Daily Reverse Repo / Standing Deposit Facility (SDF)

The Daily Reverse Repo and the Standing Deposit Facility (SDF) are key monetary policy instruments used by the central bank to absorb excess liquidity from the banking system. They play a crucial role in short-term liquidity management, interest rate signalling, and financial stability. In the context of India, these instruments are central to the operational framework of monetary policy and directly influence banking operations, money markets, and the broader economy.
While both instruments serve the purpose of liquidity absorption, the introduction of the SDF marked an important structural reform in India’s monetary policy framework, strengthening the central bank’s ability to manage surplus liquidity without expanding its balance sheet.

Concept of Daily Reverse Repo

The reverse repo is a monetary policy instrument through which the central bank absorbs liquidity from commercial banks by borrowing funds against government securities. Under this arrangement, banks lend money to the central bank for a short period, typically overnight, and earn interest at the reverse repo rate.
The Daily Reverse Repo refers to the routine, overnight absorption of surplus liquidity on a day-to-day basis. It forms the lower bound of the interest rate corridor within which short-term money market rates operate.
Key features of the daily reverse repo include:

• Overnight maturity.
• Collateralised borrowing by the central bank.
• Interest payment to banks at the reverse repo rate.
• Use as a tool to manage short-term liquidity surplus.

The reverse repo rate signals the minimum return banks can earn on surplus funds parked with the central bank.

Concept of the Standing Deposit Facility (SDF)

The Standing Deposit Facility is a relatively new monetary policy instrument that allows banks to park surplus funds with the central bank without receiving any collateral in return. It is an uncollateralised liquidity absorption facility.
The SDF was introduced to overcome certain limitations of the reverse repo mechanism, particularly the dependence on the availability of government securities. Under the SDF, banks can deposit funds with the central bank at a pre-announced rate, usually aligned with or close to the reverse repo rate.
Key characteristics of the SDF include:

• Uncollateralised deposits by banks.
• Overnight or short-term tenor.
• Interest payment at the SDF rate.
• No requirement for government securities.

The SDF strengthens the central bank’s ability to absorb liquidity even when collateral constraints arise.

Role in the Monetary Policy Framework

Both the Daily Reverse Repo and the SDF are integral to the liquidity adjustment framework operated by the Reserve Bank of India. They help maintain short-term interest rates within the policy corridor defined by the standing facilities.
In this corridor system:

• The policy repo rate acts as the benchmark.
• The marginal standing facility represents the upper bound.
• The reverse repo rate or SDF forms the lower bound.

By absorbing excess liquidity, these instruments prevent money market rates from falling too far below the policy rate, thereby ensuring effective monetary transmission.

Importance for the Banking System

For banks, the daily reverse repo and SDF provide safe and predictable avenues to deploy surplus funds. When credit demand is weak or liquidity is abundant, banks prefer parking funds with the central bank rather than lending at very low market rates.
These facilities help banks:

• Manage daily liquidity mismatches.
• Earn risk-free returns on surplus funds.
• Meet regulatory liquidity requirements.
• Stabilise short-term cash management operations.

However, prolonged reliance on these facilities may indicate weak credit growth or structural surplus liquidity in the banking system.

Impact on Financial Markets

The reverse repo and SDF influence overnight call money rates, treasury bill yields, and other short-term money market instruments. When liquidity surplus is high, large absorption through these facilities prevents market rates from collapsing.
Their impact includes:

• Anchoring short-term interest rates.
• Reducing volatility in money markets.
• Improving predictability of monetary conditions.
• Strengthening interest rate transmission.

As government securities and money markets form the foundation of India’s financial system, these effects extend to bond markets and lending rates.

Significance for the Indian Economy

At the macroeconomic level, effective liquidity absorption supports price stability and financial stability. Excess liquidity, if left unabsorbed, can fuel inflation, asset price bubbles, and speculative activity.
In the Indian economy, the daily reverse repo and SDF:

• Support inflation control by tightening liquidity when required.
• Enhance credibility of monetary policy.
• Assist in managing large capital inflows and fiscal liquidity injections.
• Complement open market operations and other policy tools.

Their use became particularly prominent during periods of surplus liquidity arising from accommodative monetary policy and large government spending.

Transition from Reverse Repo to SDF

The introduction of the SDF marked an evolution in India’s monetary policy toolkit. By providing an uncollateralised absorption mechanism, the central bank reduced its dependence on government securities for liquidity management.
This transition:

• Improves operational flexibility.
• Preserves government securities for other policy uses.
• Strengthens the lower bound of the interest rate corridor.
• Aligns India’s framework with international best practices.

The SDF has effectively replaced the reverse repo as the primary floor of the policy corridor, though both concepts remain relevant in understanding liquidity management.

Advantages of Reverse Repo and SDF

These instruments offer several advantages:

• Efficient and quick absorption of surplus liquidity.
• Strong signalling of monetary policy stance.
• Minimal credit and operational risk.
• Enhanced stability in short-term financial markets.