Business, Legal & Accounting Glossary
Federal Funds transactions redistribute bank reserves. Federal funds are reserve balances at Federal Reserve Banks that can be transferred between depository institutions within the same business day. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions, and transactions in the federal funds market enable depository institutions with reserve balances in excess of reserve requirements to sell reserves to institutions with reserve deficiencies. Federal funds transactions neither increase nor decrease total bank reserves. Instead, they redistribute bank reserves and enable otherwise idle funds to yield a return.
Participants in the federal funds market include commercial banks, thrift institutions, agencies and branches of foreign banks in the United States, federal agencies, and government securities dealers. Many relatively small institutions that accumulate reserves in excess of their requirements lend reserves overnight to money centre and large regional banks, and to foreign banks operating in the United States. Federal agencies also lend idle funds in the federal funds market.
Federal funds can be called the heart of the money market in the sense that they are the core of the overnight market for credit in the United States. Moreover, current and expected interest rates on federal funds are the basic rates to which all other money market rates are anchored. First, they are short-term borrowings of immediately available money–funds which can be transferred between depository institutions within a single business day. In 1991, nearly three-quarters of federal funds were overnight borrowings. In 1991, total daily average gross RP (Repurchase agreement) and federal funds borrowings by large commercial banks were roughly $200 billion, of which approximately $135-140 billion were federal funds.
Competition among banks for funds ties the RP rate closely to the federal funds rate. The RP rate has historically been below the federal funds rate because RPs are collateralized, which makes them safer than federal funds, and because arranging RPs entails additional transactions costs. Data on RP rates paid by banks to their corporate customers are not available, but from 1983 to 1990 the dealer RP rate (the rate government security dealers pay to obtain funds through RPs) was around 20 to 25 basis points below the federal funds rate. For reasons hard to explain, the dealer RP rate was higher than the federal funds rate during most of 1991.
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This glossary post was last updated: 13th February, 2020