Federal funds, also known as fed funds are reserves that banks hold in their Federal Reserve Bank account. These fed funds need to be maintained as per the Regulation D reserve requirement. Banks having excess fed funds above the requirement can lend to other financial institutions having account at a Federal Reserve Bank. The common terminology is fed funds purchased and fed funds sold.
- Fed funds purchases are not government-insured and are not subject to Regulation D reserve requirements or insurance assessments.
- Only depositary institutions that are required to hold reserves with Federal Reserve Banks can borrow fed funds. These include commercial banks, savings banks, savings and loan associations, and credit unions.
- These transactions do not require any formal written contract.
- These transactions are conducted on an overnight-only basis. Term fed funds generally mature between two days to one year.
- The contracts can be continuing contracts that are automatically renewed unless specifically terminated by either party. The interest payments on continuing contract are computed based on each day’s average fed funds rate.
- Fed funds transactions are usually unsecured. However, collateralization may be required for the seller if the credit quality of the purchaser is not strong.
- Funds may be transferred between depositary institutions using two methods:
- The selling institution authorizes its district Federal Reserve Bank to debit its reserve account and credit the reserve account of the buying institution. Fedwire, the Federal Reserve’s electronic funds and securities transfer network, is used to complete the transfer with immediate settlement. On the maturity date, the funds are reversed in the same way.
- A respondent bank tells its correspondent that it intends to sell funds. In response, the correspondent bank purchases funds from the respondent by reclassifying the respondent’s demand deposits as federal funds purchased. The respondent does not have access to its deposited money as long as it is classified as federal funds on the books of the correspondents. Upon maturity of the loan, the respondent’s demand deposit account is credited for the total value of the loan plus interest.
The fed funds are lent by banks to other banks which need more funds to meet Regulation D reserve requirements or as an additional funding source. Reserve accounts do not earn interest, therefore, banks prefer to sell fed funds instead of maintaining excess funds in their reserve accounts. Community banks hold overnight fed funds sold as a source of primary liquidity.