Federal Funds and Interest on Reserves

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Definition of Fed Funds Transaction
In general, a fed funds transaction is an unsecured loan of U.S. dollars to a "borrower" or "purchaser" that is a DI from a "lender" or "seller" that is a DI, foreign bank, government-sponsored enterprise or other eligible entity.1

Federal Funds Effective Rate (FFER) as a Measure of Aggregate Activity
Participants can arrange fed funds transactions directly with each other (bilaterally), or through the brokers. Because there is no central repository of fed funds transactions, there is no central collection of the rates at which they occurred. However, for decades fed funds brokers have voluntarily submitted aggregated data on the fed funds transactions they have brokered to the New York Fed. The New York Fed uses these data to calculate the FFER and related summary statistics. Various academic studies and discussions with market participants provide confidence that the FFER is broadly representative of the entire universe of fed funds trades.

The Fed Funds Market and Monetary Policy
The Federal Reserve utilizes four tools of monetary policy to manage short-term interest rates--open market operations, the discount rate, IOER and reserve requirements. Using these tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks. The interest rate on fed funds transactions is typically sensitive to the level of reserve balances in the banking system, and so changes made through these tools influences the fed funds rate.

At the directive of the FOMC, the trading desk at the New York Fed ("the Desk") adjusts the level of reserve balances in the banking system through open market operations. In fact, the directive for implementation of U.S. monetary policy from the FOMC to the New York Fed states that theDesk should "create conditions in reserve markets" that will encourage fed funds to trade at a particular level. In formulating monetary policy, the FOMC sets a target level or range for the fed funds rate appropriate for the desired level of monetary policy accommodation. When rates approach zero, the FOMC may utilize other indicators of the stance of monetary policy in addition to the fed funds target. It is important to remember that actual fed funds rates are determined by market participants, based on market conditions.

Fed Funds Transactions Redistribute Bank Reserves
DIs keep reserve balances at their Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. DIs with reserve balances in excess of reserve requirements can lend these excess reserves, or "sell" them (as such transactions are often called by market participants) to institutions with reserve deficiencies. It is important to note that the Federal Reserve Banks are not party to these transactions. Fed funds transactions neither increase nor decrease total reserves, rather they redistribute reserves.

Fed Funds Trading and Settlement Conventions
Fed funds transactions can be initiated by either the lender or the borrower. An institution seeking to lend or borrow fed funds can identify a counterparty directly through an existing banking relationship, or indirectly, through a fed funds broker. The most commonly used method to transfer funds between depository institutions is over Fedwire Funds services. Generally the lending institution authorizes its district Federal Reserve Bank to debit its reserve account and to credit the reserve account of the borrowing institution.

Funds lent in the overnight fed funds market typically must be returned to the lender within 24 hours of the settlement of the trade and are known as "regular return". "Early return" fed funds transactions are trades where the parties involved mutually agree upon a time in which the funds must be returned that is less than 24 hours. Early return federal funds transactions usually trade a few basis points below regular return to reflect the shorter tenor of the loan.

Most overnight fed funds transactions are booked without a contract. The borrowing and lending institutions exchange verbal agreements based on various considerations, particularly their experience in doing business together, and limit the size of transactions to established credit lines in order to minimize the lender's exposure to default risk. Such arrangements facilitate speedy processing at the lowest possible transaction cost.

Fed Funds and Interest on Reserves
Federal Reserve Banks have been paying interest on reserves to DIs since October 2008.2 The Board of Governors is responsible for setting the rates for IOR. IOER works to influence market rates by providing DIs little incentive to lend fed funds at rates below the IOER rate.

While IOER has been effective at influencing the FFER, it has not served as a hard minimum rate at which all institutions are willing to lend funds. This is because some institutions are eligible to lend funds in the federal funds market, but are not eligible to earn IOER, such as the government-sponsored enterprises (GSEs). DIs, U.S. branches and agencies of foreign banks, Edge Act and agreement corporations, and trust companies are eligible to receive interest on reserves and excess reserve balances held at the Federal Reserve. Pass-through correspondents that are themselves eligible to receive interest may pass the interest they receive on balances that represent their respondents required reserve balances and excess balances, but they are not required to do so. By contrast, pass-through correspondents that are not themselves eligible to receive interest must pass back to their respondents the interest they receive on balances that represent their respondents required reserve balances. Other factors that influence the rates some institutions are willing to pay for fed funds in this environment include the impact on their balance sheet, which often determines a maximum rate a DI is willing to pay.

Evolution of Trading in the Fed Funds Market
Beginning in November 2008, the FOMC directed New York Fed to expand the size of the Federal Reserve Systems balance sheet through large scale asset purchases of Treasury debt, agency debt, and agency mortgage backed securities (MBS). These purchases of securities from the primary dealers add reserves to the banking system. The significant purchase sizes led to aggregate reserves far exceeding the aggregate amount of reserves that DIs are required to hold.

The elevated excess reserves environment as well as the Federal Reserve Banks paying IOERappears to have created a new trading dynamic in the fed funds market. In this environment, those fed funds market participants which are not eligible to earn IOER on their balances at the Federal Reserve Banks because they are not DIs (such as the GSEs), appear to have become the primary sellers of fed funds. These institutions sell fed funds to DIs which have an incentive to borrow funds below IOER, to then hold the funds in their reserve account and earn IOER on those funds, though not all of these transactions are to address real funding needs. In addition to this arbitrage activity, a small percentage of fed funds trades appear to continue to occur between DIs, reflecting periodic cash management or other funding needs.

This current environment contrasts to historical observations of the fed funds market. In a monetary policy environment that did not include payment of IOER and much lower levels of reserves in the banking system, commercial banks, thrift institutions, agencies and branches of foreign banks in the United States, federal agencies, and government securities dealers were active sellers of fed funds. Many relatively small depository institutions that accumulated reserves in excess of their required reserves lent fed funds overnight to money center and large regional DIs, and to foreign DIs operating in the United States. Those buyers or borrowers of fed funds often used fed funds transactions to meet their reserve requirements. Federal agencies also lent idle funds in the fed funds market. Other financial institutions served as intermediaries in the market by borrowing and lending fed funds on the same day, usually channeling funds from relatively small to large depository institutions. (Note that brokers are not participants in fed funds trades, and so are not considered intermediaries in this context.)

Trading in Fed Funds may have Implications for Broader Financial Markets
Movements in the fed funds rate may have implications for the loan and investment policies of financial institutions, especially for commercial bank decisions concerning loans to businesses, individuals and foreign institutions. Financial managers may compare the fed funds rate with yields on other investments before choosing the combinations of maturities of financial assets in which they will invest or the term over which they will borrow. Interest rates paid on other short-term financial securities—commercial paper and Treasury bills, for example—often move up or down roughly in parallel with the funds rate. Yields on long-term assets—corporate bonds and Treasury notes, for example—are determined in part by expectations for the fed funds rate in the future.


1Fed funds transactions are excluded from reservable liabilities pursuant to the Board of Governors of the Federal Reserve System’s Regulation D: Reserve Requirements of Depository Institutions (12 CFR 204), which provides a list of entities who may be sellers or lenders for purposes of excluding such transactions from reservable liabilities. See 12 CFR 204.2(a)(1)(vii)(A).

2Under the Financial Services Regulatory Relief Act of 2006 (and the Emergency Economic Stabilization Act of 2008 which accelerated the effective date to October 1, 2008), the Board of Governors amended its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances and on excess balances.

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