There is a lot of confusion on what all these monetary terms mean. QE, OMO, TAF, LSAP, LTRO, Repo etc. This post tries to make sense of these monetary operations done by central banks.
Firstly it is important to understand what a central bank does. A central bank is a banker of banks, i.e. it provides banking services to normal commercial banks. In doing so it provides a deposit account where banks maintain balances called reserves (incidentally this is why central banks are also called reserve banks). These reserves are used by banks when they want to transfer funds to other banks.
If a bank has payments to another bank, it needs to find reserves. It can do so by borrowing in the market or by obtaining reserves from the central bank itself. It is the latter process that I want to talk about.
A bank may borrow from the central bank by providing collateral for the loan. This collateral is usually government bonds. This process is called repo (short for repurchase agreement – I agree to sell this bond to you and agree to repurchase it back tomorrow). In India the most common form of repo has been the overnight repo. In the last few months we have added term repos to the mix, where the tenor of the loan runs for multiple days and weeks.
The second source of liquidity is selling the government bond to the central bank without an agreement to buy it back. This is called an outright transaction.
Forms of repo:
Repo, Term Repo (India), Refinance Operations (US Fed), Refinance Operations and Long Term Refinance Operations (ECB).
Forms of outright transactions:
Open Market Operations (OMO, India), Large-Scale Asset Purchase (LSAP popularly called QE, US Fed) and Outright Monetary Transactions (OMT, ECB).
While both repo and outright transactions appear to be similar, in repo eventually the security returns to the borrower after the bank repays the loan to the central bank. Thus the risks associated with the bond belong to the bank and not to the central bank. In an outright transaction the future risk of the bond is with the central bank. This was brought to the fore in Europe in recent years thanks to the Greek default. The bonds which were held by the ECB in repo were returned to the borrowing banks and the banks took the losses not the ECB. In a future OMT purchase such a default would happen to the ECB.
Similarly in India in case of repo, the price risk of the bond remains with the borrowing bank while in OMO the price risk is with RBI. This means that there is a qualitative difference in the way the market treats repo and OMO transactions, especially in longer dated bonds (where the price risk is large). The market sees the repo as just a means to add liquidity to the banking system while OMO is seen to have an impact on liquidity as well as providing a signal on yields – since OMO increases the price of the bond and reduces the yield. I wrote about the large OMO programme of RBI earlier here.
I hope that clarifies. Please comment here or on my twitter account if you need more clarity.