Definitions of Money Market

Following definitions will help us to understand the concept of money market.

According to Crowther, "The money market is a name given to the various firms and institutions that deal in the various grades of near money."

According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government."

According to Nadler and Shipman, "A money market is a mechanical device through which short term funds are loaned and borrowed through which a large part of the financial transactions of a particular country or world are degraded. A money market is distinct from but supplementary to the commercial banking system."

These definitions help us to identify the basic characteristics of a money market. A money market comprises of a well organized banking system. Various financial instruments are used for transactions in a money market. There is perfect mobility of funds in a money market. The transactions in a money market are of short term nature.

Definition of 'Money Market'

A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

 

'Money Market'

The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities, but there are risks in the market that any investor needs to be aware of including the risk of default on securities such as commercial paper.

Money market

As money became a commodity, the money market became a component of the financial markets for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in the money markets is done over the counter, is wholesale. Various instruments exist, such as Treasury bills, commercial paper, bankers' acceptances, deposits, certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-lived mortgage-, and asset-backed securities.^[1] It provides liquidity funding for the global financial system. Money markets and capital markets are parts of financial markets. The instruments bear differing maturities, currencies, credit risks, and structure. Therefore they may be used to distribute the exposure.^[2]

 

History

The money market developed because parties had surplus funds, while others needed cash.^[3][4] Today it comprises cash instruments as well.

 

Participants

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short-term financial instruments commonly called "paper." This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of interbank lending--banks borrowing and lending to each other using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

Finance companies typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Certain large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf via commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt.

·         Trading companies often purchase bankers' acceptances to be tendered for payment to overseas suppliers.

·         Retail and institutional money market funds

·         Banks

·         Central banks

·         Cash management programs

·         Merchant Banks

 

Functions of Money Market

Money market is an important part of the economy. It plays very significant functions. As mentioned above it is basically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks, business corporations, non-banking financial institutions (NBFs) and other financial institutions along with investors.

The major functions of money market are given below:-

1.      To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short term monetary transactions.

2.      To promote economic growth. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc.

3.      To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly it also provides facility of discounting bills of exchange for trade and industry.

4.      To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary policy.

5.      To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in generating savings and investments in the economy.

6.      Money market provides non-inflationary sources of finance to government. It is possible by issuing treasury bills in order to raise short loans. However this dose not leads to increases in the prices.

Apart from those, money market is an arrangement which accommodates banks and financial institutions dealing in short term monetary activities such as the demand for and supply of money.

 

Functions of the money market

 

The money market functions are

·         Transfer of large sums of money

·         Transfer from parties with surplus funds to parties with a deficit

·         Allow governments to raise funds

·         Help to implement monetary policy

·         Determine short-term interest rates

 

Common money market instruments

·         Certificate of deposit - Time deposit, commonly offered to consumers by banks, thrift institutions, and credit unions.

·         Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

·         Commercial paper - short term usanse promissory notes issued by company at discount to face value and redeemed at face value

·         Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States.

·         Federal agency short-term securities - (in the U.S.). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.

·         Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.

·         Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.

·         Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months.

·         Money funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.

·         Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.

·         Short-lived mortgage- and asset-backed securities

 

Discount and accrual instruments

There are two types of instruments in the fixed income market that pay the interest at maturity, instead of paying it as coupons. Discount instruments, like repurchase agreements, are issued at a discount of the face value, and their maturity value is the face value. Accrual instruments are issued at the face value and mature at the face value plus interest.^[7]

 

Indian Money Market

The entire money market in India can be divided into two parts. They are organized money market and the unorganized money market. The unorganized money market can also be known as an unauthorized money market. Both of these components comprise several constituents. The following chart will help you in understanding the organizational structure of the Indian money market.

Indian Money Market

UNORGANISED MONEY MARKET

The unorganized money market mostly finances short term financial needs of farmers and small businessmen. The main constituents of unorganized Money market are:

1. Indigenous Bankers (IBs): The IBs are individuals or private firms who receive deposits and give loans and thereby they operate as banks. Unlike moneylenders who only lend money, IBs accept deposits as well as lend money. They operate mostly in urban areas, especially in western and southern regions of the country. Over the years, IBs faced stiff competition from cooperative banks and commercial banks. Borrowers are small manufacturers and traders, who may not be able to obtain funds from the organized banking sector, may be due to lack of security or some other reason.

