156. Australia’s foreign currency reserves are managed by the Reserve Bank of Australia (RBA). At the end of June 2002, the gross value of the reserves portfolio was US$20 billion, representing around half of the central bank’s assets. The primary role of the reserves portfolio is to fund foreign exchange market operations that arise as part of the Bank’s broader monetary policy function. Reflecting this, the reserves are managed in a manner that gives priority to low levels of credit risk, limited exposure to market risk, and maintaining a high degree of liquidity. Subject to these objectives, the Bank also seeks to earn a positive return on the portfolio.

Governance and Institutional Framework

Objectives of reserves management

156. Australia’s foreign currency reserves are managed by the Reserve Bank of Australia (RBA). At the end of June 2002, the gross value of the reserves portfolio was US$20 billion, representing around half of the central bank’s assets. The primary role of the reserves portfolio is to fund foreign exchange market operations that arise as part of the Bank’s broader monetary policy function. Reflecting this, the reserves are managed in a manner that gives priority to low levels of credit risk, limited exposure to market risk, and maintaining a high degree of liquidity. Subject to these objectives, the Bank also seeks to earn a positive return on the portfolio.

157. In 1990, the Bank undertook a formal review of its approach to foreign exchange reserves management. The outcome of the review was the establishment of a rigorously defined operational framework for managing risk and return. The centerpiece of the framework was the development and implementation of benchmark portfolios for currency and asset allocation, and for the duration of the asset portfolios. The benchmarks are intended to represent the optimal mix of risk and return for the RBA given its management objectives. The review also provided a greater role for active management to take advantage of expected movements in exchange rates, relative returns in bond markets, and changes in the level and slope of yield curves. These changes were set in place in 1991.

158. Experience with active management was reviewed in 2000 after nine years of operation. The review highlighted the fact that short-term investment decisions designed to take advantage of market anomalies had consistently made positive returns, albeit small. In contrast, investment positions taken in anticipation of medium-term macroeconomic developments had made positive returns of reasonable size in some years, but these had been largely offset by negative returns in other years, leaving only a small positive return from this activity overall. The RBA decided that the low average, and high variability, of returns did not warrant taking investment positions of the same size and frequency as in the past. As a result, management discretion was curtailed, significantly reducing the importance of discretionary management as a source of return for the reserves portfolio.

Institutional framework

159. The RBA’s responsibility to manage Australia’s foreign exchange reserves is given through broad legislative powers that allow the Bank to buy, sell, and otherwise deal in foreign exchange (among other things) to achieve monetary policy objectives. Responsibility is not shared with other government agencies, reflecting the role of reserves as a source of intervention capital. The RBA acts independently in its management decisions.

Organizational and decision-making structure

160. The organizational structure of reserves management at the RBA is summarized in Figure 1. Responsibility for management of reserves is delegated by the Governor of the Bank to the Financial Markets Group (FMG). This group comprises two departments, International and Domestic Markets. The International Department is responsible for the Bank’s front office operations in markets for foreign exchange, gold, and offshore assets.

161. The International Department front office manages the currency and asset allocation positions of the portfolio, and directs policy issues regarding investment of reserves, such as assessing instruments and the structure of the benchmarks. It is supported by three dealing centers: one each in New York, London, and the Bank’s Head Office in Sydney. These centers execute trades and have small discretion for position taking. The RBA has found considerable informational benefit in locating dealing staff in major offshore centers. The front office is also supported by an analytical group with responsibility to provide in-depth analysis of international financial and macroeconomic developments that may impact on the value of the reserves portfolio.

162. Also part of the Financial Markets Group, but not within the International Department, is a middle office function, known as Dealing Support. This unit is responsible for measuring risk and return and for maintaining front office systems. Valuation, performance, and risk information are provided to the front office operation and to senior management on a daily basis. The middle office reports directly to the Assistant Governor overseeing the Financial Markets Group.

163. There are several other areas outside of the Financial Markets Group that provide services to, or scrutinize the actions of, the front office reserve management operation. These include the back office (Payments Settlements) and accounting (Financial Administration) functions. The back office provides standard settlement and communication services to the reserves management front office and is responsible for the final approval of all transactions—dealers in the front office cannot confirm trades. There are back office operations in each of the dealing centers, with Sydney having overall responsibility. The Audit Department is also outside of the Financial Markets Group. This department has a direct reporting line to the Governor.

