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In theUnited States,federal funds are overnight borrowings betweenbanks and other entities to maintain theirbank reserves at theFederal Reserve. Banks keep reserves at Federal Reserve Banks to meet theirreserve requirements and to clear financial transactions. Transactions in the federal funds market enabledepository institutions with reserve balances inexcess of reserve requirements to lend reserves to institutions with reserve deficiencies. These loans are usually made for one day only, that is, "overnight". The interest rate at which these transactions occur is called thefederal funds rate. Federal funds are notcollateralized; likeeurodollars, they are anunsecuredinterbank loan.[1]
Federal funds transactions by regulated financial institutions neither increase nor decrease total reserves in the banking system as a whole, instead, they redistribute reserves.[2] Before 2008, this meant that otherwise idle funds could yield a return. (Since 2008, the Fed has paidinterest on bank reserves,[3] including excess reserves.) Banks may borrow these funds in order to meet the reserves required to back their deposits. Federal funds aredefinitive money, meaning that they are available for immediate spending, while checks and many other forms of money must be cleared by banks and typically take several days before becoming available for spending.
Participants in the federal funds market includecommercial banks,savings and loan associations,government-sponsored enterprises, branches of foreign banks in the United States,federal agencies, andsecurities firms. Many relatively small institutions that accumulate reserves in excess of their requirements lend reserves overnight tomoney centers and largeregional banks, as well as to foreign banks operating in the United States. Federal agencies also lend idle funds in the federal funds market.
TheFed, which is thecentral bank of the United States, conductsmonetary policy primarily by targeting a certain value for the federal funds rate. If the Fed wishes to move to, for example, a more expansionary monetary policy, it conductsopen market operations, which include primarily bank reserves; since this puts more liquidity into the banking system, it pushes down the federal funds rate.
