Domestic Market Operations
Last updated: 9 May 2016
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 monetary policy meetings. The Board's monetary policy decision is announced in a media release which is distributed through market data services and published on the Reserve Bank's website at 2.30 pm (AEST/AEDT) on the day of each Board meeting. Any change to the cash rate target takes effect from the following day. The Reserve Bank's domestic market operations are designed to ensure that the actual cash rate remains close to the target rate (Graph 1).
Exchange Settlement Funds and the Cash Rate
On a day-to-day basis, the cash rate is 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 small number of other financial institutions) and are used by account holders to meet their payment obligations with each other and with the Reserve Bank. The Reserve Bank gauges the demand for ES funds. Through its domestic market operations, the Reserve Bank supplies enough ES funds to ensure that the cash rate remains close to the Board's target.
Under arrangements introduced in November 2013, some Authorised Deposit-taking Institutions (ADIs) maintain a quantity of ES funds in their account as a buffer against intraday payments and payments they may need to settle after the time that the interbank cash market has officially closed. The size of these buffers is agreed in advance with the Reserve Bank and funds held for this purpose are paid interest at the Board's target for the cash rate. Other account holders may also receive the cash rate target on a pre-agreed amount of funds in order to manage intraday payments. All balances held by ADIs under these arrangements are directly sourced through transactions between the ADIs and the Reserve Bank, with the funding rate on these transactions also set at the cash rate target.
Any ‘surplus’ balances held by ES account holders are paid interest at a rate that is 25 basis points below the cash rate target. Although balances held at the central bank are risk-free (in contrast to an interbank loan), the 25 basis point differential is sufficiently wide to mean that ADIs seek to minimise their surplus balances; consequently, ADIs with surplus ES funds have an incentive to lend to those with a projected shortfall on their account.
Nevertheless, certain frictions in the cash market may make it difficult for funds to be fully recycled. For example, an ADI with surplus funds to lend may not wish to increase its credit exposure to the ADI that needs to borrow funds. As noted previously, the Reserve Bank seeks to maintain a supply of ES funds sufficient to ensure that these factors do not prevent the market clearing at the Board's target. In recent years, the supply of ‘surplus’ ES funds has been reasonably steady at around $1 billion (Graph 2; under the arrangements that existed prior to November 2013, all ES funds were effectively surplus). The cash rate has matched the Board's target on all days during this period.
During the period of international financial turmoil between 2007 and 2009, there were considerable frictions within the interbank market. As the financial crisis that mainly emerged in the North Atlantic economies unfolded, financial institutions in Australia also became less willing to lend funds to each other, partly due to uncertainty surrounding their own liquidity position, but also due to concerns they held about the creditworthiness of other financial institutions. These trends were most evident in the markets for longer-term debt, but were also felt in the market for overnight funds. To ensure that the cash rate traded at the Board's target throughout this period, the Reserve Bank accommodated the greater demand for ES funds by significantly increasing their supply.
The Reserve Bank needs to transact in the domestic market almost every day to keep the supply of settlement funds at the right level. This is because payments between the Reserve Bank's customers and financial institutions (and their customers) changes the supply of ES funds. As the Australian Government is a customer of the Reserve Bank, these payment flows can be very large. Expenditure by the Government adds ES funds to the account of the recipient (or their financial institution), while tax receipts have the opposite effect.
The Reserve Bank's own transactions with financial institutions also alter the supply of ES funds. When ADIs purchase banknotes from the Reserve Bank, settlement is in ES funds. Similarly, when the Reserve Bank buys and sells debt securities (such as government bonds) from financial institutions, the aggregate supply of ES funds changes.
In deciding when (and how much) to transact in the securities market each day, the Reserve Bank generally looks to offset the impact of all its other settlement obligations and those of its clients. By doing this, the Reserve Bank maintains the supply of ES funds at the appropriate level.
The Reserve Bank is the Administrator of the cash rate. It is calculated as the weighted average of the interest rate at which overnight unsecured funds are transacted in the domestic interbank market. In addition to being the Reserve Bank Board’s operational target for monetary policy, the cash rate is also an important financial benchmark in the Australian financial markets. It is used as the reference rate for Australian dollar overnight indexed swaps (OIS) and the ASX's 30-day interbank cash rate futures contract. For further information, see Cash Rate Methodology – Overview.
Open Market Operations
Securities transactions are conducted almost every day in the ‘open market’ by the Reserve Bank. Each morning, the Reserve Bank announces its dealing intentions, inviting financial institutions to propose transactions that suit the Reserve Bank's purposes. Counterparties are able to sell highly rated debt securities to the Reserve Bank either under repurchase agreement (repo) or outright sale. Under a repo, the seller agrees to repurchase the security at a future time and at a pre-agreed price. In many respects, the transaction is similar to a secured loan, with the difference between the purchase and repurchase prices representing the interest earned on the transaction. The Reserve Bank's morning round of open market operations is based on an estimate of the net payments that will settle that day between the Reserve Bank (and its clients) and ES account holders.
