Money Market: Types, Functions, Institutions Involved
What is Money Market?
This is the process of trading in short-term debt investments. This can either be by an individual or institutions. Institutions mainly deal in wholesale investment while individuals are more inclined to retail level investment. While it has low return rates, it has a high degree of safety compared to other investment options such as stocks.
In fact, money market is one of the crucial pillar of the global financial market. The highest percentage of investment is through wholesale. That is, financial institutions and companies make much of the transactions.
Types of money market instruments
Money market funds
This is a mutual fund that invests in near-term and highly liquid instruments. This involves instruments such as debt-based security, cash, and cash equivalent securities. They afford investors high liquidity and less susceptibility to risk.
Only companies that can lend or borrow $5million to $1 billion can invest in wholesale money market. However, thanks to mutual funds, individual investors can engage in wholesale money market. The net asset value of such funds should however not go below $1.
Some of the money funds you can invest in include treasury fund, prime money fund, government money fund, and tax-exempt money fund.
Money market accounts
These accounts are similar to savings accounts. Issuers of these accounts can afford certain customers permission to withdraw money before the maturity date. However, should they exceed the limit set by federal regulations; the bank converts the account to a checking account. Like savings accounts, they offer the holder interest.
Interest earned is however higher compared to conventional savings accounts. Currently, the difference in rates between the two is slightly narrow since the 2008 financial crisis. That said, the interest is dependent on the initial deposit. Most money market accounts will an interest of 0.56%. You can also use debit cards and write checks against this account.
Certificates of Deposits (CDs)
CDs are products given by a bank or credit union to a customer who agrees to leave a certain amount of money for a specific time. This is the reason why they are not termed as money market funds since they are sold after a certain period. The more you deposit and longer you hold your account, the higher the returns.
Most CDs will offer a rate of 0.50% to 0.70% depending on your initial deposit. Unlike a money market account that allows for early withdrawal, CDs penalize you for this. Besides, the rate is constant throughout the holding period.
Repurchase agreement is short-term borrowing of a money market. It mainly involves borrowing of government securities. The dealer will then sell the securities to investors. This usually happens overnight.
He or she will then buy them the next day at a slightly higher rate earning him or her an overnight interest rate. Most investors use them to raise short-term capital. Some of the most common repos include held-in custody, specialized delivery repo, and third-party repo.
Commercial papers are unsecured loans offered by corporations or institutions for short-term capital gain. For example, a company can sell commercial papers to pay off debts or buy inventory. They are mostly sold at a discount with the investor pocketing the difference between the discount and face value.
Most investors consider it a safe investment option since only companies with high credit rating can issue them. Most commercial papers are worth $100,000 and above and have a maturity period of one to nine months.
This is a short-term loan issued by a company to an investor with a bank guarantee. The drawer provides the bearer with rights to own the money at a specified date. This instrument is common in foreign trade since it makes importing and exporting easier. The maturity date is between one and six months.
Functions of money market
As mentioned money market is one of the crucial pillars in international trade. It facilitates both local and international trade with traders benefiting from short-term access to funds. Besides, it provides prompt financing to pay services and goods across the globe. It also provides access to funding for other industries such as healthcare.
Helps in growth of industries
Another function of money market is to provide means to grow industries. It provides a cost-effective and fast way for businesses to obtain money for short-term growth.
Thanks to instruments such as commercial papers and repos, companies can get the money to pay bills, employees, debts, and other pressing needs. While money market does not provide long-term financing, it helps businesses stay afloat allowing for gradual growth.
Promotes liquidity and safety in the global market
This is yet another chief function of money market. It allows liquidity in the global market allowing for individual economies to grow. Besides, the instruments have a short maturity meaning they can be converted into cash. Money market also promotes safety since only companies with high credit rating are allowed to issue instruments.
Central bank policies
As expected, central banks need to keep the economy in check ensuring the monetary policy of a country is healthy. And thanks to money market, central banks can come up with policies easily. If for example there’s rampant issuance of short-term interest rates, the central bank can come up with objective monetary policies.
Balance between supply and demand
Since money market transfers savings into investments, it guarantees surplus supply of capital. This in returns ensures a balance between supply and demand in the capital market.
Money market allows commercial banks to invest their surplus money and earn an interest while maintaining liquidity. Besides, instruments found in commercial banks can be readily converted into cash, which can be used to cushion customer withdrawal.
Top institutions of money market
Commercial banks are undoubtedly that backbone of the money market. They enable transcation to take place between individuals and institutions. They offer loans and offer short-term deposits that are instrumental in maintaining commerce and trade in the short-term. They facilitate liquidity in the market by investing in government bills, treasury bills, and commercial bills.
They also provide promissory notes through overdrafts and advances. They also put their surplus money in different investment options which allows growth of industries. Besides, the investment made is expected to earn an interest hence maintaining the banks’ liquidity.
The central bank is yet another crucial pillar in money market. It is through the central bank that monetary policies of economies are made. Without a central bank, there’d be no money. Besides, it lends, controls, and guards money for all economies in the world.
It is the sole supplier of money to an economy. When there’s high demand, it injects surplus money and vice versa. As such, it helps prevent inflation and deflation. However, it is not directly involved in money market. Rather, it functions through banks.
Acceptance houses have a rich history in London. It is during the early 20th century that merchant bankers transferred their headquarters to the London Money Market. They are an intermediary between importers and exporters. Also, they serve lenders and borrowers. It accepted commercial bills or trade bills.
Such companies are found in developed markets such as New York and London. Here, they act as discount houses discounting bills on behalf of other companies. They also act as intermediaries between borrowers and lenders. They are also found in under-developed money markets where they play a crucial role.
Non-banking financial intermediaries
These companies provide lending and borrowing services to customers. However, they do so at a short-term basis. Some of the come non-banking intermediaries include insurance companies, investment houses, and savings banks, among others.
Advantages of a money market account
For organizations and behemoth companies to access money market, they need to open a money market account. Here are some of the benefits.
Account holders can access their accounts via ATMs, checks, banks, and more. This allows them to access their assets and convert them into cash allowing them to run errands. As long as the holder does not surpass the withdrawal limit.
Money market fund has lower risk compared to other investment options such as stocks. Besides, FDIC covers assets under money markets. Thanks to FDIC, there are little to no cases of investors losing their investment.
There are no hidden charges in money markets. In addition, you do not pay to redeem funds from your account. As such, you can rest assured you will get what you’ve invested in.
High interest rates
A money market account generates more interest compared to conventional savings account. What’s more, interest rate is compounded growing year on year.