and Duffie found that fed funds trading is driven partially by individual banks’ precautionary targeting of balances, and that this targeting contributes to systemic stability. The banks’ trading of funds mitigates the risk of overconcentration of reserves in some banks, and contributes to the liquidity of the fed funds market and keeps price volatility relatively low. The second paper, by Morten Bech of the New York Fed, Walter Beyeler and Robert Glass of Sandia National Laboratories, and Kimmo Soramäki of the European Central Bank (who did not present), analyzed the network structure of interbank payments and developed a model for a payments system within such a network. The paper concluded that a liquidity market allows a payments system to achieve a specified level of performance with much less liquidity than would otherwise be required—a finding that sheds light on the trade-offs between liquidity within the payments system and friction within the liquidity market. The combination of network topology and bank behavior within a model, the study also found, is critical for analysis of systemic risk in payments systems. According to the authors, it is not sufficient just to understand the topology of the network; knowledge of the processes operating in that topology, such as bank behavior, is equally important.

SYSTEMIC DYNAMICS IN THE FEDERAL FUNDS MARKET

Ashcraft and Duffie analyzed how allocational frictions affect trading in the federal funds market. They also considered whether these frictions could lead to systemic risk in the form of “gridlock,” in which individual financial institutions fail to transfer balances quickly to counterparties as they wait for the counterparties to transfer balances to them. Gridlock creates a self-fulfilling slowdown in the efficient reallocation of excess balances.

Like every over-the-counter market, the fed funds market is subject to allocational frictions because trading is executed through bilateral negotiation.1 These frictions can be any sources of transaction costs or delays in identifying suitable counterparties, negotiating trades, or executing trades, and they can impact market efficiency. Existing theories of trading dynamics in over-the-counter markets have focused on “search” frictions, whereby traders locate each other with delays, to some extent by trial and error, and negotiate prices that depend in part on the difficulty of finding suitable alternative counterparties. Prices also reflect the relative benefits of making a trade immediately rather than later (and with a newly found counterparty) for each of the two counterparties. As frictions increase and

1

In the fed funds market, brokers reduce but do not eliminate the allocational frictions.



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