Money markets

July 27, 2023
10 MIN READ
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Large short-term debt instruments, like overnight reserves or commercial paper, are bought and sold on the money market. A person may participate in the money market by establishing a money market account at a bank, buying a money market mutual fund, or purchasing a Treasury bill. Money market assets are stable and liquid, and each share of a money market fund aims to be worth exactly $1. Although money market accounts' interest rates are greater than traditional savings accounts, they require larger opening deposits and stricter withdrawal policies.

What are money markets?

The phrase "money market" describes the financial market for trading easily convertible assets such as cash and short-term investments. Because of its usefulness in satisfying working capital needs, this market is of special value to organizations and governments. Here, investments are made for shorter periods than on the capital market (one day, three months, a year, etc.). The potential for loss and gain increases as the investment period increases. Thus, the assets traded here are safe and provide little profit potential. Investors in the market are mostly insurance firms, governments, NBFCs, financial institutions, and credit unions because of the significant transaction value in the market. Money market accounts and funds are popular investment vehicles for retail investors. Treasury bills, certificates of deposit (CDS), bills of exchange, etc., are common investment instruments.

The concept of money makers

The money market serves as a crucial component of the international monetary system. Swapping huge sums of money overnight between financial institutions and the United States government is a part of this system. Many business and financial organizations engage in wholesale trades on the money market.

Banking institutions lend to one another, large corporations in the euro currency and time deposit markets, organizations issue commercial paper that other enterprises or funds can purchase, and individual investors buy certificates of deposit from banks as a safe place to park their money for the short term. Many retail investors can access some of these wholesale deals via money market mutual funds and other financial instruments.

Functions of the Central Bank

Central banks such as the Federal Reserve in the United States manage the money supply through the money market and prevent inflation and deflation. The government buys bonds and other assets to combat deflation. It causes a larger amount of cash to enter the economy.

Gains in the money supply result in lower nominal interest rates. The cost of borrowing money corresponds to the nominal interest rates. The central bank repurchases bonds and other securities during inflation. Because of this, money supply contracts and nominal interest rates rise. The move mentioned above by the central bank may be seen in a money market chart.

The role of money markets

The money market plays several roles in international finance.

   i.       It helps the economy expand by providing capital to small businesses and multinational corporations.

   ii.     It encourages self-sufficiency by preventing businesses and financial institutions from having to take out more costly loans due to insufficient reserves.

   iii.   It is a safe location for governments to store money while they figure out how to spend it, helping them facilitate national and international commerce.

   iv.   It presents current banking sector circumstances to help central banks like the Federal Reserve execute appropriate interest rates and monetary policies.

   v.     It preserves a consistent cash flow in the market, which keeps the supply and demand in equilibrium.

Who participates in the money market?

Commercial paper is a common form of borrowing in the wholesale market due to its higher interest rates than bank time deposits and Treasury bills and its wider availability of maturities, ranging from one day to two hundred seventy days. Commercial paper, nevertheless, has a far larger risk of default than bank or government assets.

Private investors may purchase short-term CDs, municipal notes, money market funds, or Treasury bills from the United States to participate in the money market. The money market is accessible to ordinary investors via various channels, such as local banks and the TreasuryDirect website of the United States Federal Reserve. Money market investments may also be made via brokers.

The United States government usually issues Treasury bills on the money market, which have maturities ranging from a few days to a year. They are purchased in bulk by primary dealers from the government for resale to retail investors or further trading. The TreasuryDirect website allows private individuals to purchase these securities without going through a financial intermediary. Short-term notes may be issued by any level of government, not only the federal government.

The key objective of a money market fund is to preserve investor capital at all times by maintaining a $1 net asset value (NAV). The term "break the buck" comes from the fact that investors stand to lose money if the value of their holdings drops below the $1 NAV baseline. Money market funds may still lose money even though this situation occurs relatively seldom since many are not FDIC-insured.

Classifications of money market financial instruments

·       Money market funds

Only corporations and financial organizations that borrow between $5 million and more than $1 billion per trade can participate in the wholesale money market. Individuals may invest in diversified portfolios of these items via mutual funds. The NAV of such funds is expected to remain at $1 at all times. During the economic collapse of 2008, one fund dropped below that level. That caused widespread fear in the markets and a movement from the funds, prompting regulators to tighten up on their ability to invest in risky assets.

·       Money market accounts

Some issuers provide account holders the option of making periodic withdrawals or writing cheques against the account in addition to the interest they earn. Withdrawal restrictions are imposed by federal law. The account is automatically converted to a checking account if certain limits are surpassed. A money market account's interest is normally calculated daily and credited monthly.

Unlike regular savings accounts, money market accounts often provide a little higher interest rate. The disparity between savings and money market accounts used to be much larger than now, but this has been altered significantly since the 2008 financial crisis. The average rate of interest paid on a money market account shifts with the balance. In August of 2021, the highest yearly interest rate provided by a money market account with no minimum deposit was 0.56%. The FDIC in the case of banks and the NCUA in the case of credit unions both provide insurance on money market account balances.

