The fed funds market is where officials set what is probably the world's most important interest rate—yet very few people understand its current operations.
This is the market at which the Federal Reserve directs its primary energies.
The Federal Open Markets Committee targets a level or range for interest paid on overnight fed fund loans, which are dollar-denominated loans of U.S. dollars between financial institutions. The trading desk at the New York Fed buys or sells Fed funds in order to get fed funds to trade at the targeted level.
In the textbook narrative about the fed funds market, some banks borrow fed funds in order to meet their reserve requirements while other banks lend fed funds in order to earn a return on excess reserves. But this isn't quite right—and hasn't been right since the financial crisis struck, as a new note from the New York Fed shows.
Prior to the crisis, the lenders in the fed funds market resembled the textbook narrative. That is, they were a somewhat diverse group of financial institutions.
Domestic bank holding companies lent out 25 percent of the $221.7 billion of fed funds traded in the second quarter of 2007, according to data assembled by the New York Fed. Foreign entities accounted for 21.2 percent of fed funds lending. Stand-alone commercial banks were 8.2 percent of the market. The regional Federal Home Loan Banks collectively accounted for 45.3 percent of the market.
In the last quarter of 2012, things were very different.
The market for fed funds had shrunk down to $60.28 billion and lending was overwhelmingly dominated by the Federal Home Loan Banks, which accounted for 73 percent of the fed funds lent. Bank holding companies had shrunk to 13.6 percent, foreign entities to just 5.8 percent, and stand-alone banks to 6.4 percent.
In other words, the fed funds market is nothing like the textbook model of a variety of banks with different reserve positions making deals with each other to reach a market equilibrium. It's mostly banks borrowing fed funds from the Federal Home Loan Banks.
To put it differently, the primary tool of monetary policy—the FOMC target rate—now is mostly used to influence overnight fed funds lending by Federal Home Loan Banks.
Why the transformation?
The New York Fed offers a couple of explanations. First and foremost, the Fed now pays interest on excess reserves. This means that banks won't lend reserves if the rate in the fed funds market is less that what they can earn by holding on to their reserves in accounts at the Fed. The Federal Home Loan Banks, however, are government-sponsored entities that aren't allowed to earn interest on excess reserves. So they'll lend out reserves even at very low rates.
In addition, quantitative easing has greatly increased the amount of reserves in the system, which means that banks are less likely to find that they have too few reserves to meet the regulatory requirements.
(Read more: Is the Fed really driving up stock prices?)
There is something strikingly odd about this arrangement. Our central bank is now setting monetary policy by targeting an interest rate charged by the 12 Federal Home Loan Banks that were established by Congress and are regulated by the Federal Housing Finance Authority.
Sophisticated observers of the banking system have long pointed out that banks do not "lend out" reserves. Rather they make loans first and, if they are short required reserves, find the reserves afterward on the fed funds market. We now need to modify this with the observation that, by and large, banks acquire the reserves not from some diverse "fed funds market" but from the Federal Home Loan Banks.
(Read more: The irrelevance of bank reserves.)
No one, as far as I can tell, has really done much thinking about what it means to have a fed funds market so dominated by government-sponsored enterprises.
—By CNBC's John Carney. Follow him on Twitter @Carney