RDP 8702: Open Market Operations in Australia: A U.S. Perspective 3. The Australian Money Market

(a) Overview

This section describes the functioning of the official money market in Australia. It examines the roles of the major participants; dealers, trading banks, and the Reserve Bank, and how exchange settlement funds are distributed throughout the system. The major characteristics that distinguish the Australian market from the U.S. federal funds market are the requirement that banks meet their statutory reserve deposit (SRD) each day by maintaining a statutory reserve deposit account and non-negative exchange settlement account, and the more central role that dealers play in the flow of exchange settlement funds.

(b) Market Structure

In Australia cheques presented against banks at the Australian Clearing House do not affect balances in exchange settlement accounts until the next morning. Therefore, the Australian money market deals in two types of funds. The first is exchange settlement funds or same day funds. These are funds that accrue to exchange settlement accounts at the Reserve Bank. They include yesterday's cheque clearings, security transactions with the Reserve Bank, and transactions with authorised dealers. The second type of funds are bank cheque funds or next day funds. These are funds transferred by bank cheque and account for the bulk of transactions. These transfers do not affect exhange settlement accounts until the next day.

The market is also categorised into official and unofficial segments. The official market segment refers to the authorised money market dealers while the unofficial segement comprises the rest of the financial market. The main focus of the official market is the allocation of exchange settlement funds between banks, authorised dealers and the Reserve Bank. However, authorised dealers also operate in the unofficial market providing a link between the two markets.

(c) The Participants

(i) Dealers

In terms of the daily functioning of the official market dealers play a pivotal role. This is partly due to the Reserve Bank's policy of almost exclusively dealing with authorised dealers, implying that with the exception of rediscounting all movements in same day funds are initiated through the accounts of dealers at the Reserve Bank of Australia. Further, the timing convention for debiting and crediting the exchange settlement accounts of banks and dealers gives dealers the central role in distributing exchange settlement throughout the system. The interbank market also plays a role, but it is only through transactions with dealers that system wide shortages or excesses can be transferred from one day to the next.

While the basic operations of the nine authorised dealers in Australia are similar to those in the United States they are more highly regulated. The size of a dealers portfolio is constrained by a maximum gearing ratio of 33 to 1, which is measured on their assets weighted according to investment risk. Also, the composition of a dealer's assets is restricted. A dealer can hold up to 30 per cent of its gearing limit in specified assets including certificates of deposits issued by banks, commercial bills accepted or endorsed by banks, and marketable securities of major public authorities. The balance of the portfolio must be composed of Commonwealth government securities (CGS).

Besides portfolio restrictions there also exist restrictions on the type of transactions dealers can undertake with the rest of the market. For example, until recently a dealer's ability to supply funds to the market was limited to outright purchases of securities or the repayment of loans. Repurchase agreements were limited to transactions with the Reserve Bank of Australia. This restriction has at times created problems for the Reserve Bank in carrying out daily operations and sometimes resulted in fairly large discrepancies between rates in the official and unofficial markets. This restriction was lifted in August 1986.

(ii) Trading Banks

In Australia, trading banks maintain two separate accounts with the Reserve Bank. One is an SRD account that pays a below market rate of interest and is based on the previous month's deposits. Banks also maintain an exchange settlement account that is used for cheque clearing purposes and all checkable deposits must be cleared through an account with a major trading bank. However, for understanding the workings of the official market, there is no loss in assuming that all cheques are issued by banks.

Cheques received on a given day are cleared by the Australian Clearing House and settlement is made on the following morning. These cheques include transactions with the Commonwealth Government which banks at the Reserve Bank. Based on the previous day's transactions the banking system as a whole will either have a surplus or shortfall of exchange settlement funds at the beginning of the day. Since each bank must at least maintain a zero exchange settlement balance with the Reserve Bank, a bank that is short at the beginning of the day must acquire same day funds.

