Money Market Functions, Features, and Examples

From the definition above, we can see that the money market has to do with the sale and purchase of large volumes of very short-term products which include overnight reserves and commercial paper. The debt securities are highly liquid, very safe, and short-term. Because of their features, they are oftentimes seen as cash equivalents that are interchangeable for cash at short notice.

The money market is therefore an organized exchange market that provides a forum for participants to lend and borrow short-term and high-quality debt securities that have an average maturity of a year or less. Here, governments, banks, and other large institutions are able to sell short-term securities in order to fund their short-term cash flow needs. Also, through the money market, individual investors can invest small amounts of money in a low-risk setting.

Some of the instruments that are being traded in the money market include certificates of deposit, commercial paper, treasury bills, bills of exchange, and short-term mortgage-backed securities as well as asset-backed securities.

Large corporations that have short-term cash flow needs can borrow directly from the money market through their dealer whereas small companies with excess cash can borrow through money market mutual funds.

Individual investors who desire to profit from the money market can invest through their money market account or a money market mutual fund. A money market mutual fund is a fund, professionally managed that buys money market securities on behalf of individual investors.

The money market is a crucial element for the smooth functioning of the modern financial economy. Here, savers are allowed to lend money to those in need of short-term loans and allocate capital to its most productive use. It helps to facilitate the economic stability and development of a country through the provision of short-term liquidity to governments, commercial banks, and other large organizations. Investors that have excess money that they do not need can invest it in the money market and earn interest.

Features of money market instruments

1. High liquidity
2. Secured investment
3. Fixed returns
4. Short-term

High liquidity

High liquidity is one of the key features of money market securities. This is because they generate fixed income for the investor and the fact that the maturity is short-term makes them highly liquid. This attribute makes money market instruments to be considered close substitutes for money.

Secure investment

The financial instruments form one of the most secure avenues for investment available in the market. As a result of the fact that issuers of money market instruments have a high credit rating and the returns are fixed beforehand, the risk of losing capital is very low.

Fixed returns

Because money market instruments are being offered at a discount to the face value, the amount that the investor gets upon maturity is being decided in advance. This is effectively helpful to individuals in choosing the instrument that will suit their needs and investment horizon.

Short-term

The securities are short-term, that is, they last for a year or less.

Functions of the Money Market

1. Financing trade
2. Suitable monetary policy formulation
3. Industrial growth
4. Commercial banks self-sufficiency
5. Capital market development
6. Non-inflationary source of finance for government

The functions of the money market are explained below.

Financing trade

The money market provides funds to both local and international traders who urgently need short-term financing for their working capital requirements. A facility is being provided to discount bills of exchange thereby providing immediate funds to pay for goods and services. International traders derive benefits from acceptance houses and discount markets. Through the money market, funds are also available for other units of the economy including agriculture and small-scale industries. Public and private institutions are not left out as they can access funds also. With this, the development of commerce, trade, and industry within and outside the country is being facilitated.

Suitable monetary policy formulation

Conditions that prevail in the money market serve as a true indicator of an economy’s monetary state. Because of this, it serves as a guide to the government in the formulation and revision of the monetary policy then and there which is dependent upon the prevailing monetary conditions in the market.

The responsibility for guiding the monetary policy of a country as well as taking measures to ensure a healthy financial system is vested in the central bank. It is through the money market that the central bank is able to perform its policy-making function efficiently.

For example, the short-term interest rates in the money market are a representation of the prevailing conditions in the banking industry. This can help in guiding the central bank in developing an appropriate interest rate policy. Also, the integrated money markets are helpful to the central bank in the course of influencing the sub-markets and implementing its monetary policy objectives.

Industrial growth

Through the money market, an easy avenue is being provided where businesses can obtain short-term loans to finance their working capital needs. Businesses have the tendency of experiencing cash shortages related to buying raw materials, paying employees, or meeting other short-term expenses due to the large volume of transactions. It becomes easy for these businesses to borrow money on a short-term basis through commercial paper and finance bills.

Although money markets do not make provisions for long-term loans, it influences the capital market and can in turn help businesses obtain long-term financing. The capital market benchmarks its interest rates on the basis of the prevailing interest rate in the money market.

