Where Firms Go For Cash - Ins and Outs of the Money Markets
What are money markets and what do they do?
The term “money market” refers to the network of corporations, financial institutions, investors and governments which deal with the flow of short-term capital.
When a business needs cash for a couple of months until a big payment arrives, or when a bank wants to invest money to depositors may withdraw at any moment, or when a government tries to meet its payroll in the face of big seasonal fluctuations in tax receipts, the short-term liquidity transactions occur in the money markets.
The money markets facilitate the buying and selling of debt instruments maturing in one year or less. The money markets are also related to the bond markets, in which corporations and governments borrow and lend based on longer-term contracts.
What is the difference between money markets and bond markets? Whilst they are similar, bond issuers typically raise money to finance investment that will generate profits - or in the case of governments for public benefits. On the other hand, issuers of money-market instruments are usually more concerned with cash management or with financing their portfolios of financial assets.
The money markets, in a sense, attach a price to liquidity, the availability of money for immediate investment.
Why the Money Markets Exist
Up until the 1980’s, commercial banks were the go-to for lending and borrowing capital. Savers and investors could keep their assets on deposit, but usually received no or very little interest rates. Borrowers could also draw on the banks for capital which came with comparatively high interest rates.
However starting in the 1980’s, financial deregulation, change of legislation and the continued ease of moving money electronically caused banks to lose market share the borrowing/lending business. This then paved the way for investors to have the ability to park their capital within investment companies, typically getting a higher interest rate than what commercial banks offer.
Borrowers also were able to raise capital at more competitive rates than banks, avoiding negotiating on bank loans.
Essentially, the money markets became a mechanism that brings borrowers and investors together without the comparatively costly intermediation of banks.
Investing in the money markets
Investors aren’t normally interested in short-term money-market instruments, as evaluating the financial status of a borrower can be costly in time and money - typically outweighing the benefits of owning that security for 3 months for example.
Money market instruments are normally purchased through money-market funds whose job is to use their resources to quickly and effectively evaluate individual securities.
Money Market Funds - pools a number of money-market securities, allowing investors to diversify risk amongst various company and government securities held by the fund. There are retail money market funds for individual investors, and institutional money market funds for corporations, government agencies and other large investors. By law, the funds are only permitted to invest in cash equivalents.
Investing in a money market fund is way more attractive than investing in individual securities or lending to banks for three main reasons:
- To diversify risk amongst a large number of debt securities
- To save investors time and money doing research on individual securities
- Fees associated with purchasing or selling money market funds are comparatively lower than banks
Sweep Accounts - investors with large assets often invest in money-markets using sweep accounts. These are special bank accounts offered by banks and stockbrokerage firms that can still be used to pay bills, invest in shares or buy mutual funds, but any uninvested cash laying around is automatically “swept” into money market funds. This ensures investors earning the highest possible returns.
It is also common for most institutional investors to invest in money-market funds such as big banks, pension funds and insurance companies.
Types of Money Market Instruments
Commercial Paper - Short term debt obligation of a private-sector firm or a government-sponsored corporation. Typically they have a maturity of greater than 90 days but less than 9 months. It’s main advantage was that it allowed financially sound companies to meet their short term financing needs at lower rates than those typically offered at banks.
Banker’s Acceptances - an acceptance is a promissory note issued by a non-financial firm to a bank in return for a loan. The bank resells the note in the money market at a discount and guarantees payment. Acceptances usually have a maturity of less than six months.
In these cases because the bank resells the note, the investor relies on the strength of the guarantor bank rather than of the issuing company, which in some cases can lead to higher security.
Treasury Bills - securities with a maturity of one year or less, issued by national governments. They are considered the safest of all possible investments in that currency.
Local Government & Government Agency Notes - state, provincial or local governments such as school authorities or transport commissions can issue debt, only with the approval of national authorities. National government agencies and government-sponsored corporations are also heavy borrowers in the money markets.
Interbank Loans - Loans extended from one bank to another, where they have no particular affiliation.
Time Deposit - interest bearing bank deposits that cannot be withdrawn until maturity without penalty.
How Trading Occurs in the Money Markets
The money markets do not exist in a particular place or operate according to a single set of rules, nor do they offer a single set of posted prices with one current interest rate for money. Rather, it is a free market of borrowers and lenders all linked by telephones and computers.
Businesses and government agencies invest any unneeded cash as safely and as profitable and when necessary, borrow at the lowest possible cost. The constant soundings among these diverse players for the best available rate at a particular moment are the force that keeps the money markets competitive.
How the trades work is that when a borrow and lender are ready to make a transaction, they sign a contract with one another or with a central clearing house, committing themselves to complete the transactions on the terms agreed.
When the trade occurs, one of the parties is responsible for reporting the even electronically to the clearing house, in which the clearing house settles the trade by debiting the account of the lender and crediting the account of the borrower.
The clearing house acts as a safeguard for counterparty risk - the risk that the parties to a transaction might not live up to their obligations.
Short Term Interest Rates in the Money Markets
Borrowers in the money markets pay interest for the use of the money they have borrowed. This interest rate is depicted by market conditions at that particular point in time. Some issuers also offer fixed rates, and some are adjustable which also adjust to the market conditions at that point in time.
Because the time to maturity for money market instruments are so short, investors typically aren’t paid out interest periodically. Instead, when a lender decides to enter the money market, they pay a discounted rate of the face value, and at maturity they are paid back the face value. The returns lie in the difference of the discounted amount, and the face value amount.