How Is The Fed Funds Rate Calculation Changing?

|
Includes: DIA, IWM, QQQ, SPY, UUP
by: Celan Bryant

Summary

On April 1, 2014, the Federal Reserve began collecting form FR 2420 to collect Fed funds data from banks rather than brokers.

This year, it was announced that the FR 2420 would be used to calculate the effective Fed funds rate rather than broker data.

The Fed will also publish another rate referred to as the "overnight bank funding" rate.

The Fed funds rate is the blended rate at which banks lend to one another. For decades, the Fed has used the volume-weighted average of rates on Fed funds trades from major brokers to calculate the effective Fed funds rate, but that system is currently undergoing an upgrade.

What exactly is the FR 2420?

Earlier this year, the Fed announced plans to improve the process for calculating the fed funds effective rate by transitioning the data source from data supplied by federal funds brokers to data reported directly by banks through FR 2420.

- Simon Potter, FRB Executive Vice President, Remarks at the Money Marketeers of New York University, New York City

On April 1, 2014, the Federal Reserve began collecting form FR 2420, which you can view here. Over the past year, the Fed has been consolidating the information gathered from this form into transaction-level reports about Federal funds, Eurodollars, and certificates of deposits from a large number of banks and agencies. "As such", the announcement dated February 2, says:

the FR 2420 captures a greater share of federal funds activity than brokered data alone and provides a larger base of transactions for the calculation of the effective federal funds rate.

Before FR 2420, the Fed received funds from major brokers, not directly from the actual banks doing the borrowing in the market. As of February 2, there were also 163 depository institutions using the report. It was within this same announcement that the Fed also said it would be using the data collected from FR 2420 to calculate and publish the Fed funds effective rate.

Is It Worth The Effort?

So far, there's around 25% more volume based on data from FR 2420 than from broker-obtained data. Here's an except explaining the reason for the difference:

Since July 2014, the average overnight borrowing in the fed funds market reported via the FR 2420 form has been around $50 billion and the number of reported overnight transactions in fed funds has averaged about 300 per day, never dropping below 200. These overnight fed funds volumes have been roughly 25 percent larger than volumes observed in brokered data, largely because FR 2420 data include both transactions intermediated by brokers and transactions that are negotiated directly between two counterparties.

That said, "the change in data source does not seem likely to have a significant impact on FFER levels." According to the announcement, the variance between the current broker-based calculation and the FR 2420-based calculation is less than 1 basis point. Net/net, there's more data, but it provides the same answer.

Not all activity is picked up by the FR 2420, namely small banks borrowing from other banks and government-sponsored entities (GSEs). Interestingly, activity with smaller banks is occurring at rates near the interest rate on excess reserves (IOER) - .25%, whereas activity with GSEs like Federal Home Loan Bank occurs near the Fed funds rate. This is because GSEs aren't eligible to receive the IOER from the Fed, and therefore, lend their reserves to banks that are eligible at a rate that is slightly below the IOER.

Blended Eurodollar Rate

In addition to publishing a Fed funds rate with new data, the New York Fed will be publishing another rate referred to as the "overnight bank funding" rate. It will be calculated based on both Federal funds transactions and Eurodollar transactions from banking offices.

How Will This Affect Your Portfolio?

It won't, but it does add to the increasing body of events making this an increasingly volatile year. It is curious that the Fed would choose to upgrade the calculation of the Fed funds rate this year, the same year it plans on raising rates. That said, if the rate provides a more accurate calculation, it shouldn't matter when it's applied.

If you would like to express your views on the proposed changes to FR 2420 you can comment by clicking here until June 8, 2015. The implementation of the published rates will occur after revisions.

Upcoming Posts:

Is Bank Profitability Linked To Excess Reserves?

Does The Federal Reserve Care About Economic Growth?

What Can FOMC Minutes Reveal About Rate Hike Mechanics?

New Subscription Service:

If you're interested in these topics, be sure to "Follow" us to receive an announcement about our upcoming subscription collaboration with Seeking Alpha.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.