The overnight federal funds rate is currently the base interest rate which anchors the entire U.S. financial system. For years, it was the only benchmark short-term interest rate, at least until the overnight Repo rate came around.
Banks are required to keep a certain portion of their deposits as reserves at the Fed. Any cash in excess of those “required reserves” and not written as loans are a bank’s “excess reserves.” Those reserves can be deposited at the Fed or loaned to other banks in the inter-bank federal funds market.
I always wondered what “fed funds” actually meant. It’s not “Fed Funds” with a capital “F,” the term is short for “federal funds.” Where did the “federal” part come from?
The first federal funds were traded in New York in the summer of 1921. Back in the day, banks could transfer funds between each other in two ways: from their clearinghouse account or from their account at their Federal Reserve Bank. A clearinghouse transfer took at least one day to clear whilst the Fed account cleared on the same day. If a bank needed funds to clear a transfer in their clearinghouse account, they could borrow those funds from another bank which settled at the Federal Reserve Bank account. The next day, when the clearinghouse funds arrived, the overnight loan in their Federal Reserve Bank account was paired-off and netted. Thus the origin of borrowing “federal funds” – funds that could be borrowed from another bank at a Federal Reserve Bank account.
Participation in the federal funds market was limited to banks who held funds at the Federal Reserve Banks. The Fed liked the federal funds market because it provided members with a way to borrow bank reserves without tapping the discount window. By 1930, trading in federal funds included wire transfers and other payment methods. Non-banks were prohibited from the fed funds market, but it was not yet an official rule.
As the U.S. financial system matured in the 1960s, non-banks wanted an overnight cash investment that paid a market interest rate, but they were not allowed to access to the federal funds market. Instead, the overnight Repo rate became the means of allowing non-banks to earn an overnight rate, though it was slightly below the federal funds rate. The combination of the federal funds rate for banks and the Repo rate for non-banks became the dual overnight rates of the U.S. financial system.
The prohibition of non-bank access to the federal funds market was formalized by the Monetary Control Act of 1980. In it, only banks which held reserves at the Federal Reserve were allowed to participate in the federal funds market, all other financial institutions were relegated to the Repo market.
The Market Today
The fed funds market today is structured along the same lines as the Repo market. There is no exchange or central marketplace, instead, buyers and sellers meet at the different inter-dealer brokers (IDB), which include: ICAP, Tullet, Tradition, Cantor, etc. Participants in the funds market include large banks, small banks, GSEs, and foreign banks. At the end of every trading day, the Federal Reserve publishes the weighted average of all of the IDB trades which becomes the “federal funds effective rate,” along with the high and low trade of the day. The CME’s Fed Funds Futures contact is based on the effective rate, whereas the opening trade in fed funds each morning is used to price many other financial contracts.
Fed Funds And Repo
The Repo market, by comparison, is made up of banks, securities dealers, money funds, hedge funds, and many other financial institutions. The Repo market includes both the banking system and the shadow banking system, all in one place. It’s the overnight borrowing and lending market of the entire financial system.
Though the federal funds rate is the target short-term rate for monetary policy, the Fed uses the Repo market to manage the rate. In the past, the Fed used Matched-Sales (now Reverse-Repo operations) to drain funds; System RP, Customer RP to add liquidity, and just recently added the Fixed-Rate Reverse-Repo Facility. Basically, the Fed uses the Repo market to drain and add cash to keep the fed funds rate near its target rate. Under the 0% rate environment, there’s less fine tuning required. Given the fed funds target is a range of .25% to 0%, there’s much less day-to-day adjustments involved. If, and when, the fed funds rate becomes a specific target rate again, there will be more fine tuning.
The Spread Between GC And Fed Funds
The Repo rate for Treasury collateral (General Collateral or GC) should always trade a couple of basis points below fed funds, but it doesn’t. GC Repo is collateralized by a U.S. Treasury security whereas fed funds is an uncollateralized loan. In other words, there’s nothing backing that fed funds loan except the credit of the counterparty. Granted the overnight risk is minimal; GC is still more secure. Even so, GC has traded anywhere from 25 basis points above fed funds to 500 basis points below fed funds over recent years.
There’s always a general trend in the relationship between the two markets, but over time, the spread can vary wildly. The spread between GC and fed funds tells a lot about the financial markets at any given time. It’s a good indication of what’s going on behind the scenes, especially over quarter-end when cash and balance sheets are tight. At times, the spread shows when there’s stress in the market and when market participants are over-leveraged.
In general, things like a flight-to-quality, supply and demand for Treasurys, and new Treasury issuance are all factors which affect rates in the Repo market, but not necessarily the fed funds market. A crisis will move GC well below fed funds. We’ve seen terrorist events, a banking crisis, a liquidity crisis which create strong demand for Treasury collateral. In reality, they’re two separate markets that are interconnected.
Back in the 1980s, the GC Repo rate commonly traded between 25 and 30 basis points below fed funds; the relationship was simpler back then and Repo was viewed as a collateralized loan verses fed funds as uncollateralized.
When GC is above fed funds, it usually means there’s oversupply of Treasury securities in the market or bank balance sheets are limited. During the Savings And Loan Crisis in the early 1990s, the GC/fed funds relationship reversed and GC traded between 20 and 25 basis points above fed funds. Banks could not arbitrage the two markets to bring them back inline.
Beginning of 2001 there was another shift in the spread between the two markets. The CFTC changed their 1.25 rule allowing for FCMs (Futures Commission Merchants) to invest their Seg fund cash in Repo in corporates and agencys, instead of just Treasurys. The spread premium that U.S. Treasury collateral enjoyed narrowed. In late 2000, GC was averaging 7 basis points below fed funds, after the beginning of 2001, GC averaged only 3.5 basis points below funds.
One Way Arbitrage
There’s an arbitrage between the two markets, but it only works in one direction. When the GC Repo rate is greater than fed funds, funds traders can borrow collateral instead of lending funds to another bank. Thus, when there’s upward pressure in GC, cash moves from fed funds into Repo and the two rates remain connected. Higher GC rates will pull the funds rate higher. There’s a limit as to how high GC can trade relative to funds, as long as banks are willing to arbitrage the market. When the relationship between GC and fed funds is out of balance, it’s usually on a quarter-end or year-end when banks have balance sheet limitations.
The arbitrage does not work the other way around. If GC rates are below fed funds, there’s really nothing that can be done. When an investor is demanding U.S. Treasury collateral, you can’t substitute an uncollateralized loan for it. That’s why GC can drop hundreds of basis points below fed funds.
According to Liberty Street Economics, the size of the fed funds market was $200 billion in 2007 and was down to only $60 billion in 2012. The Repo market, by contrast, was as large as $7 trillion in 2007 and is estimated to be around $4.5 trillion today.
Remember, I’m a biased Repo market veteran so I don’t see much use in fed funds as the policy rate anymore. Yes, it’s good to have a market for banks to borrow and lend excess cash, but it shouldn’t be used as the benchmark rate for U.S. monetary policy and the world’s benchmark currency. The Repo market is the overnight market for the entire financial system, as opposed to just the declining inter-bank market. I’m surprised the Fed didn’t switched to targeting the Repo rate years ago.
Scott E.D. Skyrm
About the Author: Scott E.D. Skyrm
I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.