Money Market Instruments, Their Types and Role in Financial Crisis
The Hidden River of Money That Keeps Your World Afloat
Money market instruments are the investment vehicles that allow banks, businesses, and the government to meet large, but short-term, capital needs at a low cost. The duration is overnight, a few days, weeks, or even months, but always less than a year. Meeting longer-term cash needs is fulfilled by the financial or capital markets.
Businesses need short-term cash because payments for goods and services sold might take months. Without money market instruments, they'd have to wait until payments were received for goods already sold. This would delay the purchases of the raw goods, slowing down manufacturing of the finished product. A business must pay fixed costs, like the rent, utilities, and wages, to keep operating. Therefore, it will put extra cash into a money market instrument. It will do so with the knowledge that it can get it out when it needs it.
For that reason, money market instruments must be very safe. A business couldn't put extra cash into the stock market and hope prices haven't fallen when it needs the cash to pay bills. They must also be easy to withdraw at a moment's notice and not have large transaction fees. Otherwise, the business would just keep extra cash in a safe. There is $883 billion in money market instruments issued throughout the world, according to the Bank for International Settlements.
Types of Money Market Instruments
Commercial Paper: 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. This is the most popular money market instrument with $521 billion issued worldwide, according to the BIS.
Federal Funds: Banks are really the only businesses that use federal funds. These funds are used to meet the Federal Reserve requirement each night. It's roughly 10 percent 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 will dictate all other short-term interest rates.
Discount Window: 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 emergency.
Certificates of Deposit: Banks can raise short-term cash by issuing certificates of deposit for one to six months. It pays the holder higher interest rates the longer the cash is held.
Repurchase Agreements: Banks raise short-term funds by selling securities but promising at the same time to repurchase them in a short period of time. 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.
Treasury Bills: The federal government raises operational cash by issuing bills in the following durations: 4 weeks, 13 weeks, 26 weeks, and one year.
Municipal Notes: Cities and states issue short-term bills to raise cash. The interest payments on these are exempt from federal taxes.
Bankers Acceptances: 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.
Shares in Money Market Instruments: Money market funds, other short-term investment pools in banks, and the government combine money market instruments and sell shares to their investors.
Futures Contracts: These 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: 13-week Treasury bills, three-month euro time deposits, one-month euro time deposits, and a 30-day average of the fed funds rate.
Futures Options: 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. There are options on three instruments: three-month Treasury bill futures, three-month euro futures, and one-month euro futures.
Swaps: Banks act as middlemen for companies that want to protect themselves from changes in interest rates.
Backup Line of Credit: A bank will guarantee to pay 50 percent to 100 percent of the money market instrument if the issuer does not.
Credit Enhancement: The bank issues a letter of credit that it will redeem the money market instrument if the issuer does not.
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, CDs, and savings accounts. The size of the money supply affects interest rates, consequently influencing economic growth.
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. In fact, the Fed had to create many new and innovative programs to keep the money market running.
They were created quickly, so the names described exactly what they did in technical terms. This may have made sense to bankers but very few others. The acronyms resulted in an alphabet soup of programs, such as the:
Although these tools worked well, they confused the general public. The complexity created mistrust about the Fed's intentions and actions. Now that the financial crisis is over, these tools have been discontinued. The hyperlinks of these afore-mentioned programs will take you to their respective sites which discuss them in detail.