Liquidity Framework - LAF, SDF, MSF, OMOs for UPSC

Liquidity Management: LAF, SDF, MSF, OMOs | UPSC

Liquidity Framework - LAF, SDF, MSF, OMOs for UPSC

Liquidity management is the Reserve Bank of India’s method of adding or removing short‑term funds to keep interest rates stable and banks well funded. Using tools like the Liquidity Adjustment Facility (LAF), the collateral‑free Standing Deposit Facility (SDF), the emergency Marginal Standing Facility (MSF) and open market operations (OMOs), the RBI steers the overnight call money rate close to the policy repo rate. This ensures inflation control, smooth credit flow and financial stability.

Why liquidity management?

A stable money market is vital for any economy. Banks rely on the interbank market to raise and deploy funds; if this market is flush with money, interest rates can fall, fuelling inflation and asset bubbles. If money becomes scarce, lending rates spike, slowing down investment and growth. The RBI therefore acts as a conductor, ensuring that just enough cash circulates in the system. Its operating target, the overnight weighted average call rate, is kept near the policy repo rate (5.50 % in October 2025) by supplying or absorbing funds daily.

Liquidity swings occur for many reasons: tax payments, government spending, foreign capital flows or large currency withdrawals. During the pandemic, the RBI pumped liquidity to support the economy; as growth picked up, it withdrew excess funds to rein in inflation. In 2025, the stance is neutral – neither too tight nor too loose. By using a range of instruments instead of blunt measures like the cash reserve ratio, the RBI fine‑tunes liquidity and improves monetary policy transmission. UPSC aspirants should grasp why liquidity control matters: it stabilises interest rates, supports growth and keeps inflation expectations anchored.

LAF – Liquidity Adjustment Facility

The Liquidity Adjustment Facility sits at the heart of daily liquidity management. Introduced after reforms in the early 2000s, LAF enables banks to borrow from or lend to the RBI through repurchase agreements. In a repo transaction, banks pledge government securities and receive funds at the policy repo rate. They repay the loan the next day or after a short tenor with interest and reclaim their securities. When banks have excess cash, they deposit money with the RBI via the reverse leg. The repo rate is therefore the main signal of the monetary policy stance.

Over time, LAF has become more flexible. Until April 2022, the reverse repo rate was the floor of the corridor. It allowed banks to park surplus funds against collateral, but required paperwork and bid‑based auctions. In April 2022 the RBI introduced the Standing Deposit Facility – a collateral‑free deposit window that now serves as the floor. Banks can still use the reverse repo, but it is mainly a fine‑tuning tool. On the injection side, the RBI conducts fixed‑rate repo operations every day and variable rate repos (VRRs) when it needs to supply funds in bulk or for longer than overnight. VRRs use auctions, letting market forces determine the borrowing rate.

Because LAF operations are collateral‑based, they maintain discipline: banks must hold government securities and pay interest on borrowed funds. LAF works in tandem with statutory requirements like the CRR and SLR (the CRR was effectively reduced to zero by mid‑2025 and the SLR is 18 %) to influence banks’ lending capacity. When the RBI lends through repo, it adds high‑powered money to the system, lowering market rates. When it accepts funds under reverse repo or SDF, it drains money, tightening conditions. This push‑and‑pull keeps interest rates aligned with the policy signal and ensures smooth functioning of the payment system.

SDF vs MSF

The Standing Deposit Facility (SDF) was introduced on 8 April 2022 to replace the reverse repo as the main liquidity absorption tool. It is an overnight deposit facility with no collateral requirement, open to all scheduled commercial banks and cooperative banks. The SDF rate is set 25 basis points below the repo rate – 5.25 % as of October 2025 – making it the floor of the policy corridor. By allowing banks to park unlimited surplus funds with the RBI at this rate, SDF helps mop up liquidity quickly and simplifies operations.

At the other end of the corridor is the Marginal Standing Facility (MSF). Launched on 9 May 2011, MSF provides overnight funds when banks cannot meet liquidity needs from the interbank market. To access MSF, banks can borrow up to 2 % of their net demand and time liabilities by pledging securities from their SLR portfolio. The MSF rate is 25 basis points above the repo rate, currently 5.75 %, making MSF the ceiling of the corridor. Because MSF borrowing is costlier, it is used sparingly, acting as a safety valve when market rates rise sharply.

