What is the Money Market?
Money Market is a market where short-term and open-ended funds are traded between institutions and traders; where the borrower can easily meet with fund requirements through any financial assets which can be easily converted into money, providing a high amount of liquidity and transferability to an organization.
Like any other market, financial markets bring together buyers and sellers who want to invest/divest in various financial instruments such as shares, debentures, bonds, other financial instruments. Financial Markets also have their own rules and regulations, key participants, timings, competition, etc.
Financial Markets can be split into several sub-markets such as:
- Capital Market – This is a market segment in which financial instruments such as shares, bonds, etc with long-term maturities are traded.
- Money Market – This is a market segment in which financial instruments with high liquidity and very short maturities are traded.
- Derivatives Market – Derivatives are financial instruments whose value is derived from its underlying asset. There is a separate market segment in the finance market which deals in Derivatives trading.
- Foreign Currency (Forex) Market – This is the market for financial institutions such as banks, non-banking financial institutions, etc. to deal with different currencies.
- Commodities Market – This is a market that specializes in the buying and selling of commodities such as gold, silver, crude oil, etc.
Characteristics of the Money Market
Some of the special characteristics of the money market are as follows:
- The money market is a fixed income market which means it deals in financial instruments that pay a fixed rate on the investment. This is the opposite of the capital markets where there is no fixed return on investments.
- Investing in the money markets is considered to be very safe as the returns are fixed in nature. Since investing in this market is safe it also means that the returns are lower. This is on account of the risk-return trade-off. Higher the risk, the higher is the return and vice-versa. On the other hand, the capital markets which do not have a fixed return on investments are volatile in nature and riskier as compared to the money markets. However, capital markets present the opportunity to earn a high rate of return.
- Money market instruments are highly liquid in nature. This is the reason why financial institutions and governments approach the market for short-term needs. The purpose of this market is to tend to short-term cash needs rather than investing in the needs of various financial institutions.
- Money market instruments are short-term in nature. The maturity of these instruments is generally less than a year. The maturity of these securities can be as less as one day also.
- This money market is dominated by wholesale transactions and retail investors like you and me will not have direct access to this market. The main reason for this is the ticket size or the value of transactions. Money market transactions are high in value as opposed to capital market transactions. Individual investors will not have enough funds to cope up with this market.
Types of Money Market Instruments
Money market instruments have their own set of unique short-term securities. Let us understand the most important of these securities.
Type #1 – Call Money
Call money is one of the most liquid forms of money market instruments. The validity is generally one working day. Banks can have shortfalls that they can fund through borrowing call money from the money market. Other banks who have access or surplus cash can invest in other banks through call money.
This is also called Bank Money although it is not restricted to banks. Other financial institutions can also invest/borrow through call money. There is no organized market for call money and the transactions between banks generally take place by means of phone calls/emails/faxes. The rate at which call money can be borrowed or invested in the market is called as the call rate.
The main reason why banks require call money is for maintaining the statutory reserves such as cash reserves. Banks have to maintain certain liquid cash on a day-to-day basis as a mandatory requirement by most Central Banks. In case there is a shortage of liquid cash that does not cover the mandatory requirement at the end of the day, banks turn to the call money market for funds.
Type #2 – Treasury Bills
Treasury bills are issued by the Central Bank of the country on behalf of its Government. Whenever Government is in need of funds, it raises money in the market through Treasury Bills. This is considered one of the safest investments as it is backed by the government itself. The tenure of these bills is generally from 14 days to 364 days.
One of the important features of the Treasury Bills is that they are issued at a discount. E.g. if the face value of the Treasury Bills is $ 100, they will be issued at $ 95 with a discount of $ 5. So when you buy the Treasury Bills, you buy it at $ 95 and at the time of maturity, the government will pay the full amount i.e. $ 100. This discounted value of $ 5 is nothing but the upfront interest earned. Interest is not paid separately on Treasury Bills. Hence, these are also known as “Zero-Coupon Bonds” as the coupon paid (i.e. interest paid) is Zero.
Treasury Bills are used as a source of controlling liquidity in the market by the government. If the government wants to curb the liquidity in the market, it will issue treasury bills which will be bought by various financial institutions. By doing this, invested funds will be back with the government and will reduce the money supply in the market. On the other hand, if the government wants to pump in money in the financial system, it will buy back its treasury bills by means of which it can inject money into the market.
