FINANCIAL INSTITUTIONS AND MARKETS
CHAPTER 2 - MONEY MARKET
MEANING OF MONEY MARKET
Money market refers to the market where money and highly liquid marketable securities are bought and sold
having a maturity period of one or less than one year. The money market constitutes a very important segment
of the Indian financial system.
DEFINITION OF MONEY MARKET
According to the Geoffrey, “Money Market is the collective name given to the various firms and institutions
that deal in the various grades of near money.”
FUNCTIONS OF MONEY MARKET
1) Financing Trade:
Money Market plays crucial role in financing both internal as well as international trade. Commercial
finance is made available to the traders through bills of exchange, which are discounted by the bill market.
The acceptance houses and discount markets help in financing foreign trade.
2) Financing Industry:
Money market contributes to the growth of industries in two ways:
a) Money market helps the industries in securing short-term loans to meet their working capital
requirements through the system of finance hills, commercial papers, etc.
b) Industries generally need long-term loans, which are provided in the capital market. However, capital
market depends upon the nature of and the conditions in the money market. The short-term interest
rates of the money market influence the long-term interest rates of the capital market. Thus, money
market indirectly helps the industries through its link with and influence on long-term capital market.
3) Profitable Investment:
Money market enables the commercial banks to use their excess reserves in profitable investment. The
main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity
to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the
commercial banks are invested in near-money assets (example: short-term bills of exchange) which are
highly liquid and can be easily converted into each. Thus, the commercial banks earn profits without
losing liquidity.
4) Self-Sufficiency of Commercial Bank:
Developed money market helps the commercial banks to become self-sufficient. In the situation of
emergency, when the commercial banks have scarcity of funds, they need not approach the central bank
and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their
old short-run loans from the money market.
5) Help to Central Bank:
Though the central bank can function and influence the banking system in the absence of a money market,
the existence of a developed money market smoothens the functioning and increases the efficiency of
Central Bank.
Money market helps the Central Bank in two ways:
a) The short-run interest rates of the money market serve as an indicator of the monetary and banking
conditions in the country and, in this way, guide the central bank to adopt an appropriate banking
policy.
1|Page Notes compiled by Prof Akshaya Pai
b) The sensitive and integrated money market helps the central bank to secure quick and widespread
influence on the sub-markets and thus achieve effective implementation of its policy.
IMPORTANCE OF MONEY MARKET
1) Liquidity Management:
The money market allows financial institutions, corporations, and government entities to manage their
short-term liquidity needs effectively. Participants can easily convert their financial assets into cash by
trading highly liquid money market instruments like Treasury Bills and Certificates of Deposit.
2) Short-term financing:
Businesses and government entities can raise short-term capital quickly and cost effectively through the
issuance of money market instruments like Commercial Paper. This enables them to meet immediate
financial obligations, invest in projects, or bridge temporary cash flow gaps.
3) Risk Management:
The money market provides participants with opportunities to diversify their investment portfolios and
manage risks.
4) Interest rate determination:
Money market interest rates, such as the federal funds rate, serve as benchmarks that influence broader
interest rates in the economy. Central banks often use money market operations to implement monetary
policy and control short-term interest rates, impacting borrowing and lending costs throughout the
financial system.
5) Investment opportunities:
Individual and institutional investors can earn competitive yields on their surplus funds by investing in
money market instruments or money market funds. Money market investments are generally considered
safe, making them attractive options for those seeking stability.
6) Financial system stability:
A well-functioning money market contributes to overall financial system stability by ensuring the
smooth flow of funds and liquidity throughout the banking and financial sectors.
7) Government financing:
Governments can raise funds efficiently by issuing Treasury Bills in the money market, helping them
cover budget deficits and fund essential programs.
STRUCTURE OF MONEY MARKET
The entire money market in India can be divided into two parts. They are:
A. Organized Money Market:
The RBI is the apex institution which controls and monitors all the organizations in the organized sector.
