Central Banks
Central banks are an important customer base for the regular repo business covered in this guide both as an investor in repo and a lender of bonds. Repos are useful to central banks both as a monetary policy instrument and as a source of information on market expectations.
Liquidity Management
Repos have the advantage that they give central banks relatively precise control over liquidity. The fact that injections of liquidity are reversed when repos mature means central banks can absorb liquidity simply by not renewing some fraction of repos falling due.
Obviously, to use this technique to control liquidity, the maturity structure has to be tailored to ensure that sufficient stocks of repos mature on appropriate days. Central banks can also withdraw liquidity directly using reverse repos.
A key determinant of the frequency of central bank repo operations is the existence of minimum reserve requirements. For central banks in countries with reserve requirements and averaging arrangements, daily liquidity fine-tuning is sometimes not necessary and repos are used for long term provision of liquidity at less frequent intervals.
For central banks in countries without reserve and averaging requirements, where the demand for central bank money can be quite volatile, repos are conducted daily to fine-tune liquidity.
Monetary Policy Signalling
Repo operations conducted by central banks sometimes have a signalling function. The type of signal and the manner in which operations are used to convey any message vary across countries according to the institutional arrangements in place. Use of repo for signalling will also depend on the value that central banks place on this form of communication rather than other methods.
Central banks can vary the auction technique they use in repo markets depending on the signal they want to send. In some cases a central bank might use a variable (or multiple) rate auction (where the repo rates associated with the repo transactions used to manage liquidity are not revealed to the market) if it is satisfied with the level of market rates, but might prefer a fixed rate auction when it wants to indicate the desired level of rates or signal a change in policy. An example of an operating framework that combines these approaches is to use repo and reverse repo rates to define an upper and lower limit for short-term market interest rates. Central banks influence the level of market rates within this band by adjusting liquidity using repos. A shift in monetary policy can be signalled by adjusting the limits of the band.
Repos are also useful to central banks for monetary policy because:
- They carry a low credit risk as they are collateralised
- They are relatively flexible, as their features (amount, maturity, frequency, interest rate and tender system) can be tailored according to liquidity conditions
- They do not affect securities prices
- In contrast to some other instruments (e.g. discount rate), they utilise established markets accessible to a broader range of institutions.
Market Expectations
Expectations of the future levels of official interest rates are implicit (to some degree) in all financial asset prices. This wide choice of financial assets raises the question of which one central banks should use to obtain the most useful measure of market expectations. In this regard, it is useful to assess the relative advantages of different instruments.
Government securities
The cash market in government bonds is useful for deriving the term structure of interest rates at longer maturities and hence for assessing policy expectations over longer horizons as well as the credibility of the policy regime. However, computing forward interest rate curves for government bonds near to maturity (when there is less than two years to maturity) is difficult and can, at times, yield inaccurate measures of short-term policy expectations.
Private sector debt instruments
These include interest rate swaps, interbank credits and certificates of deposits. It may be difficult to extract precise information on interest rate expectations from these instruments since they contain credit spreads, which cannot be fully distinguished from information on monetary policy expectations.
Interest rates futures
Interest rates futures typically involve the right (obligation) to receive the unsecured interbank (usually the three-month rate) prevailing at the expiry of the contract. They are short maturity instruments that are highly liquid, but involve some credit risk that arises from the unsecured nature of interbank deposit.
Their usefulness as a measure of short-term expectations regarding the official (risk-free) interest rate is reduced by a credit risk premium and is limited by the fact that futures contracts are settled infrequently, typically every three months. As a result, they provide a direct measure of expectation for official rates over time horizons between the present and next settlement date.
Repos
Repo markets in most countries are typically liquid out to about three months (the US market has reasonable liquidity out to 12 months), so expectations extracted from the term structure of repo rates are unlikely to be accurate beyond the short term. At very short maturities, however, repos are likely to be the best source of such information for many countries. Moreover, credit risk is small for repos since they are collateralised transactions and depend largely on the credit risk of the underlying securities (which is usually negligible for most government securities).
As a result of these advantages, the rate in the general collateral repo market may be the best proxy for a risk-free short-term rate of interest (in countries where liquid repo markets exist). In principle, it should provide a relatively precise measure of market expectations regarding the level of central banks' official (intervention) interest rate, especially when the target rate is a repo rate. However, in practice, official rates and market repo rates can (and do) differ. Thus, for central banks to be able to use repo rates as a tool for assessing market expectations it is desirable to establish why, and to what extent, the two rates differ.
Another use for repos arises from the fact that credit risk is relatively low. This means that the spread between interest rates on repos and other short-term instruments at comparable maturities should provide a measure of the credit spread for each instrument. Estimation of credit spreads can facilitate the interpretation of interest rate expectations embedded in these other instruments because it is possible to adjust for credit risk premiums.
Other uses
- Repos can be useful to central banks in a number of domains in additional to monetary policy and market expectations.
- Management of foreign currency reserves. Most G-10 central banks use repos in their foreign currency reserve management, because repos widen the range of investment possibilities while reducing risk and providing some extra return on securities portfolios
- Repos are used to provide intraday credit to support the functioning of real-time gross settlement (RTGS) payment system.
- Repos have offsetting effects on systemic risk. They are likely to be more resilient than uncollateralised markets to shocks that increase uncertainty about the credit standing of counterparties, thus limiting the transmission of shocks.
Central banks usually invest the cash they obtain from repo transactions into Commercial Paper (CP). As a result, these two products, repo and CP, are closely related. A commercial paper is an unsecured obligation issued by a corporation or bank to finance its short-term credit needs, such as accounts receivable and inventory. Maturities typically range from two to 270 days. CP is available in a wide range of denominations, can be either discounted or interest-bearing, and usually issued by companies with high credit ratings. As a consequence, the investment is almost always relatively low risk.
Issuance of commercial paper is just an indirect means to enhance yield as the net return on the trade is increased.
Customers interested to know more about trading Commercial Paper with UBS should contact our repo desk for further information. The contact us section provides the relevant contact numbers for each timezone.
Features of a repo contract for central banks:
Central banks can design repo contracts with features most consistent with their monetary policy framework, depending on whether repos play a liquidity management and/or signalling role. It is possible to identify four dimensions over which the choice of features of repo contracts can vary.
Frequency
The frequency of repo operations is higher in those countries that use repos for daily liquidity control. Frequency can be lower when central banks use repos mainly as a long-term liquidity provision mechanism or for interest rates signalling.
Maturity
The maturity of repos determines the proportion falling due in a given period. Since this facilitates the absorption of liquidity through the non-renewal of these repos, central banks using repos for daily liquidity management tend to have a greater reliance on short-maturity repos.
Disclosure
The disclosure of central bank repo rates before the tender depends on whether repos are used for signalling as well as liquidity management.
Tender system
Tender or auction systems can be chosen depending on the signal central banks want to communicate as to the stance of monetary policy. Systems range from a multiple rate auction (low capacity to transmit interest rate signals) to a fixed rate tender (high capacity to transmit interest rates signals)
Securities lending - UBS Keylend
One of the services that UBS offers to central banks (as well as other private banks) in the securities lending business is the UBS KeyLend scheme. More on this is in the attachment below. Please contact a UBS representative for more information about UBS KeyLend.
Link to UBSKeylend.
