SNB finds new way to impose world’s lowest interest rate

Bloomberg

The Swiss National Bank (SNB) has a new way of enforcing the world’s lowest interest rate.
With the franc near a two-year high against euro, the SNB’s decade-old battle against an overly strong currency is back in focus. There’s evidence it’s been intervening again and analysts are increasingly betting that it will soon follow with a rate cut.
That would be the first change to the SNB’s new benchmark interest rate, introduced in June as a successor to one based on scandal-plagued Libor. Here’s a look inside the central bank’s machine room.

Below Zero
The SNB’s dumping of Libour is part of a global overhaul of benchmarks in the wake of a high-profile manipulation scandal that led to huge fines for banks and jail time for some traders. While Libor’s end date has been set for 2021, the SNB is switching now due to its three-year inflation forecast horizon. That allows all its projections to be based on a single rate.

What’s the new rate based on?
It’s a system similar to the US Federal Reserve and the Bank of England. The new benchmark targets the very short end of the yield curve. That’s effectively the Swiss Average Rate Overnight, or SARON, which is based on secured transactions between financial institutions. SARON is Libor’s designated replacement for pricing loans and mortgages and is administered by stock market operator SIX.

Why didn’t the SNB just use SARON?
Until now, the main tool consisted of a target for three-month franc Libour — a market interest rate. But with its credibility effectively in tatters, a Swiss working group spent years looking into how best to replace Libor. The advantage of the SNB coming up with its own rate is that it’s not relying on a tool administered by a third party.
How does the SNB get its policy rate and SARON to align?
The SNB uses a negative deposit rate to stem the appreciation of the franc, charging banks an annualized rate of 0.75% to hold their excess cash overnight. The policy rate is currently set at the same level as the deposit rate and as long as the SNB is flooding the market with cash, the two should remain roughly aligned. If, for example, officials lower the policy rate, they’ll also cut the deposit rate.
Banks will then pass on the charge in their dealings with other financial institutions, which will be reflected in SARON. The same principle holds true if policy is tightened: the SNB could just announce it was moving both rates by a certain amount.
Given that the Federal Reserve and other central banks have cut rates, and the ECB is preparing to follow suit, tightening by the SNB is probably a long way off. But it’s something Swiss policy makers will have to think about. It’s an open question how they would manage this situation.
One option would be for the SNB to go back to the system of repos it used prior to 2012. Here’s how that worked: With banks as its counterparty, the SNB would steer the amount of liquidity by buying securities for a fixed term — a day or a year, for example — and then reversing the transaction again in exchange for a rate of interest, called the repo rate.
So if the SNB announced a rise in its policy rate, it would use liquidity-draining repos to drain the interbank market and push up borrowing costs. Prior to 2014, the SNB had no deposit rate, and if it returned to a repo system it might leave it at zero.