The commercial banks can operate as lenders and operators. The Financial Institutions like IDBI, ICICI
and others operate as lenders. The organized sector of Indian money market is fairly developed and
organized, but it is not comparable to the money markets of developed countries like USA, UK and Japan.
Main components of Organized Money Market:
1. The Call Money:
It is also known as Interbank Call Money Market. Here, lending and borrowing transactions are
carried out for one day. These one-day loans may or may not be renewed the next day. The demand
for call money comes from commercial banks that need to meet requirements of CRR and SLR,
whereas supply comes from commercial banks with excess funds and FIs like IDBI, etc.
2|Page Notes compiled by Prof Akshaya Pai
2. The Treasury Bill Market:
It deals in Treasury Bills of short-term duration: 14 days, 91 days, 182 days and 364 days. They are
issued by Government and largely held by RBI. The treasury bills facilitate the financing of Central
Government temporary deficits. From May 2001, the auction of 14 days and 182 days treasury bills
has been discontinued. At present, there are 91 days and 364 days treasury bills. The rate of interest
for treasury bills is determined by the market, depending on the demand and supply of funds in the
money market.
3. The Commercial Bill Market:
It deals in bills of exchange. A seller draws a bill of exchange on the buyer to make payment within
a certain period of time. The bills can be domestic bills or foreign bills of exchange. The commercial
bills are purchased and discounted by commercial banks and are rediscounted by FIs like EXIM
Bank, SIDBI, IDBI, etc.
4. The Certificate of Deposit Market:
The scheme of Certificate of Deposit (CD) was introduced by RBI in 1989. The main purpose of CD
is to enable the commercial banks to raise funds from the market. The CDs maturity period ranges
from 7 days to 1 year (in case of FIs minimum 1 year and maximum 3 years). The CDs are issued at
a discount to its face value. The CDs are issued in denomination of 1 lakh and thereafter, multiples
of 1 lakh. The holder is entitled to receive a fixed rate of interest and have no lock-in period.
5. The Commercial Paper Market:
The scheme of Commercial Paper (CP) was introduced in 1990. Blue chip companies are for short
term financing issue CPs. As per RBI guidelines, CPs can be issued on the following conditions:
o The minimum tangible net worth of the company to be at least 4 crores.
o The CP receives a minimum rating of A-2 or such other rating from recognized rating agencies
like CRISIL, CARE, ICRA, Fitch Ratings, etc.
o The company has been sanctioned working capital limit by bank/s or all-India FIs.
o The CPs maturity period ranges from 7 days to 1 year. They can be issued in multiples of 5 lakhs
and in multiples thereof. They are sold at a discount to its face value and redeemed at its face
value.
6. Money Market Mutual Funds:
The MMMFs were introduced in 1992. The objective of MMMFs is to provide an additional short-
term avenue to the individual investors. In 1995, RBI modified the scheme to allow private sector
organizations to setup MMMFs. During 1996, the scheme of MMMFs was made more flexible by
bringing it on par with all Mutual Funds by allowing investments by corporate and others. The
scheme has been made more attractive to investors by reducing lock in period from 45 days to 15
days. Resources mobilized from MMMFs are required to be invested in call money, CDs, CPs,
commercial bills, treasury bills and government dated securities having an unexpired maturity of upto
1 year.
B. Unorganized Money Market:
The unorganized money market mostly finances short term financial needs of farmers and small
businessmen. The main components of unorganized Money market are:
1. Indigenous Bankers (IBs):
The IBs are individuals or private firms who receive deposits and give loans and thereby they operate
as banks. Unlike moneylenders who only lend money. IBs accept deposits as well as lend money
They operate mostly in urban areas, especially in western and southern regions of the country. Over
the years, IBs faced stiff competition from cooperative banks and commercial banks. Borrowers are
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small manufacturers and traders, who may not be able to obtain funds from the organized banking
sector, may be due to lack of security or some other reason.
