RDP 2019-09: Australian Money Market Divergence: Arbitrage Opportunity or Illusion? 1. Introduction

Short-term money markets primarily consist of unsecured cash market transactions, repurchase agreements (repos), bank bills and foreign exchange swaps. If markets are efficient and the risk characteristics of financial instruments are taken into account, there is no reason why the price of Australian dollar cash should differ across markets; that is, the law of one price should hold. Under these conditions, market participants would exploit deviations in interest rates if they represent a profit opportunity by borrowing in the market where rates are lowest and lending to the market where rates are higher, until it is no longer profitable to do so.

In recent years, however, interest rates in short-term money markets have significantly and persistently deviated from each other, and from overnight cash rate expectations as captured by overnight indexed swaps (Figure 1). A commonly cited example of this divergence is the Japanese yen basis, which has remained unusually wide for a number of years.^[1]

The issue of unexploited arbitrage opportunities in foreign exchange markets and the breakdown of the covered interest parity condition has been well documented.^[2] Possible explanations include increased demand to hedge US dollar exposures, changes which have reduced balance sheet capacity for such trades (Sushko et al 2016), increasingly segmented money markets, and greater heterogeneity in the funding costs of banks after accounting for risk and transaction costs (Rime, Schrimpf and Syrstad 2017).

We expand on this literature by estimating the average funding cost for major banks in Australia with respect to trading in short-term money markets. Similar to Boyarchenko et al (2018) whose work focuses on US money markets, our research examines the net returns from trades in different segments of domestic money markets. However, we go a step further and develop a novel approach to identify the cost of funding each money market trade.

This paper explores important reasons why the four major Australian banks have not transacted in a manner that would close the observed divergences between money market rates. Specifically, we estimate the profits major banks can earn on lending Australian dollar cash in the markets for repos, bank bills and foreign exchange swaps. To assess profitability we take into consideration how the major banks fund themselves. The cost of equity and non-equity funding both play an important role. Throughout, we refer to non-equity as ‘debt’, but note that it also includes deposits. The main finding is that the cost of funding trading positions with debt has not fallen as much in the low interest rate period as the available return in money markets. That is, the cost of debt funding has risen relative to the return that can be earned by investing in money markets. The relative cost of debt funding has not only eroded narrow trading margins, but has made such trades unprofitable over much of the past decade. In addition, in the post-2008 crisis period, increased equity funding has also weighed on profitability, particularly in bank bill and foreign exchange swap markets. It appears that, until recently, higher funding costs (debt and equity) have reduced the incentive to lend into money markets, despite the observed spread between interest rates.

We also compare returns on money market trades with returns earned by major banks on mortgage lending, to assess the opportunity cost of deploying their balance sheet to arbitrage differences in money market rates.

Footnotes

For more information on the Japanese yen basis, see Debelle (2017). The return enhancement offered by the persistently wide basis is regularly utilised by the Reserve Bank in its liquidity management operations (RBA 2018). However, the central bank does not face the same constraints as private market participants who are less inclined to enter the arbitrage trade. [1]

See Becker, Fang and Wang (2016), Becker and Rickards (2017), Borio et al (2016), Debelle (2010, 2017), as well as Du, Tepper and Verdelhan (2018). [2]