The money consists of an exchange market in which short-term debt is traded. The tenure of debt in money markets generally ranges from overnight to twelve months.
Due to the short life of the debt, the money markets are considered to be highly liquid and relatively low-risk. The invested amount is not inaccessible for a very long time, and the principal is also considered to be safe.
A money market allows borrowers to avail short-term credit and lenders/investors to earn interest. However, given the short-term nature of debt securities associated with the money market, the interest rates tend to be relatively low.
A Meeting Place of Nations and Governments
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The participants in the money market are institutions, banks, traders, retail investors, and governments. The money market allows its participants access to short-term debt, which can be used to fund short-term cash flow requirements. The money market also allows individual retail investors to invest small amounts of money in a low-risk environment.
Furthermore, it facilitates the trading of government bonds, certificates of deposits or fixed deposits, treasury bills, money market funds, municipal bonds, commercial paper, and short-term asset-backed securities. Money market mutual funds are like debt-funds. They buy securities from the money market on behalf of its client investors.
Professional traders and institutions tend to buy other money market securities like repurchase agreements, forex deposits (e.g., eurodollar deposit), banker’s acceptances, and commercial paper.
Securities traded in the money market
Treasury Bills (Government Bonds)
T-Bills are one of the safest debt security in the investment world. They are backed by the government of the country issuing the security. So, there is almost no chance of default. Credit risk is low, but so is the interest rate. Treasury bills are purchased by banks, dealers, funds, and individual investors. Tenures of T-bills range from a few months to a year.
Commercial paper is basically an unsecured loan availed by companies to fund their short-term needs. Companies need cash flow for working capital, and they are willing to pay interest on such funds by offering commercial papers. These are relatively riskier than CDs and T-Bills.
Certificate of Deposit (Fixed Deposit)
A fixed deposit or certificate of deposit is issued by banks. As the name suggests, this security has a fixed maturity date and a fixed interest rate. They can normally be purchased in any denomination, though the bank decides the smallest denomination. There is a penalty for withdrawing money before the maturity date. Normally, a government company backs these deposits and provides insurance in case the bank fails. FDs or CDs are also considered to be a very safe investment.
Banker’s acceptance is a short term debt instrument that is backed by a guarantee from a bank. It is used in international trade, and it allows the holder to cash out the money if there is any default. However, the tenure for banker’s acceptance is normally one to six months.
Repurchase Agreements (Repo)
Repurchase agreements are normally used by government security dealers. They sell T-bills to lenders and then agree to repurchase those T-bills at a higher price in the future. These repurchase agreements are used by central banks to regulate bank reserves and the supply of money.
The Functions of the Money Market
Money markets are a crucial part of the global financial system. They allow overnight swaps of large sums of money that change hands between the governments and the banks.
Money markets allow people who have excess money to invest (lend) to institutions and governments that need the money. Consequently, money markets provide economic stability and play a vital role in the development of a country.
Money markets finance trade. They also provide short-term liquidity to international and domestic traders. In order for businessmen to pay for goods and services, the money market provides a means to discount bills of exchange. The money market also helps farmers and other sections of the economy, like small scale industries and individual investors.
Helping central banks
The money markets also help central banks exercise its monetary policy functions more efficiently. For example, the prevailing interest rates in the money market give the central bank an idea of what conditions are like in the country’s banking industry.
Such insight is useful in developing the monetary policy and setting the interest rates accordingly. Furthermore, they also allow the central banks to implement its monetary policy once the interest rates are set. The central bank can influence the sub-markets with its policy decisions.
Just as the money market provides liquidity to banks and the government institutions, it also provides liquidity to industries. Therefore, businesses that need short-term cash flow to pay employees, buy raw materials, fund working capital, etc. can take advantage of commercial papers and short-term deposits to fulfill their funding needs.
The money market may not provide longer-term debt. However, it still manages to influence the markets for such debt. The bond market looks at the interest rates prevailing in the money market and then benchmarks its interest rates accordingly. The money market often sets the tone for other types of debt securities.
Banks have plenty of cash which they can either loan out or invest. This cash comes from customer deposits. So, the bank needs to ensure that customers can withdraw their money when they want to.
Hence, banks have to keep a certain portion of their assets in short-term liquid assets. Securities in the money markets offer just that. Money markets allow banks to keep their excess reserves in short-term securities, which can be liquidated right way if money is withdrawn by the customer.
Banks can also borrow money from the money market when they face liquidity issues. Money market interest rates can be lower than the central bank interest rates. This way, the bank saves on higher-interest payments that it may have to make if it borrows money from the central bank.
