Money Market Instruments: Types, Role in Financial Crisis

The Hidden River of Money That Keeps Your World Afloat

money market instruments
Money market instruments allow businesses quick access to large amounts of cash. Illustration: Guido Rosa/Getty Images

Definition: 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, knowing 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 

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.

Roughly 10% of all bank liabilities over $58.8 million.  A bank that without enough cash on hand to meet the requirement will borrow from other banks. The Federal funds rate is, therefore, the interest banks charge each other to borrow Fed funds.  Here's the Current Fed Funds Rate.   

Discount Window: If a bank can't Fed funds from another bank, it can go to the Fed's discount window. The Fed charges a discount rate that's slightly higher than the Fed funds rate, so most banks avoid the discount window. However, 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.

Eurodollars: Banks can also issue CDs in foreign banks, held in euros instead of U.S. dollars

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 (often 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, who guarantees the payment. The bank is accepting the responsibility for the payment. For more, see Bankers Acceptance.

Shares in Money Market Instruments: Money market funds and other short-term investment pools in banks and the government pool 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 futres 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% to 100% 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. (Source: Instruments of the Money MarketFederal Reserve Bank of Richmond, 1993)

Many of these instruments 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, and therefore 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 which may have made sense to bankers, but very few others. The acronyms resulted in an alphabet soup of programs, such as MMIF, TAF,CPPF,ABCP MMF Liquidity Facility. Although these tools worked well, they confused the general public, creating mistrust about the Fed's intentions and actions. Now that the financial crisis is over, these tools have been discontinued. Click on the hyperlink to learn more about several of them: