(Bloomberg) -- A Bank of Canada official said a recent change in how the central bank sets its deposit rate is working to improve the functioning of money markets, lowering borrowing costs.
Central bank policymakers said Jan. 29 they would start setting the deposit rate at 5 basis points below the central bank’s policy interest rate. Previously, the two rates were set at the same level.
The deposit rate is the rate the central bank pays commercial banks on deposits of overnight money.
The January reform has worked to restore market liquidity. The Canadian Overnight Repo Rate Average, known as Corra, priced at 2.99% on Friday, just below the Bank of Canada’s policy rate of 3%.
Last week’s market activity ended a monthslong streak during which Corra always settled above the policy rate.
The central bank’s change has prompted some market participants to offer up their settlement balances for lending in the repurchase agreement market, Deputy Governor Toni Gravelle said Monday at a Bank of England conference in London.
Gravelle said large institutions that have access to Lynx, the high-value payment system, have started using the repo market more because they aren’t getting the same return as before from depositing the funds with the central bank overnight.
“They have to go back to their boss and then say, ‘Well, we’re losing money relative to the target rate.’”
For nearly a year, Corra had been largely stuck above the bank’s target, an indication that short-term funding markets weren’t functioning efficiently, which was contributing to higher borrowing costs.
“We had seen very little circulation of reserves among our reserve participants,” Gravelle said. Settlement balances had been concentrated among the country’s largest banks, analysts at Canada Imperial Bank of Commerce suggested last year.
Gravelle also said firms may have been reluctant to part with the settlement balances because of uncertainty. Some institutions “keep telling us they will not lend the reserves because they worry about precautionary motives,” Gravelle said.
“They’ve finally acknowledged that reserve concentration was a key underlying issue restricting Corra converging back to the target rate,” Ian Pollick, head of fixed income, commodities and currency strategy at CIBC, said by email. “The bank is effectively increasing the velocity by which reserves travel in the system, even if the concentration issue remains.”
The central bank has said that increased participation from hedge funds that were funding their basis trading, as well as a shift to so-called T+1 settlement in North American markets, had added demand for liquidity since the beginning of last year.
At its Jan. 29 interest rate decision, the central bank announced it would effectively end quantitative tightening and start replenishing assets maturing from its balance sheet.
The central bank added hundreds of billions to its balance sheet through its large asset purchase and quantitative easing programs during the pandemic. Its assets have fallen to around C$258 billion ($181 billion) from a peak of more than C$575 billion as it allows government bonds it holds to mature, draining liquidity from the financial system.
In January of last year, the Bank of Canada resumed repo operations, then restarted daily receiver-general auctions on behalf of the government a month later, in a bid to fix distortions in short-term funding markets.
(Updates with additional information beginning in the fourth paragraph. An earlier version corrected the size of the Bank of Canada’s balance sheet in the second-last paragraph.)