Money market-Features and Composition

The money market exists as a result of the interaction between the suppliers and demanders of short-term funds (those having a maturity of a year or less). Most money market transactions are made in marketable securities which are short-term debt instruments such as T-bills and commercial paper.

THE TERM “MONEY MARKET” IS A MISNOMER.

Money (currency) is not actually traded in the money markets. The securities traded in the money market are short-term with high liquidity and low-risk therefore they are close to being money.Money market provides investors a place for parking surplus funds for short periods of time. It also provides low-cost source of temporary funds to borrowers like firms, government and financial intermediaries. The money markets are associated with the issuance and trading of short-term (less than 1 year) debt obligations of large corporations,financial institutions (Fls) and governments. Only high-quality entities can borrow in the money markets, Individual issues are large. Thus the money market is characterized by low default risk and large denomination of instruments.

Money market transactions can be executed directly or through and intermediary. Investors in money market Instruments include corporations and Fls who have idle cash but are restricted to a short-term investment horizon. The money markets essentially serve to allocate the nation’s supply of liquid funds among major short-term lenders and borrowers.

The characteristics of money market instruments are:

  • Short-term debt instruments (maturity of less than 1 year)
  • Services immediate cash need
  1. Borrowers need short-term “working capital”
  2. Lenders need an interest-earning “parking space” for excess funds.
  • Instruments trade in an active secondary market. 
  1. Liquid market provides easy entry & exit for participants.
  2. Speed ans efficiency of transactions allows cash to be “active” even for very short periods of time (over
    night)
  • Large denominations
  1. Transactions costs are low in relative terms.
  2. Individual investors do not actively participate in this market.
  • Low default risk
  1. Only high quality borrowers participate.
  2. Short maturities reduce the risk of “Changes” in borrower quality.
  • Insensitive to interest rate changes
  1. They mature in one year or less from their issue date. Maturity of less than ! year is too short for
    securities to be adversely affected, in general, by changes in rates.

In theory, the banking industry should handle the needs for short-term loans and accept short-term deposits and therefore there should not be any need for money markets to exist. Banks have an information advantage on the creditworthiness of participants- they are better able to deal with the asymmetric information between savers and borrowers. However banks have certain disadvantages.

BANKS ARE HEAVILY REGULATED.

Regulation creates a distinct cost advantage for money markets over banks. Banks also have to deal with reserve requirements these create additional expense for banks that money markets do not have. Also money markets deal with creditworthy entities- governments, large corporations and banks; therefore the problem of asymmetric information is not severe for money markets. Thus money market exists for short term loans and short term deposits of high-quality entities like governments, Large corporations and banks.

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