Money Market

Lecture 8, 9
Money Market is a financial market in which only short-term debt instruments (maturity less
than one year) are traded. MM is for transactions in wholesale short term loans and deposits and
for trading short term financial instruments. Major players in the money market are:

• Central Bank and Government

• Primary Dealers/Market Makers
• Banks
• Non-bank financial Institution
• Money Market Funds & Corporate
• Money Market Brokers

Some of the instruments traded in the money market include Treasury bills, certificates of
deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage-backed
securities and asset-backed securities. Large corporations with short-term cash flow needs can
borrow from the market directly through their dealer, while small companies with excess cash
can borrow through money market mutual funds.

The money market serves the following objectives:

• It provides an equilibrating mechanism for evening out short-term surpluses and deficits.
• It provides a focal point for central bank intervention for influencing liquidity in the
economy.
• It provides reasonable access to users of short-term money to meet their requirements at a
realistic price.

Participants in the Money Market:

1. Central Government

The Central Government is an issuer of Government of India Securities (G-Secs) and Treasury
Bills (T-bills). These instruments are issued to finance the government as well as for managing
the Government’s cash flow. G-Secs are dated (dated securities are those which have specific
maturity and coupon payment dates embedded into the terms of issue) debt obligations of the
Central Government.

These bonds are issued by the RBI, on behalf of the Government, so as to finance the latter’s
budget requirements, deficits and public sector development programmes. These bonds are
issued throughout the financial year. The calendar of issuance of G-Secs is decided at the begin-
ning of every half of the financial year.
T-bills are short-term debt obligations of the Central Government. These are discounted
instruments. These may form part of the budgetary borrowing or be issued for managing the
Government’s cash flow. T-bills allow the government to manage its cash position since revenue
collections are bunched whereas revenue expenditures are dispersed.

2. State Government:

The State Governments issue securities termed as State Development Loans (SDLs), which are
medium to long-term maturity bonds floated to enable State Governments to fund their budget
deficits.

3. Public Sector Undertakings:

Public Sector Undertakings (PSUs) issue bonds which are medium to long-term coupon bearing
debt securities. PSU Bonds can be of two types: taxable and tax-free bonds. These bonds are
issued to finance the working capital requirements and long-term projects of public sector
undertakings. PSUs can also issue Commercial Paper to finance their working capital
requirements.

Like any other business organization, PSUs generate large cash surpluses. Such PSUs are active
investors in instruments like Fixed Deposits, Certificates of Deposits and Treasury Bills. Some
of the PSUs with long-term cash surpluses are also active investors in G-Secs and bonds.

4. Scheduled Commercial Banks (SCBs):

Banks issue Certificate of Deposit (CDs) which are unsecured, negotiable instruments. These are
usually issued at a discount to face value. They are issued in periods when bank deposits
volumes are low and banks perceive that they can get funds at low interest rates. Their period of
issue ranges from 7 days to 1 year.

SCBs also participate in the overnight (call) and term markets. They can participate both as
lenders and borrowers in the call and term markets. These banks use these funds in their day-to-
day and short-term liquidity management. Call money is an important tool to manage CRR
commitments.

Banks invest in Government securities to maintain their Statutory Liquidity Ratio (SLR), as well
as to invest their surplus funds. Therefore, banks have both mandated and surplus investments in
G-Sec instruments. Currently banks have been mandated to hold 25% of their Net Demand and
Time Liabilities (NDTL) as SLR. A bulk of the SLR is met by investments in Government and
other approved securities.

Banks participate in PSU bond market as investors of surplus funds. Banks also take a trading
position in the G-Sec and PSU Bond market to take advantage of rate volatility.
Banks also participate in the foreign exchange market and derivative market. These two markets
may be accessed both for covering the merchant transactions or for risk management purposes.
Banks account for the largest share of these markets.

5. Private Sector Companies:

Private Sector Companies issue commercial papers (CPs) and corporate debentures. CPs are
short-term, negotiable, discounted debt instruments. They are issued in the form of unsecured
promissory notes. They are issued when corporations want to raise their short-term capital
directly from the market instead of borrowing from banks.

Corporate debentures are coupon bearing, medium to long term instruments which are issued by
corporations when they want to access loans to finance projects and working capital require-
ments. Corporate debentures can be issued as fully or partly convertible into shares of the issuing
corporation.

Bonds which do not have convertibility clause are known as non-convertible bonds. These bonds
can be issued with fixed or floating interest rates. Depending on the stipulated availability of
security these bonds could be classified as secured or unsecured.

