To carry out its monetary policy and financial system functions, the Bank undertakes a range of financial market operations and provides liquidity to the Canadian financial system. In addition to providing routine liquidity to reinforce its key policy rate and enable settlement in the payment system through its Standing Liquidity Facility, the Bank uses other tools to supply exceptional liquidity—on either a bilateral or market-wide basis—to financial institutions that are facing liquidity stress.
To guide these actions, the Bank has established a clear framework for market operations and liquidity provision. Each tool in this framework is affected by—and in turn influences—the size, structure and management of the Bank’s balance sheet.
Reinforcing the target for the overnight rate
Implementing monetary policy
The overnight interest rate is the rate at which banks and other financial system participants borrow and lend funds between each other in the general collateral overnight market. The level of the overnight interest rate, and expectations about its future path, influence other longer-term interest rates as well as a broad range of asset prices. The Bank conducts monetary policy mainly by setting the target for the overnight interest rate—often referred to as the target rate or policy interest rate.
The Bank’s implementation of monetary policy is closely linked to Canada’s high-value payment system, Lynx.1 Almost all payments (measured by value) flow through Lynx. Because of this, the Bank’s framework for implementing monetary policy focuses on this system. It also includes tools to support trading at the target rate. One such tool is the operating band, which in turn is supported by standing deposit and lending facilities.2
The Bank can implement monetary policy through two different approaches:
- a corridor system or
- the current floor system
Corridor system (before March 23, 2020)
In an interest rate corridor system, the Bank establishes an operating band—or corridor—around the policy interest rate. The Bank then supplies limited settlement balances (close to zero) and actively manages its balance sheet to maintain that targeted level of settlement balances on a daily basis.3
To prepare for the launch of the Large Value Transfer System in 1999, the Bank made several changes to its monetary policy framework. One of these changes was to set a 50-basis-point operating band around the policy interest rate.
Floor system (since March 23, 2020)
In a floor system, the Bank does not target a specific level of settlement balances but does ensure that the level is more than enough to meet demand from financial institutions. This higher liquidity created by the ample supply of settlement balances (Figure 1, grey shaded area) allows participants to lend settlement balances to each other at or near the Bank’s deposit rate. As a result, the deposit rate is set equal to the target rate, and the operating band is set at 25 basis points (see Figure 1).
Since March 23, 2020, the Bank has implemented monetary policy using a floor system. And on April 13, 2022, the Bank announced that the floor system would remain in place. This is for several reasons:
- The floor system has a simpler operational framework and has the ability to function effectively in both normal and exceptional circumstances. This makes it more robust than the corridor system, which is operationally more complex and requires the Bank to target a specific level of settlement balances (close to zero).
- The floor system is also better suited to handle:
- increased demand for settlement balances, driven by structural changes in the payment system
- greater access to the Bank’s balance sheet through deposits, loans and advances, and the Bank’s other facilities and programs
- shifting investor preferences toward highly liquid, risk-free assets
Figure 1: The Bank of Canada's operating band in a floor system with abundant settlement balances
When the level of settlement balances exceeds demand, the overnight rate is less sensitive to the overall level of settlement balances. Because of this, in a floor system, the need to fine-tune liquidity operations within each day is less than that required in a corridor system. While less likely, if at the end of the day a financial institution finds itself in a short position (is deficient in funds), the excess settlement balances in the floor system help ensure that it can easily find a counterparty that is in a long position (has excess funds) and is willing to lend funds close to the deposit rate.
While direct participants of the high-value payment system earn the target rate on their deposits, other financial institutions that are not direct participants can deposit their excess balances with a direct participant, which typically pays an interest rate below the target rate. Therefore, indirect participants have an incentive to try to place their funds in the overnight funding market instead to earn better returns. This can put downward pressure on overnight market interest rates and potentially lead to overnight rates below the monetary policy target rate. To address this, the Bank may need to drain liquidity through operations such as reverse repos (repurchase agreements) to reinforce the floor. In contrast, upward pressure on overnight market interest rates may arise if the level of settlement balances is too low. If this happens, the Bank can inject liquidity through repos or asset purchases, which increase the supply of settlement balances and put downward pressure on overnight interest rates.
