Who Are The Current Main Players In The Federal Funds Market?

When the Federal Reserve conducts monetary policy, it announces a target for the "federal funds" interest rate. The implication is that if this specific rate rises or falls, it will affect other interest rates throughout the US economy; for example, like federal funds interest rate moves closely together with other key benchmark interest rates, like the interest rate for overnight borrowing on AA-rated commercial paper. However, the identity of the parties borrowing and lending in the "federal funds" market has changed dramatically since the Great Recession. John P. McGowan and Ed Nosal describe the shifts in "How Did the Fed Funds Market Change When Excess Reserves Were Abundant?" (Economic Policy Review, Federal Reserve Bank of New York, forthcoming).

As part of federal financial regulation, banks and certain other financial entities (to which we will return in a moment!) are required to hold a minimum amount of reserves at the Federal Reserve. Back before 2007, banks usually tried to minimize these reserves, because the Fed didn't pay them any interest for the funds in these reserve accounts. But sometimes it would happen, at the end of a business day, that a bank would realize that its deposits and withdrawals has created a situation where it didn't meet the minimum level of reserves. For a fundamentally healthy bank, this wasn't a problem. The bank with a slight deficiency of reserves would borrow from another bank that had ended the day with a slight excess of reserves. The "federal funds" interest rate was the rate paid for this lending, which was typically for a very short-term loan, like overnight. As McGowan and Nosal write:

Prior to the 2007 financial crisis, trading in the fed funds market was dominated by banks.1 Banks managed the balances—or reserves—of their Federal Reserve accounts by buying these balances from, or selling them to, each other. These exchanges between holders of reserve balances at the Fed are known as fed funds transactions.
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