Sunday, September 13, 2009

The Nature of Federal Funds

The name of federal funds came about because early in the development of the market principal source of immediately available money was the reserve balances which member banks keep at the Federal Reserve Banks. If one member bank needs to transfer funds to another, it need only contact the Federal Reserve Bank in its district, and money is transferred into the appropriate reserve account- a transaction accomplished in minutes or seconds by computer.
Today, however, the fed funds market is far broader in scope than just reserves on deposit with the Federal Reserve banks. For example, virtually all banks maintain deposits with large correspondent banks in the principal U.S. cities, and these deposits may be transferred readily by wire from the account of one bank to that of another. Savings and loan associations, credit unions, and mutual savings banks maintain deposits wit commercial banks that also are available for immediate transfer to a customer or to another financial institution. Because corporations and state and local governments can lend Federal fund by executing repurchase agreements with securities dealers, banks, or other funds traders. Securities dealers who have received payment for securities sold can turn around and make their funds immediately available to borrowers through the federal fund market. Borrowers of Federal funds include securities dealers, corporation, state and local governments, and nonbank financial intermediaries, such as savings and loan associations and insurance companies. Without question, however, the most important of all borrowers in the Fed funds market are commercial banks, which use this instrument as the principal way to adjust their legal reserve positions.

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