The Canadian Monetary System

The Bank of Canada’s method for implementing monetary policy is closely linked to the system through which payments clear and settle daily.  With the introduction of the Canadian Payments Association’s electronic system for the transfer of payments (the Large Value Transfer System or LVTS), a new approach to the implementation of monetary policy was adopted on 4 February 1999.

Policy overview

The Bank of Canada establishes a target rate for the overnight interest rate within an operating band in order to influence other short-term interest rates and the exchange rate.  The ability to influence other short-term rates partly reflects the fact that inventories of money market securities are generally financed with overnight funds.  However other factors such as changing market expectations and exchange rate developments also affect how other interest rates, including those with relatively short terms to maturity, respond to changes in the target rate. 

Operating band

The Bank of Canada’s primary influence on the overnight rate is through its 50 basis-point operating band for the overnight interest rate.

• The interest rate charged for overdraft loans to LVTS participants at final settlement is the upper limit of the operating band.  This interest rate is the Bank Rate.

• The interest rate paid by the Bank of Canada on positive balances after settlement of the LVTS is set at the lower limit of the band.

• Changes in the operating band, and hence in the Bank Rate, are announced by 9 a.m. via a press release on the effective date.

The overnight rate typically stays within the band since participants are aware that they will earn at least Bank Rate less 50 basis-points on positive balances and need not pay more than Bank Rate to cover negative balances given the standing facilities at the Bank of Canada.

Target rate

The Bank has a target interest rate at the midpoint of the operating band for the overnight interest rate.

• To reinforce the target rate if required, the Bank of Canada will intervene in the overnight market with open market buyback operations at the target rate at 11:45 a.m.  The intervention is at midday to encourage market participants to trade with each other during the morning when a large proportion of daily funding activity occurs.

• If the overnight rate is generally trading above the target rate, the Bank will intervene with Special Purchase and Resale Agreements (SPRAs), commonly referred to as “repos”.

• If the overnight rate is generally trading below the target rate, the Bank will intervene with Sale and Repurchase Agreements (SRAs), commonly referred to as “reverses”.

• If the overnight rate is generally trading around the target rate, there will be no intervention.

• The counterparties to these transactions will be primary dealers.

• Each counterparty will have a predetermined limit for offerings of either SPRAs or SRAs.

Settlement Balance Management (cash setting)

During the initial stages of operating under this framework, the Bank of Canada typically set the level of settlement balances in the financial system at zero. Therefore any participant in the LVTS with a surplus funds position would be aware that there was at least one participant in the LVTS with an offsetting deficit position who was a potential counterparty for transactions at market rates.  However, the overnight rate typically traded above the target rate indicating that there was some demand for excess settlement balances.

Since November 1999 on a daily basis, the Bank has generally provided some positive level of settlement balances, most recently around $50 million, but somewhat higher when technical pressures occur.

Transfer of government deposits to affect the level of settlement balances

• To maintain the level of settlement balances at its desired level, the Bank must neutralize the net impact of any public sector flows between the Bank of Canada’s balance sheet and that of the financial system.  Public sector flows include government receipts and disbursements, the Bank of Canada’s own transactions, and those of its clients.

• This neutralization and any intentional change in the level of excess settlement balances is effected through the transfer of government deposits from/to the government’s account at the Bank of Canada to/from its accounts with participants in the LVTS.

• The transfer is made through the twice-daily auction of Receiver General (federal government) balances -- the first at 9:15 a.m. and the second at 4:15 p.m.

• The difference between the total amount auctioned and the total amount maturing equals the amount of the neutralization and the change in the level of excess in the system. 

For example, if the government were to receive $100 million net in taxes into its account at the Bank of Canada (the government’s banker), in the absence of any neutralizing action, settlement balances in the system would decline by this amount.  The Bank would therefore arrange a net increase of $100 million in the government deposits auction to leave the system unchanged (or a net increase of $200 million to increase the level of balances in the system by $100 million).  On the other hand, if the Bank transacted $100 million in SPRAs, there would be a net reduction of $100 million in that day’s government deposit auction (or if there were no change in the amount to be auctioned, this would represent a net increase in settlement balances of $100 million).

Presettlement period

After the close of client business in the LVTS at 6 p.m., LVTS participants have a period of one-half hour in which to enter into transactions with each other.  This will allow participants to reduce their LVTS positions -- positions that resulted from their own and their clients’ transactions -- at interest rates typically constrained by the limits of the operating band.  In fact, trades should occur at rates within the band since it is typically more advantageous for both the lending and borrowing parties to trade at a rate within the band than to resort to the Bank of Canada facilities at the limits of the operating band.

Paper-based payment items

Paper-based payment items, such as cheques, continue to be cleared through the Automated Clearing Settlement System (ACSS).  Some consideration was given to moving to a next-day settlement for the net amounts due to or due from the ACSS, but the financial institutions concerned preferred to maintain the existing system of retroactive settlement.

These institutions also chose the option of eliminating the calculation (averaging) period and having the Bank charge for overdrafts and remunerate positive balances at a given spread around the operating band for operational simplicity.  The rate spread for ACSS balances was originally 250 basis points and is now 150 basis points above and below the operating band.  The midpoint of this wider band is same as the midpoint of the operating band for the overnight rate.

Although the ACSS continues to exist, virtually all of the value of public sector flows and most market-related wholesale transactions move through the LVTS. Therefore, the LVTS is the sole focus of monetary policy operations.

Summary

In the LVTS environment, the Bank of Canada affects financial markets through its influence on the overnight interest rate by setting a target rate at the mid-point of a 50 basis point operating band for this rate and through a framework that is designed to hold the rate within this band.