SDF and MSF together define the symmetrical corridor around the repo rate. Deposits under SDF reduce the monetary base and dampen market rates; loans under MSF expand the base and cap market rates. In contrast, the older reverse repo continues as an occasional tool for absorbing liquidity through collateralised deposits. The table below highlights the differences among the key instruments:

InstrumentPurposeRate (Oct 2025)Collateral?Availability
Standing Deposit Facility (SDF)Absorb surplus liquidity5.25 % (Repo – 25 bps)NoOvernight; unlimited
Reverse RepoFine‑tune surplus liquidity≈5.25 %Yes – government securitiesOvernight or via auction
RepoInject liquidity5.50 %Yes – government securitiesFixed‑rate daily; auction‑based VRRs
Marginal Standing Facility (MSF)Emergency borrowing5.75 % (Repo + 25 bps)Yes – dip into SLROvernight; capped at 2 % of NDTL

Open Market Operations (OMOs)

Open market operations are outright purchases or sales of government securities used to adjust durable liquidity in the banking system. When the RBI buys securities, banks receive cash; when it sells securities, cash is taken out. Unlike repos, where securities are repurchased the next day, OMOs permanently change the stock of securities held by banks and the RBI. They influence longer‑term interest rates and help manage structural liquidity.

After pumping huge liquidity during the pandemic, the RBI gradually reduced OMO purchases. In FY25 it announced purchases of around ₹80,000 crore to offset a looming deficit arising from CRR cuts and currency withdrawals. By October 2025, liquidity conditions were largely balanced, but the RBI indicated it would use OMOs as needed to keep market rates aligned with policy. Aspirants should remember that OMOs complement short‑term instruments like LAF and SDF/MSF and can be tailored – for example, twist operations involve buying long bonds and selling short bonds to alter the yield curve.

Interest Rate Corridor

The interest rate corridor sets the range within which the call money rate is expected to move. The repo rate sits at the centre, the SDF rate forms the floor and the MSF rate the ceiling. Since April 2022 the corridor width has been kept at 50 basis points (±25 bps around the repo). A narrow, symmetric corridor reduces volatility and improves the transmission of policy changes to market rates. If liquidity pressures emerge, the RBI can widen the corridor temporarily to encourage or discourage banks from parking funds.

Keeping the weighted average call rate close to the repo rate signals that policy is being transmitted effectively. If call rates drift above the repo, the RBI supplies liquidity through repos or OMOs. If call rates fall below the SDF, it absorbs liquidity. Understanding the corridor helps candidates interpret why small shifts in policy rates matter and how expectations about future rates are anchored.

Variable Rate Repos and Reverse Repos (VRR/VRRR)

Variable rate repo and reverse repo auctions allow the RBI to fine‑tune liquidity beyond overnight horizons. Participants bid for funds (in a VRR) or deposit funds (in a VRRR) at rates they choose, subject to a floor or ceiling set by the RBI. These auctions are useful when liquidity needs to be supplied or absorbed in larger quantities or for a longer period than the fixed‑rate overnight operations.

For years, 14‑day VRR/VRRR auctions were the main tool for short‑term liquidity. In September 2025 the RBI revised the framework and announced that it would discontinue 14‑day operations as the mainstay, shifting to seven‑day VRR/VRRR auctions and other tenors from overnight up to 14 days depending on liquidity conditions. The change aims to align the call rate more closely with the policy rate and provide greater transparency; market participants now receive advance notice of the amount and timing of these auctions. Remember: VRRs inject liquidity, VRRRs absorb liquidity, and both rely on bidding rather than fixed rates.

For UPSC Prelims and Mains

For Prelims

  • Understand the definitions of LAF, SDF, MSF, repo, reverse repo and OMOs.
  • Memorise current rates (October 2025): repo 5.50 %, SDF 5.25 %, MSF 5.75 %.
  • Know that SDF is collateral‑free and serves as the corridor floor, while MSF is a collateralised emergency facility at the ceiling.
  • Recognise that OMOs are outright purchases or sales of securities, unlike repos which are temporary.
  • Remember that seven‑day VRR/VRRR auctions replaced 14‑day auctions in 2025.

For Mains

  • Discuss how liquidity management balances growth and inflation, referring to recent CRR cuts and rate stability in 2025.
  • Explain the evolution of the liquidity framework – the SDF’s introduction in 2022 and the switch from 14‑day to seven‑day VRR/VRRR auctions.
  • Analyse the benefits of a narrow, symmetric corridor for monetary transmission.
  • Assess how OMOs, LAF and VRRs influence bond yields, exchange rates and credit availability.
  • Use examples from 2023–25 to illustrate the RBI’s approach to injecting and absorbing liquidity.

