Federal Funds Market Research Articles

The Recent Evolution of the Federal Funds Market and its Dynamics during Reductions of the Federal Reserve’s Balance Sheet

Following its May 2024 meeting, the Federal Open Market Committee (FOMC) announced that it would slow the pace of its balance sheet reduction starting in June 2024. This will allow for a more gradual transition from an abundant to ample supply of reserves. As reserves decline, conditions in money markets, including the federal (fed) funds market, will be important in judging whether the supply of reserves is approaching ample.

Monetary policy pass-through after the LCR

After the implementation of the Liquidity Coverage Ratio (LCR), trading in the federal funds market, which generally has a relatively favorable LCR treatment, became more driven by market liquidity. As a result, we document that pass-through of the federal funds rate to other short-term interest rates strengthened.

LCR Premium in the Federal Funds Market

We document the existence of a regulatory premium in the federal funds market related to the implementation of the Liquidity Coverage Ratio (LCR). We use difference-in-differences analysis and confidential bank level data on borrowing in the fed funds and Eurodollar markets to compare the interest rates paid by banks subject to daily reporting of their liquidity profile (daily reporters) relative to other banks. We find that, after the implementation of LCR, daily reporters paid a higher rate compared to other banks when borrowing in the fed funds market given the LCR-favorability of many of the lenders in this market. In addition, on the days that banks borrowed in both the fed funds and Eurodollar markets, daily reporters paid a higher rate than other banks for their borrowing in the fed funds market but not for their borrowing in the Eurodollar market.

Regulatory Requirements of Banks and Arbitrage in the Post-Crisis Federal Funds Market

Regulatory Requirements of Banks and Arbitrage in the Post-Crisis Federal Funds Market

Demand Segmentation in the Federal Funds Market

This paper outlines a model of demand segmentation in the federal funds market with two types of borrowers - the "interest on reserves (IOR) arbitrage'' type and the "regulatory'' type - which have different reservation prices and cannot always be separated. When fed funds trade above IOR, the "regulatory" type is revealed and consequently pays an interest rate closer to its real reservation price, pushing the fed funds rate further up. When fed funds trade below IOR, a decrease in the fed funds rate encourages entry in the market for IOR arbitrage purposes thus counteracting the downward pressure on the fed funds rate. We use probit regression models and daily data for the period April 2018 to February 2020 to provide empirical support for this model. We find the following: 1) When fed funds trade above IOR, there is, on average, a 10 percentage points increase in the probability that the fed funds rate increases the following period. Furthermore, analysis using confidential bank-level data shows that this increase in the probability is higher for banks that report their liquidity profile daily and that were present all trading days during this period. 2) When the fed funds trade below IOR, the probability of a decrease in the fed funds rate decreases with the widening of the spread between the fed funds rate and IOR.

Cyberattacks and Financial Stability: Evidence from a Natural Experiment

This paper studies the effects of a unique multi-day cyberattack on a technology service provider (TSP). Using several confidential daily datasets, we identify and quantify first- and second-round effects of the event. For banks using relevant services of the TSP, the attack impaired their ability to send payments over Fedwire, even though the Federal Reserve extended the time they had to submit payments. This impairment (first-round effect) caused other banks to receive fewer payments (second-round effect), leaving them at risk of having too few reserves to send their own payments (a potential third-round effect). These innocent-bystander banks responded differently depending on their size and reserve holdings. Those with sufficient reserves drew down their reserves. Of the others, smaller banks borrowed from the discount window, while larger banks borrowed in the federal funds market. These significant adjustments to operations and funding prevented the second-round effect from spilling over into third-round effect and broader financial instability. These findings highlight the important role for bank contingency planning, liquidity buffers, and the Federal Reserve in supporting the financial system’s recovery from a cyberattack.

The Federal Funds Market, Pre- and Post-2008

The Federal Funds Market, Pre- and Post-2008

Month-End Regularities in the Overnight Bank Funding Markets

The money market rates in the United States exhibit various calendar patterns that are grounded in institutional and regulatory factors. In this paper, we document a new regularity in the overnight fed funds market. Specifically, we identify patterns of decreased volatility along with consistent and significant month-end rate drops in the fed fund rates. Our findings suggest that short-term liquidity requirements of the Basel III reforms are, in part, responsible for the regularity in fed funds.

