MONEY MARKETS

The Concise Oxford Dictionary defines money as “a current medium of exchange”. This definition,
if rather sparse, does detail the essential nature of money: it is a recognized form of exchange for
goods and services. It can take many forms: anything which is accepted by the seller, because it
has a recognized value which can be used to purchase further goods and services, will suffice as
money. The purpose of money is to fulfill the following. It must be accepted as a unit of account
and a means of exchange or payment, be durable, scarce, easily dividable, and stable in value.

Money that is on account of the Central Bank is the Real Money. All other forms for e.g. the
account balances with Commercial Banks, even cash (check out the note by the RBI governor on
Indian currency note), are promises to pay money, but not real money. Like individuals, Banks
and large institutions also transact amongst each other, lending and borrowing huge amounts of
money. In these transactions cash is not involved, real money kept in accounts with the Central
Bank will be transacted.

Consider this example. IDBI Bank needs to pay SBI Rs.10 Crores balancing figure at the end of
the day. This transaction happens by requesting RBI to increase the account balance of SBI by
10 Crores and corresponding decrease in the account balance of IDBI. Now with this the
balances or total money with IDBI reduces. But it might be requiring that money for transactions
with its other customers. This means a party (IDBI), which wants to borrow money now. There
might be another institution that might be having surplus money that it does not require in the
near future, say ICICI Bank having surplus money for15 days (the same duration that IDBI wants
it for). So we have ICICI loaning IDBI Rs.10 Crores for 15 days at an agreed rate. This was a
MONEY MARKET transaction.

More specifically, Money Market provides short-term finance (for a period less than 1 year.) The
parties involved in Money Markets are Central Bank, Commercial Banks, FIs, Mutual Funds and
Primary Dealers. (The extension of Money Market is Capital Market where finance is transacted
for a period longer than 1 year, in form of both Debt & Equity)

Money Markets exist because of the fundamental need of Working Capital Management where
balance between Liquidity and Profitability is paramount. The market provides a conduit for Cash
surplus and deficient organizations to transact and reach an equilibrium regarding the cost of
funds (interest rates.)

The borrowing and lending in money markets is high volume, low risk and short-term. Because it
is short-term, transaction costs are high relative to the interest that can be earned. And because
transaction costs are high relative to the interest that can be earned, transactions in the money
market tend to be for very large amounts. Short-term is generally understood as ‘less than one
year’, although, in fact, most money market activity is concentrated in terms to maturity between
overnight and one-week.

MONEY MARKET INSTRUMENTS

Money market borrowing and lending utilizes a variety of different instruments. These include:

• deposits and loans,

and number of securitised debt instruments:

• Treasury bills,
 • bankers’ acceptances,
• commercial paper, and
• certificates of deposit.

Borrowers in money markets are all high quality names and so the securities issued and traded
have low risk, low yield, high liquidity characteristics which are attractive to risk averse lenders

In terms of risk Profiles: Treasury Bills, Banker’s Acceptances, CD and CPs range from the
lowest to highest risk in that order, being governed by the credit worthiness of party backing it.
Consequently, the returns are in inverse order for these instruments.

Regular issues of Treasury bills backed by central government have the lowest default risk,
creating the deepest market segment of homogeneous, highly liquid paper - with consequently
the lowest yield. This is because governments’ are generally assumed to have a very low default
risk.

Bankers' Acceptances are also very safe investments as they carry the obligation to honour
payment by both a corporate and a bank, and in addition, because they usually represent a
business transaction with specific underlying goods.

Certificates of Deposit, honoured by a single bank, generally trade a few basis points higher, but
this can only be a generalisation as the market segment is itself tiered; the range of names
issuing resulting in different credit and liquidity premiums.

The Commercial Paper segment presents the greatest degree of tiering. Prime grade CP
generally trades a few basis points over CDs, but again, some corporates are perceived as being
more creditworthy than some banks. Medium grade CP offers the highest yields to attract
investors.

REPO

A repurchase (repo) agreement can be seen as a short term swap between cash and securities.
Repurchase agreements, or repos, are specialised but important aspects of many markets,
especially those for government securities. In essence, if a security holder wants to maintain his
or her long-term position but needs cash for a short period, he or she can enter into a repo
contract whereby the securities are sold together with a binding agreement to repurchase them at
a future date, usually fairly near-term. The effect is to provide the security holder with a short-term
loan based on the collateral of the government securities he or she owns. In major markets with
repo systems, it is a cheap, simple and effective way to raise short-term funds.

For banks and large corporates, liquidity management is about getting a fine return on cash,
which they may need at short notice. They do this by borrowing and lending between each other -
using either money market securities or deposits and loans - in what is called the interbank
market.

When does Banks participate in Money Market:

Take Debt –

• When they fall short of statutory Reserve requirements may be due to a change in rates
or next 2 points.
 • When they fall short of funds to meet withdrawal requirements from customers
• When they fall short of funds to lend at more attractive rates

Loan Debt –

• When they have surplus idle funds.

