RDP 2024-03: Demand in the Repo Market: Indirect Perspectives from Open Market Operations from 2006 to 2020 2. Open Market Operations

In the period we choose for our sample (2006 to early 2020), the Reserve Bank conducted open market operations almost every business day through a competitive auction process.^[3] The purpose of the auction was to inject or withdraw liquidity, primarily using repos collateralised by eligible securities.^[4] In the first leg of a reverse repo, the Reserve Bank provides the counterparty with exchange settlement balances in return for collateral on the auction date. In the second leg, this trade is reversed on a pre-agreed future date.

Over this sample period, prior to the auction the Reserve Bank published its intentions to inject or withdraw liquidity. The intended size of operations in millions of dollars, a set of preferred terms which specify the duration that cash is lent, and various measures of the aggregate system cash position were published on electronic platforms.^[5]

Prior to the auction, eligible participants submitted bids specifying the size and rate they were willing to offer for a set of terms. These terms were either those proposed by the Reserve Bank, or those nominated by banks. The minimum size of a bid was $20 million with $1 million increments. No limit applied to the total size or number of bids that each participant could make, although only Australian dollar-denominated transactions were contracted.^[6]

For each term, the Reserve Bank first allocated cash to the bid which offered to pay the highest repo rate. The auction was therefore based on the presumption that the highest bid revealed that the counterparty had the highest demand for funding on the day. Additional bids were met in descending order until the target size of operations was supplied. The lowest rate dealt to in an auction is referred to as the cut-off rate. Bids that were uncompetitive remained unfilled after intended supply was exhausted. There are some exceptions to this allocation process. Most fundamental was the regime shift between April and November 2020, when the cut-off rate was fixed at 0.18 per cent, and again since November 2020 when the rate was fixed at 0.10 per cent. The size of operations was no longer fixed, and more recently, the frequency of operations has ceased to be weekly. Changes for the framework are ongoing (see Kent (2022, 2024) for recent changes).

Becker and Rickards (2017) argue that since 2016 there has been a demand-driven increase in repo rates, which can be linked at least in part to non-residents becoming more active managers of their portfolios of Australian dollar-denominated securities. This appears to also have been the same time that pricing anomalies emerged, which made it profitable to trade the bases in markets such as foreign exchange swaps and bond futures (Becker, Fang and Wang 2016). The rise in repo rates between 2016 and the end of 2019 was accompanied by an increase in volatility for reasons that were very different to the crises-related market conditions observed during the global financial crisis or the onset of the COVID-19 pandemic. At the onset of these crises, cut-off repo rates spiked for a short period, reflecting an increase in demand for precautionary liquidity (Figure 1). Provision of central bank liquidity was able to meet that demand and market conditions became more settled relatively quickly. In contrast, repo rates remained elevated and volatile between 2016 and 2019. To a degree, it can be shown that the observed flows in the repo, bond futures, and foreign exchange markets are an indication that investors respond to arbitrage opportunities. Some of this heightened demand for funding might also be identified in banks' bidding behaviour in open market operations. Money markets are therefore interconnected, even if there are some barriers to perfect and riskless arbitrage (Cheung and Printant 2019). This paper is linked to earlier work through an explicit derivation of demand in open market operations.

Footnotes

Open market operations date back to much earlier than 2006, but we chose the start of our sample to coincide with the period just prior to the global financial crisis. [3]

For many years, the Reserve Bank has also used outright bond purchases and foreign exchange swaps to manage domestic liquidity. [4]

For a detailed illustrative example of the auction process, see Becker and Woon (2019). [5]

Details related to domestic market operations can be found on the Reserve Bank of Australia website at <https://www.rba.gov.au/mkt-operations/domestic-market-ops-and-standing-facilities.html>. [6]