2. Money Lenders (MLs):
MLs are important participants in unorganized money markets in India. There are professional as
well as non-professional MLs. They lend money in rural areas as well as urban areas. They normally
charge an invariably high rate of interest ranging between 15% pa to 50% pa and even more. The
borrowers are mostly poor farmers, artisans, petty traders, manual workers and others who require
short term funds and do not get the same from organized sector.
3. Chit Funds and Nidhis:
They collect funds from the members for the purpose of lending to members (who require funds) for
personal or other purposes. The chit funds lend money to its members by draw of chits or lots,
whereas Nidhis lend money to its members and others.
4. Finance Brokers:
They act as middlemen between lenders and borrowers. They charge commission for their services.
They are found mostly in urban markets, especially in cloth markets and commodity markets.
5. Finance Companies:
They operate throughout the country. They borrow or accept deposits and lend them to others. They
provide funds to small traders and others. They operate like indigenous bankers.
INSTRUMENTS OF MONEY MARKET
1) Treasury bill:
Treasury bills are short-term instruments issued by the Reserve Bank on behalf of the government to tide
over short-term liquidity shortfalls. This instrument is used by the government to raise short-term funds
to bridge seasonal or temporary gaps between its receipt (revenue and capital) and expenditure. They form
the most important segment of the money market not only in India but all over the world as well.
In other words, T-Bills are short term (up to one year) borrowing instruments of the Government of India
which enable investors to park their short-term surplus funds while reducing their market risk.
2) Commercial Papers:
A commercial paper as an unsecured short-term instrument issued by the large banks and corporations
in the form of promissory note, negotiable and transferable by endorsement and delivery with a fixed
maturity period to meet the short-term financial requirement There are four basic kinds of commercial
paper promissory notes, drafts, checks and certificates of deposit.
3) Certificate of Deposits:
Certificates of deposit are unsecured, negotiable, short-term instruments in bearer form, issued by
commercial banks and development financial institutions.
The scheme of Certificates of Deposits (CDs) was introduced by RBI as a step towards deregulation of
interest rates on deposits. Under this scheme, any scheduled commercial banks, co-operative banks
excluding land development banks, can issue certificate of deposits for a period of not less than three
months and up to a period of not more than one year.
4) Repurchase Agreement (Repo):
Repo is a money market instrument, which enables collateralized short term borrowing and lending
through sale/purchase operations in debt instruments. Under a repo transaction, a holder of securities sells
them to an investor with an agreement to repurchase at a predetermined date and rate. It is a temporary
sale of debt involving full transfer of ownership of the securities, that is, the assignment of voting and
financial rights.
4|Page Notes compiled by Prof Akshaya Pai
Repo is also referred to as a ready forward transaction as it is a means of funding by selling a security
held on a spot basis and repurchasing the same on a forward basis Though there is no restriction on the
maximum period for which repos can be undertaken. generally, repos are done for a period not exceeding
14 days. Different instruments can be considered as collateral security for undertaking the ready forward
deals and they include Government dated securities, treasury balls
5) Reserve Repos:
A reverse repo is the mirror image of a repo. For in a reverse repo, securities are acquired with a
simultaneous commitment to resell. Hence whether a transaction is a repo or a reverse repo is determined
only in terms of who initiated the first leg of the transaction. When the reverse repurchase transaction
matures, the counter party returns the security to the entity concerned and receives its cash along with a
profit spread. One factor which encourages an organization to enter into reverse repo is that it earns some
extra income on it, otherwise idle cash.
6) Inter Corporate Deposits (ICD):
An Inter-Corporate Deposit (ICD) is an unsecured borrowing by corporate and FIs from other corporate
entities registered under the Companies Act 1956. The corporate having surplus funds would lend to
another corporate in need of funds. This lending would be an uncollateralized basis and hence a higher
rate of interest would be demanded by the lender The short term credit rating of the corporate would
determine the rate at which the corporate would be able to borrow funds.
