Money Market Definition Instruments Rates How It Works

Money Market Definition

Investments here fall under the range of a day to a year, with the risks and gains both being low.

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Key Takeaways

Money Market refers to the financial segment for the trade of liquid and short-term assets that can be easily converted into cash. Businesses and governments particularly benefit from this market as it helps in meeting their working capital requirements.Unlike a capital market where long-term securities are exchanged, here the trades investments range from a day, three months, 365 days, etc.Longer the period of investment, higher the risk and gains. As such, the assets traded here come with low risk and gains.Due to high transaction value, market investors are largely insurance companies, governments, NBFCs, banks, credit institutions, etc. Retail investors invest using money market funds and accounts.Popular investment instruments include treasury bills, certificate of depositCertificate Of DepositA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period.read more (CDS,) bills of exchangeBills Of ExchangeBills of exchange are negotiable instruments that contain an order to pay a certain amount to a particular person within a stipulated period of time. The bill of exchange is issued by the creditor to the debtor when the debtor owes money for goods or services.read more, etc.

Money Market Explained

A money market provides easily available cash to businesses, institutions and governments for day-to-day operations. For example, businesses borrow short-term loansShort-term LoansShort-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements.read more available in the market to fulfill daily business needs such as uninterrupted electricity, timely wage payments, etc.

In 2020, the US money market assets grew to $4.77 trillion, which throws light on the massive role the market plays in keeping liquidity in the economy. The trading instruments are open market funds and short-term securities that come with high liquidity. As such, assets can be easily converted into cash.

Moreover, the tenure of investments ranges from a day to a year, usually not more than 365 days. Since investments with longer tenure earn better, the assets traded here have low risks and gains. Thus, money markets differ from capital marketsCapital MarketsA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets.read more where long term securities trade, and rates, risks and returns are high.

Besides, the high-value transactions make it difficult for retail investors to supply funds. The predominant market investors are insurance companies, governments, NBFCs, banks, and credit institutions, among others. Retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more can invest their savings through the indirect route of mutual funds and specialized banking accounts.

Role of Central Bank

Central banks like the US Federal Reserve control the supply of money and curtail inflationInflationThe rise in prices of goods and services is referred to as inflation. One of the measures of inflation is the consumer price index (CPI). Rate of inflation = (CPIx+1–CPIx )/CPIx. Where CPIx is the consumer price index of the initial year, CPIx+1 is the consumer price index of the following year.read more/deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more using the money market. To tackle deflation, the central bank buys bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more and securities. As a result, more money is pumped into the economy.

When the money supply increases, nominal interest ratesNominal Interest RatesNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans.read more fall. The nominal interest rates can be understood as the cost of borrowed money. In inflation, the central bank buys back bonds and securities. As a result, it reduces the supply of money in the economy, pushing up the nominal interest rates. A money market graph depicts the above action of the central bank.

Money Market Functions

Types of Money Market Instruments

#1 – Call Money

Call money is one of the most liquid instruments. The validity is generally one working day. Banks can face shortfalls that can be solved by borrowing through call money. In contrast, those with surplus cash can invest in other banks through call money.

Call money work as statutory reserves, the minimum cash balance which banks must hold as part of the central bank’s mandate to ensure enough liquid cash for daily operations. The investment is available to other financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more as well. Borrowing and lending take place at the call rate. With no organized market, the transactions generally occur using phone calls/emails/faxes.

#2 – Treasury Bills

T-billsT-billsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more are issued by a country’s central bank on behalf of its government. The government often raises funds through Treasury Bills that provide quick money. In the money market, it is considered one of the safest investments due to the government backing. They don’t offer an interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more.

T-bills are issued at a discount and redeemed at par, with the investor pocketing the difference as profit. The tenure of T-bills is generally from 14 days to 364 days.

#3 – Commercial Papers (CPs)

Companies generally use commercial papers to fund their short-term working capital needs, such as payment of accounts receivables, inventory purchases, etc. However, these are unsecured in nature. As such, in case of liquidation of the company, they will not have priority against other secured financial short-term instruments.

CPs come with an average maturity of two odd months. However, just like the Treasury Bills, these are also issued at a discount, and therefore, they don’t come with separate interests.

#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 depositsTime DepositsTime deposit, also known as term deposit, refers to the deposit account with fixed maturity and interest rate.read more, CDs also have a fixed maturity date and cannot be withdrawn before maturity. This acts as a major disadvantage for the instrument.

#5 – Repos

Repo is a repurchase agreement with repo as its abbreviation. For example, Bank A in need of funds, with Bank B having surplus funds. Bank A will enter into an agreement with Bank B to sell its securities (mostly Treasury Bills). Bank B will receive the required funds. However, on a fixed date in future, the Bank A will repurchase these securities from Bank B as part of the agreement.

These are very short-term in nature. Tenure ranges from overnight to a month, while the securities can be directly transferred without the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more.

Money Market Funds

Retail investors can gain indirect access to this market through money market fundsMoney Market FundsA money market fund is a form of short-term debt security or open-ended mutual fund with a shorter maturity, offering good returns at high liquidity and low credit risk. The instruments it invests in include US Treasury bills, bank debt funds, and corporate commercial papers that could be taxable or free from tax.read more which are mutual funds with a portfolio of liquid instruments. The portfolio usually contains a mix of CDs, treasury bills, commercial paperCommercial PaperCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note.read more, etc. It offers high liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, short-tenure and low risk.

Retail investors can buy and sell units of the mutual fund at the prevailing NAVNAVNet Asset Value is calculated by subtracting the total value of the entity’s liabilities from the total value of its assets and dividing the result by the total number of outstanding shares.read more through the mutual fund market, a part of the capital market. Regulators are trying to develop mechanisms to ensure the resilience of this sector as the pandemic exposed many of its vulnerabilities.

Money Market Account Vs Savings Account

Aside from mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more, retail investors also invest in this market using a money market account, a hybrid of a current and savings account. Their popularity has emerged from better earnings and withdrawal flexibility than a traditional savings account.

Many banks provide money market accounts; for example, the Bank of America offers high interest in banking rewards to the customers. In addition, the money is insured with Federal Deposit Insurance Corporation (FDIC), giving it safety compared to mutual funds.

As per a report from the FDIC, the average rate or APY on money market accounts under $100000 is 0.07%. The earnings are affected by minimum deposit and fee requirements. As such, finding a bank with better rates and fewer monetary requirements can enhance the earnings.