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Trading and Capital-Markets Activities Manual

Instrument Profiles: Federal Funds 
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Federal funds (fed funds) are reserves held in a bank's Federal Reserve Bank account. If a bank holds more fed funds than is required to cover its Regulation D reserve requirement, those excess reserves may be lent to another financial institution with an account at a Federal Reserve Bank. To the borrowing institution, these funds are fed funds purchased. To the lending institution, they are fed funds sold. 

CHARACTERISTICS AND FEATURES 

Fed funds purchases are not government-insured and are not subject to Regulation D reserve requirements or insurance assessments. They can be borrowed only by those depository institutions that are required by the Monetary Control Act of 1980 to hold reserves with Federal Reserve Banks: commercial banks, savings banks, savings and loan associations, and credit unions. These transactions generally occur without a formal, written contract, which is a unique feature of fed funds. 

Most fed funds transactions are conducted on an overnight-only basis because of the unpredictability of the amount of excess funds a bank may have from day to day. Term fed funds generally mature between two days to one year. Continuing contracts are overnight fed funds loans that are automatically renewed unless terminated by either the lender or the borrower- this type of arrangement is typically employed by correspondents who purchase overnight fed funds from respondent banks. Unless notified to the contrary by the respondent, the correspondent will continually roll the inter-bank deposit into fed funds, creating a longer-term instrument of open maturity. The interest payments on continuing contract fed funds loans are computed from a formula based on each day's average fed funds rate. 

Fed funds transactions are usually unsecured. Nevertheless, an upstream correspondent bank that is selling funds may require collateralization if the credit quality of the purchaser is not strong. All fed funds transactions involve only Federal Reserve Bank accounts. Two methods are commonly used to transfer funds between depository institutions: 

The selling institution authorizes its district Federal Reserve Bank to debit its reserve account and credit the reserve account of the buying institution. Fedwire, the Federal Reserve's electronic funds and securities transfer network, is used to complete the transfer with immediate settlement. On the maturity date, the buying institution uses Fedwire to return the funds purchased plus interest. 
A respondent bank tells its correspondent that it intends to sell funds. In response, the correspondent bank purchases funds from the respondent by reclassifying the respondent's demand deposits as federal funds purchased. The respondent does not have access to its deposited money as long as it is classified as federal funds on the books of the correspondents. Upon maturity of the loan, the respondent's demand deposit account is credited for the total value of the loan plus interest. 

USES 

Banks lend fed funds to other banks which need to meet Regulation D reserve requirements or need additional funding sources. Since reserve accounts do not earn interest, banks prefer to sell fed funds rather than keep higher than necessary reserve account balances. Community banks generally hold overnight fed funds sold as a source of primary liquidity. 

DESCRIPTION OF MARKETPLACE 

Transactions may be done directly between banks, often in a correspondent relationship, or through brokers. They may be initiated by either the buyer or the seller. Many regional banks stand ready to buy all excess funds available from their community bank correspondents or sell needed funds up to a predetermined limit. Consequently, there is a large amount of demand in the fed funds market, with selling banks easily able to dispose of all excess funds. Correspondent banks may also broker funds as agent as long as their role is fully disclosed. Fed funds, including the term fed funds, are nonnegotiable products and, therefore, there is no secondary market. 

Market Participants 

Participants in the federal funds market include commercial banks, thrift institutions, agencies and branches of banks in the United States, federal agencies, and government securities dealers. The participants on the buy side and sell side are the same. 

Market Transparency 

Price transparency is high. Inter-bank brokers disseminate quotes on market news services. Prices of fed funds are active and visible. 

PRICING 

Fed fund yields are quoted on an add-on basis. All fed funds yields are quoted on an actual/360-day basis. The fed funds rate is a key rate for the money market because all other short-term rates relate to it. Bid/offer spreads may vary among institutions, although the differences are usually slight. The fed effective rate on overnight fed funds, the weighted average of all fed funds transactions done in the broker's market, is published in The Wall Street Journal. Thompson Bank watch rates the general credit quality of banks, which is used by banks when determining credit risk for fed funds sold. 

Rates on term fed funds are quoted in the broker's market or over the counter. In addition, money market brokers publish indicative quotes on the Telerate screen. 

HEDGING 

Due to the generally short-term nature of fed funds, hedging does not usually occur, although fed funds futures contracts may be used as hedging vehicles. 

RISKS 

Interest-Rate Risk 

For non-term fed funds, interest-rate risk is minimal due to the short maturity. For term fed funds, interest-rate risk may be greater, depending on the length of the term. 

Credit Risk 

Fed funds sold expose the lender to credit risk. Upstream correspondent banks may require collateral to compensate for their risks. All banks should evaluate the credit quality of any bank to whom they sell fed funds and set a maximum line for each potential counterparty. 

Liquidity Risk 

The overnight market is highly liquid. As there is no secondary market for term fed funds rates, their liquidity is directly related to their maturity. Banks may purchase fed funds up to the maximum of the line established by selling financial institutions. Those lines are generally not disclosed to purchasing banks. Active users may need to test the availability of funds periodically to ensure that sufficient lines are available when needed. 

ACCOUNTING TREATMENT 

Fed funds sold should be recorded at cost. Term fed funds sold should be reported as a loan on the call report. 

RISK-BASED CAPITAL WEIGHTING 

A 20 percent risk weight is appropriate for fed funds. For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.'' 

LEGAL LIMITATIONS FOR BANK INVESTMENT 

A bank may sell overnight fed funds to any counterparty without limit. Sales of fed funds with maturities of one day or less or under continuing contract have been specifically excluded from lending limit restrictions by 12 CFR 32. Term fed funds are subject to the 15 percent lending limit with any one counterparty and may be combined with all other credit extensions to that counterparty. Sales of fed funds to affiliates are subject to 12 USC 371c, ''Loans to Affiliates.'' 

REFERENCES Federal Reserve Bank of New York. Fedpoints #15. New York, June 1991. 
Federal Reserve Bank of Richmond. Instruments of the Money Market. Richmond, Virginia. 1993. 
Stigum, Marcia. The Money Market. 3rd ed. Homewood, Illinois: Business One Irwin, 1990. Woelfel, Charles J. Encyclopedia of Banking & Finance. 10th ed. Chicago: Probus Publishing Company, 1994.

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