Money Markets

MONEY MARKETS The Concise Oxford Dictionary defines money as “a current medium of exchange”. This definition, if rather sparse, does detail the essential nature of money: it is a recognized form of exchange for goods and services. It can take many forms: anything which is accepted by the seller, because it has a recognized value which can be used to purchase further goods and services, will suffice as money. The purpose of money is to fulfill the following. It must be accepted as a unit of account and a means of exchange or payment, be durable, scarce, easily dividable, and stable in value. Money that is on account of the Central Bank is the Real Money. All other forms for e.g. the account balances with Commercial Banks, even cash (check out the note by the RBI governor on Indian currency note), are promises to pay money, but not real money. Like individuals, Banks and large institutions also transact amongst each other, lending and borrowing huge amounts of money. In these transactions cash is not involved, real money kept in accounts with the Central Bank will be transacted. Consider this example. IDBI Bank needs to pay SBI Rs.10 Crores balancing figure at the end of the day. This transaction happens by requesting RBI to increase the account balance of SBI by 10 Crores and corresponding decrease in the account balance of IDBI. Now with this the balances or total money with IDBI reduces. But it might be requiring that money for transactions with its other customers. This means a party (IDBI), which wants to borrow money now. There might be another institution that might be having surplus money that it does not require in the near future, say ICICI Bank having surplus money for15 days (the same duration that IDBI wants it for). So we have ICICI loaning IDBI Rs.10 Crores for 15 days at an agreed rate. This was a MONEY MARKET transaction. More specifically, Money Market provides short-term finance (for a period less than 1 year.) The parties involved in Money Markets are Central Bank, Commercial Banks, FIs, Mutual Funds and Primary Dealers. (The extension of Money Market is Capital Market where finance is transacted for a period longer than 1 year, in form of both Debt & Equity) Money Markets exist because of the fundamental need of Working Capital Management where balance between Liquidity and Profitability is paramount. The market provides a conduit for Cash surplus and deficient organizations to transact and reach an equilibrium regarding the cost of funds (interest rates.) The borrowing and lending in money markets is high volume, low risk and short-term. Because it is short-term, transaction costs are high relative to the interest that can be earned. And because transaction costs are high relative to the interest that can be earned, transactions in the money market tend to be for very large amounts. Short-term is generally understood as ‘less than one year’, although, in fact, most money market activity is concentrated in terms to maturity between overnight and one-week. MONEY MARKET INSTRUMENTS Money market borrowing and lending utilizes a variety of different instruments. These include: • •

deposits and loans, repurchase agreements,

and number of securitised debt instruments: •

Treasury bills,

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bankers’ acceptances, commercial paper, and certificates of deposit.

Borrowers in money markets are all high quality names and so the securities issued and traded have low risk, low yield, high liquidity characteristics which are attractive to risk averse lenders In terms of risk Profiles: Treasury Bills, Banker’s Acceptances, CD and CPs range from the lowest to highest risk in that order, being governed by the credit worthiness of party backing it. Consequently, the returns are in inverse order for these instruments. Regular issues of Treasury bills backed by central government have the lowest default risk, creating the deepest market segment of homogeneous, highly liquid paper - with consequently the lowest yield. This is because governments’ are generally assumed to have a very low default risk. Bankers' Acceptances are also very safe investments as they carry the obligation to honour payment by both a corporate and a bank, and in addition, because they usually represent a business transaction with specific underlying goods. Certificates of Deposit, honoured by a single bank, generally trade a few basis points higher, but this can only be a generalisation as the market segment is itself tiered; the range of names issuing resulting in different credit and liquidity premiums. The Commercial Paper segment presents the greatest degree of tiering. Prime grade CP generally trades a few basis points over CDs, but again, some corporates are perceived as being more creditworthy than some banks. Medium grade CP offers the highest yields to attract investors. REPO A repurchase (repo) agreement can be seen as a short term swap between cash and securities. Repurchase agreements, or repos, are specialised but important aspects of many markets, especially those for government securities. In essence, if a security holder wants to maintain his or her long-term position but needs cash for a short period, he or she can enter into a repo contract whereby the securities are sold together with a binding agreement to repurchase them at a future date, usually fairly near-term. The effect is to provide the security holder with a short-term loan based on the collateral of the government securities he or she owns. In major markets with repo systems, it is a cheap, simple and effective way to raise short-term funds.

For banks and large corporates, liquidity management is about getting a fine return on cash, which they may need at short notice. They do this by borrowing and lending between each other using either money market securities or deposits and loans - in what is called the interbank market. When does Banks participate in Money Market: Take Debt – •

When they fall short of statutory Reserve requirements may be due to a change in rates or next 2 points.

• •

When they fall short of funds to meet withdrawal requirements from customers When they fall short of funds to lend at more attractive rates

Loan Debt – •

When they have surplus idle funds.