164. The structure and delineation of responsibilities in reserves management have evolved over time as the nature of, and the RBA’s approach to, reserves management has changed. Until the late 1980s, the International Department was responsible for both middle and front office functions. Indeed, front office staff performed many of the middle office responsibilities. Importantly, the back office was also located in the International Department, albeit with separate reporting lines to the Assistant Governor, Financial Markets Group, from those of the front office. This seemed to be a reasonable structure, given the conservative limits on risk and the lack of flexibility in the RBA’s investment operations at the time. However, as the approach to reserves management changed in the early 1990s and the scale of the operation increased, the Bank set in place a number of changes to reduce operational risk and reflect best-practice in funds management.

165. Establishment of a middle office within the Financial Markets Group, which reports independently to the corresponding Assistant Governor, was a major change that occurred in the mid-1990s. Separation of the back office function was completed in 1998 when the back office was physically relocated to a different floor of the RBA’s Head Office building and put under control of the Assistant Governor, Business Services.

166. Decision-making processes have also evolved. In the early 1980s, almost every transaction in reserves management had to be approved by higher management. While this maximized control over the management process, it made decision making unwieldy and, therefore, poorly suited to a more active risk management framework. It also constrained initiative at manager levels. With the move to more active management in the early 1990s, the Governor’s discretion for day-to-day management of reserves was delegated to an Investment Committee within the Financial Markets Group. The Committee, made up of senior managers from units involved in reserves management, had discretion to take sizable positions in currency and asset allocation subject to limits approved by the Governor. The Investment Committee met regularly and took positions largely based on assessments of the medium-term macroeconomic outlook of countries in which the reserves were invested. A small and qualified amount of trading discretion was delegated to managers in the trading centers.

167. The Investment Committee’s structure and its discretion to take positions changed following the review in 2000. Senior managers overseeing front office operations are now responsible for day-to-day management of currency and asset allocation, maintaining the portfolio close to benchmark. They report directly to the Assistant Governor of the Financial Markets Group. An outline of the decision-making structure is shown in Figure 2.

168. Reflecting the more passive trading environment, there are no longer any formal meetings to discuss investment strategy. In contrast, managers in the dealing centers have retained their small amount of discretion to set short-term tactical positions. These centers are also responsible for lending stock from the portfolio.

Transparency and accountability

169. With the introduction of a more rigorous approach to reserves management, where decision making was delegated to a large extent, the RBA needed to be confident that an adequate level of control was being maintained and that its actions were properly accounted for in line with market best practice. This required a system where individuals and operational units were fully aware of their delegated authorities, the risks, and the value added from their decisions.

170. A key element in the control of operational risk has been the development of manuals detailing investment and risk management procedures. The manuals specify the kinds of instruments in which investments can be made, the risk parameters for each portfolio, and the responsibilities of various positions associated with reserves management. They also specify how risks and returns are calculated and how office systems should be used in specific circumstances. Procedures manuals also exist for middle and back office staff.

171. Staffing policy is another key element. The RBA has found considerable benefit in specialization of professional staff in operational areas. Frequently rotating staff in and out of these areas in order to provide a breadth of experience was felt to be a significant constraint on maintaining adequate levels of experience and knowledge. Over the past ten years, efforts have been made to maintain a core of experience at senior levels within the operational areas while, at the same time, allowing rotation at junior levels in order to build a foundation of experience. Compensation is reviewed regularly to ensure competitiveness with other organizations and staff are encouraged to participate in a range of courses, both internal and external, relevant to their work. These measures have contributed to an average tenure over the operational areas of four years.

172. The Governor requires that reserves are accounted for in line with best practice and that the level of transparency is consistent with that in other parts of the RBA’s monetary policy operations. To this end, the RBA publishes statistical information on its reserves and foreign currency transactions in its monthly Bulletin. Also, since 1992, the Bank has provided an overview of reserves management operations and return relative to benchmark in its Annual Report. This has included in recent years an outline of the composition of the benchmark portfolios and a discussion of the RBA’s approach to risk management.

