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 borrower 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 attractiveness 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 anonymously exposed to every other order with a centralized 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 market is a rare exception. We go beyond a previous study of the microstructure of the federal funds market (Craig H. Furfine 1999) by modeling 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 market theory (see, for example, Duffie, Nicolae Gârleanu, and Lasse Heje Pedersen 2005; Ricardo Lagos 2005; and Dimitri Vayanos and Pierre Olivier Weill 2005).
The rate that a borrower or lender bank negotiates on a loan is less attractive than current average rates negotiated in the market if the bank has more to gain from trade than its counter-party, and if the bank is less active in the market, after controlling for prior trading relationships. We offer alternative search-based explanations, going beyond credit risk variation.
More generally, we show how the likelihood that some bank i borrows from some other bank j during a particular minute t of a business day, and how the interest rate negotiated on the loan, depend on: the prior trading relationship between these two banks; the extent to which their balances at the beginning of minute t are above or below their normal respective balances for that time of day, their overall levels of trading activities, the amount of time left until their end-of-day balances are monitored for reserve-requirement purposes, and the volatility of the federal funds rate in the trailing 30 minutes.