Domestic Market Operations
The Reserve Bank of Australia is responsible for the formulation and implementation of monetary policy. In Australia, the stance of monetary policy is expressed in terms of a target for the ‘cash rate’ – the interest rate on unsecured overnight loans between banks. The Reserve Bank Board determines the target cash rate at its monthly monetary policy meeting. The Board’s explanations of its monetary policy decisions are announced in a media release, which is distributed through electronic news services and published on the Reserve Bank’s website at 2.30 pm on the day of each Board meeting. Any change to the cash rate target will take effect from the following day. The Bank’s domestic market operations, also known as open market operations, are designed to ensure that the actual cash rate remains close to the target rate.
Graph 1 [D]
On a day-to-day basis, deviations in the cash rate around the target are determined by the supply and demand for exchange settlement (ES) funds. These funds are held in accounts at the Reserve Bank by banks as well as a number of other institutions, and are used by these account holders to meet their settlement obligations to each other and to the Bank. The daily aggregate net settlement obligation between ES account holders and the Bank can be very large. This is mostly because the Reserve Bank acts as banker to the Australian Government. Expenditure by the Australian Government results in funds flowing into ES accounts, while the payment of federal taxes has the opposite effect. Similarly, purchases of Commonwealth Government Securities (CGS) from the Government by investors reduce ES balances while redemptions of such securities increase ES balances. The daily aggregate net settlement obligation between ES account holders and the Bank also reflects transactions by the Bank’s other customers (mostly other official institutions) and by the Bank itself. The latter include the purchase of banknotes by banks from the Reserve Bank (which reduce ES balances) and transactions undertaken by the Bank with market participants (including the unwind of repurchase agreements – see below – arising from previous operations).
The Reserve Bank’s domestic market operations determine the aggregate supply of ES funds and are designed to ensure that supply equals demand at the target cash rate. If the supply is too high, holders of ES funds will wish to lend their excess funds in the overnight market, putting downward pressure on the cash rate. If the supply is too low, they will wish to borrow, putting upward pressure on the rate.
The Reserve Bank does not place any restrictions on the amount of ES funds that an individual institution holds (other than that the institution cannot go into overdraft). Moreover, unlike central banks in a number of other countries, the Bank imposes no reserve requirements. Because ES balances earn an interest rate below the cash rate, ES account holders generally attempt to minimise overnight ES balances. Nevertheless, most ES account holders maintain modest precautionary balances in their ES accounts overnight. With the tensions that emerged within global financial markets in mid 2007 intensifying at various times over 2008/09, the Bank judged that a relatively high volume of ES balances was necessary. Over 2008/09, ES balances averaged almost $4 billion, compared with $2.5 billion in 2007/08 and around $750 million in the five years prior to the onset of the financial crisis. As market tensions eased, ES balances were reduced.
The Reserve Bank’s open market operations, together with other elements of the framework used for the implementation of monetary policy in Australia, have proved very effective when measured by the stability of the cash rate around the target. Over the 2008/09 financial year, the cash rate did not deviate from its target on any days.
Open market operations are undertaken almost every business day. At the start of the day, the Reserve Bank estimates the aggregate net settlement obligation between the Bank and ES account holders for that day. This represents the likely change in the supply of ES funds that would take place in the absence of open market operations. The Bank publishes this estimate at 9.30 am on the various electronic news services, together with its dealing intentions for the day. The latter indicate whether the Bank is looking to buy or sell securities and its preferred terms for repurchase agreements (see below).
If ES balances are expected to fall in the absence of market operations, the Reserve Bank would typically announce an intention to buy securities. When the Bank buys securities, it pays for them by crediting the seller’s ES account, adding to ES balances. If ES balances are expected to rise in the absence of market operations, the Bank would normally sell securities to reduce ES balances. Sales of securities by the Bank reduce ES balances as buyers pay for the securities from their ES accounts.
After the 9.30 am announcement, market participants have 15 minutes to approach the Reserve Bank with any bids for, or offers of, funds. These bids/offers are ranked in order of attractiveness according to yield for a given maturity, and sufficient deals are undertaken to achieve the desired supply of ES funds. The dealing is completed by around 10.00 am, when participants are informed by telephone whether or not they have been successful. The Bank publishes the results of the operations through the electronic media at around 10.15 am each day. Settlement takes place over the course of the day.
