The Federal Funds Market
The federal funds market is a market that deals with reserve balances that are readily available at the Federal Reserve. The main aim of creating the Federal Funds Market was to deal with the banking panics that were being experienced at the time. Institutions that are of a depository nature can keep accounts at the Federal Reserve where they are allowed to sell or buy reserve balances. The term Federal Funds is used to refer to unsecured loans offered at the Federal Reserve. Banks borrow these federal funds with the aim of maintaining their reserves. Banks can also keep their reserves at the Federal Reserve Banks in order to clear their financial transactions, meet the reserve requirements and to also prevent the occurrence of any overnight drafts due to the payment activities done with other depository institutions (Willis 50). The rate at which the federal funds transactions take place is called the fed funds rate. The duration of most trades is typically overnight but there are those trades that take longer terms. They are referred to as fed funds. The federal funds market offers one option of adjusting the level of bank reserves as the day to day activities of a business to and from a bank are usually most likely to leave a bank with low levels of reserves.
The federal funds don’t decrease or increase the total bank reserves. They help the bank to utilize their idle funds so that they can yield a return as well as redistributing the reserves. Federal funds are always available for immediate spending making them definitive money unlike checks which have to be cleared by banks taking several days in the process before the money becomes available for spending (Levy 100). There are several participants in the federal funds market. These participants include federal agencies, security firms, loans and savings associations, commercial banks, foreign banks’ branches in the U.S and government sponsored institutions.
The Federal Funds Market originated in New York and was created on 23rd December, 1913 through the formation of the Federal Reserve Act, mainly due to an economic crisis that was going on at the time. The Great Depression that was experienced after the world cup was a major contributor to the formation of the market. The depression led to disparities in reserve positions of major New York City banks. Some banks had an excess while others had to borrow from the reserve bank. A meeting of bank officials was done and some of them from various banks agreed to be selling and buying excess reserves as a means of adjusting their reserve positions (Balles 68). The New York acceptance houses soon joined the market and became very active in their dealings with the reserve bank of New York. They paid out and also received Federal Funds as they went on with their operations.
New York City was the dominant player in the early Federal funds market. After the World War 2, dealers increased their dealings with the Federal Reserve Market. A marked improvement in the wire-transfer facilities together with increased competition from the banks also largely contributed to the development of the Federal funds market. This led to the accommodation of other correspondent banks. The Federal Bank Market is loosely organized with no particular dealer maintaining a position in the Federal funds. This means that no dealer stands ready to sell or buy the reserves at a quoted price. Of the total volume of transactions, a large part is played by correspondent banks. The Federal Reserve Market/System is made up of Board of Governors that are appointed by the president, advisory councils, the Federal Open Market Committee, twelve Federal Reserve Banks that are located in several regions throughout the country and many privately owned member banks in the United States (Roberts 80).
Many of the participants in the federal funds market now use the market to adjust their reserve positions. This is to meet their reserve deficiencies or to dispose off any excesses that may have accrued. There are three groups of adjusting banks. The first one consists mainly of the large banks that are usually involved in trying to balance their reserves without either a deficiency or an excess. This makes up the largest group. They mainly shift between borrowing and lending with the aim of covering a deficiency or disposing an excess in their own reserves. The second group consists of the smaller banks which have a policy of trying to keep a cushion on their excess reserves (Stogner 40). These banks are mainly engaged in buying and are considered to be rare buyers. Lastly, the third group consists of a small group of banks that use the Federal funds market to meet persistent deficiencies in their reserves. They are mostly engaged in buying or, in case they are both sellers and buyers, their balance reflects that they are net buyers.
There is also another category of banks that accommodate other banks. These banks have two uses of the Federal funds market. The first purpose is to for adjusting their reserve positions while the second purpose is to accommodate other customers together with their correspondents (Balles 72). These banks are two-way traders and they usually sell and buy federal funds on the same day. They engage in transactions that are contrary to heir reserve positions. There are several factors that determine to what extent banks use the Federal funds market. One of these factors is the relative cost of other alternative sources even though it is not considered as a dominant factor in the market.
The level of time that a reserve deficiency or excess is supposed to last is also an important factor with the short-dated securities being more appropriate for adjustments of deficiencies and excesses that will persist over a period of time. There is also the issue of the attitude that bank officials have towards the borrowing from the Reserve Bank. Some banks use the Reserve Bank as a last resort. The banks usually have a strong preference for the Federal funds market than the Reserve bank. There are others that prefer to use the Reserve Bank to correct their deficiencies while using the Federal funds market to dispose their reserve excesses (Stogner 90). There are also cases where excess reserves are largely held by banks that don’t participate in the market making the available supply quite limited and this can end up affecting the market as there is no availability of funds.
The Federal funds market aims at keeping the interest rates at a moderate level, keeping prices stable and maintaining employment by regulating the monetary policy. This is of great importance today as it helps deal with financial global crisis that is being experienced by helping regulate the monetary policy. The Federal funds market also helps in the supervision of the banking system in the United States as well as furnishing an elastic currency and rediscounting the commercial paper (Stogner 102). The current functions of the Federal funds market are addressing the problem of banking crisis that may arise from time to time, serving as the United States central bank, regulating and supervising banking institutions, protecting consumers credit rights, moderating interest rates, stabilizing the prices to prevent deflation or inflation, to create maximum employment, maintaining the financial system’s stability, responding to local liquidity needs, facilitating payments’ exchange among regions and strengthening the standing of the United States in the global economy.
Bank runs lead to a number of economic and social problems and should therefore be controlled by the Federal Reserve to keep them at a minimum serving as a last resort lender in the case a bank run occurs. The bank runs can also be prevented by having an elastic currency-a currency that has the ability to expand when needed and also to contract according to the current economic conditions ((Roberts 85). The Federal Reserve System also acts as a last resort lender for those institutions which are on the brink of collapse or which cannot obtain credit elsewhere and their collapse would have adverse implications on the nation’s economy.
In conclusion, it is evident from the above that the Federal funds market plays a vital role in the stabilization of the economy of the United States. There are situations that if not tackled would have adverse effects on the economy. The collapse of some institutions can lead to inflation which would in turn raise the living standards of the citizens. The maximization of employment opportunities is also another positive of the Federal funds market which helps the citizens to keep their jobs while also allowing others to acquire jobs (Levy 98). The regulation of interest rates ensure that banks don’t exploit their customers by charging exorbitant interest rates that would quickly enrich them in turn frustrating the customers. The regulation of prices ensures that the citizens are able to meet their daily needs at reasonable prices. All these shows that the Federal funds market helps to maintain the living standards of the American people or even in some instances making them better. This ensures that the United States economy is stable.
Works Cited
Balles, John. The federal funds market. Washington, DC: Board of Governors of the Federal Reserve System, 1959.
Levy, Marvin. The federal funds market: development, structure, and potential for growth. New York: New York Institute of Technology, 1978.
Roberts, Paul. The Federal funds market: a short-term money market mechanism. Illinois: Southern Illinois University, 1962.
Stogner, Charles. The Federal Funds Market: its impact on monetary policy. Texas: Texas Technological College, 1964.
Willis, Parker. The Federal Funds market: its origin and development. Boston: Federal Reserve Bank of Boston, 1970.