Commercial banks self-sufficiency

Through the money market, commercial banks are provided with a ready market where they can invest their excess reserves as well as earn interest while maintaining liquidity. Short-term investments such as the various types of bills of exchange are easily convertible to cash to support customer withdrawals.

In essence, commercial banks are being provided with facilities for temporarily employing their surplus funds in assets that are easily realizable. In times of need, the banks can get back funds quickly by resorting to the money market. By economizing on their cash balances in hand, commercial banks gain immensely as they can meet the demand for large withdrawals of their depositors. The money market also enables commercial banks to meet their statutory requirements of cash reserve ratio (CRR) as well as Statutory Liquidity Ratio (SLR) by utilizing the money market mechanism.

Capital market development

The short-term interest rates and prevailing conditions in the money market influence the long-term interest and the mobilization of resources in the capital market. Hence, the development of capital is dependent upon the existence of development of the money market.

Non-Inflationary source of finance for government

Through a developed money market, the government is able to raise short-term funds through treasury bills floated in the market. If a developed money market is absent in a country, the government will be forced to print and issue more money or borrow from the central bank. Either way, bring about an increase in prices and a consequent inflationary trend in the economy.

Money market instruments

Money market instruments are those financial securities that are issued with a maturity period of one year or less.

Types of money market instruments

1. Money market funds
2. Money market accounts
3. Certificates of deposit
4. Commercial paper
5. Bank acceptances
6. Treasury bills
7. Repurchase agreements

Money market funds

A money market fund refers to a kind of mutual fund that invests in instruments that are highly liquid and near-term. These instruments can be cash or cash equivalent. The aim of money market funds is to offer investors high liquidity with a very low level of risk. We can refer to money market funds as money market mutual funds.

Money market accounts

Money market accounts refer to a type of savings account. They pay interest, however, some issuers offer account holders limited rights to occasionally withdraw money or write checks against the account. Oftentimes, federal regulations limit federal regulations. If these withdrawals are exceeded, the bank will promptly convert them to a checking account. Typically, it is on a daily basis that banks calculate interest and they make monthly credits to the account. Generally, money markets account offer interest rates that are slightly higher than that of savings accounts.

A money market account can also take the form of a money market deposit account (MMDA). This is a type of savings account that possesses some features that are not contained in the regular money market savings account.

Certificates of deposit (CDs)

Commercial banks directly issue certificates of deposit but they are purchasable through brokerage firms. It comes with a maturity date that ranges from three months to five years and can be issued in any denomination. Most certificates of deposit offer a fixed maturity date and interest rate, and they attract a penalty for withdrawing before the time of maturity. Just like the checking account of a bank, a certificate of deposit is issued by the Federal Deposit Insurance Corporation (FDIC).

Commercial paper

The commercial paper is an unsecured loan that large institutions and corporations issue in order to finance short-term cashflow needs including inventory and accounts payables. These institutions issue them at a discount with the difference between the price and face value of the c.ommercial paper which is the investor’s profit. It is only institutions with a high credit rating that can issue commercial paper and we can consider it a safe investment. Individual investors can invest in the commercial paper market indirectly through money market funds. The maturity period of commercial papers ranges from one month to nine months.

Banker’s acceptances

A banker’s acceptance is a short-term loan that a bank guarantees. It is used extensively in international trade and it is like a post-dated cheque. It serves as a guarantee that an importer can pay for the goods. In essence, the drawer creates a banker’s acceptance which gives the bearer the rights to the money indicated on its face at a specified date. A secondary market exists for the trade of bankers’ acceptance at a discount. Its maturity date ranges from one month to six months from the issuing date.

Treasury bills

Treasury bills are government bonds or debt securities that have a maturity period of less than a year. They are usually issued by the central bank. These are considered the safest instruments because the government issues them with a full guarantee. Their maturity ranges from one to twelve months. Treasury bills are usually purchased by individual investors, banks, broker-dealers, insurance companies, pension funds, and other large institutions.

Repurchase agreements (repo)

A repurchase agreement is a short-term form of borrowing that has to do with selling a security with an agreement to repurchase it at a higher price in the future. It is dealers in government securities that commonly use this. They sell treasury bills to a lender and agree to repurchase them at an agreed price in the future.