Late each afternoon, the Reserve Bank announces whether an additional round of open market operations is required. Uncertainty in the timing of payments to, and from, clients that hold accounts with the Reserve Bank (mainly the Australian government) can give rise to unforeseen fluctuations in ES funds during the day. The additional round gives participants the opportunity to either lend excess balances back to the Reserve Bank or borrow the shortfall on a secured basis. Notably, the Reserve Bank assesses the need for these additional rounds on a system-wide basis rather than on the position of individual institutions, thereby preserving the incentives for institutions to participate in the interbank cash market.
Very occasionally, the Reserve Bank might announce further additional rounds of open market operations later in the evening. These are conducted prior to the close of the SWIFT End Session. For further information on additional rounds, see Technical Notes: Open Market Operations (Section 1.1.2).
In addition to open market operations (where financial institutions compete with each other to transact with the Reserve Bank), the Reserve Bank also operates standing facilities that are available to eligible counterparties on pre-specified terms.
As mentioned above, the Reserve Bank has a standing facility that allows ES account holders to access a certain amount of funds at the cash rate target. These funds are obtained through ‘open’ repos with the Reserve Bank (that is, repos contracted without a maturity date). To the extent that account holders retain matching funds against their open repo position, those ES funds earn the cash rate, with an allowance made for variations in ES funds arising from certain payments, such as direct entry (DE) payments, that settle during the evening. A 25 basis point charge is applied to any shortfall in the ES account.
The Reserve Bank offers a standing facility for intraday repos. These repos carry no interest charge and provide a means by which financial institutions can meet payments in advance of funds being received.
The Reserve Bank also has a standing facility where it agrees to extend overnight funding to an eligible counterparty at an interest charge set 25 basis points above the cash rate target. These ‘overnight’ repos are rarely used as the higher rate of interest attached to them creates the incentive to source funds in the interbank market.
The Committed Liquidity Facility
Since January 2015, those ADIs to which APRA applies the Basel III liquidity standards have been required to hold high-quality liquid assets (HQLA) sufficient to withstand a 30 day period of stress under the liquidity coverage ratio (LCR).
In the domestic securities market, only Australian Government Securities (AGS) and securities issued by the borrowing authorities of the states and territories (semis) meet the Basel criteria for HQLA. While ADIs have significantly increased their holdings of government debt in recent years, a large proportion of the current stock on issue is held by non-residents, and ADIs' holdings are well below the amount that would be needed if all ADIs were to meet their LCR requirement through this means. Compelling ADIs to acquire most of the stock of AGS and semis would very likely interfere with the properties of the market that qualified it as HQLA in the first place; namely, its depth and liquidity.
Apart from AGS and semis, the only other assets recognised as HQLA are liabilities of the Reserve Bank; namely, cash and ES funds. While banknotes yield no return, the rate paid on surplus ES funds is set at 25 basis points below the cash rate target. If ADIs were to view ES funds as the easiest and/or cheapest means of complying with APRA's liquidity standard, the demand for settlement balances would very likely be less stable, varying with factors that altered an institution's degree of compliance with the LCR requirement, rather than simply with their cash position. In effect, the Reserve Bank would meet the entire liquidity demands of the domestic banking system upfront.
To avoid such a situation, which derives from an insufficient supply of HQLA, the Basel III standards allow jurisdictions to use an alternative treatment for holdings in the stock of HQLA. The Committed Liquidity Facility is the Reserve Bank and APRA's alternative treatment and, under this arrangement, certain ADIs are able to use a contractual liquidity commitment from the Reserve Bank towards meeting their LCR. The Reserve Bank's CLF was approved by the Reserve Bank Board in November 2010 and announced via media release in the subsequent month. (See the CLF Operational Notes for further details on the facility.)
ADIs that wish to count the CLF towards their LCR requirement must first seek approval from APRA. Under the CLF, the Reserve Bank commits to providing an amount of funding to approved ADIs via repurchase agreement. A per annum fee of 15 basis points is assessed on the size of the Reserve Bank's commitment, regardless of whether it is drawn or not (see Box).
In practice, the CLF does not change the way ADIs access the Reserve Bank's existing standing facilities. The only difference is that in the absence of a CLF the Reserve Bank has made no contractual commitment to transact repos with any ADI under its standing facilities; each individual repo is subject to the Reserve Bank's agreement. The CLF provides a means by which ADIs may obtain a contractual commitment from the Reserve Bank to extend funding. Nevertheless, the Reserve Bank's commitment is always contingent on the ADI having positive net worth in the opinion of the Reserve Bank, having consulted with APRA.
