Why Bank Deposits Earn Yield: EFFR, OBFR, SOFR, and AIEOU

As the title of the article suggests, startups that park their cash with banks earn yield, but why? Well, the short answer is that banks take the cash and invest it in a variety of vehicles, securities, investments, and more. By doing so, they generate a return, some of which they pass back to you in the form of yield. The various rates they earn go by a vast array of names, such as EFFR, OBFR, and SOFR (we were being a bit facetious with AEIOU). In this guide, we break down what each of these is, how they impact the yield you earn on your bank deposits, and why that yield varies day by day, week by week, and so on—let’s dive in!

Overview: how banks make money

In the simplest of terms, banks make money primarily through two avenues: deposits and credit.

• Deposits - Banks make money through the float, which is the difference between the rate they receive from the Federal Reserve and the yield they pay out to their customers. 
• Credit - Banks also make money by issuing loans, such as venture debt, and charging interest on it.

In addition to these avenues, some banks also offer treasury management services where they partner with brokerage firms or asset managers to invest in Treasury Bills, also known as T-Bills, and Government Bonds, generating yield through the interest paid on these investments.

Finally, banks may also generate revenue through banking service and product fees, interchange revenues from credit and debit card transactions, and one-off features and services that they offer. Check out this guide for a more in-depth look at how banks generate billions in revenue.

An overview of the most common rates startups come across

Given you’re reading this guide, you’re probably familiar with the basic terms surrounding bank rates. That said, while you certainly may come across all of these terms, as a startup, typically you’ll only ever hear about LIBOR, or “Prime” if you’re borrowing funds, EFFR if you’re storing funds in a bank, and bond yield if you’re purchasing or laddering T-bills.

• Effective federal funds rate (EFFR) - the average rate US banks and financial institutions charge each other for borrowing funds overnight.
• Overnight bank funding rate (OBFR) - a weighted average measure of overnight bank funding costs that is calculated using the EFFR, certain Eurodollar transactions (SOFR, LIBOR…etc.), and certain domestic deposit transactions.
• Secured overnight financing rate (SOFR) - the average overnight rate that banks borrow US dollars at while providing T-Bills as collateral.
• Euro short-term rate (ESTER) - the average rate European banks and financial institutions charge each other for borrowing funds overnight. ESTER may also be used to describe the rate at which short-term government paper is issued or traded in the market.
• Sterling overnight index average (SONIA) - the average rate banks and financial institutions charge each other for borrowing sterling overnight.
• Overnight repo rate (ORR) - similar to the SOFR, this is the average rate banks and financial institutions charge each other for swapping treasuries for cash overnight.
• London Interbank Offered Rate (LIBOR) - the globally accepted rate that banks and financial institutions charge each for borrowing funds. 
• Bond Yield - the return generated through the purchase of a Treasury bill (T-Bill) that is held to maturity.

A more in-depth look at the effective federal funds rate 

The effective federal funds rate refers to the interest rate at which depository institutions (such as banks) borrow funds from each other. Banks participate in the program because they either a) have excess reserves and want to generate revenue through risk-free lending or b) have insufficient reserves and need cash to maintain compliance with the reserve requirements mandated by the Federal Reserve.

The Federal Reserve sets a target for the federal funds rate, which serves as a guide for market participants. To achieve this target, the Federal Reserve conducts open market operations, such as buying or selling U.S. Treasury securities (overnight repo), which influences the amount ($) of reserves, or liquidity in the banking system.

In addition to providing liquidity to the banking system, the EFFR has a broader impact on the economy. The Federal Reserve uses Federal Funds Rate as a means of controlling inflation, stimulating economic growth, or slowing down an overheating economy. This is because changes in the Federal Funds Rate ultimately impact the interest rates that banks charge startups for loans, and the rate they pay startups for holding funds in checking or savings accounts.

How the EFFR affects bank deposit yields

As mentioned above, the EFFR can affect the yield paid out on deposits stored in banks. Generally speaking, the higher the EFFR, the higher the yield paid out by banks, but that’s not always the case. Traditional banks, for example, earn the full EFFR, which as of April 2023, is 4.83% APY, yet they only pay out 0.01 - 0.20%... cough cough Chase, Wells Fargo, and Capital One. Fintechs on the other hand, which partner with banks, also earn some percentage of the EFFR, but they pay out 100-400x more than traditional banks, at 4.00%+ APY. There is no standard or rule for how much yield banks are required to pay out for deposits—they can determine how much risk-free revenue they generate.

How rate hikes impact the EFFR and the yield earned on bank deposits

Fed Rate changes directly impact the EFFR: when rates go up so does the EFFR, when rates go down so does the EFFR. But, as mentioned above, banks can set their own yield, so even though rates may go up a hundred basis points, the yield banks pay may stay the same. That said, Fintechs typically raise the yield they pass along as rates (and the EFFR) increase.

The impact of the bond yield curve on TBill prices

The relationship between bond prices and yields is inverse, meaning that when yields rise, bond prices tend to drop, and vice versa. This is because bond yields are a form of interest (though not technically interest), and increases in interest rates, such as the EFFR, can lead to higher yields and thus lower bond prices. That said, while the EFFR set by the Federal Reserve can impact shorter-term interest rates, such as the one-year rate on T-Bills, longer-term interest rates, such as those on the 10-year Treasury bond, may not closely correlate with the federal funds rate.

Check out this guide for a more in-depth look at interest rates, bond yields & the cost of capital.

Why TBill yields fluctuate from day to day

T-bill yields fluctuate day to day due to a combination of factors, including market supply & demand, economic data releases, monetary policy decisions, and market sentiment. They may also be influenced by investor expectations and market dynamics.

• Market Supply & Demand: If there is high demand for T-bills, their prices may increase and yields may decrease. Conversely, if the supply of T-bills increases, it may put downward pressure on prices, leading to higher yields.
• Economic Data Releases: The release of economic data, such as employment reports, inflation data, and GDP figures, can impact T-bill yields. Strong economic data may increase expectations of higher interest rates, leading to higher yields, while weak economic data may have the opposite effect.
• Monetary Policy: The Federal Reserve's monetary policy decisions, including changes in the federal funds rate or other policy tools, can affect T-bill yields. For example, if the Federal Reserve raises interest rates, it leads to higher T-bill yields.
• Market Sentiment and Risk Appetite: Market sentiment and risk appetite among investors can also impact T-bill yields. During times of uncertainty or market volatility, investors may seek safer assets such as T-bills, leading to increased demand and lower yields. Conversely, during periods of optimism and higher risk appetite, demand for T-bills may decrease, leading to higher yields.

If you’re interested in learning more about T-Bills check out these resources: 

• How to structure Tbill ladders to balance returns & liquidity
• How to maximize yield with a treasury bill ladder
• How to hedge the principal risk of Tbill ladders with credit default swaps
• The importance of T-Bills in a startup’s treasury management strategy

Final thoughts on bank deposit yield

While maximizing the yield earned on bank deposits definitely is a factor to consider when selecting a bank, the more important factor is how safe your deposits are. While most banks offer FDIC Insurance, the question you should ask is whether they offer just the basic coverage of $250,000 or if they participate in a cash sweep program that can protect more of your startup's capital. Once you’ve nailed that question, then ask about the yield rate the bank offers and whether it fluctuates with EFFR. Also, consider asking if they offer further diversification through T-Bills, which generate yield and are effectively risk-free.

P.S. we offer all of the above: a high-yield reserve account, a cash sweep program that provides $5.25M in FDIC coverage¹ , and a brokerage account that provides access to T-Bills which pay 4.90%+².