Note: Since treasury bills are considered as the safest form of investment, the interest rate at which Treasury Bills are traded in the market is considered as the risk-free rate of return in many financial models e.g. the Capital Asset Pricing Model
Type #3 – Commercial Papers (CPs)
As the name itself suggests, Commercial Papers are generally used by various companies to fund their short-term working capital needs such as payment of accounts receivables, buying of inventory, etc. These are unsecured in nature which makes that there is an underlying asset of the company attached to it. In case of liquidation of the company, they will not have priority against other secured financial money market instruments.
They are short-term in nature with the average maturity being two odd months. Just like the Treasury Bills, these are also issued at a discount and therefore, interest is not paid separately. The rate of interest is determined by the forces of demand and supply of liquid funds in the market.
As we discussed, these are secured in nature and are generally used to fund short-term working capital requirements of various companies. This leads to the obvious question of the safety of investing in these money market instruments. Investing in these instruments is considered to be safe it is easy to predict the future of the companies in the next two or three months which is the tenure of the Commercial Papers. At the same time, there are other means to find out the creditworthiness of the company by means of credit rating scores, goodwill in the market, etc.
Who invests in these Commercial Papers? Generally, banks and mutual funds are the investors of these commercial papers. They earn through the discount at which the Commercial Papers are issued. The rate of interest is higher compared to Treasury Bills as they are unsecured in nature.
Type #4 – Certificate of Deposits (CDs)
A Certificate of Deposit is a type of Time Deposit with the bank. Only a bank can issue a CD. Like all other Time Deposits, even CDs have a fixed maturity date and cannot be liquidated or withdrawn prior to that date. This tends to be one of the major disadvantages of Certificate of Deposit as it restricts its flexibility.
This disadvantage can be negated by the fact that CD is transferable security which means you can easily sell it to someone else. This is the reason why CDs are also traded on the secondary market at a brokerage. This means that once a CD is issued, it can be re-purchased by someone else by paying specific brokerage fees. (For ease of understanding, this is similar to that of trading of shares on a stock exchange. Once the shares are issued by the company, multiple buyers and sellers exchange these shares.)
They have a specific rate of interest which is higher than that of the Treasury Bills as the risk factor is more in this case. This does not mean that the CDs are risky money market instruments but since Treasury Bills are issued directly by the Government the level of risk will obviously vary in both the cases.
Type #5 – Repos
Repo is a short repurchase agreement. Let us take an example of Bank A is in need of funds and Bank B has surplus funds. Bank A will enter into an agreement with Bank B for selling its securities (mostly Treasury Bills) and get the required funds from Bank B. However, this does not end here. There is a twist in the agreement which states that Bank A will repurchase these securities from Bank B at a fixed future date.
These are very short-term in nature. They can be for just overnight purposes or up to a period of one month depending on the agreement between the banks. These are popular amongst banks because this eliminates the credit risk involved as the securities are directly transferred to one another.
There is something also known as a reverse repo. This is just the opposite of Repos. Here, a bank having excess funds will approach another bank. Instead of selling the securities, the bank will look for buying securities from another bank with the agreement of selling it at a later date.
Participants of the Money Market
The key participants of the money market are as follows:
- The government of different countries
- Central Banks
- Private & Public Banks
- Mutual Funds
- Insurance Companies
- Non-banking financial institutions
- Other organizations (these organizations are generally at the borrowing side of the market and generally trade in Commercial Papers, Certificate of Deposits, etc.)
Some of the functions of Money Market are as follows:
- Monetary Equilibrium: This market helps to bring a balance between the demand and supply of short-term funds in the market. This helps to bring a monetary equilibrium
- Availability of funds: By making funds available to various different participants in the market, the money market promotes the economic growth of the country
- Check on liquidity: The Government can keep a check on the liquidity in the country by means of the money market. (Please refer Treasury Bills section to understand how liquidity can be controlled by the Government and the Central Bank)
- Check on inflation: By controlling the liquidity in the marketing, the Government can keep a check on the inflation of the country as well. If the liquidity is controlled, it will tend to control the ever-increasing prices in the market.
- Promotes saving and investment in the country by giving a platform to wholesale as well as retail investors for investing/borrowing of funds.
Also, have a look at Guide to Macroeconomics
Money Market Funds
As we have seen earlier, entry for retail investors is restricted/limited in the money market due to the volume of transactions. However, retail investors can gain indirect access to this market through Money Market Funds. These are Mutual Funds that invest the money of retail investors into various money market instruments. Retail investors can buy and sell units of the Money Market Funds at the prevailing NAV through the mutual fund market which is a part of the Capital Market.