RDP 9214: The Cash Market in Australia 2. Daily Equilibrium

Although it is the smaller part, it is the ES funds market which is central to an understanding of the operation of the overall market. It is here that the Reserve Bank operates, setting the parameters for the cash market as a whole.

Daily equilibrium in the ES funds market requires that the demand for and supply of ES funds to banks and authorised dealers are equated.

Supply of ES funds to banks comes from:

• an opening surplus of the banking system — i.e. the net amount owed by the Reserve Bank to other banks on account of the previous day's transactions in non-ES funds involving the Reserve Bank and its banking customers;^[4]
• sales of currency to the Reserve Bank (these are usually small, the exceptions being immediately after Christmas and Easter holidays);
• recall by banks of ES loans made in the past to authorised dealers;
• rediscounts by banks of CGS at the Reserve Bank.

It should be noted that, while interbank loans of same-day funds do exist, they can only redistribute the supply between banks and cannot alter the supply to banks as a group.

Sources of ES funds to authorised dealers are:

• sales of CGS to the Reserve Bank in its daily operations at about 10:30;
• loans from banks transferred in ES funds;
• sales of CGS to the Reserve Bank under late repurchase arrangements after 14:30.

Demand by banks stems from:

• an opening deficit of the system;
• purchases of currency from the Reserve Bank (these are usually small, the exceptions being immediately before Christmas and Easter holidays);
• take-up of CGS won at tenders but not yet settled;
• placement of new loans with authorised dealers;
• leaving cash in exchange settlement accounts at the Reserve Bank.

Demand by authorised dealers stems from:

• purchases of CGS from the Reserve Bank in its daily operations at 10:30;
• take-up of CGS won at tenders but not yet settled;
• recall by banks of past ES loans;^[5]
• leaving cash in clearing accounts at the Reserve Bank.

Also relevant are dealers' sales and purchases of securities, or loan transactions in non-ES funds, with banks and non-banks.^[6] These sources all provide or use non-ES funds, but are relevant to the ES market as the Reserve Bank gives authorised dealers same-day value in their clearing accounts for these transactions. Hence, the authorised dealers can offset a potential surplus (respective shortage) of ES funds by creating a matching shortage (respective surplus) in their transactions in non-ES funds.

Of all the uses of ES funds listed above, the options of leaving positive balances in accounts at the Reserve Bank are rarely used in any significant degree, as the Reserve Bank pays zero interest on balances in these accounts.^[7] All other uses pay a market return to the owner of the cash.

Equilibrium

Ignoring the options of leaving cash uninvested — i.e. in exchange settlement accounts at zero interest — the equilibrium condition for the official market can be represented algebraically for day t by:

where	St	= net opening surplus of the market (negative if deficit)
	Ot	= net purchases of CGS by the Reserve Bank in its open market operations and late repurchases (excludes unwinding repurchases, which are included in St)[8]
	Rt	= rediscounts of CGS by banks
	Tbt	= take-up of newly-issued CGS by banks
	Tdt	= take-up of newly-issued CGS by authorised dealers
	Lnt	= net new loans to authorised dealers from non-banks
	Bnt	= net sales of securities by authorised dealers to banks and non-banks

The net opening surplus of the market itself reflects a number of factors:

where	Gt−1	= net Government deficit on day t−1 arising from budget transactions
	Mnt−1	= maturities of and interest due on CGS paid to non-banks on day t−1
	Mbt	= maturities of and interest due on CGS paid to banks
	Mdt	= maturities of and interest due on CGS paid to authorised dealers
	Zt−2	= net sales of foreign exchange to the Reserve Bank on day t−2
	Nt	= net sales of Australian currency to the Reserve Bank
	Udt	= net repurchases of CGS by the Reserve Bank as a result of past sales under repurchase agreements (negative if resales)
	Lnt−1	= net new loans in non-ES funds to authorised dealers from banks and non-banks on day t−1
	Bnt−1	= net sales of securities by authorised dealers to banks and non-banks on day t−1

Those items which appear dated t−1 are paid on day t−1 in non-ES funds and affect ES on day t after being cleared overnight. Z is dated t−2 because foreign exchange transactions are normally arranged two days before settlement, with that settlement being effected in ES funds.