A floor system gives the Bank the necessary flexibility to implement monetary policy effectively in both normal and exceptional circumstances. For example, in a corridor system—with its requirement for a minimal (near-zero) targeted level of settlement balances—the Bank must switch to a floor system once it begins implementing unconventional monetary policy or providing exceptional market liquidity and settlement balances start to passively increase. In a floor system, however, the Bank can supply the additional levels of settlement balances needed to support its policy objectives without having to change how it implements monetary policy.
Standing Liquidity Facility
Through its Standing Liquidity Facility (SLF), the Bank can provide, if needed, overnight credit (advances) to Lynx participants that find themselves short. These advances under the SLF are made on a secured basis against a wide range of high-quality collateral.
In a floor system, the level of settlement balances is large enough to meet the demand of Lynx participants, so the need for overnight advances through the SLF is minimal. If Lynx participants find themselves short and unable to borrow from other participants, the SLF ensures the smooth functioning of the financial system by facilitating overnight settlement in Lynx, which in turn helps reinforce monetary policy. When participants access the SLF, they must pay the Bank rate (target rate plus 25 basis points), whereas participants that are in a long position will deposit their excess funds with the Bank and earn the deposit rate (target rate).
It is important to note that a prolonged increase in overnight advances or an extended period in which the overnight rate is above target—or a combination of these scenarios—is a signal that the level of settlement balances is too low. The Bank would then need to supply additional settlement balances to meet demand.
The SLF is not intended for use by an institution experiencing liquidity stress or persistent liquidity shortages. In those types of extraordinary circumstances, the institution should consider requesting a Standing Term Liquidity Facility loan or Emergency Lending Assistance from the Bank.
Overnight Standing Repo Facility
In 2009, the Bank introduced a new standing facility—the Overnight Standing Repo Facility (formerly the Overnight Standing Purchase and Resale Agreement Facility)—to provide another source of funding for distributors and dealers that may not have access to the SLF. The facility provides a funding backstop (backup support for funds) to primary dealers on an overnight secured basis at the Bank rate, reinforcing the top of the operating band.
Overnight Repo and Overnight Reverse Repo Operations
Through its overnight repo and overnight reverse repo (OR/ORR) operations, the Bank can support the effective implementation of monetary policy by intervening and either injecting or withdrawing liquidity into or out of the general collateral overnight market, when needed. This reinforces the Bank’s target for the overnight rate and complements its standing deposit and lending facilities.
The Bank’s OR operations:
- inject liquidity
- include a competitive auction
If transactions in the general collateral overnight market involve rates that are generally above the target, the Bank may inject liquidity using OR operations by purchasing Government of Canada securities from primary dealers, with an agreement to resell those securities back to the same counterparty the next business day. The difference in price is equal to the interest for one business day. These operations are less likely to take place when the Bank is operating a floor system with abundant settlement balances.
The Bank’s ORR operations:
- withdraw liquidity
- involve a fixed-rate, full-allotment auction
If transactions in the general collateral overnight market generally involve rates below the target, the Bank may withdraw liquidity using ORR operations. It does this by selling some of its holdings of Government of Canada securities to primary dealers, with an agreement to repurchase them at a value that includes interest for one business day. These transactions are conducted on a fixed-rate and full-allotment basis, with the fixed rate set at the Bank’s key policy rate.
Supporting the efficient functioning of Canadian financial markets
The Bank’s balance sheet
The Bank’s balance sheet differs from that of other financial institutions and reflects the Bank’s unique role as Canada’s central bank. The assets and liabilities on the Bank’s balance sheet are there to support the Bank’s core functions and ensure its independence, not to maximize profits. Normally, the Bank’s holdings of financial assets are driven mostly by its role as the exclusive issuer of Canadian bank notes. However, in exceptional circumstances, the Bank may choose to actively and deliberately change the size and composition of financial assets on its balance sheet. This is done to promote the effective implementation of the Bank’s monetary policy and to achieve its financial system objectives by helping to establish financial conditions that are consistent with the Bank’s desired policy objectives.