·       Certificates of deposit (CDs)

CDs often have longer periods than money market funds since they may be purchased for up to ten years. However, you may get CDs with only three to six months of maturity. Like money market accounts, savings accounts provide higher interest rates in exchange for larger deposits and longer durations. In August of 2021, 12-month CD rates were around 0.50% to 0.70%, spanning from larger deposits to smaller ones. The interest rate given on a CD does not fluctuate as it does on a money market account. Withdrawing money from a certificate of deposit before the maturity date frequently results in a financial penalty.

·       Bankers' acceptances

The banker accepts an unsecured loan with a limited repayment period and a bank guarantee. A banker's acceptance is similar to a postdated check in that it guarantees payment for products imported from another country. You may purchase and sell banker's acceptances at a discount on a secondary market.

·       Commercial papers (CPs)

Businesses often use commercial papers to meet their short-term working capital requirements, such as acquiring goods or settling outstanding accounts receivable. But they are not secure in any way. Therefore, they will be subordinate to other secured short-term financial instruments in the event of the company's insolvency. Certificates of deposit typically mature after two months. These, like Treasury Bills, are discounted when issued. Therefore there is no interest accrued on the discount.

·       Eurodollars

Because eurodollars are denominated in foreign currency, they are not controlled by the Federal Reserve. The banking systems of the Cayman Islands and the Bahamas are home to enormous Eurodollar deposits. They pay a little more interest rate than the government of the United States debt, so money market funds, international banks, and major businesses invest in them.

·       Repos

Repo is an acronym for repurchase agreement. For instance, Bank 1 may be short on cash, whereas Bank 2 may have a surplus. To sell its assets (especially Treasury Bills), Bank 1 will contract with Bank 2. The necessary cash will be sent to Bank 2. Bank 1 will buy back these assets from Bank 2 on a future date as per the terms of the arrangement. The duration of these measures is brief. Securities may be transferred immediately without any credit risk, and maturities can be anywhere from overnight to one month.

Difference between the money and capital markets

The money market specializes in short-term debt (one year). Investors might expect an average return on their money, while governments and enterprises can maintain a continuous income flow.

Long-term debt and equity securities are the primary focus of the capital market. Capital markets include both the bond and stock markets as a whole. Corporations issue stock to raise money for long-term operations, even though anybody may purchase and sell a stock in seconds. A stock's value may rise and fall, but unlike many money market instruments, it will never become worthless (until the firm goes out of business).

Comparing a savings account to a money market account

In addition to mutual funds, money market accounts are another common option for regular investors to get exposure to this sector. Their prominence may be attributed to their excellent earnings potential and more liquidity than a conventional savings account.

Many financial institutions offer money market accounts; Bank of America, for instance, lures consumers with high-interest rates. Unlike mutual funds, this money is protected thanks to the Federal Deposit Insurance Corporation's (FDIC) insurance.

The average annual percentage yield (APY) for money market accounts below $100,000, according to data from the FDIC, is 0.07%. Minimum deposit and charge restrictions have an impact on earnings. Therefore, switching to a bank with lower minimum deposits and better interest rates increases profits.

The benefits and drawbacks of money markets

Money market investments have their benefits and drawbacks. Due to factors such as FDIC insurance, government or financial institution backing, or the high credibility of the debtors, money market instruments are often regarded as exceptionally low risk. They are also very liquid and can quickly be converted into cash.

Modest-risk investments often offer modest returns, though. Money markets often do not even keep up with inflation, much alone outperforming other asset classes. Moreover, account fees may quickly eat away at already meager profits.

Furthermore, not all money market assets have these benefits. Several are not FDIC-insured, and even the most reliable borrowers have a (small) risk of defaulting. There may be withdrawal limits or minimum balances on certain money market accounts.

Importance of investing in money market funds and accounts

Both money market accounts and mutual funds are often considered very secure, liquid investment options. Several functions of money market accounts and funds include:

·       They cater to unexpected expenses or store an unexpected gain

·       They provide diversity to your investment portfolio

·       They serve as a holding area for money while you look for a more promising investment (one that will increase in value)

Money market instruments may be considered "cash with benefits," giving a modest but constant interest income. They reflect the short-term debt they invest in and are hence quite liquid. Loan terms typically range from one day to one year, making these financial instruments extremely liquid (simple to trade) and very low risk.

Conclusion

Short-term assets and open-ended funds are exchanged between institutions and dealers on the money market, which is a financial market. Liquidity in the market is elevated because most assets can be quickly and readily exchanged for cash. As a result, it facilitates government and commercial efforts to satisfy working cash needs. It entails large-volume exchanges between institutions and dealers at the wholesale level. Traders who invest in mutual funds or establish money market accounts at financial institutions are included.