The anti-arbitrage auction

Arbitrage happens when rates of return in an economy conflict with one another across sectors and markets. While not necessarily a bad thing, it feeds on itself and is self-perpetuating. It thrives on divergence and disparities. It is nourished by volatility. When there is volatility, investors tend to fly from market to market, cherry-picking and taking their investments where yields are the highest, thus, catalyzing even more volatility.

Volatility is where arbitrage’s negative effects lie. From the perspective of investors seeking stable, longer-term returns from the direct-investments kind, as opposed to those earned by marginal short-term players, volatility is, indeed, an ugly word.

In an economy such as ours—one that exhibits domestic growth, albeit cursed with little economic inclusivity and limited capital expansion, foreign direct investments is one of the key objectives that might import surpluses from outside the economy into ours. That entails controlling domestic volatility.

In a Keynesian world, the responsibility to mitigate volatility is on the Monetary Board of the Bangko Sentral ng Pilipinas (BSP). In contrast with the systemic buffoonery we’ve seen in at least two branches of the current dispensation, this monetary authority is populated with competent professionals.

Recently, they’ve come up with a mechanism that would prevent arbitraging against divergent rates and, thus, smoothen against rate volatility. The Interest Rate Corridor (IRC), which they see to implement within the next few months, has a number of upsides compared to the old tools to govern interest rates in the market.

While the authorities have about a handful of instruments they can still apply to curb volatility, increasingly these have had less and less impact and require expensive means some of which might be inflationary in the short run.

One is to print more pesos. The other is to purchase foreign currency through open-market operations.

The most common tool is reserve management. The central monetary authorities periodically check overall money supply and, depending on economic exigencies, they directly mandate the amount of reserves a bank can hold. Technically, funds held within the vaults do not circulate thus, affecting both the supply and demand of money in circulation that consequently determines the value of the peso.

Recent developments and the increasing sophistication of bank products have dampened reserve management’s effectivity to control money supply. Note the proliferation of automated teller machines (ATMs) and e-Cash. Note also developments in the payment and reconciliation system governing check and other similar non-cash transactions.

Reserves are thought to be money kept in a vault. By affecting the amount of money in circulation, they control the value of the peso. Money however, that is stored within an ATM is considered vault cash and is counted as a reserve. In the reconciliation system, banks maintain clearing balances thought to be reserves not meant for circulation. These balances can, however, be used to pay for clearing and other service costs, thus enabling these as legal tender. Both distort money supply and water down the effectivity of reserves as an economic tool.

The IRC, however, provides an option and promises better supply controls and less arbitraging from rate volatility.

Operating like an interest rate setting weekly auction, it offers financial institutions a narrow corridor of term deposits that they bid the right to keep with the BSP. Within that corridor, the upper limit is set by the repurchase rate, while the lower limit is the yield on special deposit accounts.

Effectively, these are the parameters that the BSP uses to borrow and lend to banks. As such, the facility approaches the real economy rates more closely than do rates set by reserves thus, mirroring money-market realities. Arbitraging due to volatility is lessened by the narrowness of the corridor and rate swings are kept at a minimum.

Congratulations to our monetary authorities. At least we know someone isn’t sleeping all day.