Quick Facts

  • Current policy rates: repo 5.50 %, SDF 5.25 %, MSF/Bank rate 5.75 % (October 2025).
  • Corridor width: 50 basis points (±25 bps around the repo).
  • Introductions: SDF launched on 8 April 2022; MSF on 9 May 2011.
  • Reserve requirements: CRR effectively 0 % after 2025 cuts; SLR 18 %.
  • Operating target: the weighted average call rate (WACR).
  • VRR/VRRR operations: seven‑day auctions are now the norm.
  • OMOs: used to manage durable liquidity; twist operations adjust the yield curve.
  • Impact: liquidity management affects interest rates, credit growth, bond yields and the rupee.

UPSC Previous Year Questions (Selected)

  1. Prelims 2020: With reference to the Liquidity Adjustment Facility, which statements are correct?
    1. It allows banks to borrow funds from the RBI by pledging government securities.
    2. The repo rate under LAF influences short‑term interest rates.
    3. A higher repo rate usually dampens inflation.
    Answer: All three statements are correct.
  2. Prelims 2022: Regarding the Standing Deposit Facility:
    1. It is collateral‑free and provides a floor to the policy corridor.
    2. Its rate is always lower than the repo rate.
    3. It replaced the reverse repo as the primary absorption tool.
    Answer: Statements 1 and 3 are correct; statement 2 is correct because the SDF rate is below the repo.
  3. Mains 2023 (GS III): “Explain the role of open market operations in RBI’s liquidity management. How do they affect long‑term interest rates and credit availability?”

Practice MCQs

Test your understanding with the following questions (answers below).

  1. Which facility forms the floor of India’s policy corridor?
    A. Reverse repo
    B. Marginal Standing Facility (MSF)
    C. Standing Deposit Facility (SDF)
    D. Cash Reserve Ratio (CRR)
  2. What distinguishes OMOs from repo operations?
    A. OMOs permanently change liquidity; repos are temporary.
    B. OMOs are collateral‑free; repos require collateral.
    C. OMOs can only inject liquidity; repos can only absorb liquidity.
    D. OMOs always have lower rates than repos.
  3. The RBI switched from 14‑day to seven‑day VRR/VRRR auctions in 2025 to:
    A. Increase the corridor width.
    B. Improve policy transmission and reduce uncertainty.
    C. Remove the need for SDF.
    D. Raise the CRR.
  4. Under the MSF, banks may borrow up to what percentage of their net demand and time liabilities?
    A. 1 %
    B. 2 %
    C. 3 %
    D. 5 %
  5. Which of the following best describes the interest rate corridor?
    A. The repo rate is the ceiling and the SDF the floor.
    B. The SDF rate is 25 bps below the repo and the MSF 25 bps above.
    C. It fixes the lending rate for all banks.
    D. It is no longer used after 2025.

Answer Key: 1 – C; 2 – A; 3 – B; 4 – B; 5 – B

Frequently Asked Questions

What is the policy repo rate?
The repo rate is the interest rate at which the RBI lends funds to banks against government securities. It anchors short‑term interest rates and is 5.50 % in October 2025.

How does the Standing Deposit Facility differ from reverse repo?
SDF is a collateral‑free facility introduced in 2022 for banks to park surplus funds. Reverse repo, though still available, requires securities as collateral and is now mainly used for fine‑tuning operations.

When do banks use the Marginal Standing Facility?
Banks borrow under MSF when they face an acute liquidity shortage and cannot raise funds in the market. The MSF rate is 5.75 %, 25 basis points above the repo.

What are open market operations?
OMOs are the RBI’s purchase or sale of government securities to adjust durable liquidity. Buying securities injects liquidity, while selling them drains it. Unlike repos, OMOs permanently change banks’ holdings.

Why were 14‑day VRR/VRRR auctions replaced?
The RBI shifted to seven‑day auctions in 2025 to better align market rates with policy and provide clarity on tenor and timing of liquidity operations.

How does liquidity management affect inflation?
By increasing or decreasing the supply of money, the RBI influences borrowing costs. Tight liquidity cools inflation, while easy liquidity can stoke inflation if credit growth outpaces supply.

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