173. The RBA’s annual financial statements are prepared in accordance with Australian Accounting Standards and other mandatory reporting requirements contained in the Commonwealth Authorities and Companies Act. The statements are scrutinized by an external auditor, the Australian National Audit Office, to ensure that they comply with relevant standards.

174. Reserves management functions are audited internally each year in accordance with recommended control frameworks published by the Bank for International Settlements and requirements set out by the Australian Financial Markets Association. The internal audit reports on compliance with controls and seeks to strengthen management processes where it sees potential for loss through inadequate control. It reports to an Audit Committee, which is chaired by the Deputy Governor of the RBA and consists of a non-executive member of the RBA’s Board and an external appointee.

Capacity to Assess and Manage Risk15

Benchmark portfolios

175. The composition of the currency and asset benchmarks, and the duration benchmark for each asset portfolio, are shown in Table 2. The benchmarks represent the risk-return trade-off acceptable to the RBA over the long term, given its management objectives and its primary objective for holding reserves. Statistical, practical, and judgmental factors relevant to the RBA are important in deciding the appropriate composition.

Table 2.

Currency, Asset, and Duration Benchmarks

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176. With the aim of maximizing the Bank’s capacity to intervene, it was decided that a trade-weighted basket of currencies would be an appropriate currency and asset composition for the foreign currency portfolios. The decision was taken to spread the composition across the three major reserve currencies—the U.S. dollar, deutschemark (later the euro), and Japanese yen. This also provided a diversified portfolio and meant, too, that the RBA’s assets would be invested in capital markets that are liquid and highly rated. From very early on, mean-variance analysis, in addition to judgmental factors, has played a major role in deciding on the weights assigned to the three currencies in the benchmark portfolio.

177. The choice of a duration benchmark of 30 months for each of the asset portfolios was made on the basis of factors specific to the RBA in its responsibility for managing reserves and analysis of risk and return for each asset. This duration represents the maximum price risk that the RBA will allow itself while keeping the probability of capital loss to an acceptable level over the Bank’s investment horizon. An example of this analysis is given in Figure 3.

178. The RBA’s investment horizon is twelve months. This is based on the Bank’s investment objectives and the period in which it reports on its operations to the Australian Parliament. Over a twelve-month period, the RBA expects the return on the portfolio to fall within a 95 percent confidence band around the mean return, and will accept a negative return on only 2.5 percent of occasions. On this basis, return is maximized at point A in Figure 3, where the lower boundary of the confidence band crosses the horizontal axis.

179. In addition to the currency and asset benchmarks, the RBA has established benchmarks for the composition of each of the three asset portfolios. These benchmarks are set out in Table 3. Like the other benchmarks, practical and judgmental factors, combined with the liquidity characteristics in each market, are important in deciding the appropriate asset structure of the portfolios.

Table 3.

Composition of Individual Portfolio Benchmarks

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180. The desire to maintain a liquid and secure portfolio led the RBA to limit its benchmark investments to government securities and cash instruments. Typically, some 75 to 80 percent of the RBA’s benchmark foreign investment portfolios are held in government paper. This comprises Treasury bills and notes in the U.S. portfolio, and Japanese government bills and bonds in the yen portfolio. For the European portfolio, the RBA has decided on a combination of French and German government securities as the best structure to satisfy requirements for credit risk and liquidity. In order to limit exposure to price risk, the maximum maturity of securities holdings is restricted to 10½ years in each portfolio.

181. Cash invested under repurchase agreements (repo) and deposits with highly rated banks make up the balance of the asset benchmarks. Historically, the RBA has found the short duration offered by deposits to be attractive in markets where access to short-term government debt was limited. They have also been a good, immediate source of liquid funds during episodes of currency intervention. That said, the proportion of foreign exchange reserves invested in deposits has declined in recent years, reflecting tighter credit constraints and changes in cash management practices. The RBA now makes greater use of cash repo, which has the security advantage of being collateralized with government securities.