Policy for acquiring and managing financial assets
The Bank’s Statement of Policy Governing the Acquisition and Management of Financial Assets for the Bank of Canada’s Balance Sheet outlines how the Bank obtains and manages financial assets on its balance sheet. These assets help the Bank promote its operational independence and carry out its responsibilities under the Bank of Canada Act.
Decisions about acquiring and disposing of financial assets and managing the Bank’s balance sheet are governed by three key principles:
When the Bank acquires assets to offset government deposits and the issuance of bank notes, these assets are said to be acquired under the normal course of business.4 Accordingly, both the size and composition of the asset side of the Bank’s balance sheet are driven mainly by growth on the liability side. Conversely, the Bank may also undertake a range of financial market transactions with eligible counterparties to help stabilize the financial system and achieve financial conditions that are consistent with its desired policy objectives. When the Bank acquires assets in support of policy objectives, these are referred to as assets acquired under exceptional circumstances for policy purposes.
Government of Canada securities portfolio
Government of Canada bonds and treasury bills normally make up the largest holdings on the Bank’s balance sheet. They can be acquired at the time of issue at auction (primary market) or through the secondary markets (after initial issuance). Primary market purchases are conducted on a non-competitive basis (passive participation) by buying at the average yield of successful auction bids. Secondary market purchases, in contrast, are made through competitive offers in a reverse auction process.
Occasionally, the Bank also purchases Canada Mortgage Bonds. These purchases offer additional flexibility in the Bank’s range of high-quality assets. In the normal course of business, the Bank chooses the amount of individual bond purchases to limit market distortions and minimize the impact on market prices. The Bank can also acquire these assets for policy purposes in the secondary market like it did through its Canada Mortgage Bond Purchase Program.
Term repo operations
These operations—where high-quality assets are acquired temporarily through the repo market—are typically conducted to:
- manage the Bank’s balance sheet
- promote the orderly functioning of Canadian financial markets
- provide the Bank with information on conditions in short-term funding markets
In the normal course of business:
- Term repo operations allow the Bank to acquire assets on a temporary basis for its balance sheet. This gives the Bank flexibility to manage its assets and helps reduce the Bank’s need to acquire Government of Canada securities outright for its balance sheet, which may help support the liquidity of the Government of Canada securities market.
- Term repos conducted by the Bank typically have approximately one- and three-month terms. In these transactions, the Bank purchases from primary dealers marketable securities (denominated in Canadian dollars) that are directly issued or explicitly guaranteed by the Government of Canada or by a Canadian provincial or territorial government. At the end of the term, the Bank sells these same securities back to the original counterparty at a predetermined price. The difference between the Bank’s initial purchase price and the subsequent sale price equals the interest for the term of the transaction.
- The Bank may also conduct term repos for different terms—for example, less than one month to offset seasonal and short-term fluctuations in liabilities.
- Term repo operations also support the Bank’s monitoring of liquidity conditions in term funding markets and may encourage further development of, and liquidity in, the longer-term repo market in Canada.
In exceptional circumstances:
- Term repos may be used to inject significant amounts of liquidity into the financial system and support funding conditions for financial institutions in times of stress, such as during the global financial crisis of 2008–09 and the COVID‑19 pandemic.
- To support market functioning the Bank can, as it did during the pandemic, expand the term repos conducted with eligible participants by temporarily extending the frequency, size, term and types of eligible securities. The Bank can also expand the list of institutions eligible to access term repos by activating the Contingent Term Repo Facility. For more on this, see Providing liquidity in exceptional circumstances below.
