The Federal Reserve Bank of New York announced that it was making some changes to the Federal Funds rate last week in a release entitled, "Statement Regarding the Calculation Methodology for the Effective Federal Funds Rate and Overnight Bank Funding Rate." In February, the NY Fed announced plans to enhance the effective federal funds rate calculation process by "transitioning the data source from data supplied by federal funds brokers to transaction-level data collected from depository institutions in the FR 2420 Report of Selected Money Market Rates." Also in February, the New York Fed also announced a new overnight bank funding rate (OBFR) that's calculated based on both federal funds transactions and the Eurodollar transactions of U.S.-managed banking offices, as reported in the FR 2420. The new release says, "As part of the preparation for these changes, the methodology for calculating the EFFR was reviewed to determine if enhancements could be made to provide a more robust measure of trading conditions in the federal funds market."
The statement continues, "Analysis conducted as part of the review suggested that changing the calculation of the EFFR to a volume-weighted median -- the rate associated with transactions at the 50th percentile of overnight transaction volume -- would have a number of advantages relative to the current practice of using a volume-weighted mean. As noted in the minutes of the June 2015 Federal Open Market Committee (FOMC) meeting, the results of the review were discussed with the FOMC, and the New York Fed will implement this change to the calculation methodology concurrently with the change in data source to the FR 2420. The OBFR will also be calculated using a volume-weighted median when publication commences. The change to a volume-weighted median for the EFFR and publication of the OBFR are expected to be implemented in the first few months of 2016, after revisions to the FR 2420 data collection are complete and the reported data are well-established."
The Fed statement explains, "As noted in the February statement, the Desk will announce a specific implementation date and additional information closer to the effective date of the changes. For both the EFFR and OBFR, use of a volume-weighted median is expected to enhance the resilience of the calculated rates to various measurement issues. Under most circumstances the volume-weighted median and volume-weighted mean measures are expected to result in similar levels for these rates. No inferences should be drawn about changes to the stance of monetary policy from the implementation of this revision."
Finally, it adds, "In order to provide insight into the attributes of the volume-weighted median, a technical note is being issued concurrently with this statement. This technical note discusses the historical relationship between the two central tendency measures and provides analysis that supports the choice of the volume-weighted median."
In his weekly Short-Term Fixed Income update, JP Morgan Securities' strategist Alex Roever comments, "The first change will redefine the rate as a volume-weighted median of Fed funds transactions instead of the volume-weighted mean. The second change will replace the data source that the Fed uses to calculate Fed funds. Instead of using brokered Fed funds transactions data, the Fed will source data from FR2420, which currently collects various money market rate information, including Fed funds transaction-level data, from a large set of domestic banks and agencies of foreign banks operating in the US. The changes are set to take place in early 2016."
Roever continues, "Broadly speaking, the amendments to the Fed funds calculation methodology will produce a rate that is going to be less volatile, more stable and represent a much more accurate and comprehensive picture of the Fed Funds market. We have commented previously that the existing Fed funds market is somewhat dysfunctional since banks have less need to borrow funds overnight, as they are flush with reserves and discouraged from borrowing short-term. Volumes have shrunk, and remaining transactions are concentrated among a smaller set of buyers and sellers, exposing the rate to increased volatility. Furthermore, the Fed funds effective rate has historically only relied on transactions conducted via Fed funds brokers and ignored Fed funds transactions that are directly negotiated between counterparties to calculate the rate."
In another recent commentary, "Confidence Contagion and the Fed's Headache," Barclays strategist Joseph Abate writes, "We suspect that a Greece- or China-related financial shock to US money markets -- if one occurs -- would share some similarities with the 2011 sovereign debt crisis. The 2011 flare-up began as a confidence shock that rippled through money funds and eventually spilled over into the real economy as a reduction in financing for non-financial and non-EU firms. Even though money fund had no direct exposure to Greece in 2011, media reports linked Greek debt to money fund holdings of French bank paper. In May 2011, French bank exposure in money funds was indeed large at $233bn or nearly 10% of the industry's holdings. Nervous investors immediately began pulling their money out of prime funds -- and within 6m, prime fund balances fell by $210bn or 13%. Approximately half of the $210bn leaving prime funds in the summer and fall of 2011 shifted into lower risk government-only funds. The balance migrated into bank deposits at large US institutions that at the time were covered by unlimited deposit insurance from the FDIC."
He continues, "We see some similarities between 2015 and 2011, although in important ways the starting conditions are different today. Money funds still hold no Greek paper. But money fund holdings of French bank paper have increased significantly since December 2011 -- rising to $211bn and are just slightly off their 2011 peak. Similarly, money fund holdings of European paper (both secured and unsecured) are about as large today as they were in 2011 (at about $350bn). But, unlike 2011, most of the exposure to Greece is held by large official institutions such as the IMF, ECB, and euro zone governments so there is little room to link it indirectly to money fund holdings of European bank debt. Money funds hold just $32bn in SSA paper -- mostly from institutions in the Netherlands or in Germany. Moreover, a significant portion of the paper has explicit government guarantees. Finally, money fund exposure to Chinese institutions is very low at just $6bn, despite its notable growth since 2011."
He notes, "Clearly, predicting swings in investor confidence is tricky -- especially given the money fund investor base's well-documented risk aversion and propensity to flee. Thus, while the fundamentals of money fund holdings are quite different today, we judge there is still a risk of a confidence shock that precipitates a 2011 exodus from prime funds. Given the potential for a confidence shock, are there any leading indicators worth watching? We expect any confidence-driven shock (again, assuming there is one) to quickly show up in two leading indicators of front-end markets: the level of prime fund money fund balances and usage of the Fed's overnight RRP program."