The CLF allows ADIs to hold towards their LCR requirement securities eligible in the Reserve Bank's operations that are not HQLA securities, provided a fee is paid on the CLF amount. As noted above, the Reserve Bank is willing to purchase highly rated debt securities (in addition to AGS and semis) in its operations. As is its standard practice, the RBA applies haircuts to the securities available to be presented, such that ADIs need to hold securities with a higher value than the size of the CLF.
Box: Pricing the CLF
For the payment of a fee, the CLF gives ADIs the option of selling eligible securities to the Reserve Bank under repurchase agreement, with the (effective) repo rate set 25 basis points above the cash rate target.
In many respects, this arrangement is little different to how the Reserve Bank's standing facilities operate for an ADI without a CLF. However, for such an ADI, there is no contractual commitment by the Reserve Bank to provide standing liquidity arrangements and hence there is no fee. In this sense, the CLF fee can be seen as a means of charging the large ADIs an appropriate price for a liquidity option they have always implicitly held.
Ideally, the CLF is priced so as to replicate the cost to an ADI of holding HQLA should there have been sufficient supply. However, this does not mean that the CLF fee should simply reflect the differential between yields on available HQLA (such as government bonds) and yields on those other securities eligible for the CLF.
Under the CLF, the Reserve Bank is only committing to provide funding against the value of a security at the time the facility is utilised, not the value at the time the commitment is established. Moreover, when the facility is utilised, the Reserve Bank discounts the security's value by a margin (or ‘haircut’); these margins vary depending on the type of security. Hence, the CLF is only (and not completely) insuring an ADI against the liquidity risk on its securities. The credit and market risks attached to the securities remain with the ADI. As is the case with all repos contracted by the Reserve Bank, should the value of a security sold to the Reserve Bank decline, the Reserve Bank demands that additional securities be delivered to restore the original value of the repo. Similarly, should the credit quality of a security held by the Reserve Bank fall below a certain threshold, the ADI is required to replace the security with one that meets the eligibility criteria.
Consequently, to derive the appropriate CLF fee from the yields of eligible securities, an adjustment has to be made for the non-liquidity premia embedded in these yields as well as for that part of the liquidity risk which the Reserve Bank is not insuring (namely, the haircut).
In practice, the task of estimating any such premia is not straightforward and is further complicated by the influence that the comparative scarcity of HQLA in Australia has had on relative yields. For example, in recent years AGS have generally been more expensive (relative to bank rates) than sovereign debt in other currencies, partly because of the modest amount on issue.
Theoretically, some indication of the cost of hedging liquidity risk can be extracted from term repo rates on eligible securities. For example, if a security can be funded overnight at the cash rate, the spread over cash at which a twelve-month repo in that security is priced indicates how expensive it is to hedge against not being able to roll the overnight repo at the cash rate continuously through that period.
Few such long-term repos are contracted in the Australian market, however. As noted above, the CLF is similar to an option with a strike price set 25 basis points above the cash rate. Of course, during periods of market stress, the cost of liquidity can rise significantly and it is the potential for this to occur that gives the option some value.
Separate to any market-derived estimates, an equally important consideration in pricing the CLF is to ensure that it is consistent with the Reserve Bank's operating framework for monetary policy and does not compromise the Reserve Bank's ability to implement that policy.
The high degree of correspondence between the actual cash rate and the Board's target for that rate is quite unusual by international standards and is largely due to how the ‘corridor’ between the rate paid on ES funds and the effective cost of the Reserve Bank's overnight standing facility has been calibrated.
As discussed above, an important feature of the Reserve Bank's framework is that surplus ES funds are remunerated at a rate that is slightly below ‘fair’ market levels during normal times (so as not to be viewed as a primary store of liquidity for banks), but not so low that the cash market is disrupted by unexpected changes in system liquidity. By design, the spread of 25 basis points to the cash rate exceeds the credit risk premium generally priced into overnight interbank loans. A similar argument can be made for the 25 basis point margin attached to repos accessed via the Reserve Bank's standing facility; the rate is high enough to discourage routine use (such borrowings only occur a few times a year) but not so high as to prevent ADIs from drawing on it when appropriate (in preference to failing on payments or otherwise disrupting the financial system).
The resultant stability in the actual cash rate under this framework contributes to broader stability in money market rates, lowers the cost of hedging interest rate risk and enhances the transmission of monetary policy.
The purpose of establishing the CLF was to ensure that ES funds retained their current role within the Reserve Bank's operating framework. Setting the CLF fee at 15 basis points should ensure that this is the case.
‘Spread over cash’ in this context means the spread over an overnight indexed swap (OIS) rate for that term to maturity. As OIS are referenced to the cash rate, these spreads abstract from any expectation of a change in the cash rate that has been incorporated in longer-term repo rates.