The major players and their main role in the money market is listed below :

Player Role

Central Bank Intermediary

Government Borrowers/Issuers

Banks Borrowers/Issuers

Discount Houses Market Makers

Acceptance Houses Market Makers

Fis Borrowers/Issuers

MFs Lenders/Investors

FIIs Investors

Dealers Intermediaries

Corporates Issuers

Role of Government :

To increase the stability of Financial Institutions and Markets, Government intervenes in the
interest rates and money supply in the Money Markets. Government has several ways to control
income and interest rates, which can be divided into two broad groups, fiscal policy and monetary
policy. The government to adjust the exchange rate intervenes with the foreign exchange
markets; there may be an effect on the monetary base and the supply of money. When the
currency is falling, foreign currencies must be sold and the currency must be bought to stabilize
its price. The use of deposits of the national currency to do this suggest that the operational
deposits of the banking sector must be reduced, causing the monetary base to fall, affecting the
supply of money. Conversely, by selling the national currency to reduce its rate, the monetary
base will rise. Securities may be sold on the open market in an attempt to dampen the effects of
inflows of the national currency, but this would imply an increase in interest rates and cause the
currency to rise further still.

A number of institutions can affect the supply of money, but the greatest impact on the money
supply is had by the central bank and the commercial banks.
Role of Central Bank :

• Firstly, the central bank could do this by setting a required reserve ratio, which would
restrict the ability of the commercial banks to increase the money supply by loaning out
money. If this requirement were above the ratio the commercial banks would have
wished to have, then the banks will have to create fewer deposits and make fewer loans
then they could otherwise have profitably done. If the central bank imposed this
requirement in order to reduce the money supply, the commercial banks will probably be
unable to borrow from the central bank in order to increase their cash reserves if they
wished to make further loans. They might try to attract further deposits from customers by
increasing their interest rates, but the central bank may retaliate by increasing the
required reserve ratio.
• The central bank can affect the supply of money through special deposits. These are
deposits at the central bank, which the banking sector is required to lodge. These are
then frozen, thus preventing the sector from accessing them, although interest is paid at
the average treasury bill rate. Making these special deposits reduces the level of the
commercial banks’ operational deposits, which forces them to cut back on lending.
• The supply of money can also be controlled by the central bank by adjusting its interest
rate, which it charges when the commercial banks wish to borrow money (the discount
rate). Banks usually have a ratio of cash to deposits, which they consider to be the
minimum safe level. If demand for cash is such that their reserves fall below this level,
they will able to borrow money from the central bank at its discount rate. If market rates
were 8%, and the discount rate were also 8%, then the banks could reduce their cash
reserves to their minimum ratio, knowing that if demand exceeds supply they will be able
to borrow at 8%. The central bank, though, may raise its discount rate to a value above
the market level, in order to encourage banks not to reduce their cash reserves to the
minimum through excess loans. By raising the discount value to such a level, the
commercial banks are given an incentive to hold more reserves, thus reducing the money
multiplier and the money supply.
• Another way the money supply can be affected by the central bank is through its
manipulation of the interest rate. This is akin to the discount rate mentioned above. By
raising or lowering interest rates, the demand for money is respectively reduced or
increased. If it sets them at a certain level, it can clear the market at level by supplying
enough money to match the demand. Alternatively, it could fix the money supply at a
certain rate and let the market clear the interest rates at the equilibrium. Trying to fix the
money supply is not easy, so central banks usually set the interest rate and provide the
amount of money the market demands.
• The central bank may also affect the money supply through operating on the open
market. This allows it to manipulate the money supply through the monetary base. It may
choose to either buy or sell securities in the marketplace, which will either inject or
remove money respectively. Thus, the monetary base will be affected, causing the
money supply to alter. To illustrate this, suppose the central bank sold gilts(Risk-free
bonds) worth $10 million. $10 million would flow from the deposits of the purchasers to
the central bank, taking the $10 million out of the monetary base. To inject money into the
economy, the central bank would have to buy the gilts.

Can individual investors invest in Money markets?

One of the main differences between the money market and the stock market is that most money
market securities trade in very high denominations and so individual investors have limited
access to them. The easiest way for individual investors to gain access to the money market is
with a money market mutual fund, or sometimes a money market bank account. These accounts
and funds pool together the assets of thousands of investors and buy the money market
securities on their behalf. Although, some money market instruments like treasury bills may be
purchased directly or through other large financial institutions with direct access to these markets.

In summary, Money markets are markets for financing the short term fund requirements of
Government, Banks, Corporate and other Financial Institutions. Like any other markets there are
intermediaries like Dealers who make transactions possible and easy for these participants. The
instruments in the market are to a great extent governed by Central Bank’s policies regarding
supply of money, hence inflation, in the economy and the rates of interest. The efficient operation
of the markets is very crucial for any developed economy to enable the large institutions get easy
access to cheap funds, hence enabling them maintain the important balance between profitability
and liquidity.