2. Money Lenders (MLs): MLs are important participants in unorganized money markets in India. There are professional as well as non professional MLs. They lend money in rural areas as well as urban areas. They normally charge an invariably high rate of interest ranging between 15% p.a. to 50% p.a. and even more. The borrowers are mostly poor farmers, artisans, petty traders, manual workers and others who require short term funds and do not get the same from organized sector.

3. Chit Funds and Nidhis: They collect funds from the members for the purpose of lending to members (who are in need of funds) for personal or other purposes. The chit funds lend money to its members by draw of chits or lots, whereas Nidhis lend money to its members and others.

4. Finance Brokers: They act as middlemen between lenders and borrowers. They charge commission for their services. They are found mostly in urban markets, especially in cloth markets and commodity markets.

5. Finance Companies: They operate throughout the country. They borrow or accept deposits and lend them to others. They provide funds to small traders and others. They operate like indigenous bankers.

MEASURES TO IMPROVE INDIAN MONEY MARKET

The major drawback of India Money Market is its high volatility. Gradually the money market transaction is increasing. But, on the recommendation of the Sukhmoy Chakravarty Committee (on the review of the working of the Monetary System) and the Narasimham committee (on the Report on the working of the financial system in India, 1991), RBI initiated a series of reform in Indian Money Market. The following are some of the measures undertaken,

ORGANISED MONEY MARKET

Indian money market can be divided into various sub-markets depending on their nature and scope of the transactions and the features of the instruments.

The RBI is the apex institution which controls and monitors all the organizations in the organized sector. The commercial banks can operate as lenders and operators. The FIs like IDBI, ICICI, and others operate as lenders. The organized sector of Indian money market is fairly developed and organized, but it is not comparable to the money markets of developed countries like USA, UK and Japan.

1. The Call Money: It is also known as Interbank Call Money Market. Here, lending and borrowing transactions are carried out for one day. These one day loans may or may not be renewed the next day. The demand for call money comes from commercial banks that need to meet requirements of CRR and SLR, whereas supply comes from commercial banks with excess funds, and FIs like IDBI, etc.

It an important sub market of the Indian money market. It is also known as money at call and money at short notice. It is also called inter bank loan market. In this market money is demanded for extremely short period. The duration of such transactions is from few hours to 14 days. It is basically located in the industrial and commercial locations such as Mumbai, Delhi, Calcutta, etc. These transactions help stock brokers and dealers to fulfill their financial requirements. The rate at which money is made available is called as a call rate. Thus rate is fixed by the market forces such as the demand for and supply of money.

The call money market is a system in which dealers and brokers borrow money to finance their investments on a very short-term basis. The source of the funds, usually a bank, can request return of the money at any time. This makes "call money" a risky transaction.

Function: The call money market makes short-term loans that can be recalled at any time. These loans provide money to conduct transactions between other market dealers, financial institutions and banks. The loans can either be secured or unsecured. The lender considers features such as the credit worthiness of the borrower, the rate at which the money is being sought and the amount of time until repayment of the loan.

Features: Individual investors do not usually take part in call money market transactions. The investor approaches a broker firm that finances the money for the investor. Then the brokerage firm gets a call money loan from the best source of funds, which are suited to the individual's specific needs and circumstances.

Time Frame: A call money market is operational for a very short period of time. The loan must be repaid to the source, usually a bank, on demand. The time span for repayment usually ranges from one to less than 15 days. The rate of interest at which the money is borrowed is known as the call money rate and is determined by the lender.