A New Daily Federal Funds Rate Series and History of the Federal Funds Market, 1928-54

This article describes the origins and development of the federal funds market from its inception in the 1920s to the early 1950s. We present a newly digitized daily data series on the federal funds rate from April 1928 through June 1954. 

A New Daily Federal Funds Rate Series and History of the Federal Funds Market, 1928-1954

This article describes the origins and development of the federal funds market from its inception in the 1920s to the early 1950s. We present a newly digitized daily data series on the federal funds rate from April 1928 through June 1954. We compare the behavior of the funds rate with other money market interest rates and the Federal Reserve discount rate. Our federal funds rate series will enhance the ability of researchers to study an eventful period in U.S. financial history and to better understand how monetary policy was transmitted to banking and financial markets. For the 1920s and 1930s, our series is the best available measure of the overnight risk-free interest rate, better than the call money rate which many studies have used for that purpose. For the 1940s-1950s, our series provides new information about the transition away from wartime interest-rate pegs culminating in the 1951 Treasury-Federal Reserve Accord.

Reserve balances, the federal funds market and arbitrage in the new regulatory framework

We study demand for reserves and trading dynamics in the federal funds market in the context of two banking regulatory changes: the widening of the FDIC assessment base and the introduction of the Basel III regulatory ratios. Using a novel panel of FDIC fee rates, we show that the widening of the assessment base changed the relative funding costs and incentives for banks to hold reserves. We document that foreign banks, not subject to the FDIC fee, experienced positive conditions for arbitraging between borrowing funds in the federal funds market and holding those funds in their reserves accounts to earn interest on excess reserves. As a result, foreign banks increased their reserve holdings and federal funds borrowing relative to domestic banks, contributing to a change in the distribution of reserves in the banking system and in the composition of banks’ balance sheets. Furthermore, we find that since the implementation of the Basel III leverage ratio, foreign banks have engaged in window dressing, with reserves and federal funds borrowing temporarily declining on reporting days. We introduce a model that incorporates the new regulatory framework and derive testable hypotheses to support our findings. Results suggest that: 1) following the implementation of the FDIC rule, the share of reserves over assets held by domestic banks was 4.5 percentage points lower than the share held by foreign banks. 2) after the public disclosure of the Basel III leverage ratio, foreign banks’ reserves on reporting dates relative to the period average dropped by 18.3 percentage points compared to domestic banks.

Can Monetary Policy Prevent Financial Crises?

Monetary policy is an important public policy, but it is not the only one to stabilize our economy and reduce its business cycles. The leading central bank, the Federal Reserve of the U.S., has introduced, after the 2008 global financial crisis, new instruments and unusual facilities to implement its new innovative monetary policy. The financial world and mostly the social scientists watch as the Federal Open Market Committee (FOMC) decides on a target interest rate in the federal funds market for the next period. The framework that the FOMC uses to implement monetary policy has changed over the last twelve years and continues to evolve today. Here, we try to evaluate the new instruments and their “effectiveness”. Before the 2008 financial crisis, policymakers used one set of traditional instruments (tools) to achieve the target rate. However, several policy interventions, introduced soon after the crisis, drastically altered the landscape of the federal funds market and the traditional economic theory. This new and uncertain environment, with enormous reserves and even interest on reserves, necessitated a new set of instruments by the Fed for its monetary policy implementation. Lately, after seven years of zero interest rate, the FOMC began in December 2015 to increase the target rate and then, went back again to a lower one, but many questions arise. How did they evaluate the effectiveness of these new instruments? Is the current federal funds rate the appropriate one for our economic wellbeing? How efficient was so far this ZIR monetary policy after the latest global financial crisis? Why the Fed put all these burdens of its ‘innovated” new monetary policy to the poor taxpayers (bail out) and to the risk-averse depositors (bail in)? Is it possible for the Fed’s policy to prevent the future financial crises? The federal funds rate was very low and affected negatively the financial markets (bubbles were growing), the real rates of interest (it is negative for twelve years), and the deposit rates (they are closed to zero for twelve years). The redistribution of wealth of depositors and taxpayers continues, which means the true economic welfare is falling and a new global recession was in preparation, if the current unfair easy money policy will persist, ignoring the necessity of a prevention of financial crises. Then, it came as an unexpected plague the coronavirus pandemic, following with a new but, the worse in economic history global crisis (chaos).

