The Case of Federal Funds Lending
This chapter1 shows how the intraday allocation and pricing of overnight loans of federal funds reflect the OTC interbank market in which these loans are traded. A would-be borrower or lender typically finds a counterparty institution by direct bilateral contact. Once in contact, say by telephone, the two counterparties to a potential trade negotiate terms that reflect their incentives for borrowing or lending, as well as the attractiveness of their respective options to forego a trade and to continue [shopping around.] This OTC pricing and allocation mechanism is quite distinct from that of most centralized markets, such as an electronic limit-order-book market in which every order is anonymously exposed to every other order with a centralized order-crossing algorithm. Afonso and Lagos (2011) have developed supporting theory.
Among other new empirical results, this chapter provides estimates of how the likelihood that some bank i borrows from some other bank; during a particular minute t of a business day, as well as the interest rate on the loan, depend on the prior trading relationship between these two banks, the extents to which their balances at the beginning of minute t are above or below their normal respective balances for that time of day, their overall levels of trading activities, the amount of time left until their end-of-day balances are monitored for reserve-requirement purposes, and the volatility of the federal funds rate in the trailing 30 minutes.
While there is a significant body of research on the microstructure of specialist and limit-order-book markets, most OTC markets do not have
1 This chapter, joint work with Adam B. Ashcraft, is a revised and extended version of Ashcraft and Duffie (2007), which appeared in 2007 as [Systemic Illiquidity in the Federal Funds Market] in American Economic Review, Papers and Proceedings, vol. 97, pp. 221–225. The views expressed here are not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.