Economist Guide to Financial Markets. Ch. 3. Money Markets
Sources of “short term liquidity” for businesses, banks, and governments who need capital ahead of some sort of financial activity. There are money markets for each currency, because there are different interest rates for each currency set by a central bank. The instrument value of these markets has risen throughout the 90s and early 00s. In the early 1980s money was held in commercial banks predominantly, where even investments had long maturities, mostly held as ‘Time Deposits’ (see typology below). Deposits were thereby the main method a bank's’ capital acquisition and it meant that money was of low ‘cost’ to a bank. Consequently, commercial banks were the main credit source for businesses and consumers alike. In the 1980s, deregulations, such as the Monetary Control Act of 1980 in the United States, allowed “market forces rather than regulators to determine interest rates”.
Trading on a money market means trading in “debt instruments maturing in one year or less” (38). In this sense money markets facilitate DEBT INVESTMENT, in that (like bond markets), they are selling debt claims rather than equity (ownership) claims. But whereas bond money is usually used for projects that have long term effects (business innovation, government projects, etc) and this is taken into account when calculating interest, money markets are used for satisfying financial obligations. The spread between rate funds pay investors and rate at which they lend is smaller than banks because they don’t have to maintain physical offices or offer small individual accounts.
METHODS OF INVESTMENT IN MONEY MARKETS:
Individual Sweep Accounts-
Where individual account asset REMAINDERS (those left after investment by stockbrokers in mutual funds, etc) are ‘swept’ into short term money markets in order to earn the highest possible return.
Institutional Investors-
All banks and pension funds hold a small percentage of their assets in money markets in order to comply with short notice client demands for liquidity without being penalised for compromising the long-maturity securities.
MONEY MARKET INVESTMENT INSTRUMENTS:
Commercial Paper-
-Debt obligation of a commercial firm.
-Overwhelmingly used by financial firms.
-Euro denominated commercial paper has increased in market share after 1992: (no currency risk).
-Companies often use new issuance to repay principal on old, thereby getting long term loans at short term rates. (Risky due to potential downgrading of credit rating ---> lack of cash source.)
Bankers’ Acceptances
Non-financial company issues a ‘promissory note’ in exchange for a loan from a bank. The bank resells the loan at lower price and guarantees repayment. No interest collected, just redeemed at full face value. Rests on bank’s good credit standing.
T-Bills
Treasury bills issued by national govts with a <1yr maturity; hence- usually safest. Popular with emerging markets who are not trusted with longer maturity debt.
Government Agency Paper
As above but issued by govt agency (Tennessee Valley Authority, an electric utility, and Sallie Mae)
Interbank
Many short-term securities issued between internationally located banks. Interest rates tied to LIBOR or EURIBOR
International Agency Paper
Issued by World Bank, etc.
Time Deposits
Have penalty for early withdrawal.
Repos or repurchase agreements, are agreements in which the owner of a security (such as a bank) agrees to sell it to an investor and buy it back within a short period (usually maturity of few days) for a higher price. (or the reverse)
-In money markets - this is usually done with government securities, overnight.
How is this different from options?
Futures contracts can also be used to guarantee that the short term security is sold in a particular (above/below) relation to the underlying asset?
The relationship between these instruments and agents is contingent upon ratings, interest rates, and spreads. “One important set of spreads is that between uncollateralised loans and repos. As repos are fully collateralised, there is almost no risk that repayment will be disrupted. Uncollateralised loans among banks, however, are at risk if a bank should fail. The spread between these two types of lending thus reflects perceived creditworthiness.”
One interesting thing to note would be the extent to which insurance plays a role. As most short term securities belong to large firms and governments, they did not suffer the same crunch during the 2008 crisis as highly rated high-risk (but uncollateralized, insured by companies like AIG) shares in SPVs held by pension funds. And yet, if these instruments are used by financial firms to raise large profits on a daily basis, to what extent does a lack of collateral matter?
-Alexey