Review of Banknote Distribution Arrangements: Issues Paper 3. Australia's Banknote Distribution System

The Reserve Bank aims to ensure that banknotes are available to meet public demand and that banknotes in circulation are of a good quality. Good-quality banknotes support the community's confidence in using physical currency by making it more difficult for counterfeits to be passed or remain in circulation; they also help to prevent problems with banknote accepting and dispensing equipment, such as ATMs and ticketing machines.

This section provides an overview of the current system for distributing banknotes across Australia, as well as the evolution of that system and how it compares to models employed in other countries. It also asks whether changes should be made to these arrangements given the shifting nature of cash use.

3.1 The cash cycle

The movement of banknotes from the Reserve Bank into the hands of businesses and consumers – the cash cycle – involves a number of participants. The Reserve Bank is the wholesaler of banknotes and ensures that the banking sector has sufficient access to banknotes so as to meet its customers' needs. The private sector then plays an important role in banknote distribution and processing – a role that has increased over time (see Box A for a discussion of previous distribution arrangements in Australia). CIT companies carry out the majority of the logistics associated with distributing and processing banknotes on behalf of banks, other authorised deposit-taking institutions (ADIs) and retailers (Figure 1). The wholesale part of banknote distribution involves the bulk movement of banknotes from the Reserve Bank to CIT cash depots around the country. Banknotes are then distributed from these depots to bank branches, ATMs and retailers, from where they are available to the public (retail distribution). Delineating between wholesale and retail distribution, however, is not straightforward, as it tends to involve the same industry participants and infrastructure.

3.1.1 Production and issuance of banknotes

The Reserve Bank is responsible for the production and issuance of Australia's banknotes. Banknotes are printed by Note Printing Australia Limited (NPA), a wholly owned subsidiary of the Reserve Bank. Once printed, they are delivered to the Reserve Bank's primary storage, processing and distribution site in Victoria – the National Banknote Site (NBS). The Reserve Bank also has a contingency site for banknote distribution located in Sydney.

The issuance of banknotes from the Reserve Bank into circulation is facilitated by a series of legal agreements, known as the Banknote Distribution Agreements (BDAs). These are bilateral agreements between the Reserve Bank and participating institutions – currently the four major Australian commercial banks (the BDA participants). The BDAs provide the legal framework under which the distribution and processing of banknotes in circulation is carried out. Only BDA participants can purchase banknotes directly from the Reserve Bank. They take ownership of the banknotes upon collection from the Reserve Bank's distribution site. At this point, banknotes are considered to be in circulation.

As an alternative to purchasing banknotes directly from the Reserve Bank, BDA participants are encouraged to purchase surplus banknotes from each other. This is also how organisations that are not party to a BDA are able to obtain banknotes. The exchange and distribution of bulk cash between the four BDA participants is governed by the Australian Cash Distribution and Exchange System (ACDES), which is managed by the Australian Payments Network (AusPayNet).^[1]

3.1.2 Transport, storage, processing and quality sorting

The distribution of banknotes throughout the country is carried out by the private sector. The BDA participants engage CIT companies to transport, process and store banknotes on their behalf. In order to collect banknotes from the Reserve Bank, these CIT companies must be nominated by a BDA participant and approved by the Reserve Bank (approved CITs). These approved CITs collect banknotes from the Reserve Bank's distribution site and transport them to their cash depots for distribution to financial institutions and retailers throughout Australia. There are currently four approved CITs that operate around 60 approved depots around the country. There are also a large number of smaller CIT companies operating in the Australian market that are not part of these wholesale arrangements but nevertheless support retail cash distribution. The CIT industry is described further in Section 4.1.

The BDA participants hold some banknote stocks within Reserve Bank-approved depots (approved depots) to enable them to meet the cash demands of their customers as well as for contingency and risk management purposes. These banknote stocks are known as verified cash holdings (VCH). The Reserve Bank compensates the BDA participants for interest forgone on their holdings of banknote stocks at approved depots, provided the banknotes have been quality sorted and the depots are regularly audited to verify the reported banknote holdings. The interest compensation payment is in line with the interest that would have been earned by the commercial banks were they to instead hold electronic balances at the Reserve Bank.

