Money Market Instruments and How They Are Used
The Hidden River of Money That Keeps Your World Afloat
Money market instruments are securities that provide businesses, banks, and the government with large amounts of low-cost capital for a short time. The period is overnight, a few days, weeks, or even months, but always less than a year. The financial markets meet longer-term cash needs.
Businesses need short-term cash because payments for goods and services sold might take months.
Without money market instruments, companies would have to wait until payments were received for goods already sold. This would delay the purchases of the raw goods and slow down the manufacturing of the finished product.
In 2014, there was $916 billion in money market instruments issued throughout the world.
Business Investment of Extra Cash
Money market instruments allow managers to get cash quickly when they need it. For that reason, money market instruments must be very safe.
Businesses also use money market instruments to invest extra cash. It will earn a little interest until it needs to pay its fixed operating costs. These fixed costs can include rent, utilities, and wages. For example, the stock market is too risky. Prices might have fallen by the time the firm needs to pay bills and will return less than they need for these expenses.
Money markets must also be easy to withdraw the funds from at a moment's notice. They can’t have large transaction fees. Otherwise, the business would just keep extra cash in a safe.
Many of these instruments of the money market are part of the U.S. money supply. This includes currency, check deposits, as well as money market funds, certificates of deposit, and savings accounts. The size of the money supply affects interest rates, consequently influencing economic growth.
Types of Money Market Instruments
There are 15 types of money market instruments. Each meets the specific needs of different customers. Some businesses may use an assortment of different money market accounts to cover their financial needs. Also, some are designed for the use of banks and large financial institutions while others focus on businesses.
Large companies with impeccable credit can simply issue short-term unsecured promissory notes to raise cash. Asset-backed commercial paper is a derivative based upon commercial paper.
Banks are the only businesses that use federal funds. Banks use them to meet the Federal Reserve requirement each night. It's roughly 10% of all bank liabilities over $58.8 million.
A bank without enough cash on hand to meet the requirement will borrow from other banks. The federal funds rate is the interest banks charge each other to borrow fed funds. The current fed funds rate dictates all other short-term interest rates.
If a bank can't borrow fed funds from another bank, it can go to the Fed's discount window. The Fed intentionally charges a discount rate that's slightly higher than the fed funds rate. It prefers banks to borrow from each other. Most banks avoid the discount window, but it's there in case of an emergency.
Certificates of Deposit
Banks issue certificates of deposit to raise short-term cash. Their duration is from one to six months. The CDs pay the holder higher interest rates the longer the cash is held.
Banks also issue CDs in foreign banks. These are held in euros instead of U.S. dollars.
A repo is when a bank issues securities but promises at the same time to repurchase them later at a higher price. This often means the next day with a little added interest. Even though it's a sale, it's booked as a short-term collateralized loan. The buyer of the security, who is actually the lender, executes a reverse repo.
This works like a bank loan for international trade. The bank guarantees that one of its customers will pay for goods received, typically 30-60 days later. For example, an importer wants to order goods, but the exporter won't give him credit. He goes to his bank which guarantees the payment. The bank is accepting the responsibility for the payment.
A swap is a contract between two parties to exchange all future interest rate payments from a loan. They are a type of derivative. The value of the swap is derived from the underlying value of the two streams of interest payments.
Swaps allow banks to act as middlemen for companies that want to protect themselves from changes in interest rates.
Swaps are like exchanging the value of the bonds without going through the legalities of buying and selling actual bonds. Most swaps are based on bonds that have adjustable-rate interest payments that change over time. Swaps allow investors to offset the risk of changes in future interest rates.
Backup Line of Credit
The backup line of credit is a short-term note that protects the investors in a company. Here, a bank will guarantee to pay 50% to 100% of the money market instrument if the issuer defaults.
The bank issues a letter of credit that it will redeem the money market instrument if the issuer does not.
The federal government raises cash by issuing Treasury bills. Their duration is for one year or less.
Cities and states issue short-term municipal bonds to raise cash. The interest payments on these are exempt from federal taxes.
There are investments based on money market instruments.
Shares in Money Market Instruments
Money market funds combine money market instruments. The fund companies sell shares of these funds to investors.
Futures contracts obligate traders to either buy or sell a money market security at an agreed-upon price on a certain date in the future. Four instruments are typically used: Treasury bills, interest swaps, eurodollars, and a 30-day average of the fed funds rate.
Traders can also buy just the option, without an obligation, to buy or sell a money market futures contract at an agreed-upon price on or before a specified date. For example, Treasury options are offered on 5-year, 10-year, and "ultra" 10-year Treasury notes.
Role of Money Market Instruments in the Financial Crisis
Since money market instruments are generally so safe, it came as a surprise to most that they were at the heart of the 2008 financial crisis.
On Tuesday, September 16, 2008, the $62.6 billion Reserve Primary Fund "broke the buck." That meant the fund managers couldn't maintain its share price at the $1 value. Money market funds used that value as a benchmark.
Investors panicked after the bankruptcy of Lehman Brothers. They were taking out their money too fast. They worried that the fund would go bankrupt due to its investments in Lehman Brothers.
The Fed had to create many new and innovative programs to keep the money market running.
The Fed's programs were created quickly, so the names described exactly what they did in technical terms.
For example, the Money Market Investor Funding Facility (MMIF) allowed the Federal Reserve Bank of New York to provide "senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors." This may have made sense to bankers but very few others.
Although these tools worked well, they confused the general public. The complexity created mistrust about the Fed's intentions and actions. Once the financial crisis was over, these tools were no longer needed and were discontinued.
What It Means to You
You can take advantage of the liquidity of many money market instruments. You can get money market mutual funds, Treasury bills, Treasury bill mutual funds, and municipal note mutual funds from your broker. You can also buy treasury bills directly from the U.S. Treasury if you intend to hold them until maturity.
You can purchase CDs from a bank. You can purchase futures contracts from a brokerage. You can trade futures options at a financial services company or broker.
Protection During Rising Interest Rates
Some of these instruments will protect you during rising interest rates. Look for savings products with variable interest rates that will rise along with rates. These include money market mutual funds, short-term CDs, and Treasury bills.
You can also get savings accounts and money market accounts from your bank. These aren’t based on money market instruments. Instead, they are interest-bearing accounts issued by your bank. These accounts are insured by the Federal Deposit Insurance Corporation, unlike money market mutual funds.
If interest rates are rising, this could adversely affect some investments. Assets with longer term maturities, for example, will be more sensitive to rising interest rates and will likely lose value as interest rates rise.
These include CDs and short-term bond funds. Both only pay the same low rate over time. As interest rates rise, their values fall. For the same reason, avoid any long-term bond funds. Only use them to diversify your portfolio and reduce risk.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
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