The Federal Reserve Bank of New York posted a brief entitled, "Who's Lending in the Fed Funds Market?. Authors Gara Afonso, Alex Entz, and Eric LeSueur write, "The fed funds market is important to the framework and implementation of U.S. monetary policy. The Federal Open Market Committee sets a target level or range for the fed funds rate and directs the Trading Desk of the New York Fed to create "conditions in reserve markets" that will encourage fed funds to trade at the target level. In this post, we use various publicly available data sources to estimate the size and composition of fed funds lending activity. We find that the fed funds market has shrunk considerably since the financial crisis and that lending activity is now dominated by one group of market participants."
The Fed economists explain, "The fed funds market consists of unsecured loans of U.S. dollars among depository institutions and certain other eligible entities, including government-sponsored enterprises (GSEs). It's no easy matter to gauge the size of the market, as comprehensive data aren't available. However, we can estimate its size and composition by aggregating data from publicly available regulatory filings, such as the FR Y-9C, call reports, and 10-Qs. We collect information from hundreds of institutions and use data from the highest level of each organization to avoid double counting. Although we can't obtain a complete view of the market, our conversations with market participants suggest that these reports capture most fed funds transactions."
It continues, "Our estimates suggest that fed funds lending activity has decreased significantly since the beginning of the financial crisis. As shown in the chart below, at the end of 2012 institutions reported lending over $60 billion in fed funds -- compared with over $200 billion in 2007. Several factors have contributed to this decline in trading volume. For one, the expansion of the Federal Reserve's balance sheet since late 2008 has elevated the level of excess reserves in the banking system. This has reduced the need for many institutions to borrow fed funds to meet reserve requirements and to clear financial transactions. Also, in the fall of 2008 Federal Reserve Banks began paying interest on excess reserves (IOER) to depository institutions. The payment of such interest has reduced the incentives for depository institutions to lend (sell) fed funds at rates below IOER."
In other news, Standard & Poor's distributed a press release entitled, "Report Says EC Money Market Fund Reform Plans Enhance Risk Management But May Not Effectively Reduce Run Risk." It explains, "Proposals by the European Commission (EC) to tighten regulations for money market funds (MMFs) domiciled or sold in Europe could help enhance risk management for most MMF operators and investors in Europe, says Standard & Poor's Ratings Services in a new report: "EC Regulation For Money Market Funds May Have Unintended Consequences."
It continues, "However, the overall size of the European MMF industry may shrink if the regulation is adopted in its current form." S&P's Francoise Nichols comments, "While we think some elements of the proposals are positive for the overall European MMF industry, others may inadvertently make it more difficult for funds to manage risks effectively. They may also increase costs, reduce transparency, and deter investors."
S&P adds, "The EC's proposals, announced in September this year, aim to standardize investment parameters for European MMFs. Furthermore they seek to mitigate the potential systemic risk that European money market funds, which represent close to E1 trillion in assets, might constitute to the stability of the wider European financial system in the event of a run on a fund or the MMF industry. In particular, providers of constant net asset value (CNAV) money market funds, which represent more than 40% of European MMF assets, could suffer considerable economic and operational costs as a result of the EC proposal either to convert them to variable net asset value (VNAV) funds or else maintain a capital buffer of at least 3% as a backstop or reserve to protect against potential losses."
Andrew Paranthoiene tells us, "We believe these providers may lose assets to alternative liquidity management instruments or to CNAV MMFs domiciled outside the EU. The proposed 3% capital buffer applicable to CNAV MMFs could be prohibitive to implement, and could translate in higher operational costs, which fund providers could attempt to pass on to their investors." The release continues, "A significant contraction of MMF assets under management in Europe could also reduce the liquidity of short-term capital markets in Europe, the report says. It would also make funding sources for financial institutions, sovereigns, and non-financial corporations less diversified."
Finally, S&P writes, "In addition, the reform may lead to greater consolidation in the European MMF industry to the detriment of smaller players. This would not just reduce competition, but could also lead to the emergence of a small number of very large MMFs, posing potentially new systemic risks. Standard & Poor's believes that other market-based mechanisms that are not part of the current proposals are also worthy of consideration. These include ensuring that all European MMFs have the possibility to halt investor redemptions at times of market stress, since this could serve the interests of all shareholders and help mitigate run risks."
