Systemic Illiquidity in the Federal Funds Market

Abstract

This paper shows how the intraday allocation and pricing of overnight loans of federal funds reflect the decentralized interbank market in which these loans are traded. A would-be bor-rower or lender typically finds a counterparty institution by direct bilateral contact. Once in contact, the two counterparties to a potential trade negotiate terms that reflect their incentives for borrowing or lending, as well as the attrac-tiveness of their respective options to forego a trade and to continue “shopping around. ” This over-the-counter (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 anony-mously exposed to every other order with a cen-tralized order-crossing algorithm. While there is a significant body of research on the microstructure of specialist and limit order book markets, most OTC markets do not have comprehensive transaction-level data available for analysis. The federal funds mar-ket is a rare exception. We go beyond a previ-ous study of the microstructure of the federal funds market (Craig H. Furfine 1999) by model-ing how the likelihood of matching a particular borrower with a particular lender, as well as the interest rate that they negotiate, depend on their respective incentives to add or reduce balances and their ability to conduct further trading with other counterparties (proxied by the level of their past trading volumes). Our results are consistent with the thrust of search-based OTC financial

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