FILE PHOTO: Four thousand U.S. dollars are counted out by a banker counting currency at a bank in Westminster, Colorado November 3, 2009. REUTERS/Rick Wilking/File Photo

By Gertrude Chavez-Dreyfuss and Laura Matthews

NEW YORK (Reuters) -The effective federal funds rate - the interest banks charge each other for overnight loans to meet reserve requirements - rose unexpectedly last week ahead of quarter end, mainly on the back of shrinking cash balances at foreign banks, according to market participants.

The latest fed funds rate of 4.09% was one basis point higher than the 4.08% seen after the Fed cut interest rates at the September 16-17 meeting. It's still within the Fed's range of 4.00% to 4.25% though.

So-called foreign banking organizations or FBOs are major players in the roughly $100 billion fed funds market. The fed funds rate is central to the financial system as the official policy reference that the Federal Reserve sets a target range for each time it meets.

The uptick in the fed funds rate comes shortly after the Federal Reserve lowered the range by 25 basis points, even as the market grows cautious over a potential liquidity crunch as September comes to a close, along with the quarter. The modest increase was the first outside of a Fed rate move since 2023.

The effective fed funds rate is market driven and in recent years usually hovered 8 bps above the lower end of the fed's target range.

Analysts noted that the ongoing buildup in the U.S. Treasury's cash balance has siphoned off reserves from the banking system, including those from FBOs. That cash effectively reduces bank reserves as it grows.

The latest data showed total bank reserves, which include those from FBOs, have fallen to $3 trillion as of September 24, from $3.3 trillion a few weeks ago. FBO reserves represent about 38% of total reserves at the Fed, while U.S. banks hold 57% and credit unions have 5%, according to the New York Fed's Liberty Street Economics.

FBO cash holdings, a proxy for reserves, fell to $1.176 trillion as of the latest Fed data from September 17, down $28 billion from a week earlier. Since August 20, their cash has declined by $255 billion.

FBOs are major borrowers in the fed funds market, a source of liquidity that also provides opportunities for arbitrage. Foreign banks borrow at a lower rate of 4.09% from Federal Home Loan Banks (FHLBs) in the fed funds sector and then park the cash as reserves at the Fed earning an interest of 4.15%. That rate is called the interest on reserve balances (IORB.

The decline in foreign bank reserves has tightened liquidity in the fed funds market, while reducing trading volume, analysts said. After averaging $113 billion per day from late April until September 12, the fed funds volume fell to an average of just $94 billion. On Friday, that volume was $95 billion.

"If you look at the distribution of those reserves, they have come down, particularly from non-U.S. banks," said Joseph Abate, head of rates at SMBC Nikko Securities.

"They don't have access to FHLB advances and they don't have an insured deposit base so their funding tends to be less stable and therefore they like to maintain thicker liquidity cushions."

Domestic banks typically don't engage in this arbitrage because it increases their balance sheet size and triggers leverage ratio and liquidity coverage ratio (LCR) costs, analysts said. Those regulatory costs often eat up or exceed any spread between fed funds and IORB.

BANK RESERVES AND QUARTER-ENDS

There are obvious explanations for the decline in FBO holdings, analysts said, with such moves coinciding with the end of financial reporting periods, but they usually recover after that. The latest decline, however, began well before the end-August date and continued into September.

Lou Crandall, chief economist at money market research firm Wrightson ICAP noted that "while some of this decline reflects a shift into alternative front-end investments like repos," the bulk could be attributed to deleveraging in the balance sheets of foreign banks.

That said, the tick higher in the fed funds rate, while unexpected, did not surprise some analysts given that overnight repurchase (repo) rates are also trending firmer ahead of the end of the quarter.

Repo rates, or the cost of borrowing overnight cash secured by Treasuries or other debt securities as collateral, tend to spike at the end of a quarter or year as primary dealers, mostly large banks, reduce their activity as middlemen in money market transactions due to higher balance sheet costs.

FED FUNDS AND FUTURES MARKET

The fed funds move has spurred selling of futures tied to it, analysts said, leading to record open interest at the CME, suggesting possibly tighter funding conditions in repos at the end of the quarter.

Futures open interest hit a record last Tuesday, surpassing three million, CME data showed. It was at 2.9 million last Friday. There was also a massive block trade of 30,000 October contracts on fed funds futures seen on Wednesday, the equivalent of $1.25 million per basis point in risk.

In the end, Josh Barone, wealth manager at Savvy Advisors, said the fed funds blip was all about plumbing, not policy, echoing other people's view that it likely reflects balance-sheet constraints at the end of the quarter.

(Reporting by Gertrude Chavez-Dreyfuss and Laura Matthews; Editing by Alden Bentley and Andrea Ricci)