The variable rate tender is one of two auction procedures that are used in open market policy transactions between central and commercial banks. The focus is on the purchase or sale of securities by the central banks as part of an auction process. The commercial banks not only name the desired volume, but also offer an interest rate that they are willing to accept.
- The tender procedure is primarily used in the Eurosystem when central banks provide individual financial institutions with money to maintain their liquidity.
- The fixed rate tender offers an alternative to the variable rate tender. With this procedure, banks only name the desired scope – the interest rate is fixed.
- In the case of variable rate tenders, the Eurosystem is allotted using the American method. This means that the banks receive their money at the interest rate that they have offered.
Background: Importance of open market operations for monetary policy
The Eurosystem banks have a constant need for central bank money. Based on the decisions of the European Central Bank (ECB), the national central banks ensure the liquidity of the respective commercial banks. In addition, the banks are obliged to always hold a minimum reserve of central bank money. This is currently one percent of the reserve liabilities, which include, for example, customer deposits, money market papers and bonds. In this way, the Eurosystem has indirect influence on the commercial banks, which are dependent on the central banks. Control over key interest rates and the minimum reserve is a monetary policy instrument.
In order to get the money they need from central banks, commercial banks can take various routes. Outside of times of crisis, open market operations are the source of central bank money. Banks can borrow from their central bank or sell them securities. The transactions differ in terms of duration, frequency and procedure. There are the following types of open market operations:
- Main financing operations
- longer-term refinancing operations
- Fine control operations
- structural operations
In which open market transactions is the variable rate tender used?
Tender transactions are nothing more than auctions. All open market transactions can be carried out using a tender procedure. The banks can also carry out fine-tuning operations or structural operations in the form of bilateral transactions. The variable rate tender is a possible procedure for tender transactions in which the banks outbid each other in terms of the level of the interest rate.
The second common practice is the quantity tender. Here the interest rate is already fixed, so that the banks only have to indicate the amount of central bank money they need.
This is how variable rate tenders work
In the case of variable rate tenders, the Eurosystem usually indicates before the auction how much central bank money it is making available at what minimum bid rate. By setting a minimum interest rate, which the ECB is charging, it is simultaneously sending out monetary policy signals. In order to be taken into account, the banks must offer at least the interest rate specified by the central bank. The higher interest rates you choose, the greater your chance of participating in the distribution. The bid is made in secret, so banks don’t know how much their competitors are bidding.
Allocation in the variable rate tender procedure
As part of the variable rate tender procedure, the central bank does not have to access an interest rate, but can instead divide and thus allocate the tranches according to the interest rates requested by the banks. It serves the banks that have offered the highest interest rate first. If their tranches are fulfilled, the banks with the next highest interest rate come into play. This continues until the total allotment volume is divided. Banks with the lowest of the interest rates considered may only be taken into account by the central bank on a pro-rata basis.
The allocation for variable-rate tender transactions can be made either according to the Dutch procedure or the American procedure. With the Dutch method , commercial banks receive their central bank money at a uniform interest rate; however, the bank that offers the highest interest rate is taken into account first. With the American method , the banks receive their money at the interest rate that they have offered. This procedure is also used in the Eurosystem.
After the variable rate tender with a minimum bid rate and limited allotment volume had previously been the norm in open market transactions in the Eurosystem, the ECB switched back to the variable rate tender as a result of the financial and banking crisis.