Banknotes in circulation that are surplus to the requirements of the public are returned by financial institutions and larger users of banknotes (such as major retailers) to approved depots. These banknotes are then processed by the approved CITs, which involves verifying, counting and sorting banknotes based on their denomination and whether they are fit or unfit (i.e. the extent of any damage associated with regular wear and tear).^[2] Poor-quality banknotes that are no longer fit for circulation (unfit banknotes) are packaged and returned to the Reserve Bank. Banknotes that are deemed to be of good quality (fit banknotes) remain in circulation. Part of this processing involves CIT companies packaging banknotes for individual financial institutions, ATMs and retailers.

3.1.3 Removal from circulation and destruction

Banknotes are returned to the Reserve Bank by approved CITs on behalf of the BDA participants, and ownership transfers from the BDA participant to the Reserve Bank on receipt at the Reserve Bank's distribution site. Banknotes are deemed ‘out-of-circulation’ once they have been returned to the Reserve Bank. Over the past decade, $5½ billion worth of banknotes (or 160 million banknotes) have been returned to the Reserve Bank each year on average, compared to $10 billion worth of banknotes (or 240 million banknotes) that were issued by the Reserve Bank each year (Graph 8).

BDA participants return two types of banknotes to the Reserve Bank – surplus and unfit banknotes. First, given the seasonal nature of banknote demand, they return banknotes that are surplus to their current needs. These banknotes are stored at the NBS and reissued into circulation as they are demanded. Second, as already noted, BDA participants are responsible for returning unfit banknotes to the Reserve Bank. These banknotes are processed by the Reserve Bank to count them, confirm their authenticity and to remove any fit banknotes. Unfit banknotes are then destroyed by the Reserve Bank, while fit banknotes are repackaged and returned to circulation as they are demanded.

3.2 The Banknote Distribution Agreements

The bilateral BDAs that the Reserve Bank has with BDA participants govern the wholesale distribution of banknotes. These agreements (which are periodically renegotiated) outline the contractual terms, conditions and procedures associated with:

• meeting the demand for banknotes, which includes wholesale banknote purchases and returns, as well as the payment of interest compensation to BDA participants on their cash holdings at approved depots
• maintaining the Reserve Bank's quality standards for banknotes in circulation, by quality sorting banknotes and returning unfit banknotes to the Reserve Bank; this also includes payments by the Reserve Bank to support accurate quality sorting by the industry to the standards specified by the Reserve Bank.^[3]

3.2.1 Meeting demand for banknotes

Wholesale access to banknotes

In principle, any organisation can enter into a BDA with the Reserve Bank, provided they are prepared to sign up to the contractual requirements. In practice, however, there are aspects of the arrangements that may limit the ability of some organisations to enter into a BDA. For example, the nature of the BDA requirements means that participants need to have sufficient financial resources to purchase banknotes that are held in inventory in the depot system.^[4] They also need to be prepared to meet the control measures outlined in the BDAs – such as procedural, reporting and auditing requirements – and bear the cost of those measures. Further, the BDA as it is currently framed is comprehensive and relates to banknote purchases, returns and quality management. Hence, one area for consideration in this review is whether the nature of the BDA system provides sufficient flexibility to support different types of participation in wholesale banknote distribution (discussed in Section 5.2).

Contingency stocks

It is important that there are sufficient stocks of banknotes throughout the country, both to meet day-to-day demand and to provide for unexpected and large increases in demand, such as during the GFC or the COVID-19 pandemic. In the extreme, if a financial institution was unable to meet banknote demand from the public for a period of time, particularly in a time of heightened economic uncertainty or stress, this could have significant reputational consequences for that institution and, more broadly, could impact confidence in parts of the financial system. While temporary minor disruptions to cash supply do occur from time to time without substantial consequences (such as individual ATMs running out of banknotes), the arrangements for banknote distribution need to be sufficiently robust to prevent a prolonged disruption in the ability of the public to access cash.