The Collateral Supply Effect on Monetary Policy

This paper starts by describing the evolution of US money markets over the course of the 1990s and the 2000s. The crucial transition was from an unsecured core money market, the Federal Funds market, to a collateralized market, the repo market. Due to this shift, collateral supply has become an important factor in money market dynamics. Three important implications of this transformation are discussed: First, government debt issues now affect the money market not just due to the need to settle payment for the debt, but also due to the on-going need to fund the carry of the debt. Second, because long-term debt is an important component of collateral supply, any significant increase in long-term rates will have a dramatic effect on the value of the aggregate collateral supply thereby making monetary policy implementation more difficult. Third, the events of March 2020 provide evidence of structural instability in the repo market, and of the problematic nature of a ‘dealer of last resort’ solution. This paper argues that the collateral supply implications of the new money market environment merit careful study, and critically evaluates the dealer of last resort, the proposal for a centralized counterparty for Treasuries, and the proposal for a standing repo facility.

How Did the Fed Funds Market Change When Excess Reserves Were Abundant?

Prior to the 2007-2008 financial crisis, excess reserves in the U.S. banking system were scarce. After the financial crisis and up until early 2018, excess reserves were abundant. In this article, the authors document, analyze, and explain the differences in the performance of the federal funds market under the two different excess reserves frameworks.

THE EVOLUTION OF THE FEDERAL RESERVE MONETARY POLICY GROUNDS IN THE LATE XX – EARLY XXI CENTURIES

The full-scale financial crisis in 2008–2009 years caused serious challenges for governments and central banks responsible for general economic policies and especially monetary policy measures. The Federal Reserve System of USA (or Fed) turned out to be among the most successful players who reacted adequately to the crisis. That’s why the evolution of monetary policy approaches in the USA during the last decades is of great theoretical and practical interest. The grounds of monetary policy in the USA can be studied within the analysis of the federal funds market, where the interaction of demand for and supply of reserves determines the federal funds rate. Since 1989 Federal Reserve used federal funds rate targeting, keeping this rate lower than the discount rate. In those times the main monetary tools of Fed were represented by open market operations, required reserves changes and discount rate changes. In January 2003 the role of discount rate had changed substantially. Since then Federal Reserve has kept the discount rate higher than the target for federal funds rate and treats it as a tool for limiting federal funds rate fluctuations and means of liquidity providing. The next important change was dated by October 2008, when the Fed decided to pay interest on reserve balances held by banks. The rate on reserves became an efficient low bound for the federal funds rate. By this Federal Reserve to a great extent copied the channel/corridor system for its basic short-term interest rate used earlier in Canada and some other countries. Under such conditions, the role of reserve requirements declined as the central bank received alternative means for controlling federal funds rate fluctuations. Summarizing the dynamics of monetary tools application by Federal Reserve we can conclude that during the last 30 years the situation has changed dramatically. Only open market operations are still used as a primary tool of monetary policy in the USA, because of their full control by Fed, flexibility, and quickness in implementation. Changes in reserve requirements are no used more. The role of discount rate evolved and together with the newly created tool – the interest rate on reserves paid by Federal Reserve – it is used today to determine the bounds for federal funds rate fluctuations. From the other hand, discount lending enables the Fed to perform its role of lender of last resort efficiently. During the year 2008 as crisis exploded, Federal Reserve used all the potential for interest rate decrease and faced the so-called zero-lower-bound problem. As a result, some nonconventional monetary policy tools such as quantitative easing (massive asset purchase programs) and forward guidance (management of economic agents’ expectations using commitments to future monetary policy actions) were proposed. Such measures turned out to became efficient enough to stabilize the economy of the United States. Key words: monetary policy, Federal Reserve, federal funds market, federal funds rate, open market operations, discount rate, reserve requirements, the rate on reserves.

