Discussion Paper I, November 1995

Discussion Paper I,
23 November 1995

Executive Summary

In implementing monetary policy, the Bank of Canada operates through its influence on the overnight interest rate. The Bank sets a 50-basis-point operating range for this rate and designs its actions to hold the rate within this range. Changes in the overnight rate, and in the Bank's operating range, are the first stage in the transmission mechanism whereby the monetary policy actions taken by the Bank affect total spending in the economy and, ultimately, inflation.

The method used by the Bank to implement monetary policy is closely linked to the system through which payments clear and settle on a daily basis. Currently, these payments are mainly in the form of cheques and other paper-based items, which clear overnight and are settled on a retroactive (back-dated) basis. Therefore, those financial institutions directly engaged in the final settlement of payments do not know the outcome of the daily clearings, or the end-of-day level of their settlement balance at the Bank of Canada, until the following morning. This uncertainty is currently central to the framework within which the Bank acts to influence the overnight interest rate.

The Bank is now making preparations for the new electronic system for the transfer of large value payments (the Large Value Transfer System or LVTS) that the Canadian Payments Association (CPA) expects to introduce in the first half of 1997. Among other things, this system will permit participating financial institutions to track their LVTS receipts and payments throughout the day and to know the net outcome of these flows by the end of the day. As a result, a significant part of the current uncertainty regarding settlement balances at the Bank will disappear. Hence, following the introduction of the LVTS, a new approach to monetary policy implementation will be needed.

The attached discussion paper sets out a proposed framework for implementing monetary policy in the LVTS environment. The key feature of this framework would be an operating range of 50 basis points for the overnight interest rate, much as we have now. However, under the proposed system, the limits for the range would be defined differently. The upper limit would be the Bank Rate, the rate the Bank would charge to participating financial institutions requiring an overdraft loan to cover a deficit following settlement of the LVTS at the end of the day. The bottom of the range would be the rate at which the Bank would remunerate surplus settlement balances of participating institutions at the end of the LVTS day. These arrangements would discourage transactions in the market for overnight funds at rates higher or lower than this range.

Changes in this operating range, and, hence, in the Bank Rate, would typically be announced early in the morning. In addition, the Bank would signal its desired overnight rate within the range by intervening directly in the market for overnight funds. For example, the Bank might give that signal by offering to do a limited amount of Special Purchase and Resale Agreements (SPRAs) or Sale and Repurchase Agreement (SRAs), at its desired level for the overnight rate, at a regular time each morning.

In practice, end-of-day deficits or surpluses in the settlement balances held by participating financial institutions at the Bank of Canada should be very small. The proposal includes a pre-settlement trading period for these institutions, following the close of client business, to allow them to undertake transactions to eliminate deficits or surpluses. Typically, the Bank would set the total level of balances for the system as a whole at zero.

The attached paper also discusses two important technical matters raised by the introduction of the LVTS system. First, there is the issue of how to neutralize the impact on the level of settlement balances of the flows of federal government payments through the Bank of Canada, as well as the Bank's own transactions. The second matter is the treatment of the clearing results of the remaining paper-based payments, for which there are currently two options. The net clearing outcome of paper payments for a given day could be dated on the next day, or dated that same day on a retroactive basis following the clearing process as is currently the case. The discussion paper explores some of the implications of these two options.

For full text of this discussion paper