MANAGEMENT OF FOREIGN CURRENCY RESERVES

The RBA's Reserves Management Framework

Objectives

Australia's foreign currency reserves are owned and managed by the Reserve Bank of Australia (RBA). The RBA's responsibility to manage Australia's foreign exchange reserves is established through the broad legislative powers that allow the Bank to deal in foreign exchange to achieve its monetary policy objectives primarily by maintaining a capacity to intervene in foreign currency markets. Foreign currency reserves are also used to augment our domestic liquidity operations and to manage the day-to-day foreign currency requirements of the Australian Government. Reflecting these objectives, an emphasis is placed on maintaining a relatively liquid portfolio.

Investment Mandate

Australia does not target a particular level of reserves either on an outright basis or relative to the size of the economy or its financial markets. Notwithstanding this, we find that Australia's reserve ratios are comparable with those of other industrialised nations (Table 1).

Given the size and relative stability of our foreign currency portfolio, the RBA also does not manage separate liquidity and investment reserve tranches. That said, foreign asset holdings resulting from domestic liquidity transactions are included in ORA but are managed separately on a fully hedged basis.

In terms of management style, significant scope was provided for the active management of the Bank's foreign currency portfolio against its benchmark when the reserves mandate was specified in the early 1990s. Experience showed, however, that while managers were on average adding to returns, the volatility of returns relative to benchmark was high. As a result, in 2000 the RBA adopted a management style that was largely passive. In order to retain the benefits from trading market anomalies and managing day-to-day flows of reserves, however, portfolio managers did retain a small amount of discretion to take positions against the benchmark.

The RBA has typically maintained a very conservative universe of eligible instruments in its foreign exchange portfolio – investing in securities issued by highly-rated supranational agencies and governments (US, Japan, Germany, UK, France, Netherlands and Switzerland), repurchase agreements (collateralised loans) and commercial bank deposits. The term to maturity of all instruments is limited to 10½ years.

In 1994, the RBA began trading interest rate futures contracts. This decision was driven by a desire to improve our management of market risk, and in particular to provide a liquid hedging instrument to minimise the risk of capital losses when interest rates were rising. The RBA does not use any other over-the-counter or exchange-traded derivatives in its reserves management operations.

The RBA also uses foreign currency swaps in its management of its assets. These swaps are the main instrument that the Bank uses to sterilise its intervention activities and they have also been increasingly used as part of the Bank's domestic liquidity management operations as an alternative to domestic currency instruments.

Operational Mandate 

Risk Management Structure

Responsibility for the management of foreign currency reserves is delegated by the Governor to the Bank's Financial Markets Group (FM). Within this group, International Department is responsible for the Bank's Front Office operations in markets for foreign exchange, gold, and offshore assets.

The Front Office is charged with managing the currency, asset allocation and duration exposures of the portfolio. The Front Office comprises three dealing centres: Head Office in Sydney, and one each in New York and London. These centres execute trades and have some discretion for taking positions. They also examine policy issues relating to the investment of reserves including evaluating new products and reviewing the structure of benchmarks. The Front Office is supported by a separate analytical group with the responsibility of providing in-depth analysis of international financial and macroeconomic developments that may impact on the value of the reserves portfolio.

The Middle Office has an independent reporting line to the Assistant Governor responsible for Financial Markets Group and is responsible for all aspect of performance and risk measurement. This performance and risk measurement information is provided to the Front Office and to senior management on a daily basis. The Middle Office also monitors compliance with credit and market risk limits. Compliance with limits is reported on a daily basis to senior management as well as to the Bank's Risk Management Unit. The Middle Office is also responsible for maintaining all Front Office trading and analytical systems.