PLAYERS OF MONEY MARKET
1) Reserve Bank of India:
The Reserve Bank of India is the most important player in the Indian Money Market The organised money
market comes under the direct regulation of RBI. The RBI operates in the money market is to ensure that
the levels of liquidity and short-term interest rates are maintained at an optimum level so as to facilitate
economic growth and price stability. RBI also plays the role of a merchant banker to the government. It
issues Treasury Bills and other Government Securities to raise funds for the government.
2) Government:
The Government is the most active player and the largest borrower in the money market. It raises funds
to make up the budget deficit. The funds may be raised through the issue of Treasury Bills (with a maturity
period of 91day/182day/364 days) and government securities.
3) Commercial Banks:
Commercial Banks play an important role in the money market. They undertake lending and borrowing
of short-term funds. The collective operations of the banks on a day to day basis are very predominant
and hence have a major impact and influence on the interest rate structure and the liquidity position
4) Financial Institutions:
Financial institutions also deal in the money market They undertake lending and borrowing of short-term
funds. They also lend money to banks by rediscounting Bills of Exchange Since, they transact in large
volumes, they have a significant impact on the money market.
5) Corporate firms:
Corporate firms operate in the money market to raise short-term funds to meet their working capital
requirements. They issue commercial papers with a maturity period of 7 days to 1 year. These papers are
issued at a discount and redeemed at face value on maturity These corporate firms use both organised and
unorganized sectors of money market.
6) Discount Houses and Primary Dealers:
They are the intermediaries in the money market. Discount Houses discount and rediscount commercial
bill and Treasury Bills. Primary Dealers were introduced by RBI for developing an active secondary
market for Government securities. They also underwrite developing Government Securities.
5|Page Notes compiled by Prof Akshaya Pai
7) Money Market Mutual funds:
A money market fund is a mutual fund that invests solely in money market instruments. Money market
funds are generally the safest and most secure of mutual fund investments. The goal of a money-market
fund is to preserve principal while yielding a modest return. Money-market mutual fund is akin to a high
yield bank account but is not entirely risk free. When investing in a money-market fund, attention should
be paid to the interest rate that is being offered.
RECENT TRENDS IN MONEY MARKET
1) Low Interest Rate Environment:
Central banks in various countries, including the US. Federal Reserve, have maintained historically low
interest rates as part of their monetary policy response to the COVID-19 pandemic. This has impacted
money market yields and influenced investment decisions.
2) Digital Payment Systems:
The growth of digital payment systems, including mobile wallets and Unified Payments Interface (UPI),
has transformed the way transactions are conducted in the money market. Digital platforms have gained
popularity due to convenience and contactless transactions.
3) Cash Management Strategies:
With interest rates at low levels, corporations and institutional investors have been focusing on optimizing
their cash management strategies to maintain liquidity while seeking higher yields within the money
market.
4) Shifts in demand for short-term Instruments:
The demand for short-term money market instruments such as Treasury Bills and commercial paper has
been influenced by factors like liquidity needs, market conditions, and changes in investor sentiment.
5) Government Stimulus and Market Liquidity:
Government stimulus packages and liquidity measures by central banks have provided support to money
market during times of market stress, helping to maintain stability and prevent disruption.
6) Investor preference for safety:
The uncertainty caused by the pandemic has led investors to prioritize safety and liquidity in their
investment choices, favoring money market funds and instruments perceived as lower risk.
7) Regulatory Reforms:
Regulatory bodies have continued to monitor and implement reforms in money market segments to
enhance transparency, stability, and investment protection. These reforms aim to prevent a recurrence of
the disruptions seen during the 2008 financial crisis.
8) Short-term funding markets:
Developments in short-term funding markets, such as the repurchase agreement (repo) market, have
implications for liquidity management and financial stability.
9) Global economic recovery:
As economies recover from the pandemic's impact, shifts in economic data, inflation expectations, and
central bank actions can influence money market conditions.
10) Alternative Cash Investments:
Institutional investors have explored alternative cash investment options beyond traditional money market
funds, seeking potential higher yields and diversification.
6|Page Notes compiled by Prof Akshaya Pai