This requirement of settling up each day is one of the interesting differences between the U.S. and the Australian systems. In the United States, banks need only meet their reserve requirements on average and therefore have some flexibility in determining the profile of their required reserve balances. Flexibility in terms of adjusting exchange settlement funds on a day to day basis is accomplished in the Australian system through the use of float. As mentioned, interbank settlement is on a next day basis since cheques presented to the Australian Clearing House do not affect exchange settlement balances until the next morning. This means that banks cannot obtain same day funds through transactions with non-banks. Also, the interbank market like the Federal funds market can only distribute funds among banks and cannot provide funds for the banking system as a whole. However, some transactions such as those involving authorised money market dealers are settled on a same day basis. This differential in timing effectively allows the banking system to borrow and lend across days of the week and gives the system some flexibility in satisfying reserve requirements on any day. The use of float, however, can not be used to augment reserves over time.

Similarly, since exchange settlement accounts pay no interest, banks wish to keep their clearing balances at the Reserve Bank to a minimum. Excess same day funds can only be disposed of through the interbank market and by lending funds to authorised dealers. The latter method is the only way for reducing the entire system's same day funds.

(iii) The Reserve Bank of Australia

The monetary policy of the Reserve Bank of Australia is implemented by influencing its exchange settlement position with the banking system. By controlling the tightness or looseness of market conditions the monetary authority influences overnight interest rates directly and other interest rates indirectly. In turn, this provides a mechanism by which the Reserve Bank attempts to satisfy its broader objectives, among which may be the control of monetary aggregates.

In order to influence the cash position of the banking system the Reserve Bank actively uses open market operations. These operations consist of outright purchases and sales and repurchases and reverse repurchase agreements and are almost exclusively implemented through transactions with authorised dealers, although in unusual circumstances the Reserve Bank may transact directly with banks. Much of the trading would be characterised as defensive in nature. That is, in order to avoid volatility in interest rates the central bank will attempt to offset flows of cash that would tend to move rates. For conditions that are deemed to be short-term or seasonal, repurchase agreements are frequently employed, while outright purchases and sales are more often used to offset longer-term market conditions that do not accord with desired policy.

(c) Interaction of the Major Participants and the Workings of the Market

In order to obtain a basic understanding of how the money market works it will be useful to track the results of an open market operation. Let us assume that at the beginning of the day the banking system's exchange settlement accounts have a zero balance. Further, assume that banks have loans outstanding with dealers of $900 million, and that taxes of $600 million are being paid to the Treasury. At approximately 9.30 a.m. the Reserve Bank announces the systems opening cash figure resulting from the previous day's cheque clearings. In this example the figure is zero. At the same time, the Bank also indicates its dealing intentions.

In Australia, the amount of loans outstanding with dealers is an important indicator of market conditions because it represents the amount of same day funds available for the banking system. Under the current accounting procedures, banks are credited with same day funds when they recall a dealer loan and debited when they lend money to dealers. The loans are collateralised with government securities and the direction of lending is one way. Dealers can not make loans to banks.

In this example banks are not losing any exchange settlement funds on the day in question. However, they are aware that tax payments will be leaving the system and as a result they will have a cash deficit of $600 million tomorrow morning. Reserves leave the system because the Treasury keeps all its accounts with the Reserve Bank. Under the assumptions in this example, banks have enough loans outstanding with dealers to cover the shortfall, but the resulting loss in dealer loans would certainly be greater than banks desire at the existing interest rate. Therefore, individual banks will try to acquire next day funds by bidding for deposits or selling securities either to dealers or non-banks and rates will rise. While any one bank can acquire funds in this manner, the system as a whole can only acquire funds if the Reserve Bank provides accommodation by buying securities from dealers, if dealers finance the purchase of securities through central bank borrowings, or if someone uses the rediscount facility of the Reserve Bank.

If the Reserve Bank does not desire any upward pressure on rates it can add funds today and allow the system to transfer the funds from today until tomorrow. The banks and dealers will do so because exchange settlement funds do not earn interest. For example suppose the Reserve Bank buys $300 million in repurchase agreements from authorised dealers. Dealer's exchange settlement accounts will be up $300 million and they could use these funds to purchase securities from non-banks (or banks) either outright or under repurchase agreements.

