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Systemic Illiquidity in the Federal Funds Market

This paper shows how the intra-day allocation and pricing of overnight loans of federal funds reflect the decentralized inter-bank market in which these loans are traded. A wouldbe 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 overthe-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 anonymously exposed to every other order with a centralized order-crossing algorithm. While there is a significant body of research on the micro-structure of specialist and limit-order-book markets, most OTC markets do not have comprehensive transactionslevel data available for analysis. The federal funds market is a rare exception. We go beyond a previous study by Craig Furfine (1999) of the microstructure of the federal funds market by modeling how the likelihood of matching a particular borrower with ∗Banking Studies, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045. We are grateful for support and data from The Federal Reserve Bank of New York and for comments from Guillaume Plantin, Jamie McAndrews, Craig Furfine, Michael Fleming, and anonymous federal funds traders. We have also benefited from comments by Andrew Metrick, Jeremy Stein, Ken French, Larry Harris, Owen Lamont, John Taylor, and Randy Westerfield. The views expressed here are not necessarily those of The Federal Reserve Bank of New York or the Federal Reserve System.