Banks Seize Arbitrage Opportunity in SDF-TREPS Spread
Financial institutions, particularly those with abundant liquidity, are actively engaging in a profitable arbitrage strategy by borrowing funds at lower rates in the Tri-Party Repo (TREPS) market and simultaneously deploying these funds with the Reserve Bank of India (RBI) through the Standing Deposit Facility (SDF) at higher fixed rates. This practice allows banks to lock in a near risk-free spread, according to market dealers who confirmed the trend on Tuesday.
Understanding the Rate Differential
The arbitrage opportunity has emerged due to a significant and widening gap between the RBI's SDF rate and the rates prevailing in the TREPS market. Dealers report that banks can currently earn up to 0.70 percent through this strategy. The TREPS market is a collateralized segment of the money market where banks and mutual funds participate in lending and borrowing activities, with mutual funds typically acting as lenders. Rates in this market are highly dynamic, influenced by:
- Current liquidity conditions in the banking system
- Demand and supply dynamics for short-term funds
- Regulatory requirements and compliance factors
- Overall market sentiment and economic indicators
In contrast, the SDF rate remains fixed and only adjusts when the central bank modifies its policy repo rate, providing a stable benchmark for banks seeking secure returns.
Tracking the Spread Widening
Recent data from the RBI reveals a steady expansion in the spread between TREPS and SDF rates over several days:
- January 30: Spread at 0.33 percent
- February 2: Increased to 0.43 percent
- February 3: Rose further to 0.60 percent
- February 4: Peaked at 0.76 percent
- February 5: Settled at 0.70 percent
- February 6: Narrowed to 0.40 percent
- Monday (February 9): Expanded again to 0.63 percent
This fluctuating but generally widening gap has made the arbitrage strategy particularly attractive in the short term, especially for banks flush with surplus liquidity.
Liquidity Surplus and Market Dynamics
The arbitrage opportunity became viable after liquidity in the banking system transformed into a large surplus following recent RBI liquidity infusion measures. This surplus has exerted downward pressure on overnight market rates, which are highly sensitive to liquidity conditions. V Ramachandra Reddy, Head of Treasury at Karur Vysya Bank, explained to PTI that historically, periods of surplus liquidity would prompt the RBI to conduct Variable Rate Reverse Repo (VRRR) operations to absorb excess funds. However, the current phase is notable for the absence of such operations, allowing overnight rates to remain anchored below the SDF rate—a stance that appears deliberate.
"With term premia in the 3-12 month money market segment remaining elevated, the RBI may be attempting to compress these spreads by keeping overnight liquidity abundant and rates soft. Lower TREPS rates incentivise banks to meet short-term funding requirements at a reduced cost, helping contain the overall cost of funds amid tight deposit conditions," Reddy elaborated.
RBI's Concerns and Historical Context
Despite the profitability of this strategy, it has drawn regulatory attention. Banks have been increasingly parking funds with the RBI under the SDF instead of participating in the call money market, a trend that has concerned the RBI for several months. The central bank has been encouraging banks to enhance their participation in the call money market to deepen liquidity and improve price discovery mechanisms. However, lenders continue to prefer the SDF route due to its security and predictable returns, according to money market experts.
This is not the first instance of such arbitrage activity. A similar pattern was observed last year in May, when banks leveraged the rate differential between SDF and TREPS to generate arbitrage profits. The recurrence highlights how banks strategically respond to evolving market conditions and regulatory frameworks to optimize their returns on surplus liquidity.