182. The benchmarks are reviewed periodically to ensure that they continue to reflect the RBA’s long-term management objectives. There have been relatively few changes. They have been made to take account of structural changes to markets or changes in the nature of the Bank’s operations.


183. In addition to the assets held in the benchmark portfolios, the RBA’s dealing centers have discretion to hold a small range of other highly rated instruments. These include the U.K. Gilts, Dutch and Swiss government paper, and deposits and medium-term notes issued by the Bank for International Settlements. With the exception of BIS deposits, these investments have accounted for a negligible share of total holdings. Discretion to hold U.K., Dutch, and Swiss paper is a remnant of a period in the 1980s when the composition of Australia’s official foreign currency liabilities influenced the composition of the reserves portfolio. Discretion also exists to hold U.S. Federal Agency debt in the U.S. portfolio as a source of return enhancement. However, total holdings are restricted to a maximum of US$500 million.

184. In 1994, the Bank began trading interest rate futures contracts. This decision was driven by a desire to improve management of market risk and, in particular, to provide a liquid hedging instrument to minimize the risk of capital losses when interest rates were rising. An additional attraction of using futures was the greater liquidity and flexibility they provide in some markets when implementing investment strategies. Some futures markets are more liquid than their underlying physical bond markets in that the bid-offer spread is usually much narrower. Futures trading has been concentrated in the European and Japanese portfolios. The RBA does not use any over-the-counter or exchange-traded options in its reserves management activities.

185. Stock lending is also an activity undertaken by the dealing centers. Over the past few years, stock lending, particularly from the U.S. portfolio, has risen to be a major component of return enhancement. Though the back office workload associated with this activity can be large, the RBA sees this activity as relatively low risk.

Risk and performance measurement

186. Market risk and return enhancement are measured relative to the benchmark portfolios. For currency and asset allocation, senior management in the operational areas of the RBA’s International Department may allow the portfolio to vary by 1 percent either side of the benchmark weights.16 Currency and asset positions are managed separately within the discretionary band through the use of foreign currency swaps. The cost/benefit of these swaps is taken into account when measuring the performance of the asset and currency positions relative to benchmark. Foreign exchange dealers in each of the three dealing centers have a small amount of discretion (set in terms of a maximum open position) that falls within the ±1 percent discretionary limit on currency allocation.

187. Risk measurement and trading discretion around the duration benchmark for each asset portfolio are based on the concept of “dollars-at-risk.” This is the change in portfolio value arising from a one basis point change in yield. Within each of the portfolios, the dealing centers are required to maintain dollars-at-risk to within US$70,000 per basis point at all times. This limit applies to the aggregate position of the portfolio and to the position undertaken in each maturity bucket of the portfolio in order to control the amount of curve risk. Breaches of the limit are reported to Assistant Governor on the day they occur. The dealing centers are also required to report daily losses that exceed US$1 million to senior management in the Financial Markets Group.

188. The “dollars-at-risk” measure also forms the basis of the Value-at-Risk (VaR) methodology, which the RBA has used since 1995 to estimate the consolidated exposure of the Bank’s foreign currency reserves to market risk. Though the overall limits to control market risk—i.e., the discretionary trading bands around the benchmark—are not defined in terms of VaR, the RBA has found that it nonetheless provides a useful tool for conveying information about the overall portfolio exposure to senior management and staff involved in reserves management.

189. The VaR number represents the portfolio loss the RBA could incur once every 20 business days in normal market conditions. Two VaR measures are calculated each day—one based on the correlation method and the other based on historical simulation methodology. The assumptions underlying these VaR methodologies are reviewed periodically and their performance is tested regularly. In accordance with best practice, the RBA also stress tests the portfolio. This involves simulating and evaluating the impact of extreme market movements on the value of the portfolio.

Information system

190. All international transactions entered into by the RBA are processed through a main-frame electronic Global Trading and Settlement System (GTS). This system has been developed by an external software provider to our specifications, with functionality expanded as new products are introduced. All stages of a transaction—from deal entry to confirmation of settlement from nostro banks and custodians—are handled by the system, which has an interface to SWIFT. The segregation of front and back office duties is achieved through the control of user security levels by the Dealing Support section, which is also responsible for ensuring the system’s operation.