The Locations of the Money Market
The money market is not restricted to a single location. In fact, it has multiple locations or channels for its participants to enter and exit. For example, a retail bank branch can be considered as a retail location for the money market. The bank branch can allow the investor to purchase a bond or invest in a deposit.
Similarly, websites like TreasuryDirect (US Government) which sell government securities and treasury bills are also considered as a channel of the money market. The website acts as a connecting platform bringing together the investor (lender) and the US government (borrower).
Your broker can also be considered as a “branch” or channel of the money market. The broker has the ability to give you access to debt securities, which are part of the money market.
Wholesale Component of the Money Market
A majority of the money market transactions are wholesale. They take place between companies and institutions and are of large denominations. As a result, large volumes of short-term debt products are traded in the money markets.
Individual and retail investors make up a small portion of the total value of trade in the money market. However, some of the large volume transactions are actually on behalf of individual investors. For example, money market mutual funds purchase short-term debt securities in bulk volumes on behalf of their investor clients.
Government securities like treasury bills are also issued through the money market. However, primary dealers of such government paper tend to purchase most of those securities in bulk.
They then trade these securities amongst themselves or sell it to individual investors and brokers. Of course, the individual investor can always log on to websites like TreasuryDirect and purchase government paper directly. However, wholesale participants tend to make up a large part of the government paper trade.
Risks associated with money markets
As money market deals in debt tenures of one year or less, the level of risk is also low. The money market is a way for governments and large companies to maintain steady cash flow and raise money at a cheaper rate. The money market is also a source of low volatility investments for individual investors.
There are two sources of risk in debt security.
Credit risk is the risk that occurs from the possibility of the issuer/borrower not making interest payments. This can happen if the borrower is not financially sound or becomes illiquid for a variety of reasons. Bankruptcy and insolvency are also major sources of credit risk.
The higher the quality of the borrower, the lower is the possibility of credit risk. Hence, good quality borrowers offer low-interest rates. This fact is quite evident if you compare government securities with commercial paper.
Government is considered to be a very credible borrower and can hence raise money at lower interest rates. Commercial papers are often issued by private entities which carry plenty of business risks. Hence, commercial papers offer more interest but are also more prone to credit risk.
Interest rate risk
Interest rate risk is the risk of a price change in the debt-security because of a change in the interest rates set by the central bank. Central banks may increase or decrease interest rates as part of its responsibility for setting a country’s monetary policy. Such changes in interest rates have a deep impact on the money market.
It is a well-known fact that bond yields and prices move in the opposite direction. So, when interest rates drop, the bond prices move up such that the yield falls down. Similarly, when interest rates rise, bond prices fall, and yields move up.
This fall in the price of the debt-security is considered to be an interest rate risk. For investors, interest rate risk can bring in capital gains or capital losses.
Analysing Both Risks against Tenure
Looking at the two risks associated with debt securities, it is fair to assume that the longer the time horizon, the greater the threat of credit risk and interest rate risk. That is because a lot of things can go wrong in a longer time span.
Companies may suffer losses, face black-swan events, or go bankrupt. In the long term, almost all companies will go out of business. So, credit risk increases as the tenure of the debt security increases. That is the reason why longer tenure deposits and commercial papers tend to have a higher interest rate than a shorter duration deposit. This trend holds true in normal cases.
As time goes on, interest rate changes also become more likely. Macroeconomic factors change over time, and the central banks and governments have to adapt their monetary policies accordingly. Hence, the longer the tenure of the debt security, the greater the possibility of interest rate changes and interest rate risks.
As pointed out above, the money market is an exchange market for short-duration debt securities. The duration varies between overnight to one year. Hence, the level of risk in the money market is relatively lower than the risk in the bond market or the stock market. Therefore, a shorter time span means lesser chance of large interest rate changes or companies defaulting on repayments.
Low risk but low return?
There is still a risk in the money market as no investment is risk-free. However, the possibility of the risks playing out is lower when the time duration is compressed. This is the reason why money markets are considered to be “safer” than capital markets. However, there is a trade-off. The low risk is compensated by a lower rate of return as well. Money market securities have some of the lowest interest rates among all debt securities.
For debt securities of durations longer than twelve months, the capital market is the appropriate exchange market. It deals in trading of stocks and bonds. Stocks are one of the riskiest assets historically. However, they also provide the highest returns.
Longer-term deposits and commercial papers also provide higher returns than short-duration debt.
However, commercial papers are risky as the company issuing the paper can default if the business does not go as planned. Those who want returns and are willing to take on higher risk, the stock and bond markets are the right place to go.
All in all, those who want stability and capital preservation can use the money market to find the right securities.