What Are Federal Funds? How the Market Works — And What Happens When It Breaks
The Federal Funds market is the core overnight funding mechanism in the U.S. banking system. It allows banks to borrow and lend reserves—balances they hold at the Federal Reserve—to meet daily liquidity needs.
Under normal conditions this market is stable, quiet, and rarely noticed. But during systemic crises, it can fail spectacularly. Three such breakdowns occurred in 2008, 2020, and 2023, when almost every bank in the system suddenly wanted to borrow and almost no one was willing to lend.
This article introduces:
What Federal Fuxnds are
How Fed Funds loans and rates work
Why banks rely on them
Why the market can freeze
Three historical cases where this actually happened
1. What Are Federal Funds?
Every bank in the U.S. maintains a reserve account at the Federal Reserve. These reserves are used for:
Meeting reserve requirements
Settling payments
Ensuring daily liquidity
A Federal Funds loan is an overnight, unsecured loan of reserves from one bank to another. There is no collateral. If Bank A lends Bank B $100 million at a 5% annualized Fed Funds rate, Bank B repays $100M + interest the next day.
Because these loans are unsecured, trust is essential. If lenders doubt a borrower’s solvency, the market can stop functioning instantly.
2. The Fed Funds Rate
The Effective Federal Funds Rate (EFFR) is the weighted average rate at which banks actually lend reserves to each other overnight. The Federal Reserve sets a target range for this rate, and open market operations nudge the rate into that range.
In normal times:
The Fed Funds market is small
Rates stay within the target range
Banks lend excess reserves to earn a small return
Everything is calm.
3. Why Banks Borrow Federal Funds
Banks borrow Fed Funds mainly for three reasons:
1. To meet reserve requirements
If a bank ends the day short of required reserves, it must borrow overnight to avoid penalties.
2. To manage daily cash flow mismatches
Banks process millions of payments daily. Outflows may exceed inflows temporarily, creating a small liquidity gap.
3. Because it is cheap
Fed Funds are often cheaper than other forms of short-term financing.
Under normal circumstances:
Some banks have extra reserves and lend
Some banks need reserves and borrow
The market balances itself
But this mechanism only works when banks trust each other.
4. The Fragility of the Fed Funds Market
The Fed Funds market is unsecured. That means:
The lender bears all credit risk
If the borrower fails, the lender loses the full amount
So the market only functions when lenders believe:
“Other banks are safe.”
If lenders suddenly doubt that belief, the entire Fed Funds market can collapse in a single day.
This is exactly what happened in 2008, 2020, and 2023—but in different ways.
5. Extreme Case: When Every Bank Wants to Borrow
Under normal conditions, liquidity shocks across banks tend to cancel out:
One bank has a small deficit
Another has a small surplus
They exchange reserves
But in a crisis, every bank experiences liquidity stress simultaneously. This is the key mechanism:
Everyone wants to borrow
Nobody wants to lend
The Fed Funds market freezes
When this happens, the Federal Reserve must step in as the lender of last resort.
Below we examine the three modern events when this actually happened.
6. Case Study 1: 2008 — The Fed Funds Market Freezes
What happened: Lehman Brothers collapsed. No one knew which bank might fail next. Credit risk shot up overnight.
Because the Fed Funds market is unsecured, lenders panicked:
Banks hoarded reserves
Almost no one was willing to lend
But almost every bank wanted to borrow
The effective Fed Funds rate spiked above the Fed’s target range. This was a clear sign of market failure.
How the system survived: Banks turned to the Federal Reserve’s emergency lending tools:
Term Auction Facility (TAF)
Primary Dealer Credit Facility (PDCF)
Asset-Backed Money Market Liquidity Facility (AMLF)
Commercial Paper Funding Facility (CPFF)
These programs replaced the broken interbank market. Without them, the financial system would have collapsed.
7. Case Study 2: 2020 — Treasury Market Breaks and Banks Lose Access to Repo
In March 2020, the COVID shock caused investors to panic-sell U.S. Treasuries to raise cash. Treasuries are normally the most liquid assets in the world, yet suddenly:
Bid–ask spreads exploded
Market depth disappeared
Repo haircuts increased
Lenders refused to accept even Treasuries as collateral
Banks rely on Treasuries to borrow cash overnight through the repo market. When repo liquidity vanished:
Banks could not raise cash through collateralized loans
They turned to Fed Funds borrowing instead
But many banks needed cash at the same time
This pushed the entire system close to a funding crisis.
How the system survived: The Federal Reserve intervened with unlimited QE, buying Treasuries and mortgage-backed securities in massive quantities.
This restored liquidity and stabilized the banking system.
8. Case Study 3: 2023 — SVB Triggers System-Wide Deposit Outflow
In March 2023, Silicon Valley Bank experienced a massive, fast-moving bank run. Depositors at many regional banks panicked and withdrew funds.
Suddenly:
Hundreds of regional banks lost deposits
Their cash positions fell rapidly
They needed liquidity immediately
More than 2,800 banks tapped the Federal Reserve’s Bank Term Funding Program (BTFP). This was effectively a system-wide borrowing spree from the Fed.
BTFP allowed banks to borrow at par against Treasuries—even if market prices had fallen—giving them an emergency cash lifeline.
Again, the Fed replaced the entire interbank funding system.
9. Why These Extreme Events Don’t Happen Normally
Outside crisis periods:
Banks’ cash flows offset each other
Repo markets provide abundant secured funding
Banks carry sufficient liquidity buffers
Counterparty trust remains intact
Because of this, only a few banks need liquidity on any given day, and other banks are able to supply it.
But during crises:
Liquidity shocks become highly correlated
Everyone needs cash
Nobody wants exposure to anyone else
The market can no longer clear
This is why the Fed Funds market is inherently fragile.
10. The Deep Structural Lesson
The Federal Funds market works beautifully in normal times. It completely fails in systemic crises.
When every bank needs liquidity at the same time:
The interbank market disappears
The Fed Funds rate becomes meaningless
The repo market may stop functioning
Only the Federal Reserve can supply liquidity
This is the fundamental reality of modern banking:
A decentralized interbank market cannot survive a system-wide liquidity shock. Only a central bank can.
If you'd like, I can also prepare:
A version with diagrams and charts
A more mathematical version with liquidity SDE models
A teaching slide deck version
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