Standing Term Liquidity Facility
The Standing Term Liquidity Facility (STLF) is intended to provide improved confidence that an eligible financial institution facing liquidity stress will have access to central bank liquidity on terms that are known in advance. A financial institution can face liquidity stress from various sources, including system-wide liquidity conditions as well as operational incidents such as cyber attacks, system failures and natural disasters. The institution is eligible to draw on the facility if the Bank has no concerns about its financial soundness.
The STLF provides:
- a larger number of eligible counterparties with access to central bank liquidity and allows a broader set of collateral at a higher price relative to routine term repo operations and the Standing Liquidity Facility (see Figure 2)
- the Bank with a larger menu of complementary tools that support graduated and well-designed interventions, consistent with the Bank’s previously established principles for liquidity intervention
As with other Bank liquidity tools, provision of liquidity under the STLF is at the sole discretion of the Bank.
Figure 2: Graduated nature of the Bank of Canada's liquidity provision tool kit
The Bank established its Securities-Lending Program in 2002 to help support the liquidity of Government of Canada securities by providing the market with a secondary, temporary source of these securities.
When the program is active, the Bank can lend a portion of its holdings of Government of Canada securities to primary dealers after it judges that a specific bond or treasury bill is trading below a certain threshold or is unavailable in the repo market. Once the intervention threshold is triggered, the Bank can make up to 50% of its portfolio of Government of Canada bonds and treasury bills available on any given day. Securities are lent through a tender process, once a day (typically at 11:15 a.m. ET) for a term of one business day.
This program and its design support both the liquidity of the Government of Canada securities and the efficiency of clearing and price discovery. A liquid and efficient market for Government of Canada securities is important for Canadian financial markets to function effectively. It helps the government and other borrowers in their financing activities and supports the Bank’s objectives in the transmission of monetary policy.
Securities Repo Operations
During the COVID-19 pandemic, the Bank acquired a substantial amount of Government of Canada securities through its quantitative easing program. To support core funding markets and the proper functioning of the Government of Canada securities market, the Bank decided to make its holdings of Government of Canada securities available through its Securities Repo Operations program. This program offers a temporary source of Government of Canada nominal bonds and treasury bills to primary dealers to support liquidity in the securities financing market. The Bank makes a portion of its holdings of these securities available on an overnight basis through daily repurchase operations.
Providing liquidity in exceptional circumstances
Overview of extraordinary liquidity provision
Under exceptional circumstances, the Bank has the authority to provide extraordinary liquidity to support financial system stability.5
To respond to severe, system-wide liquidity stress, the Bank can provide liquidity in a number of ways, including:
- conducting exceptional repo transactions, to a maximum term of up to 24 months, and using an expanded range of securities and instruments, provided that certain criteria are met (e.g., expanded term repo facility, Contingent Term Repo Facility)
- lending to a broader range of financial institutions than Lynx participants for terms longer than overnight and against a wider range of collateral
- engaging in outright purchases of an expanded range of securities and instruments, provided that certain criteria are met and subject to the Bank of Canada Policy for Buying and Selling Securities under subsection 18.1(1) of the Bank of Canada Act
- increasing the level of settlement balances
- using its bilateral liquidity swap facilities with various central banks to enter into reciprocal arrangements to exchange currencies, should both the Bank of Canada and the corresponding central bank determine that market conditions warrant an exchange, after which the foreign currency can then be made available to Canadian counterparties through a market-wide repurchase facility
To address funding shortages at specific financial institutions, the Bank can also provide secured advances through Emergency Lending Assistance, subject to the Rules Governing Advances to Financial Institutions.
Providing market-wide liquidity
To support the efficient functioning of Canadian financial markets in response to a severe, system-wide liquidity shortage, the Bank can expand existing operations (e.g., term repos) along different dimensions or introduce additional facilities to provide extraordinary market-wide liquidity.
When determining the form and quantity of extraordinary liquidity to provide, the Bank considers five guiding principles for central bank intervention:
- Targeted—Intervention should target market failures (liquidity distortions) that are of system-wide importance and that a central bank can rectify.