Because dealers accounts are debited (or credited) on the same day their exchange settlement funds will now be square. Non-banks will deposit the dealers' cheques with a bank and the funds will be credited to the banking system's exchange settlement accounts on the next day. In effect the $300 million has spilled over to the next day so that banks will only have to reduce their loans with dealers by $300 million rather than $600 million. In this case, the rise in interest rate will be lessened.

The above example highlights an interesting feature of Reserve Bank behaviour that does not seem to be fully understood. Specifically, maintaining the current level of short-term interest rates does not imply that the Bank should merely offset daily injections of funds into the system. Since bank behaviour in bidding for funds depends on the expected flows of cash over subsequent days, the Reserve Bank's operations must also recognise likely flows of cash in the future. Otherwise needless variations in interest rates would arise. Therefore, to ascertain whether the Reserve Bank is seeking to move market rates requires a detailed examination of not only conditions existing on the current day but on conditions that are liable to arise in the near future.

The description of the daily workings of the official market also highlights some of the differences that exist between the Australian and U.S. systems. In the U.S. tax payments would not generally result in a large decline of funds from the banking system since the U.S. Treasury would shift an equivalent amount of deposits between its account at the Fed and its accounts with private banks. In Australia, the use of the Reserve Bank as the Government's bank means that flows between the private sector and the Government result in changes in the banking system's settlement position. These flows, besides arising from government expenditures and tax payments, also arise when the central bank markets government debt and when debt issues mature. While these flows need not cause problems there have been times when the combination of market conditions, restrictions on dealer operations, tax payments and bond tenders have produced problems for operating procedures.

Another major difference between the U.S. and Australian systems is the accounting conventions. In the U.S. open market operations can routinely provide same day funds to the banking system by wiring funds into a dealers account at a bank. In this way an open market transaction directly results in a change in reserve balances. As shown in the proceeding example, an open market operation in Australia immediately affects funds to dealers and only affects the exchange settlement funds of banks and bank loans to dealers on the next day. It is through the expected change in bank loans to dealers that pressures in the official market develop.

The one day lag between transactions that provide exchange settlement funds to banks reduces forecasting errors since banks start each day with a known cash position. If interbank settlement were on a same day basis, the Reserve Bank would have difficulty forecasting banks' needs for cash and this could lead to larger swings in overnight interest rates. Of course there is always the possibility that banks would just hold additional loans with dealers. However an optimal inventory strategy would not cover all contingencies. Also, the ability to borrow and lend across days allows the system to more gradually adjust to movements, especially temporary movements, in settlement funds. Given that the Reserve Bank is adverse to sharp swings in interest rates, this is a desirable characteristic. In the U.S. the regulation that banks only need to meet their reserve requirements on average has much the same effect.

Although the accounting procedures in Australia provide the system with some ability to adjust to temporary reserve pressures without movements in rates, a concerted effort by the central bank to move rates will result in a gradual and continued change in loans to dealers. In the case of a tightening in policy, dealers will be forced to seek funds by borrowing from non banks or selling securities. These actions place upward pressure on rates. Eventually, the necessary exchange settlement funds can only come from two sources, lender of last resort loans to dealers and rediscounting of government securities.

(e) Lender of Last Resort Loans and Rediscounting

The final major way for the banking system in Australia to acquire exchange settlement funds is through loans from the central bank. The Reserve Bank of Australia lends funds in two distinct ways. The first is through a line of credit to authorised dealers (in the banking literature). The other is through the rediscounting of specific Treasury notes at the Reserve Bank. The rediscount facility is available to any noteholder but is primarily used by banks and authorised dealers. Unlike the U.S. these loans are not made at subsidised rates and are not as quantitiatively important as discount window lending in the U.S.^[1]

Loans under the line of credit to authorised dealers are made with a term of 7–10 days. The minimum term is seven days and it is the dealers perogative on which day he will repay the loan, as long as it is repaid by the tenth day. Since dealers can always acquire same day funds by borrowing from non-banks, dealers will only borrow if overnight rates rise to the level of the lender of last resort loan rate.

