Fed Funds: Explained
- Raghav Duseja
- Feb 21, 2020
- 4 min read
Updated: Aug 26, 2020
What are Fed Funds
The fed funds market is an interbank borrowing market. What they are lending are bank reserves which are liabilities of the Fed - so given the hierarchy of money, reserves are 'money' for the banks. On the other hand, Fed funds are credit, i.e., interbank promises to pay reserves.
Fed funds are not the liability or asset of the fed.
Fed uses the FF target rate to try and influence the real economy. However, when we are near the 'lower bound' (which is currently 0), the Fed uses QE or expansion/contraction of its B/S to influence the economy (and markets).
There was a time when bank reserves were scarce and the Fed even tried to use this scarcity to control the disciple/elasticity balance in the monetary system. Not the case anymore though. The underlying reserves are not scarce anymore but the FF market is still active - because Fed funds are being used in the payment system.
How does it work
The fed account of any bank, during the day, will go into overdrafts multiple times. This leads to expansion of credit during the day. The banks are charged a small time weighted fee for this feature. However, if this overdraft has to go overnight, then there is a substantial cost.
So what a bank will do is find another bank which has excess reserves which it lend to it - overnight for a cost less than what the Fed is charging. This happens in the Fed Funds market. It is an interbank market where cash rich banks lend to banks which need cash. Fed funds is a promise to pay reserves tomorrow morning.
This same expansion of daylight B/S also happens on a private network called CHIPS. These also are eventually settled on the fedwire (there can be an overdraft at the fedwire also, which essentially means a double layer of credit expansion).
Member banks make deposits of collateral at CHIPS. Other members can borrow from CHIPS during the day. The obligations to any member bank is supposed to be of all the clearinghouse members together. The relevant interbank market for CHIPS is the Eurodollar market. This is a much larger market which also caters to banks which don't have convenient access to the Fed. This clearinghouse based system was actually the system which preceded the formation of the Fed.
All in all, these overnight overdrafts explain why there is a need for these interbank markets in the first place. However, banks don't come to the FF market only when they have overdrafts, they are trading all the time - they anticipate their needs.
Systemic risk
Credit doesn't reduce during these transaction, it just becomes bilateral - that is, away from Fed and CHIPS. So FF rate will show that daily imbalances are being pushed the next day (those that couldn't be cleared intraday), with the hope that they the balance will move the opposite way the next day. These balances are highly sensitive measure of the payment patterns in the economy.
Rolling over is an essential feature of financial markets today. If the markets freeze and you can't rollover, it can lead to serious distress in the system.
How does the Fed influence FF?
It manipulates the FF rate by influencing other things like the quantity of reserves in the system. It does this by entering other markets like the repo market. By changing quantity of reserves in the system, it manipulates the need for this interbank credit expansion.
So it changes money to influence credit.
So it makes overnight loans (repo) that creates additional reserves. So bank A gets reserves from Fed by repo. Now Bank A, if it wants to, can lend these reserves in the Fed Funds market. So the security dealer that is funding his security position by using his collateral to borrow from the fed - but winds up with reserves which it doesn't want - so can lend it in the Fed Funds market.
Another way the Fed influences the rate is through the FF-IOER arb.
FF-IOER arb
With the advent of the IOER, banks can borrow in the FF market and deposit at the Fed to earn IOER (interest on excess reserves.). The Fed relies on this arb to maintain control of the Fed Funds rate (practically doesn't hold all the time)
Taxpayer funded FHBLs are the primary lenders in the FF market. FHLBs don't get interest on their reserves at the Fed, therefore they lend in the FF market. FF borrowers are either Foreign banks or regional US banks.
Foreign banks borrow cash in FF and keep in at the Fed for IOER to get a risk free arb. Furthermore, EU banks only have quarterly leverage ratio disclosure requirements and don't have FDIC insurance fees, which makes it easier for them to conduct this arb.
Regional US banks, however, mostly use the FF market to meet their short term funding requirements.
There has been some fair criticism and rethink on this FHBL liquidity backstop. All this amount to essentially is a collateral upgrade by the FHBL. Follow this thread to understand how:
https://twitter.com/gamesblazer06/status/1239596569185472519?s=20 Unsecured overnight loans
FF market is the market for the best money in the world, ie, reserves at the Fed. However, these loans are unsecured and FF is mostly a brokered market, ie, not dealer based. So, in times of crisis, one bank may say to the broker that I am not willing to lending to this bank UNLESS you can get a dealer to come stand in between.
Repo, on the other hand is collateralized and dealer based. But there you have to ensure that the collateral is good.
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