- Graduated—The degree of intervention should match the severity of the problem.
- Well designed—The right tools should be used for the right job. Central banks should use market-based transactions, in most cases provided through auction mechanisms, to ease market-wide liquidity problems, and they should use loans to address liquidity shortages affecting specific institutions.
- Efficient and non-distortionary—Central bank transactions should be at market-determined prices to minimize distortions.
- Mitigation of moral hazard—Central banks should carefully consider the risk of creating adverse incentives that could harm the functioning of the financial system over time and take measures to lessen such risk. These measures can include, for example, limited, selective intervention and penalty pricing, where appropriate.
In terms of expanding existing operations—which are auction-based and subject to minimum bid rates—the Bank could increase the overall amount of liquidity provided (possibly alongside an increase in the level of settlement balances) or the term or frequency of operations. Additional enhancements to existing operations could include broadening the set of eligible securities or expanding the list of eligible counterparties, subject to any criteria deemed appropriate by the Bank.
Another area where the Bank could expand flexibility in response to severe, market-wide liquidity stress is to activate its Contingent Term Repo Facility.
Contingent Term Repo Facility
The Bank’s standing—or non-auction-based—facility to respond to severe market-wide liquidity stress is the Contingent Term Repo Facility (CTRF). When activated, the CTRF offers liquidity to eligible counterparties on a standing, bilateral basis. This provides the Bank with the flexibility to offer liquidity beyond primary dealers and their affiliates at its discretion, should the Bank decide it is necessary to support the stability of the Canadian financial system. Counterparties beyond primary dealers and their affiliates would need to:
- demonstrate significant activity in the Canadian-dollar money and/or fixed-income markets
- be subject to federal or provincial financial sector and market regulation
- meet any other conditions the Bank requires
The CTRF is not used to address idiosyncratic liquidity shocks at individual institutions. Activation and deactivation of the CTRF is at the Bank’s sole discretion as conditions warrant. The CTRF was activated in response to the COVID-19 pandemic and subsequently suspended after 12 months. Updated terms and conditions for the CTRF are published upon activation.
Emergency Lending Assistance
Through the Bank’s Emergency Lending Assistance program, an eligible financial institution or financial market infrastructure can receive a loan or advance from the Bank, at the Bank’s discretion. The provision of emergency lending assistance is extraordinary and designed to provide last-resort liquidity to individual financial institutions or financial market infrastructures that are facing serious liquidity problems.
- 1. The Large Value Transfer System (LVTS) was introduced in February 1999 and was replaced by Lynx in 2021. For more information on these systems, see Bank of Canada and Payments Canada, “An Overview of Lynx, Canada’s High-Value Payment System” (May 2022); N. Arjani and D. McVanel, A Primer on Canada’s Large Value Transfer System” (March 2006); and Bank of Canada, “A Primer on the Implementation of Monetary Policy in the LVTS Environment” (June 2010).[←]
- 2. The Bank has two standing lending facilities: the Standing Liquidity Facility, available to Lynx participants; and the Overnight Standing Repo Facility, which is available to primary dealers.[←]
- 3. For more information on the interest rate corridor system, see M. de Guzman, “Market Operations and Liquidity Provision at the Bank of Canada,” Bank of Canada Review (Autumn 2016): 12–24.[←]
- 4. Occasionally, the Bank may allow settlement balances to grow to meet structural shifts in the level of settlement balances required by Lynx or financial system participants.[←]
- 5. The Bank acts as lender of last resort, which has been a fundamental role of central banks since at least the 19th century. The Bank provides routine liquidity to reinforce the target for the overnight rate and to facilitate settlement in the payment system. The Bank has various tools at its disposal to respond to situations where exceptional or emergency liquidity may be required, either on a bilateral basis to specific entities through the provision of emergency lending assistance or on a market-wide basis through the use of extraordinary liquidity facilities.[←]