Banks borrow in this money market for the following purpose:
• To fill the gaps or temporary mismatches in funds
• To meet the CRR & SLR mandatory requirements as stipulated by the Central bank
• To meet sudden demand for funds arising out of large outflows.
Thus call money usually serves the role of equilibrating the short-term liquidity position of banks

Call Money Market Participants :
1.Those who can both borrow as well as lend in the market - RBI (through LAF) Banks, PDs
2.Those who can only lend Financial institutions-LIC, UTI, GIC, IDBI, NABARD, ICICI and mutual funds etc.
Reserve Bank of India has framed a time schedule to phase out the second category out of Call Money Market and make Call Money market as exclusive market for Bank/s & PD/s.                                                               

Repurchase agreements: The repurchase agreement or the Repo is used by the government security holder when he sells the security to a lender and promises to repurchase from him overnight. These are short-term borrowings normally for less than two weeks and often for an overnight basis – arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. They are very safe due government backing. In it’s essence, repo transaction can be viewed as a secured short term cash loan. The buyer of the security effectively acts as a lender, while the seller of the security is effectively acting as a borrower that uses a security as collateral for a secured cash loan at a fixed rate of interest.

 

Reverse Repo Rate

Affect the Bank Loan interest rates: Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system.
Due to this fine tuning of RBI using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man.

2. The Commercial Bill Market: It deals in bills of exchange. A seller draws a bill of exchange on the buyer to make payment within a certain period of time. The bills can be domestic bills or foreign bills of exchange. The commercial bills are purchased and discounted by commercial banks, and are rediscounted by FIs like EXIM Bank, SIDBI, IDBI, etc.

3. The Treasury Bill Market: This is a market for sale and purchase of short term government securities. These securities are called as Treasury Bills which are promissory notes or financial bills issued by the RBI on behalf of the Government of India. It deals in Treasury Bills of short term duration 14 days, 91 days, 182 days and 364 days. The treasury bills facilitate the financing of Central Government temporary deficits. From May 2001, the auction of 14 days and 182 days treasury bills has been discontinued. At present, there are 91 days and 364 days treasury bills. The rate of interest for treasury bills is determined by the market, depending on the demand and supply of funds in the money market.

There are two types of treasury bills.

(i).  Ordinary or Regular Treasury Bills and

(ii).  Ad Hoc Treasury Bills. The maturity period of these securities range from as low as 14 days to as high as 364 days. They have become very popular recently due to high level of safety involved in them.

4. The Certificate of Deposit : The scheme of Certificate of Deposit (CD) was introduced by RBI in 1989. The main purpose of CD is to enable the commercial banks to raise funds from the market. The CDs maturity period ranges from 7 days to 1 year (in case of FIs minimum 1 year and maximum 3 years). The CDs are issued at a discount to its face value. The CDs are issued in denomination of Rs. 1 lakh and thereafter, multiples of Rs. 1 lakh. The holder is entitled to receive a fixed rate of interest and have no lock-in period. The return on the certificate of deposit is higher than the Treasury Bills because it assumes a higher level of risk.

Advantages of Certificate of Deposit as a money market instrument:
1. Since one can know the returns from before, the certificates of deposits are considered much safe.
2. One can earn more as compared to depositing money in savings account.
3. The Federal Insurance Corporation guarantees the investments in the certificate of deposit.

Disadvantages of Certificate of deposit as a money market instrument:
1. As compared to other investments the returns is less.
2. The money is tied along with the long maturity period of the Certificate of Deposit. Huge penalties are paid if one gets out of it before maturity.

5. The Commercial Paper: Commercial Paper is short-term loan that is issued by a corporation use for financing accounts receivable and inventories. Commercial Papers have higher denominations as compared to the Treasury Bills and the Certificate of Deposit. The maturity period of Commercial Papers are a maximum of 9 months. They are very safe since the financial situation of the corporation can be anticipated over a few months.

The scheme of Commercial Paper (CP) was introduced in 1990. Blue chip companies for short term financing issue CPs. As per RBI guidelines, CPs can be issued on the following conditions:

·         The minimum tangible net worth of the company to be at least Rs. 4 crores.

·         The CP receives a minimum rating of A-2 or such other rating from recognized rating agencies like CRISIL, CARE, ICRA, Fitch Ratings, etc.

·         The company has been sanctioned working capital limit by bank/s or all-India FIs.

The CPs maturity period ranges from 7 days to 1 year. They can be issued in multiples of Rs. 5 lakhs and in multiples thereof. They are sold at a discount to its face value and redeemed at its face value.

