Term Federal Funds: What It is, How it Works

What are Term Federal Funds?

Term federal funds are balances purchased in Federal Reserve accounts for more than a single day. Term federal funds generally mature between two days and one year. 

Banks and related financial institutions may need to obtain these funds when their borrowing needs last for several days, or they cannot merely borrow overnight funds. Otherwise, borrowing funds overnight is the standard practice for financial institutions worldwide.

Understanding Term Federal Funds

hen banks need short term liquidity to fund normal operations they are able to borrow from other banks through the Federal Reserve System (FRS). This borrowing is known as federal funds. Member banks of the FRS historically have been required to hold some primary reserve funds as deposits on account with the Federal Reserve, though in March 2020 the Fed eliminated all reserve requirements. Any excess reserves that a bank holds can be lent to other banks in need of immediate liquidity at the federal funds rate. Usually these are overnight loans, though banks can continue to borrow federal funds day-to-day as needed.  

Term federal fund loans are when a bank borrows federal funds for a period ranging between two days and one year. Term federal funds normally make up only a small percentage of fed funds activities. Banks are more likely to seek term fed funds when they anticipate ongoing funding needs and they expect the fed funds rate to rise.

Term federal funds transactions take place between two large banks or other financial organizations. A contract defines the specifics of the deal and includes the fixed interest rate of borrowing and repayment terms. The agreement may also stipulate whether the lender can call in the loan before it reaches maturity and if the borrowing bank can repay the funds early. Term federal funds are typically unsecured and extended at low-interest rates, though slightly higher than the fed funds overnight rate.

The Federal Open Market Committee (FOMC) meets eight times a year to set the federal funds rate. Led by Jerome Powell, the FOMC makes periodic adjustments to the rates through its permanent open market operations by adjusting the supply of money to the banking system required to meet target rates.

The Appeal of Term Federal Funds

There are several reasons why financial institutions find term federal funds to be a convenient and appealing tactic for efficient business operations. 

For a bank or lending institution, the process of obtaining term federal funds is relatively simple. It is also financially appealing because of the minimal fees incurred. The method of transferring funds for term federal funds is somewhat similar to the process involved in exchanging overnight funds in what is known as the overnight market. 

Banks also purchase term federal funds to lock in the current short-term interest rate in a rising rate environment. These funds resemble overnight federal funds which are not subject to reserve requirements. Reserve requirements are the dollar amount an institution must have on-hand at any given time. For this reason, they are often purchased instead of other comparable instruments with similar maturities.