Money Market

We often associate money with cash in our wallets or bank account balances. However, the term ‘money’ accounts for more than just banknotes or coins. In this article, you will find out what ‘money’ actually means as we dive deeper into the concept of money and money markets. What are they? Why are they important? What do they consist of? How do they function?

The characteristics and functions of money

Money serves two main functions in the economy as seen in figure 1 below:

Fig. 1 - Functions of money

• It's an exchange medium: in the old days, goods were traded through ‘barter’ (swapping). This wasn’t so effective as equally valuable goods or services were not always available for an exchange. With money, people can trade their products quickly without having to look for an equivalent item.
• It’s a value storage: money is an asset that allows people to store their wealth. However, inflation affects it and it devalues over time. An alternative to holding cash is purchasing financial assets such as bonds, shares, or physical assets such as a house or a piece of art.

Other functions of money include:

• A measure of value.
• A standard of deferred payment.

These two functions together are known as the unit of account function of money. Money is a unit that allows us to compare the relative values of goods and services in the marketplace. For example, a wooden writing desk costs £50 which is more costly than a £6 plastic table.

Deferred payment means that you can pay for something after the transaction is carried out. For example, you can place an order at a furniture store but only pay the invoice after the goods are delivered.

What are money markets?

The assets are highly liquid. This means that they can be converted into cash quickly without losing value. Some examples include treasury bills and commercial bills (money market assets in the UK).

Money markets are the opposite of capital markets, which are also part of financial markets but deal with medium to long-dated financial assets.

Why are money markets important

The money market exists to meet the need for short-term lending and borrowing by individuals, corporations, or the government.

It is less risky than the capital market as participants can trade high-quality debt securities (loans) for a short period of time, usually one year or less. Also, the securities are highly liquid and can be cashed out with ease.

Loans in money markets are often used by governments, banks, or large corporations (borrowers) to meet their short-term cash-related requirements. Individuals (savers) investing in these loans can expect a small interest at the maturity date.

Types of money market instruments

Money market instruments are split into two main categories: money market funds and money market accounts.

• Money market funds are mutual funds that invest in highly liquid and short-term debt instruments such as Certificates of Deposit (CDs), Commercial Paper (CP), Bankers' Acceptances (BA), and Repurchase Agreement (RP). These instruments are issued by banks, governments, and other large institutions and are thus, arguably, safer to invest in than equities issued by individual companies.
• Money market accounts are basically savings accounts that yield higher interest than a standard savings account. The issuer of money market accounts may limit the number of times the account holder can withdraw cash or write checks during the lending period.

Let's look further into some types of short-term securities.

Certificates of Deposit

For a set period of, usually 3, 6, or 12 months, the depositors can’t access the money they have invested in the CD. Only when the certificates expire can they get back the principal along with some interest. CDs tend to offer a more attractive interest rate than the normal savings account.

Commercial paper

To issue commercial paper, the firm must have an excellent credit rating to ensure it can pay back the face amount on the maturity date. The transactions are sometimes backed by the issuing bank.

A Banker’s Acceptance should include all the relevant details such as the issuing maturity date, the amount of money deposited, and the individual’s information. A banker's acceptance is mostly used in international trade to reduce credit risk between unknown parties. The maturity periods can range from 30 to 180 days.

Repurchase agreements

Repo loans are relatively safe as the securities traded tend to come from the government. Overnight repo loans have maturity as short as one day. However, both the buyer and seller can have the option to extend the period of the loan. In some cases, repurchase agreements have no expiry date at all.

Functions of money markets

Money markets play many important roles in an economy, including:

• Providing funds for trading and the industry.
• Balancing the supply and demand in short-term financial transactions.
• Boosting economic growth by allowing corporations to access funds quickly.
• Providing the government with non-inflationary finance sources.
• Facilitating monetary policy implementation.
• Helping with the money creation process.

How do banks create money?

As your parents might have told you, money doesn’t grow on trees. It grows in banks! Banks are responsible for the creation of money through ‘bank deposits’.

Here’s how it works:

Every time you deposit a certain amount of money, instead of letting it sit idle, the bank will make loans to those in need, e.g. another individual, a company, or the government. Though banks don’t actually transfer money from your account to another account. They create new money (yes, out of thin air!) and deposit it into the borrower’s account.

To ensure the money is available in case of sudden withdrawals, banks hold a number of funds in reserves, known as reserve requirements.

Money market vs capital market

There are two primary differences between a money market vs capital market:

1. First, money markets are associated with the lending and borrowing of securities in the short run, usually, one year or less, whereas a capital market supplies financial assets in the medium to long term (more than one year).
2. Second, assets in money markets are mostly issued by governments or corporations to stabilize the cash flow. Investors only receive a modest return on investment. Meanwhile, a capital market is made up of shares and bonds which are riskier but come with potentially substantial yields.

Companies issue stocks (shares) in the capital market to raise funds for their operations or investments and almost anyone can buy them. Stocks have no expiry date, unlike short-term debt instruments such as CDs and CPs in the money market. Of course, unless the issuing company shuts down!

Money markets are, arguably, a main component of the financial market.

The existence of money markets is critical to an economy as it satisfies the need for short-term lending and borrowing in society.

References

1. Hugh Patrick, Money Market, Britannica, 2018.