Monday, September 14, 2009

Mechanics of federal fund trading

The Mechanics of federal fund trading vary depending upon the locations of the buying (borrowing) and selling (lending) institutions. For example, suppose two commercial banks involved in a Federal funds transaction are located in the heart of the New York money market. These banks can simply exchange checks. The borrowing bank is given a check drawn on the lending bank‘s reserve account at the Federal Reserve Bank of New York or drawn on a correspondent balance held at some other bank in New York City. This check is payable immediately ("same day money"), and, therefore Fed funds are transferred to the borrower‘s reserve account before the close of business that same day. The lender, on the other hand, receives a check drawn on the borrower. This check is "one-day money" (i.e., payable the following day) because it must pass through the New York Clearing House for proper settlement. thus, funds flow instantly to the borrowing bank‘s reserve account and are automatically returned to the lending bank‘s reserve account the next day or whenever the loan agreement terminates.
Interest on the loan may be included when the funds are returned, paid by separate check, or settled by debiting and crediting correspondent balances. If the transacting institutions are not both located within the New York Federal Reserve District, the loan transaction proceeds in much the same way except that two Federal Reserve banks are involved. Once borrower and lender agree on the terms of a Federal funds loan, the lending institution will directly, or indirectly through a major correspondent bank, contact the Federal Reserve Bank in its district, requesting a wire transfer of funds. the Federal Reserve bank then merely transfer reserves trough the Fed‘s wire network to the Federal Reserve bank serving the region of the country where the borrowing institution is located. Funds travel the reverse route when the loan is terminated.

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