Recent Trends: Initially, the CP amount outstanding rose from Rs.86 crore as at the end of financial year 1989-90 to Rs. 577 crore as at the end of the year 1992-93 (Table I) and the CP outstanding was declined to Rs.76 crores since typical discount rate was touched to 20.20 – 20.15  in 1995-96.  Following various relaxations in the terms and conditions for issue of CP, CP issuances gathered momentum thereafter and reached Rs. 7,224 crore by end-March 2002. 

A couple of better rated corporate have managed to raise 90 days money in the CP market for as low as 5.55%, which is just five basis points above the repo rate and ACC and  L&T are the two players that have raised money at very fine rates in 1994. The sudden spurt in volumes could indicate revival of economic activity. The total outstanding amount as on 30^th April 2005 is Rs. 15199 and the effective discount rate per annum during the last fortnight of April 2005 is 5.50-6.65.

6. Money Market Mutual Funds (MMMFs): The MMMFs were introduced in 1992. The objective of MMMFs is to provide an additional short term avenue to the individual investors. In 1995, RBI modified the scheme to allow private sector organizations to setup MMMFs. During 1996, the scheme of MMMFs was made more flexible by bringing it on par with all Mutual Funds by allowing investments by corporate and others. The scheme has been made more attractive to investors by reducing lock in period from 45 days to 15 days. Resources mobilized from MMMFs are required to be invested in call money, CDs, CPs, commercial bills, treasury bills, and government dated securities having an unexpired maturity of up to 1 year.

7. Banker's Acceptance: It is a short-term credit investment. It is guaranteed by a bank to make payments. The Banker's Acceptance is traded in the Secondary market. The banker's acceptance is mostly used to finance exports, imports and other transactions in goods. The banker's acceptance need not be held till the maturity date but the holder has the option to sell it off in the secondary market whenever he finds it suitable.

8. Euro Dollars: The Eurodollars are basically dollar- denominated deposits that are held in banks outside the United States. Since the Eurodollar market is free from any stringent regulations, the banks can operate at narrower margins as compared to the banks in U.S. The Eurodollars are traded at very high denominations and mature before six months. The Eurodollar market is within the reach of large institutions only and individual investors can access it only through money market funds.

DEFECTS OF INDIAN MONEY MARKET

Money market is the market for lending and borrowing of short term funds. A well developed money market denotes an implementation of effective monetary policy. But the Indian money market suffers from many weaknesses.

1.      Lack of integration: The Indian Money Market is divided into two sectors viz, the organized and unorganized money market. But both the markets are completely separate from each other. They are working independently and have little effect on each other. RBI is fully effective in controlling the organized sector. But, it has very less control on the unorganized sector.

2.      Lack of rational interest rates structure: The Indian Money Market exist too many interest rates. For example, the deposit and lending rates of commercial banks, the borrowing rate of Government etc. In the past these created excess demand for credit and the RBI had to rely often on cash reserve ratio. Though the RBI has tried to bring rationality in the interest rates, the situation in the Indian money market is still not effective.

3.      Existence of Unorganized Money Market: The existence of the unorganized sector in money market still prevails in Indian Money Market. The indigenous banker does not make any distinction between short term and long-term finance. They have no coordination with each other and have no link with other banking sectors. They do not follow any sound banking regulations. The RBI has no control over these bankers.

4.      Absence of an organized bill market: In Indian Money Market, there is an absence of adequate bill market. There is an absence of commercial bill market or a discount for short term commercial bills. There are many factors responsible for the underdeveloped bill market such as (i) relying more on cash transaction, (ii) cash credit of commercial bank, (iii)seller’s limited use of bills, (iv) imposition of heavy stamp duty, (v) absence of acceptance houses etc.

5.      Shortage of funds in the Money Market: The lack of banking habit, inadequate banking facility, less saving habit, etc created have shortage of fund in the money market. On the other hand, the increasing demand for loan able funds in the money market far exceeds its supply.

6.      Inadequate banking facility:  Now-a-days, the commercial banks have opened many new branches of banking facilities. But, it still leaves much scope for further development. In a developing country like India, people live below poverty line and have less saving habit. Their savings are very small and they do not have much access to banking facilities till now.

Seasonal Stringency of Money: During the part of the year the interest rates are become high due to the increasing demand for funds in the money market for the operation in the agricultural sector. Basically, it is seen in the period from October to June.