The future of the Fed Funds market looks pretty grim

When the European Central Bank reduced the rate they pay on cash held in their deposit facility to zero, there was an expectation that the Fed would do the same. So far, that hasn’t happened. But it might be interesting to contemplate the impact of such a move on the Fed Funds market.

As we wrote in Finadium’s August research report, “Repo Indices, Overnight Index Swaps and Other Alternatives to LIBOR”, Fed Funds don’t trade that much any more. Banks can park cash at the Fed and earn 25bp on reserves (required and excess). The banks would rush to lend out excess reserves if the clearing rate was above 25bp, so it never gets there. It is mostly the GSEs lending FF to the banks since they can’t earn any return on cash held at the Fed. The Fed Funds effective rate hovers in the mid-teens.

If the interest on excess reserves (IOER) goes to zero, will it mean the Fed Funds market will go from its current moribund state to a market-driven benchmark, full of vim and vigor? Not likely. First, the cash just gets passed from one institution to another. Banks with excess reserves, no longer able to take advantage of the above-market rate that the Fed is paying, will all be one way: lenders.

Will zero look better than the other alternatives out there to park cash? It depends on how risk adverse the bank is. These days, it might be hard to shake cash loose, even when the alternative is being paid zero, to invest in some other short-term asset. Anything paying a lot above zero probably has some hair on it. Or banks could invest longer. But then there is that whole maturity transformation thing which, while a legitimate banking activity, still means sticking your head out of the foxhole. Classic liquidity trap.

Banks could lend the cash to their clients. While it would make for a nice political sound bite, banks are still in the business of lending money to those who they believe will pay them back. Simply lowering the return on the cash held isn’t going to change much about the credit status of borrowers – good or bad.

Even if the banking system shifts from hugely positive excess reserves to a more balanced market, Basel 3 rules, specifically the LCR, will discourage banks from sourcing liquidity in the Fed Funds market.

While being paid zero on excess reserves does change the psychology of holding the cash at the Fed, until the alternatives look better, we wonder if the money won’t just stay put and the Fed Funds market will remain irrelevant.

A link to Finadium’s August paper “Repo Indices, Overnight Index Swaps and Other Alternatives to LIBOR” is here.

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