The federal funds network and monetary policy transmission: Evidence from the 2007–2009 financial crisis

Using a network approach, we show how the federal funds market was transformed during the financial crisis through the collapse of the ABCP market in 2007, changes in monetary policy implementation, and an increase in counterparty credit risk. For both aggregate and bank-level network metrics, we find that increases in counterparty and liquidity risk are associated with reduced lending activity within the network. We also provide evidence that network peer effects are strong and influence banks’ holdings of reserve balances and rates paid in the federal funds market. Finally, we document how these changes to the network structure dampened the transmission of monetary policy.

Estimating the money market microstructure with negative and zero interest rates

The Furfine [The microstructure of the federal funds market. Financ. Markets Inst. Instrum., 1999, 8(5), 24–44] algorithm is a key tool for researchers in monetary economics and central banking because it allows identification of the interbank money market microstructure. Furfine's method has been used in numerous studies of money markets but little work has examined how valid its application is at zero and negative interest rates. This work seeks to address this gap. We first extend the standard algorithm to include negative rates and show the bias introduced by the zero interest rate. Secondly, we propose a econometric procedure based on market regularities and the economic likelihood of interbank bilateral relationships to correct the bias. Thirdly, the methodology is applied to TARGET2 data. The impacts of recent monetary policy decisions on key interest rates are studied. We find significantly biased figures when the market microstructure is not correctly estimated.

Implementing Monetary Policy after the 2008 Financial Crisis

Every six weeks or so (9 times during the year), the financial world watches as the Federal Open Market Committee (FOMC) decides on a target interest rate in the federal funds market for the next period. But what happens next? How do policymakers make sure that interest rates in the fed funds market trade within the target range? What will be the effect of the new target rate on the Wall Street and the Main Street? How efficient is so far the monetary policy after the latest global financial crisis? Is the target rate the correct one? The framework that the FOMC uses to implement monetary policy has changed over the last decade and continues to evolve today. Before the 2008 financial crisis, policymakers used one set of instruments to achieve the target rate. However, several policy interventions introduced soon after the crisis drastically altered the landscape of the federal funds market. This new and uncertain environment, with enormous reserves, necessitated a new set of instruments for monetary policy implementation. Lately, after December 2015, as the FOMC began to unwind the effects of these policy interventions, some questions arise: What rules will be followed by the Fed? What happens next as the federal funds market converges to a “new normal”? How effective will be the new policy? Can the Fed prevent a new crisis? The federal funds rate is very low and affects negatively the financial markets (bubbles are growing), the real rates of interest, and the deposit rates, which means the true economic welfare is falling and a new global recession is in preparation, if the latest easy money policy will continue.

Federal Funds Rate Control with Voluntary Reserve Targets

This note describes a framework for implementing monetary policy, dubbed a voluntary reserve targets framework, that could reintroduce significant margins in the federal funds market, reviving the market no matter the aggregate quantity of reserves, while simultaneously limiting the volatility of rates.

Clustering Heterogeneous Commercial Bank Lending Models

This research aims to uncover commercial bank business models through cluster analysis. Detailed regulatory snapshots of bank balance sheet data are used to derive a small set of bank lending features for clustering. These snapshots can be considered chronologically to better understand trends in the banking industry. For instance, the number of commercial banks has dramatically declined from 1980 to 2013 (the window of analysis). In addition, commercial bank business models have become more uniform or homogeneous with respect to lending activities. Characterizing banking business models is part of a larger research initiative focusing on agent-based modeling and simulation of the Federal funds market, as well as the detailed inter-bank lending market. Understanding banking business models is key to populating the agent ecosystem, implementing better behavior models and interpreting the simulation results. Unsupervised learning methods such as cluster analysis are a natural fit for this business model discovery challenge.