As noted in Section 3.1, the Reserve Bank compensates BDA participants for interest forgone on VCH within approved depots. In an environment where interest rates are at or close to zero, the financial incentive paid to BDA participants to hold banknotes is reduced.

3.2.2 Maintaining banknote quality

Quality sorting of banknotes is a key function of Australia's wholesale distribution system. As banknotes are returned from public use to CIT depots, they are checked for wear and damage before being returned for public use if they remain fit for circulation. There are three key elements of the Reserve Bank's approach to maintaining the quality of banknotes in circulation:

• setting quality standards that specify when a banknote is no longer fit for circulation^[5]
• providing financial incentives for the industry to sort banknotes to the Reserve Bank's desired quality standards
• providing financial incentives for the return of unfit banknotes to the Reserve Bank.

As mentioned, BDA participants must sort to the Reserve Bank's quality standards for their banknote holdings at approved depots to qualify for interest compensation payments. The Reserve Bank further incentivises the quality sorting of banknotes via the Note Quality Reward Scheme (NQRS) (Cowling and Howlett 2012). Under the NQRS, the Reserve Bank samples fit banknotes that have been quality sorted at approved depots, quantitatively measures their quality and makes payments to the BDA participants based on the assessed quality of banknotes sampled (Graph 9). By rewarding accurate quality sorting, NQRS payments are intended to incentivise industry participants to carry out ongoing investment in their quality-sorting capability. Since the start of the NQRS scheme in late 2006, the Reserve Bank has paid BDA participants more than $150 million in NQRS payments.

At the same time, the cash handling industry has its own requirements for banknote quality, so as to minimise problems with banknote processing equipment. For example, folded banknotes and banknotes with tears can cause issues in ATMs and ticketing and vending machines; these issues are costly as they can take the machine out of service and/or require a technician to rectify the problem. The Reserve Bank's standards for banknote quality are higher than private sector standards as it also seeks to remove from circulation banknotes with worn or damaged security features. The Reserve Bank regards this as important because security features, such as the raised print on the banknote or the top-to-bottom window, can be used by the public to determine whether a banknote is genuine or counterfeit. The BDA encourages the industry to sort to the Reserve Bank's higher quality standards.

Quality sorting banknotes does, however, impose costs on the private participants in the cash distribution system. These include the cost of investing in and maintaining the necessary banknote processing equipment, as well as the cost of employing the workers required to operate that equipment. While the Reserve Bank provides incentive payments for quality sorting, ongoing investment in banknote processing equipment in the current environment may become increasingly challenging.

Another important element of maintaining the quality of banknotes in circulation is removing poor-quality banknotes from circulation. The Reserve Bank encourages BDA participants to return these banknotes to the Reserve Bank by making incentive payments for the transportation of these unfit banknotes. Setting the transport rate at an appropriate level is an ongoing challenge. While a higher rate would further encourage the removal of unfit banknotes from circulation, it could also encourage inefficient transportation of unfit banknotes by the industry, which would not be a good use of public funds. If the transport rate is set too low, it could incentivise BDA participants to recirculate unfit banknotes to reduce their transportation costs, thereby decreasing the quality of banknotes in circulation.

Endnotes

AusPayNet is the self-regulatory body and industry association for payments in Australia. Its role includes setting industry standards and facilitating coordination between industry participants. [1]

While some bank branches quality sort themselves, the majority of quality sorting is performed by approved CITs. [2]

The Reserve Bank partially subsidises the transport associated with the return of unfit banknotes. [3]

The smallest quantity of a single denomination that can be purchased is 100,000 banknotes. Accordingly, the starting price of wholesale banknote purchases ranges from $500,000 for $5s to $10 million for $100s. [4]

See RBA, ‘Banknote Sorting Guide’. Available at <https://banknotes.rba.gov.au/assets/pdf/sorting-guide.pdf>. [5]