Substituting (2) into (1) yields:

The dynamics of daily equilibrium arise because of the presence of the term in equation (3). This represents the net flow of non-ES cash obtained by authorised dealers from banks and non-banks on day t−1, either in the form of new loans or sales of securities. This net flow helped to balance the sources and uses of cash on day t−1, but also spills over to affect the equilibrium of the cash market on day t.

Of the terms in equation (3), and () are all predetermined, so the equation can be written:

where

The intertemporal workings of equation (4) can best be illustrated with a simple example. Assume that on day 1 X₁, R₁, and T^b₁ + T^d₁ are all zero — i.e. the system starts off in balance, there are no rediscounts and there is no take-up. Assume now that the Reserve Bank sells $100 million worth of securities to the authorised dealers in its daily operations — i.e. O₁ = −100. As there are no additional ES funds available, authorised dealers will need to choose one of two options in response:

• raise $100 million in non-ES funds to finance the purchase of the securities from the Reserve Bank, either by raising new loans of $100 million or selling securities worth $100 million to banks or non-banks. In either case, and the cash market is in equilibrium.

  Assume for the moment that this is what the authorised dealers do. On day 2, the spillover term from day 1 is and, if all other terms in X₂, R₂, and T^b₂ + T^d₂ are again assumed to be zero, banks will have to pay the Reserve Bank $100 million in ES funds to settle their overnight clearances and will call back this amount from authorised dealers, in turn causing dealers to have to raise another $100 million from non-banks. If the Reserve Bank does not purchase securities from the dealers to offset this, will be equal to $100m, and the banks will be short $100m on day 3. The process would repeat on the third day, and so on.

  While the process continues, the level of banks' loans to authorised dealers will decline by $100 million each day. This is offset by a combination of rises in the level of dealers' borrowings in non-ES funds and rises in the holdings of securities by banks or non-banks as dealers seek $100 million from non-banks each day. The result would be upward pressure on interest rates and security yields, which would persist and even intensify as the process went on from day to day;

• sell CGS worth $100 million to the Reserve Bank under the late repurchase facility. In this case, the value of O_t is reset to zero and the ES market is in equilibrium.

  When the late repurchase agreement expires (which could be next day), O_t will have a value of −100 if the Reserve Bank does not do any other dealing. Authorised dealers will then have to raise another $100 million from non-banks on that day, and the opening situation on day t is replicated.

  Hence, use of the late repurchase facility merely postpones the need for other adjustments of the type outlined in the first option.

Of course, in practice the Reserve Bank would not allow the adjustment process to continue until banks' ES loans to authorised dealers became too low. During this process, interest rates on cash and securities will change as demand by and supply from the authorised dealers and banks change from day to day (the ways in which this occurs are discussed in some detail in Section 3 below). But the Reserve Bank has announced targets for cash rates — in order to keep to that target rate, the Reserve Bank would remove the imbalance by stepping in to inject cash through its market operations if no injection occurred from exogenous sources (e.g. from a Government deficit) or from rediscounts by banks (if cash rates rose to the point where rediscounts were cost-effective). Nevertheless, what this market structure does provide is a high degree of leverage by the Reserve Bank over the market and hence it ensures that the Bank has the power to move the cash market quickly backward or forward, as the case may be, should there be some disturbance to cash rates caused by one of the exogenous factors in equation (4).

Footnotes

This also includes some transactions in ES funds which were pre-arranged — e.g. sales of foreign exchange to the Reserve Bank (which would have been arranged two days in advance). [4]

Authorised dealers are not permitted to make loans to other parties. [5]

Banks do not lend non-ES funds to dealers directly, but can sell or buy securities with them for non-ES payment, including under repurchase agreements. [6]

The Reserve Bank can at its discretion accept interest-bearing deposits from banks, but these are rarely used. [7]

If the Reserve Bank conducts foreign exchange swap transactions in ES funds, they would also be included in this term as their effect on the cash market is identical to that of conducting transactions in repurchase agreements using CGS. [8]