The Reserve Bank undertakes both outright transactions and repurchase agreements in its open market operations.1 Until the middle of the 1980s, the Bank’s open market operations were conducted exclusively through outright transactions in CGS. Through the 1990s, repurchase agreements became an increasingly important instrument. Now almost all Bank open market operations in domestic securities markets are implemented using repurchase agreements.
Since the mid 1990s, the Reserve Bank has gradually widened the range of highly-rated securities that it is prepared to accept under repurchase agreements in response to the decline in CGS on issue and to take account of the changing structure of financial markets. The current list of Australian dollar denominated securities acceptable for repurchase agreements includes all short-term securities rated A–1 and all long-term securities rated AAA. Additionally, all bills and certificates of deposit issued by authorised deposit-taking institutions (ADIs) which hold an ES account at the Bank are eligible as are certain longer-dated securities issued by these institutions.
The Reserve Bank has also broadened the list of securities it will purchase outright through its daily open market operations to include short-dated issues by State and Territory central borrowing authorities. The Reserve Bank will also purchase long-dated issues of these securities (and CGS) on an outright basis in separate operations to its daily market transactions (see Long-dated Liquidity Operations in the Technical Notes menu).
In the second half of 2007, early in the financial crisis, the Reserve Bank expanded the range of eligible collateral to include a wider range of securities issued by ADIs and securities backed by high-quality residential mortgages, thereby making these securities more liquid. The Bank further expanded the range of eligible securities in November 2008 to include all A–1 or AAA-rated assets.
Around the same time, the Reserve Bank relaxed the restriction that prevented banks from using asset-backed securities (ABS) in which a related party was involved in the loan origination or securitisation. Most Australian banks, and a number of building societies and credit unions, have put together securities backed by mortgages on their books to meet the criteria specified by the Bank – ‘self-securitised’ residential mortgage-backed securities (RMBS). This served to increase significantly the pool of assets that ADIs could use in the Bank’s repo operations. By December 2008, the Bank had repos of $45 billion backed by self-securitised RMBS as collateral. Much of this collateral was accepted in the Bank’s longer-term repos and in the US dollar term repo facility, and has subsequently matured. The expiration of US dollar term repos, and the general improvement in funding markets, which reduced the need of institutions to fund themselves using self-securitised RMBS, resulted in a substantial decline in the value of the Bank’s repos involving these assets.
These developments are reflected in changes in the composition and size of the Bank’s portfolio of domestic securities (Graph).
Graph 2 [D]
Prior to the crisis, the longest term the Reserve Bank generally offered for repos was around three months; such repos were offered about once a week. As tensions emerged in financial markets in the second half of 2007, and with greater pressure in longer-term markets, the Reserve Bank extended the terms of its dealing, first to regular dealing in three-month repos, then periodically in six-month and one-year repos.
When the dislocation in term funding markets became extreme in mid September 2008, the Reserve Bank announced that it would offer six-month and one-year maturities every dealing day. This helped improve liquidity in the underlying market for bank paper, since counterparties must use collateral with a term at least as long as that of the repo. The regular offering of long-term repos also provided greater certainty of term funding to financial institutions. As market conditions improved, the Bank’s use of these long-term repos declined.
Despite the broadening of the range of domestic securities in which the Reserve Bank is willing to deal, increases in the size of the Bank’s balance sheet coupled with greater seasonal concentration of flows between the Bank and the private sector has meant that the Bank has had to augment its open market operations with foreign exchange swaps.2 Such transactions may be unwound within a very short period or rolled forward on a short-term basis.
Further information on this topic is provided in publications and speeches. Daily and monthly data on open market operations can be found on the Reserve Bank’s website.
Footnotes
- Repurchase agreements involve a purchase or sale of securities with a simultaneous undertaking to reverse the transaction at an agree date and price in the future.
- These can be thought of as repurchase agreements in foreign exchange rather than government securities. For example, the Reserve Bank can enter into a swap to buy foreign exchange from banks for Australian dollars, with an agreement to sell the foreign exchange back, at an agreed exchange rate, at a specified time in the future. The Reserve Bank pays for the foreign exchange by crediting a bank’s ES account with Australian dollars (which increases aggregate ES balances). When the swap matures, the counterparty bank’s repayment of Australian dollars to the Reserve Bank is effected by a debit to that bank’s ES account (which reduces aggregate ES balances).
