Some ABCs Of Trading In Fed Funds

The interbank market for fed funds is a key source of the reserves that banks need to meet Fed requirements.

Banks must keep reserves equal to 12% of most of their demand deposits over a two-week reserve maintenance period. To do that, they retain cash generated by their businesses and borrow reserve funds in the interbank market - the federal funds market - from banks with surpluses.

The Fed sets the target fed funds rate as an indication of its monetary policy. If the Fed thinks interest rates are too low, it pushes up the funds rate by selling Treasury securities. That effectively drains cash from the market.

Most banks try to avoid holding more fed funds than they need. Holding surplus borrowed funds means paying unnecessary interest charges. And the Fed allows banks to come up a little short from time to time. But the penalty for having insufficient reserves during a maintenance period is tight regulatory scrunity - or worse, if violations are repeated.

A Balancing Act

Keeping the optimal amount of fed funds should be easy. All a bank must do is compute its needs based on the amount of deposits it has.

But the period in which a bank's reserves requirement is measured almost exactly overlaps that in which it must settle with the Fed. As a result, banks must try to predict not only the best time to buy within a measurement period so as to pay the lowest rate, but also the amount of fed funds they'll need in the period.

"As you get closer to the end of the settlement period, if you've missed and you've only got one day left, it gets a little more critical," said Paris Thermenos, treasurer of Barnett Banks Inc.

When banks make mistakes in predictions, or when technical glitches suddenly leave them with a reserve position they did not expect at the end of a two-week settlement period, the fed funds rate can soar.

Wednesday afternoon, for example, banks that had deferred fed funds, purchases earlier in the week suddenly started to buy more.

Banks had waited to buy because they thought the Federal Reserve would lower interest rates, reducing the banks' interest costs, traders said. But with hours to go in the settlement period, they were hurrying to buy the reserves they needed. As a result, fed funds traded at 8% Wednesday afternoon, well above the 5.5% target.

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