Also, since market rates do fluctuate, the interest rate on these loans is adjusted on a regular basis. Because a loan involves a minimum term of seven days, the decision to borrow depends not only on current market rates but on expected market rates over the term of the loan.

With respect to the rediscounting of government securities, the Reserve Bank stands ready to purchase securities at a price P, determined by

where r is the rediscount rate and n is the number of days to maturity on the note. As Poole (1981) points out, this procedure produces an effective rediscount rate of r*, commonly known as the “give-up yield”, given by

This implies that the effective rediscount rate is larger than r and varies inversily with the number of days to maturity on the rediscounted note.

Borrowing behaviour by banks and dealers is depicted in Chart 1 and in Table 3. One observes that rediscounting usually occurs when market rates exceed the rediscount rate. Similarly, authorised dealers only borrow from the central bank when market rates are expected to rise above the rate on the central bank's line of credit.

These lending methods differ significantly from the operation of the discount window in the United States.^[2] In the U.S., discount window loans are usually at a subsidised rate. Therefore, controlling their volume involves some sort of non-price rationing. Since rediscounting involves a penalty rate and excess same day funds are allowed to earn market rates of interest through loans to dealers, the central bank lending facilities in Australia are guantitiatively less important than those in the United States. Also, bank loans to dealers in Australia are proportionately greater than excess reserve holdings in the U.S. This implies that a substantial draining of reserves would be required in order to induce banks in Australia to use the rediscount facility.

Although the use of rediscounting and the central bank line of credit may not be as great as discount window use in the United States, this does not imply that the nature of these facilities are unimportant in affecting both bank's and dealer's behaviour. These facilities represent a cost of acquiring same day funds and the rates charged and the rate on LLR loans will play an important role in determining the supply of bank loans to dealers and the demand for short term funds by dealers. In essence, the penalty rate charged for same day funds represents the cost of being caught short and will therefore be an important determinant for banks in deciding how much of an inventroy of same day funds they should maintain.

(f) Reserve Bank Operations

As noted earlier, the major aim of the Reserve Bank's domestic market operations is to maintain cash rates at levels consistent with the objectives of monetary policy. This type of policy has been implemented since the floating of the exchange rate in December 1983. However, while the Reserve Bank uses the cash rate as its operating instrument it does not peg the interest rate. Rather its policy can be viewed as a combination of two theoretically differenct approaches neither of which is solely followed in practice. Under one approach the bank could peg the interest rate at a level consistent with policy objectives while under an alternative approach it could target some reserve measure. As shown in Section 4, this latter method is really an indirect interest rate instrument.

In Australia, bank's loans to authorised dealers are an important indicator of market conditions because they are generally the only source of same day funds. If these loans are low banks run the risk of rediscounting and incurring the associated penalty. Therefore, a decrease in bank's loans to dealers forces banks to bid for funds and places upward pressure on interest rates. The relationship between bank's loans to dealers and interest rates provides the Reserve Bank with a useful indication of how market operations will affect rates. However at times there can be a conflict between the signals provided by bank's loans to dealers and the interest rate. The Reserve Bank appears to regard the interest rate as the more reliable guide for market operations.

This type of procedure allows for some variability in interest rates and is similar to the procedure currently followed by the Federal Reserve System under borrowed reserve targeting. However, as shown in the next section institutional arrangements in the two countries imply that the economic consequencies of the two pure policies differ and that an interest rate peg is likely to be more efficient than reserve targeting in Australia.

Footnotes

Technically, rediscounting is not a loan. However, it is equivalent to borrowing at a penalty rate for the remaining term of the security [1]

A detailed analytical treatment of the discount window can be found in Goodfriend (1985). [2]