'Federal Funds' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Federal Funds refers to the excess reserves which financial institutions such as commercial banks choose to deposit with their regional Federal Reserve Bank. These are also often called Fed Funds. Such funds may be lent out to other participants in the market who lack enough immediate cash on hand to cover their own mandatory minimum reserves and lending opportunities. Such loans are never secured and are offered at comparatively lower interest rates. This rate is known as the overnight rate or the Federal Funds rate. The name comes from the time period over which such loans are actually offered.
Such Fed Funds aid the commercial banks in their daily needs to attain their required reserves. These represent the sum of money which the banks must keep on hand with the regional Federal Reserve Bank. It is actually the total volume of a bank’s customer deposits which determine the level of their particular reserve requirements. The Fed establishes either a range or alternatively a particular target rate for its fed funds rate. This is then adjusted from time to time according to monetary needs and economic conditions in the country.
Within the U.S., the market for fed funds operates on a parallel basis with the Eurodollar offshore deposit market. These Eurodollars trade on an overnight basis. Not surprisingly their interest rate proves to be nearly equal to that of the fed funds rate. Yet the transactions have to be actually booked from anywhere outside of the borders of the U.S. In fact many international banks will commonly employ their branches residing in Panama or the Caribbean (such as the Cayman Islands or Bermuda) to run such accounts. This is ironic, given that such transactions are typically executed from trading rooms located within the United States. Each of the two markets is wholesale and covers any transactions which range from at least two million dollars on up to in excess of a billion dollars.
The Federal Reserve carries on an important function using its Fed Funds. They deploy their famed open market operations in order to control the amount of money flowing through the national level economy and utilize adjustments to short term interest rates. This translates into the Fed selling and buying up a portion of the government bills and bonds it has previously issued out to commercial banks. Doing so actually decreases or increases the total money supply for the country. As a benevolent side effect, it then raises or lowers the shorter term time frame interest rates. It is actually the Federal Reserve Bank of New York (FRBNY) that physically carries out these open market operations.
As a point of fact, this federal funds rate is most similar to the shorter term time frame interest rates in the commercial markets. It means that their actions and the ensuing market reactions literally impact not only U.S. rates, but also LIBOR rates in London and Eurodollar rates. At the conclusion of every trading day, the Fed announces its daily effective fed funds rate. This proves to be the weighted average transaction rate for all tallied transactions throughout the business day.
There are a variety of participants in this enormous fed funds market. The key players prove to be the American- based commercial banks, American branches of the foreign
-based banks (like USB, Credit Suisse, HSBC, Barclays, RBS, RBC, Societe Generale, and BNP Paribas, to name just a few), government sponsored enterprises like Fannie Mae and Freddie Mac, savings and loan entities, agencies of the federal government, and securities companies.
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