RDP 9214: The Cash Market in Australia 1. Introduction

This note outlines a model of the Australian cash market. This is the market where overnight interest rates are determined and where the Reserve Bank conducts its market operations. An understanding of the structure and operation of this market is helpful in analysis of the Reserve Bank's implementation of Australian monetary policy.

The paper explains the structure of the market and the determination of overnight interest rates (or “cash rates”). The analysis in the paper is based on the Reserve Bank's present approach to monetary policy in which it announces a target cash rate and operates to maintain rates close to the announced target rate; however, the model itself is equally useful in analysing the workings of the cash market prior to the adoption of this approach in January 1990.^[1]

There are two parts to the cash market:

• the market for exchange settlement (ES) funds – those funds that can be transferred for same-day value between accounts at the Reserve Bank and used by banks to meet their daily ES obligations. Participation in this market is restricted to the Reserve Bank and those institutions with “same-day” accounts at the Reserve Bank: the banks (which have exchange settlement accounts) and the authorised short-term money market dealers (which have clearing accounts). Institutions in both groups must keep their Reserve Bank accounts in credit at the end of each day — there are no overdrafts permitted — and the Reserve Bank does not pay interest on credit balances.

  The mainstay of this market is therefore the lending by banks of their surplus ES funds to authorised dealers. Like all loans to authorised dealers, these must be secured (if secured with Commonwealth Government securities (CGS), the loans can be counted as PAR assets). Banks also borrow and lend ES funds between themselves on an unsecured basis in the interbank market at a rate of interest which tends to be slightly higher than that on bank-dealer loans, reflecting the lack of collateral.

  Both banks and authorised dealers also transact in non-ES funds, both with each other and with other non-bank institutions;

• the market for non-ES funds (often called “next-day” or “bank-cheque” funds). This part of the market deals in funds transferred by cheques paid into an account at a commercial bank. These funds are cleared overnight and give rise to ES obligations for banks on the next day. Banks, authorised dealers and other non-bank institutions participate in this market.

The interest rate paid by the authorised dealers on overnight ES loans from banks is called the interest rate on ES funds. The interest rate paid by the dealers on overnight loans in non-ES funds is the secured non-ES funds rate. The weighted average of these two rates is called the official cash rate.

The interest rate on unsecured overnight loans of non-ES funds is called the unofficial cash rate — this is generally higher than either of the two components of the official cash rate, reflecting the lack of collateral.

Of the two markets, that in non-ES funds is the larger — there are no statistics collected, but there could be $15 billion or more outstanding at any time. The market in ES funds typically has about $2½ billion outstanding.

The two markets are closely linked. Banks expecting to receive inflows (respectively pay outflows) of ES funds tomorrow can either wait until tomorrow and lend (respectively borrow) in the ES market then or they can lend (respectively borrow)^[2] in the non-ES market today to offset tomorrow's expected flows. In the latter case, the banks are using what is called “float” — the amount which spills into the ES market tomorrow as a result of transactions today. Banks' choice between the two options will be based on a number of factors. One is a comparison of the non-ES rate today and the expected ES rate tomorrow. More important is the level of ES balances that each bank has — if high, the bank is likely to lend non-ES funds today so as to avoid building ES balances up further; if low, the bank is likely to wait so as to build up its ES balances and lend them in the ES market tomorrow. Indeed, in the latter case, the bank may even seek to borrow non-ES funds today to add to its ES surplus tomorrow.^[3]

Authorised dealers facing a surplus (respectively deficit) today can meet this by repaying loans (respectively borrowing) in either the ES or non-ES markets today. In both cases they will balance their clearing accounts at the Reserve Bank, but each will have a different implication for flows of ES cash tomorrow. The decision will be based on comparing ES and non-ES interest rates today.

Overall, the linkages between the two parts of the cash market create a dynamic (or intertemporal) effect which is the key to understanding the operation of the cash market as a whole.

Footnotes

Earlier papers have examined the workings of the cash market at different stages of its development: see Macfarlane (1984) and Dotsey (1991). A less technical introduction to the cash market can be found in Battellino (1990) or Reserve Bank of Australia (1990) . [1]

In this context, “lend” should be taken to include buying securities and “borrow” should be taken to include selling securities (either outright or under repurchase agreements). [2]

When a bank (say, Bank A) lends non-ES funds today to a party which is, or banks with, another bank (say, Bank B), it must pay Bank B the “float” interest rate on this amount overnight — as it does on all uncleared payments. This normally does not affect the decision to lend, however, since Bank A will receive the float rate on the same amount when the loan is repaid. The float rate is set each week as the average of the official cash rate during that week. Banks settle for their net float payments each month in arrears — as this example suggests, the netted payments tend to be quite small given the large flows of funds that occur through the overnight clearings. [3]