Commercial banks reap windfall from surplus liquidity arbitrage

TREP, CD rates crash as RBI stays away from surplus liquidity absorption

Commercial banks are borrowing from the overnight market and parking the funds in the Reserve Bank of India’s (RBI’s) standing deposit facility (SDF), exploiting a widening spread between the two as the central bank has stayed away from absorbing surplus liquidity through variable rate reverse repo (VRRR) auctions. The SDF is offering returns at least 60 basis points higher than prevailing overnight market rates. Tri-party repo (Trep) rates — one of the key overnight benchmarks, with volumes significantly higher than the call money rates — have fallen sharply in February.   

 

The weighted average Trep rate, which was above 5 per cent in the final week of January, declined to 4.4 per cent on Tuesday, after closing at 4.27 per cent on Monday.

 

Liquidity surplus in the banking system, measured by funds parked by banks under the liquidity adjustment facility (LAF), has exceeded ₹3 trillion. The SDF rate, fixed at 25 basis points below the policy repo rate, stands at 5 per cent.

 

Banks placed a record ₹5.3 trillion in the SDF on Friday, followed by ₹4.5 trillion on Monday, according to RBI data. The banking system is flush with liquidity due to government spending, bond purchases by the central bank, and dollar-rupee buy-sell swap operations.

 

“The large amount parked in the SDF is due to surplus liquidity in the system. Additionally, some banks may be borrowing at lower rates in the Trep market and parking those funds in the SDF to capture the spread,” said a dealer at a primary dealership.

 

The RBI’s decision to allow overnight rates to soften is also exerting downward pressure on certificate of deposit (CD) rates. The one-month CD rate has declined by 51 basis points in February so far, while the three-month CD rate has fallen by 26 basis points over the same period. Six-month and 12-month CD rates have softened by 13 basis points and 15 basis points, respectively. 

 

“The crash in money market rates has trickled to CD rates, which appears to be a deliberate effort,” said a market participant. “Banks need deposits, given that credit offtake is typically high in the final quarter.”

 

With the SDF rate at 5 per cent and the Trep rate trading closer to 4.40 per cent, the RBI is allowing overnight rates to ease, a move that is helping compress term premia at the short end of the yield curve, particularly in the one- to three-year segment.

 

“Liquidity conditions have turned distinctly comfortable, with funds parked in the SDF largely reflecting surplus liquidity in the system. The RBI’s recent open market operations and foreign exchange swap transactions have augmented durable liquidity to around ₹6 trillion,” said V R C Reddy, treasury head at Karur Vysya Bank.

 

“In addition, 90-day variable rate repo operations of about ₹1.31 trillion have further added to surplus conditions. Under normal circumstances, the RBI would have absorbed this excess through VRRR auctions; however, it has consciously refrained from doing so… The central bank appears comfortable allowing overnight rates to soften. This is already feeding through to money market pricing, putting downward pressure on certificate of deposit rates and compressing term premia at the short end of the yield curve, particularly in the one- to three-year segment,” he added.

 

The weighted average overnight call money rate was trading at 5.03 per cent on Tuesday, while the weighted average overnight Trep rate stood at 4.40 per cent, compared with the previous close of 4.27 per cent. Only banks are permitted to park funds at the call money rate.

 

Although the LAF window offers a higher rate, parking funds under the LAF requires banks to provide eligible government securities as collateral and to participate during the designated operating window, which coincides with normal market hours. By contrast, the SDF allows banks to park funds without collateral and is available later in the day, making it operationally easier -- particularly when surplus funds arise close to market close or when banks prefer to conserve securities.

 

Following the extension of the overnight call money market trading hours to 7 pm, the central bank decided that the standing deposit facility and the marginal standing facility (MSF) would be available between 7 pm and 11.59 pm with effect from July 1 2025.

 

In the current calendar year, the weighted average overnight call rate has softened by 53 basis points, while the weighted average overnight Trep rate has declined by 120 basis points over the same period.