There are several other areas outside of FM that supplement and scrutinise the actions of the Front Office but which report to different Assistant Governors:

• The Back Office provides standard settlement and communication services for the Front Office operation and is responsible for the final approval of all transactions – dealers in the Front Office cannot confirm nor arrange the settlement of trades. The Back Office also perform cash and inventory reconciliations in order to ensure that counterparties and custodians have correctly reflected all transaction events. Reflecting operational practicalities, there are Back Office operations in each of the RBA's three dealing centres, although Payments Settlements Department in Head Office has overall responsibility.
• The Financial Administration Department is responsible for the preparation of the RBA's financial accounts that are published in the RBA's Annual Report.
• The Internal Audit Department is responsible for ensuring compliance with procedures and other internal controls. It reports to the RBA's Audit Committee, which also includes a non-executive member of the RBA Board as well as an external appointee. When the RBA is preparing its annual financial accounts, external auditors are employed to provide independent support to Internal Audit.
• The Risk Management Unit is responsible for the RBA's enterprise-wide risk management policy and is in charge of risk assessment and reporting. It reports directly to the RBA's Risk Management Committee. Compliance with limits is also reported to this Committee on a quarterly basis.

Benchmark

The RBA's foreign currency reserves have been managed against internal benchmarks since 1991. The current composition of the currency and asset benchmarks, and the duration benchmark for each asset portfolio, are presented in Table 2.

When defining the asset benchmarks, consideration is given to a number of factors including portfolio return, creditworthiness and liquidity as well as the more practical economies of scale considerations relating to the management of a diversified portfolio. As a result, benchmark investments are restricted to sovereign securities and cash instruments. Typically, around 75 per cent of the RBA's benchmark portfolios are held in sovereign paper (Table 3). This includes Treasury bills and notes in the US portfolio, and Japanese government bills and bonds in the Japanese portfolio. In the European portfolio, the RBA invests in a combination of French and German government securities. Consistent with our investment mandate, the maximum term to maturity of these securities is 10½ years.

The benchmarks are reviewed periodically to ensure that they continue to reflect the RBA's long-term objectives. Despite this, there have been few changes to the RBA's benchmarks since their introduction in the early 1990s. These changes were made to take account of structural changes to markets (such as the introduction of the euro) or for changes in the nature of the Bank's operations.

Risk Measurement

The trading discretion around the duration benchmark for each asset portfolio is based on the concept of a dollars-at-risk exposure. This limit applies to the aggregate exposure and, in order to control the amount of curve risk, it also applies to the exposures in each maturity bucket of the portfolio.6 The dealing centres are required to maintain their dollars-at-risk exposure within this limit at all times. Adherence to limits is also independently monitored by the Middle Office with daily reports provided to senior management.

The dollars-at-risk measure also forms the basis of the Value at Risk (VaR) methodology which the RBA has used since 1995 to estimate the consolidated exposure of the Bank's foreign currency reserves to market risk. Although the overall limits to control market risk – that is, the discretionary trading bands around the benchmark – are not defined in terms of VaR, the RBA has nonetheless found it to be a useful tool for conveying information about the overall portfolio exposure to senior management and staff involved in reserves management.

The VaR exposure represents the portfolio loss which the RBA would reasonably expect to incur once every 20 business days in normal market conditions. Two VaR measures are calculated each day – one based on a correlation methodology and the other based on historical simulation methodology. The assumptions underlying these VaR methodologies are reviewed periodically and their performance is back tested.

The Middle Office has also developed a range of instrument and counterparty-specific limits to restrict the concentration of credit risk between issuers and counterparties. These limits are expressed relative to the size of the portfolios and as absolute amounts. While it is the responsibility of the Front Office to adhere to these limits at all times, the Middle Office also independently verifies their compliance each day and reports any breaches to senior management in Financial Markets and to the Bank's Risk Management Unit.

Performance Measurement

Each day the Middle Office calculates portfolio returns on an absolute basis and relative to the benchmark. Since the introduction of the risk management framework 15 years ago, the average annual return on the RBA's benchmark (in SDRs) has been 5.1 per cent (Graph 4). Decisions taken by RBA portfolio managers have added a further 23 basis points to that return.

Footnote

6. Each portfolio is segmented into twelve maturity buckets ranging from 3 months to 10 years. (back to text)