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Why the Effective Federal Funds Rate Can Fall Below IORB

Article Quant Q&A · Author: Piotr
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Summary

The note explains why the effective federal funds rate can trade below the Federal Reserve’s interest rate on reserve balances (IORB). The rate corridor has IORB as its lower reference point and the standing repo facility as a theoretical upper bound, but market access to these facilities differs across participants.

When reserves are abundant, some cash holders need a place to invest overnight but cannot earn IORB directly. Banks with access may accept that cash and pay a rate below IORB, keeping part of the difference as compensation for intermediation. Cash lenders may still prefer that return to leaving funds in an account that earns no IORB. This explanation describes a market-access and liquidity effect; the note offers no data or model to quantify it, and the rate relationship can depend on prevailing market conditions.

Key ideas

  • IORB is a key reference point in the federal funds rate corridor.
  • Some participants cannot earn IORB directly, which can create demand for intermediated overnight placements.
  • Banks may pay cash providers less than IORB and retain an intermediation spread.
  • Abundant liquidity can contribute to the EFFR trading below IORB.

Tags

Fixed incomeUS marketsMarket microstructure
Full text
# Why can the Effective Federal Funds Rate (EFFR) be below the deposit rate at the Federal Reserve (FED)?


# Why can the Effective Federal Funds Rate (EFFR) be below the deposit rate at the Federal Reserve (FED)?












I have a question. From what I know, banks lend money to each other, and it’s done at the Effective Federal Funds Rate (EFFR). However, I’m wondering why this rate is lower than the Federal Reserve’s rate. I understand that it’s because banks can lend money to each other at a lower cost, but is there any other explanation for this phenomenon?

## Answer by user68819 (score 3, accepted)

https://quant.stackexchange.com/a/81301

The FEDs interest rates form a corridor. The lower bound is IORB (Interest on reserve balances), the upper bound (theoretically) is the SRF (standing repo facility). Why fed funds can trade below IORB, is that in a regime of excess liquidity people are looking to park cash, not everyone has access to the IORB (ot ar least the rate payable by this facility), therefore people who do, usually charge an intermediation spread to park this cash and/or the particpants would rather earn IORB-x bps over night as opposed to 0 if left at the fed (not in IORB). Hence EFFR trades under the lower bound (as of now at least).

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.