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In our previous article on the risk-free rate, we explained that only three types of assets qualify as genuinely risk-free:
- The portion of individual and business bank deposits guaranteed by the government (in France: up to €100,000 per person, per institution).
- Deposits held at the central bank.
- Short-term debt issued by the most stable governments (known as “Treasury Bills”).
This article addresses a key question: how is the risk-free rate determined?
The critical role of central Banks
Today, central banks—most notably the Federal Reserve (Fed) in the U.S. and the European Central Bank (ECB) in Europe—are the ultimate arbiters of risk-free rates.
Markets may attempt to anticipate rate hikes or cuts, and much of a central banker’s work involves managing these expectations. However, the actual influence of markets on risk-free rates is minimal to nonexistent; it is central banks that make the final call.
How does this work?
As part of their public mandate to combat inflation and deflation, central banks are entrusted with setting short-term “policy rates.” These rates determine the terms at which they lend to commercial banks and pay interest on overnight deposits.
The level of these policy rates directly impacts:
- The borrowing conditions for businesses and individuals.
- The interest rates offered on their deposits.
In times of inflationary pressure, central banks raise policy rates to make borrowing more expensive, thereby slowing economic activity. Conversely, during deflationary periods, they lower rates to encourage borrowing and stimulate the economy.
Central banks pay interest on bank deposits
In practice, every commercial bank has an account at the central bank. Any cash they deposit there—referred to as “reserves”—earns interest at the current policy rate.
Since inflation began to rise in mid-2021, these rates have been significantly increased (especially throughout 2022-2023), reaching 4% in euros at the ECB and 5.4% in dollars at the Fed.
Access to the central bank is a privilege reserved for commercial banks, meaning businesses and individuals rely on the banks’ discretion when it comes to earning interest on their own deposits.
In France, as in most countries, the current market practice is that checking accounts don’t earn interest. Banks are making substantial profits today, with no risk involved, simply by keeping liquidity parked at the central bank.
Access to risk-free rates
Fortunately for businesses and individuals, there’s a way out—by directly investing cash in Treasury Bills. Those issued by the most stable governments offer a risk profile and returns comparable to central bank deposits.
In our upcoming articles, we’ll dive deeper into these financial instruments, which today provide the best means of democratizing access to risk-free rates (a mission close to our hearts here at Spiko!).
At Spiko, we offer easy access to risk-free rates in euros and dollars through regulated financial products called “money market funds.”
Spiko’s money market funds hold Treasury Bills issued by the most stable governments in the eurozone and the U.S. federal government. They provide daily returns on your cash, along with constant access to your money—no notice periods, penalties, or withdrawal fees.
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