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.
The Fed Wire is an electronic funds transfer system linking
Settlement of transfers is same-day, which is convenient for large fund transfers. US banks maintain deposits with their regional Federal Reserve banks, which allows them to use the system for settling a variety of interbank transactions, such as loans, certificates of deposit, or repos. The deposits are called Fed funds. The main reason banks hold them is that the Fed requires them to maintain cash reserves as Fed funds.
Deposits at the regional Federal Reserve banks earn no interest, so banks perform a balancing act every day, trying to offset transactions in and out of their accounts so they end each day with Fed funds that equal but do not exceed their reserve requirements for the day.
On any given day, some banks find themselves short Fed funds while other banks find they have excess Fed funds. There are various ways banks can lend each other their Fed funds. Repos are a form of secured lending. There is also a large market for unsecured loans. This is called the Fed funds market. Most of those loans are arranged by brokers. Transactions can be for terms of as long as a year, but the vast majority are overnight loans.
One way the Fed conducts its monetary policy is to set a target interest rate for overnight Fed Funds. The actual rates banks pay are negotiated by those banks, but by expanding or contracting the money supply, the Fed can usually move those rates towards its target rate. When you hear people speak about the Fed funds rate, they may be referring to the Fed’s stated target rate. They may also be referring to the effective fed funds rate. This is a dollar-weighted average of interest rates payable on overnight Fed funds. It is compiled daily by the New York Federal Reserve Bank and is based on transactions arranged by major brokers.
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This glossary post was last updated: 29th December, 2021 | 0 Views.