Private Sector Companies with cash surpluses are active investors in instruments like Fixed
Deposits, Certificates of Deposit and Treasury Bills. Some of these companies with active
treasuries are also active participants in the G-Sec and other debt markets.

6. Provident Funds:

Provident funds have short term and long term surplus funds. They invest their funds in debt
instruments according to their internal guidelines as to how much they can invest in each
instrument category.

Functions of the Money Market

The money market contributes to the economic stability and development of a country by
providing short-term liquidity to governments, commercial banks, and other large organizations.
Investors with excess money that they do not need can invest it in the money market and earn
interest.

Here are the main functions of the money market:

1. Financing Trade

The money market provides financing to local and international traders who are in urgent need of
short-term funds. It provides a facility to discount bills of exchange, and this provides immediate
financing to pay for goods and services.

International traders benefit from the acceptance houses and discount markets. The money
market also makes funds available for other units of the economy, such as agriculture and small-
scale industries.

2. Central Bank Policies

The central bank is responsible for guiding the monetary policy of a country and taking measures
to ensure a healthy financial system. Through the money market, the central bank can perform its
policy-making function efficiently.

For example, the short-term interest rates in the money market represent the prevailing
conditions in the banking industry and can guide the central bank in developing an appropriate
interest rate policy.

3. Growth of Industries

The money market provides an easy avenue where businesses can obtain short-term loans to
finance their working capital needs. Due to the large volume of transactions, businesses may
experience cash shortages related to buying raw materials, paying employees, or meeting other
short-term expenses.

Through commercial paper and finance bills, they can easily borrow money on a short-term
basis. Although money markets do not provide long-term loans, it influences the capital market
and can also help businesses obtain long-term financing. The capital market benchmarks its
interest rates based on the prevailing interest rate in the money market.

4. Commercial Banks Self-Sufficiency

The money market provides commercial banks with a ready market where they can invest their
excess reserves and earn interest while maintaining liquidity. Short-term investments, such as
bills of exchange, can easily be converted to cash to support customer withdrawals.

Also, when faced with liquidity problems, they can borrow from the money market on a short-
term basis as an alternative to borrowing from the central bank. The advantage of this is that the
money market may charge lower interest rates on short-term loans than the central bank typically
does.
Types of Instruments Traded in the Money Market

Several financial instruments are created for short-term lending and borrowing in the money
market. They include:

1. Treasury Bills

Treasury bills are considered the safest instruments since they are issued with a full guarantee by
the United States government. They are issued by the U.S. Treasury regularly to refinance
Treasury bills reaching maturity and to finance the federal government’s deficits. They come
with a maturity of one, three, six, or twelve months.

Treasury bills are sold at a discount to their face value, and the difference between the
discounted purchase price and face value represents the interest rate. They are purchased by
banks, broker-dealers, individual investors, pension funds, insurance companies, and other large
institutions.

2. Certificate of Deposit (CD)

A certificate of deposit (CD) is issued directly by a commercial bank, but it can be purchased
through brokerage firms. It comes with a maturity date ranging from three months to five years
and can be issued in any denomination.

Most CDs offer a fixed maturity date and interest rate, and they attract a penalty for withdrawing
prior to the time of maturity. Just like a bank’s checking account, a certificate of deposit is
insured by the Federal Deposit Insurance Corporation (FDIC).

3. Commercial Paper

Commercial paper is an unsecured loan issued by large institutions or corporations to finance

short-term cash flow needs, such as inventory and accounts payables. It is issued at a discount,
with the difference between the price and face value of the commercial paper being the profit to
the investor.

Only institutions with a high credit rating can issue commercial paper, and it is therefore
considered a safe investment. Commercial paper is issued in denominations of $100,000 and
above. Individual investors can invest in the commercial paper market indirectly through money
market funds. Commercial paper comes with a maturity date between one month and nine
months.

4. Banker’s Acceptance

A banker’s acceptance is a form of short-term debt that is issued by a firm but guaranteed by a
bank. It is created by a drawer, providing the bearer the rights to the money indicated on its face
at a specified date. It is often used in international trade because of the benefits to both the
drawer and the bearer.
The holder of the acceptance may decide to sell it on a secondary market, and investors can
profit from the short-term investment. The maturity date usually lies between one month and six
months from the issuing date.

5. Repurchase Agreements

A repurchase agreement (repo) is a short-term form of borrowing that involves selling a security
with an agreement to repurchase it at a higher price at a later date. It is commonly used by
dealers in government securities who sell Treasury bills to a lender and agree to repurchase them
at an agreed price at a later date.

The Federal Reserve buys repurchase agreements as a way of regulating the money supply and
bank reserves. The agreements’ date of maturity ranges from overnight to 30 days or more.