The major players and their main role in the money market is listed below : Player

Role

Central Bank

Intermediary

Government

Borrowers/Issuers

Banks

Borrowers/Issuers

Discount Houses

Market Makers

Acceptance Houses

Market Makers

Fis

Borrowers/Issuers

MFs

Lenders/Investors

FIIs

Investors

Dealers

Intermediaries

Corporates

Issuers

Role of Government : To increase the stability of Financial Institutions and Markets, Government intervenes in the interest rates and money supply in the Money Markets. Government has several ways to control income and interest rates, which can be divided into two broad groups, fiscal policy and monetary policy. The government to adjust the exchange rate intervenes with the foreign exchange markets; there may be an effect on the monetary base and the supply of money. When the currency is falling, foreign currencies must be sold and the currency must be bought to stabilize its price. The use of deposits of the national currency to do this suggest that the operational deposits of the banking sector must be reduced, causing the monetary base to fall, affecting the supply of money. Conversely, by selling the national currency to reduce its rate, the monetary base will rise. Securities may be sold on the open market in an attempt to dampen the effects of inflows of the national currency, but this would imply an increase in interest rates and cause the currency to rise further still. A number of institutions can affect the supply of money, but the greatest impact on the money supply is had by the central bank and the commercial banks.

Role of Central Bank : •

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Firstly, the central bank could do this by setting a required reserve ratio, which would restrict the ability of the commercial banks to increase the money supply by loaning out money. If this requirement were above the ratio the commercial banks would have wished to have, then the banks will have to create fewer deposits and make fewer loans then they could otherwise have profitably done. If the central bank imposed this requirement in order to reduce the money supply, the commercial banks will probably be unable to borrow from the central bank in order to increase their cash reserves if they wished to make further loans. They might try to attract further deposits from customers by increasing their interest rates, but the central bank may retaliate by increasing the required reserve ratio. The central bank can affect the supply of money through special deposits. These are deposits at the central bank, which the banking sector is required to lodge. These are then frozen, thus preventing the sector from accessing them, although interest is paid at the average treasury bill rate. Making these special deposits reduces the level of the commercial banks’ operational deposits, which forces them to cut back on lending. The supply of money can also be controlled by the central bank by adjusting its interest rate, which it charges when the commercial banks wish to borrow money (the discount rate). Banks usually have a ratio of cash to deposits, which they consider to be the minimum safe level. If demand for cash is such that their reserves fall below this level, they will able to borrow money from the central bank at its discount rate. If market rates were 8%, and the discount rate were also 8%, then the banks could reduce their cash reserves to their minimum ratio, knowing that if demand exceeds supply they will be able to borrow at 8%. The central bank, though, may raise its discount rate to a value above the market level, in order to encourage banks not to reduce their cash reserves to the minimum through excess loans. By raising the discount value to such a level, the commercial banks are given an incentive to hold more reserves, thus reducing the money multiplier and the money supply. Another way the money supply can be affected by the central bank is through its manipulation of the interest rate. This is akin to the discount rate mentioned above. By raising or lowering interest rates, the demand for money is respectively reduced or increased. If it sets them at a certain level, it can clear the market at level by supplying enough money to match the demand. Alternatively, it could fix the money supply at a certain rate and let the market clear the interest rates at the equilibrium. Trying to fix the money supply is not easy, so central banks usually set the interest rate and provide the amount of money the market demands. The central bank may also affect the money supply through operating on the open market. This allows it to manipulate the money supply through the monetary base. It may choose to either buy or sell securities in the marketplace, which will either inject or remove money respectively. Thus, the monetary base will be affected, causing the money supply to alter. To illustrate this, suppose the central bank sold gilts(Risk-free bonds) worth $10 million. $10 million would flow from the deposits of the purchasers to the central bank, taking the $10 million out of the monetary base. To inject money into the economy, the central bank would have to buy the gilts.

Can individual investors invest in Money markets? One of the main differences between the money market and the stock market is that most money market securities trade in very high denominations and so individual investors have limited access to them. The easiest way for individual investors to gain access to the money market is with a money market mutual fund, or sometimes a money market bank account. These accounts

and funds pool together the assets of thousands of investors and buy the money market securities on their behalf. Although, some money market instruments like treasury bills may be purchased directly or through other large financial institutions with direct access to these markets. In summary, Money markets are markets for financing the short term fund requirements of Government, Banks, Corporate and other Financial Institutions. Like any other markets there are intermediaries like Dealers who make transactions possible and easy for these participants. The instruments in the market are to a great extent governed by Central Bank’s policies regarding supply of money, hence inflation, in the economy and the rates of interest. The efficient operation of the markets is very crucial for any developed economy to enable the large institutions get easy access to cheap funds, hence enabling them maintain the important balance between profitability and liquidity.