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All depository institutions in the United States are required by law to hold reserves based on a percentage of their transaction deposits These reserves consist of cash in their vaults and balances in accounts at Federal Reserve Banks Some financial institutions use their accounts at Reserve Banks not only to satisfy their reserve requirements but also to clear financial transactions these institutions usually try to maintain a cushion of funds to protect themselves against unexpectedly large debits that could leave their accounts overdrawn and thus subject to penalty The Federal Funds Market is a market where banks to help maintain their reserve accounts at their desired level the Federal Reserve allows banks to actively trade reserves among themselves Banks with surplus balances in their accounts transfer reserves to banks that need to boost their balances These reserve balances that can be transferred between banks are called federal funds and the rate of interest charged on the use of these funds is the federal funds rate Federal funds neither increase or decrease total bank reserves but instead redistribute them This redistribution allows funds that would otherwise not be used to bring a return Federal funds transactions can be initiated by either a lender or a borrower A bank seeking to lend funds identifies a borrower directly through an existing banking relationship or indirectly through a federal funds broker The most common type of federal funds trans action is an overnight unsecured loan between two financial institutions Most overnight loans are made without a contract The borrowing and lending banks exchange verbal agreements based on several factors particularly their experience in doing business together and limit the size of transactions to establish credit lines to minimize the lenders exposure to the risk of default Such arrangements help speed up processing while keeping transaction costs as low as possible Many overnight federal funds transactions occur under a continuing contract that is renewed automatically until either the lender
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