2006, and at year-end had nearly 30 active depository institutions. The fee will take effect in July 2007, giving depository institutions a year to adjust their operations. Additionally, to assist institutions in their planning, the Cash Product Office has sent pro forma billing statements since mid-2004.

Improving Investment Decisions: Cash Payments Study
The infrastructure and resources required to run the Federal Reserve’s cash business are highly capital intensive—requiring the investment of hundreds of millions of dollars in processing equipment, software and hardware, and vault facilities. Projecting the future growth of the cash business is critical to managing investment decisions. Yet, projecting this growth is complicated by several factors. First, it is difficult to estimate the precise amount of U.S. currency that circulates domestically, the measure which drives the Federal Reserve’s cash processing service. Second, changes in the processing methods depository institutions use, along with their inventory management behaviors, can have a major impact on Federal Reserve processing volumes. Finally, the adoption of alternative payment options by consumers and businesses undoubtedly will affect currency growth, but data on cash payment usage trends and displacement of cash by other payment options is very limited and sketchy.

Within this context, the Cash Product Office, with the assistance of staff from the Board of Governors and the Boston, Cleveland, and Richmond Reserve Banks, is conducting a market research study to understand the acceptance of cash by businesses. Understanding cash substitution, the cash cycle, and cash holding policies and behaviors from a business-centric perspective will help shed light on the future demand for Federal Reserve cash services—in terms of the number of cash payments in general and the volume of cash held by or flowing through businesses.

The cash payments study involves qualitative interviews with 30 to 50 large businesses with substantial cash receipts and a quantitative survey of hundreds, perhaps thousands, of businesses to establish a baseline against which future payment activity and behavior can be measured. The Cash Product Office formally launched the study in 2006, with completion slated for 2008.

Strengthening Customer and Business Partnerships
The Federal Reserve’s cash business is a partnership that includes external participants from both the private and governmental sectors. Many of these participants are directly affected by policy, process, and currency design changes. At the same time, they are important channels in the distribution of safe, reliable currency to the public. Recognizing these important connections, the Cash Product Office has made significant efforts over the years to strengthen these relationships and to understand participants’ needs as part of the decisionmaking process for cash services.

Depository institutions make up one of the Federal Reserve’s most critical constituencies. They represent the next link in the network for distributing U.S. currency to the public. To ensure timely and useful information flows with this group, the Cash Product Office formed an advisory council consisting of 16 of the largest institutions by cash processing volume. Virtually all of these institutions have a multistate presence. Staff from the Product Office meet with members of this group in person at least twice a year, with regular conference calls scheduled between meetings. Their input has helped shape a number of key policies and programs over the past few years and will continue to provide invaluable input for future decisionmaking.

The armored carrier industry is another important constituency. This group provides the critical link between the Federal Reserve, depository institutions, and cash handling businesses. The Product Office meets regularly with large national carriers and the association representing local, independent carriers. The importance of this relationship becomes very apparent when unanticipated events occur, such as Hurricane Katrina in 2005. As the events surrounding Katrina unfolded, established relationships combined with solid contingency planning enabled new transportation routes and processes, as well as new partnerships, to be put into place quickly to ensure the public had access to currency.

Within the government sector, the Cash Product Office is a member of the Advanced Counterfeit Deterrence Committee. This committee consists of participants from the Board of Governors, the U.S. Treasury, the Bureau of Engraving and Printing, and the U.S. Secret Service. These entities work together to develop and coordinate anti-counterfeiting strategies, including new currency designs, to preserve public confidence in U.S. currency.

Looking Ahead
Will cash count in the future? With the steady growth of U.S. currency and its broad acceptance supported by public confidence, it is likely cash will remain a vital component of the payments system for the foreseeable future. Even so, there’s little doubt that electronic payments will continue to challenge how cash is used.

Assessing cash usage through initiatives such as the Cash Payments Study will help the Federal Reserve paint a clearer picture of the future. And looking ahead, one thing is certain: cash will continue to count for the Federal Reserve. The Federal Reserve and the Cash Product Office will continue to develop strategies, resources, and technologies to evolve with the market. So, no matter what the future holds, the Federal Reserve will work to ensure that U.S. currency remains safe, reliable, and accessible.

Where Does All That Money Go? At the end of 2006, slightly more than $783 billion of U.S currency was in circulation. Interestingly, estimates indicate that well over half of this amount, perhaps as much as two-thirds, is held outside U.S. borders. There are numerous reasons why U.S. currency is held abroad. Individuals in foreign countries may want to hold an internationally accepted currency as a hedge against inflation of their local currency, or because of concerns about the local banking system or political climate. More routine reasons include growing business and leisure travel between the United States and other countries, as well as the transfer of earnings from immigrant workers to their families in other countries. For these reasons and many more, Federal Reserve notes can be found in most places in the world. Such a large stock of dollars held abroad has a number of benefits, not the least of which is that currency represents a claim on the United States that does not require the payment of interest. If foreigners purchased U.S. Treasury securities instead of holding U.S. currency, our government would pay interest totaling billions of dollars per year. So, these foreign holdings of dollars can be thought of as an interest-free loan made to the United States. Of course, there are some modest costs, relatively speaking, to print and process the currency, but these pale in comparison to the forgone interest.

Moving Money The activation warning alarm sounds. A brief moment of silence follows before the automated storage and retrieval machine launches. Like a small roller coaster, the machine travels along a single 160-foot rail at speeds up to seven miles per hour across the floor of the cash vault to deposit and retrieve currency storage containers filled with bundles of cash. Many Reserve Banks have integrated automated processes, such as the automated crane pictured here in the Los Angeles Branch’s vault, to improve the capacity, safety, and productivity for the storage and handling of the vast amounts of cash that enter and leave the Federal Reserve. In addition to automated cranes, some locations use robotic vehicles to move containers.

What about Coins? Reserve Banks distribute new coins to the public through depository institutions when they order cash. The Reserve Banks buy coins from the U.S. Mint at face value and account for them as an asset on their balance sheets. The Cash Product Office oversees the centralized management of coin inventories and distribution within the Federal Reserve. In this role, it serves as the liaison with the Mint. Each month, the Product Office sends a coin order to the Mint, which plans its production based on this order and its own internal forecast. The Product Office coordinates the distribution of new coins to the Reserve Banks, monitors their coin inventories, and redistributes inventories among offices to meet fluctuations in regional demand for coins. In addition to coins stored in Reserve Bank vaults, the Federal Reserve has agreements with 185 armored carrier locations to store, process, and distribute coins on behalf of the Federal Reserve. The establishment of these coin terminals has improved the efficiency of the coin distribution process. Testing New Models The demand for coin, as for currency, varies seasonally and with economic activity. This creates challenges for managing coin inventory and production levels. In late 2006, the Cash Product Office and the Mint completed a proof-of-concept trial to determine if a new approach for inventory management could effectively maintain the right inventory levels by location when needed to meet fluctuating demand and reduce volatility in coin production. The trial focused on three strategies: (1) managing coin production and distribution at the market level; (2) supplying new coins to the trial market at a constant rate; and (3) allowing inventory levels at specific sites to fluctuate in line with anticipated seasonal needs. In contrast, current practices generally focus on managing coin production and distribution for local offices, which leads to more volatile inventory levels. The Product Office will complete an evaluation of the pilot program and develop recommendations for a new coin inventory management strategy in early 2007. Early indications are that the new approach will reduce costs and improve efficiency. The Product Office would oversee the implementation of the new strategy, if approved.