Examples of money market institutions

1. Central bank
2. Commercial banks
3. Non-bank financial intermediaries
4. Discount houses and bill brokers
5. Acceptance houses

The above-mentioned institutions that deal in short-term loans in the money market are its members.

Central bank

The central bank of any country is the center around which the entire money market revolves. It guides the money market and in essence, it controls the supply of money. that is, it can increase and decrease its supply as well as credit in the interest of economic stability. The central bank itself does not enter into direct transactions with private individuals and firms. It controls the money market through open market operations and through variations in the bank rate.

Commercial banks

Commercial banks are financial institutions that also deal in short-term loans that they lend to businesses and trade. They are responsible for discounting bills of exchange and treasury bills. Also, they lend against promissory notes through overdrafts and advances.

Non-bank financial intermediaries

Aside from commercial banks, there are non-bank financial intermediaries that lend short-term funds to borrowers in the money market. These financial intermediaries include investment houses, savings banks, provident funds, insurance companies, and other financial corporations.

Discount houses and bill brokers

In money markets that are developed, private companies operate discount houses. The major function of the discount house is to discount bills on behalf of others. In turn, they form the commercial banks and acceptance houses. Alongside discount houses, there are bill brokers in the money market that intermediate between borrowers and lenders by discounting bills of exchange at a nominal commission. In money ma\rkets that are underdeveloped, only bill brokers operate.

Acceptance houses

Acceptance houses serve as agents between exporters and importers as well as between lender and borrower traders. They accept bills that are being drawn on merchants whose financial standing is unknown in order to make the bills negotiable in the money market. Through the acceptance of a trade bill, the payment of a bill at maturity is guaranteed.

However, there has been a decline in their importance because commercial banks have undertaken the business of acceptance. All these institutions that comprise the money market do not work in isolation but there is interdependence and interrelationship with one another.

Money market graph

The money market graph is a representation of the relationship that exists between the money supplied and the money market interest rate. The ways in investing in the money market include purchasing a treasury bill or opening a money market account.

The money market graph has a demand curve and a supply curve as well as an equilibrium price and quantity. The X-axis represents the quantity of a currency that is being demanded or supplied while the Y-axis on the graph is a representation of the nominal interest rate. The nominal interest rate here implies that the component in the Y-axis, that is the nominal interest rate, is not adjusted for inflation of the stocks but also the change in the price.

A Money Market Graph has a supply curve, a demand curve, an equilibrium price, and an equilibrium quantity. In the Money Market Graph, axis labels are present. The y-axis of the graph represents the Nominal Interest Rate. The Nominal Interest Rate means that the component in the y-axis is not just adjusted for inflation of the stocks but also the change in the price. In the graph below, the demand curve is the downward slope (decreasing) while the supply curve is the vertical line which implies that it is inelastic.

Money market vs savings account

The major difference between a money market account and a savings account is the access that one has to his funds. We note this in money market accounts’ inclusion of an ATM card. While you can always have access to a savings account at an ATM through the debit card of your checking account, the savings account itself has no card of its own. Also, one cannot typically write checks that have connection with savings account.

Another difference that exists is in the rates. Compared to savings accounts money market accounts earn at higher rates. Oftentimes, banks bill their money market accounts as “high-yield” because their rates perform very well. This however, may not be factual for every bank. Also, money market accounts earn in accordance with account balances which is typically with higher balance earning at better rates.

Money market accounts and savings accounts differ in their minimum deposit requirements. The minimum deposit requirements for money market accounts are higher than that of savings accounts.

Money market vs CD

Usually, certificates of deposit pay more interest than money market accounts although one has to lock his money away for a set period. In other words, CDs tend to have higher interest rates and they do not grant one access to his money until the end of the term. Oftentimes, the rates of CD are fixed. Compared to CDs, money market accounts offer some access and rates. It is possible for one to withdraw money six times a month.

Money markets vs capital markets

The money market deals in short-term debts or securities, that is, securities that last for one year or less. Primarily, governments and corporations use it to keep their cash flow steady as well as for investors to make a modest profit. On the other hand, the capital market deals in long-term debts and securities such as bonds and equities. Capital markets are usually referred to as stock and bond markets. In essence, capital market securities have longer maturity periods than money market securities.

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Last Updated on November 6, 2023 by Nansel Nanzip Bongdap