|
What Is the Money Market?
The money market refers to trading in very short-term debt investments. At the
wholesale level, it involves large-volume trades between institutions and
traders. At the retail level, it includes money market mutual funds bought by
individual investors and money market accounts opened by bank customers. In all
of these cases, the money market is characterized by a high degree of safety
and relatively low rates of return.
Understanding the Money Market:
The money market is one of the pillars of the global financial system. It
involves overnight swaps of vast amounts of money between banks and the U.S.
government. The majority of money market transactions are wholesale
transactions that take place between financial institutions and companies.
Institutions that participate in the money market include banks that lend to
one another and to large companies in the eurocurrency and time deposit
markets; companies that raise money by selling commercial paper into the
market, which can be bought by other companies or funds; and investors who
purchase bank CDs as a safe place to park money in the short term. Some of
those wholesale transactions eventually make their way into the hands of
consumers as components of money market mutual funds and other investments.
In the wholesale market, commercial paper is a popular borrowing mechanism
because the interest rates are higher than for bank time deposits or Treasury
bills, and a greater range of maturities is available, from overnight to 270
days.1? However, the risk of default is significantly higher for commercial
paper than for bank or government instruments. Individuals can invest in the
money market by buying money market funds, short-term certificates of deposit
(CDs), municipal notes, or U.S. Treasury bills. For individual investors, the
money market has retail locations, including local banks and the U.S.
government's TreasuryDirect website. Brokers are another avenue for investing
in the money market. The U.S. government issues Treasury bills in the money
market, with maturities ranging from a few days to one year.2? Primary dealers
buy them in large amounts directly from the government to trade between
themselves or to sell to individual investors. Individual investors can buy
them directly from the government through its TreasuryDirect website or through
a bank or a broker. State, county, and municipal governments also issue
short-term notes.
At the wholesale level, it involves large-volume trades between institutions
and traders. At the retail level, it includes money market mutual funds bought
by individual investors and money market accounts opened by bank customers. In
all of these cases, the money market is characterized by a high degree of
safety and relatively low rates of return. Key Takeaways The money market
involves the purchase and sale of large volumes of very short-term debt
products, such as overnight reserves or commercial paper. An individual may
invest in the money market by purchasing a money market mutual fund, buying a
Treasury bill, or opening a money market account at a bank. Money market
investments are characterized by safety and liquidity, with money market fund
shares targeted at $1
Understanding the Money Market:
Money market funds seek stability and security with the goal of never losing
money and keeping net asset value (NAV) at $1. This one-buck NAV baseline gives
rise to the phrase "break the buck," meaning that if the value falls
below the $1 NAV level, some of the original investment is gone and investors
will lose money. However, this scenario only happens very rarely, but because
many money market funds are not FDIC-insured, meaning that money market funds
can nevertheless lose money.
Types of Money:
Market Instruments: Money Market Funds:
The wholesale money market is limited to companies and financial institutions
that lend and borrow in amounts ranging from $5 million to well over $1 billion
per transaction. Mutual funds offer baskets of these products to individual
investors. The net asset value (NAV) of such funds is intended to stay at $1.
During the 2008 financial crisis, one fund fell below that level.3? That
triggered market panic and a mass exodus from the funds, which ultimately led
to additional restrictions on their access to riskier investments. Money Market
Accounts Money market accounts are a type of savings account. They pay
interest, but some issuers offer account holders limited rights to occasionally
withdraw money or write checks against the account. (Withdrawals are limited by
federal regulations. If they are exceeded, the bank promptly converts it to a
checking account.) Banks typically calculate interest on a money market account
on a daily basis and make a monthly credit to the account. In general, money
market accounts offer slightly higher interest rates than standard savings
accounts. But the difference in rates between savings and money market accounts
has narrowed considerably since the 2008 financial crisis. Average interest
rates for money market accounts vary based on the amount deposited. As of
August 2020, the best-paying money market account with no minimum deposit
offered 0.99% annualized interest. 4?
Funds in money market accounts are insured by the Federal Deposit Insurance
Corporation (FDIC) at banks and the National Credit Union Administration (NCUA)
in credit unions. Certificates of Deposit (CDs) Most certificates of deposit
(CDs) are not strictly money market funds because they are sold with terms of
up to 10 years. However, CDs with terms as short as three months to six months
are available. As with money market accounts, bigger deposits and longer terms
yield better interest rates. Rates in August 2020 for twelve-month CDs ranged
from about 0.5% to 1.5% depending on the size of the deposit.5? Unlike a money
market account, the rates offered with a CD remain constant for the deposit
period. There is a penalty associated with any early withdrawal of funds
deposited in a CD. Commercial Paper The commercial paper market is for buying
and selling unsecured loans for corporations in need of a short-term cash
infusion. Only highly creditworthy companies participate, so the risks are low.
Banker's Acceptances:
The banker's acceptance is a short-term loan that is guaranteed by a bank. Used
extensively in foreign trade, a banker's acceptance is like a post-dated check
and serves as a guarantee that an importer can pay for the goods. There is a
secondary market for buying and selling banker's acceptances at a discount.
Eurodollars Eurodollars are dollar-denominated deposits held in foreign banks,
and are thus, not subject to Federal Reserve regulations. Very large deposits
of eurodollars are held in banks in the Cayman Islands and the Bahamas. Money
market funds, foreign banks, and large corporations invest in them because they
pay a slightly higher interest rate than U.S. government debt. Repos The repo,
or repurchase agreement (repo), is part of the overnight lending money market.
Treasury bills or other government securities are sold to another party with an
agreement to repurchase them at a set price on a set date.
Money Markets vs. Capital Markets:
The money market is defined as dealing in debt of less than one year. It is
primarily used by governments and corporations to keep their cash flow steady,
and for investors to make a modest profit. The capital market is dedicated to
the sale and purchase of long-term debt and equity instruments. The term
capital markets refers to the entirety of the stock and bond markets. While
anyone can buy and sell a stock in a fraction of a second these days, companies
that issue stock do so for the purpose of raising money for their long-term
operations. While a stock's value may fluctuate, unlike many money market
products, it has no expiration date (unless, of course, the company itself
ceases to operate).
Frequently Asked Questions:
Why is it called the money market? The money market refers to the market for
highly liquid, very safe, short-term debt securities. Because of these
attributes, they are often seen as cash equivalents that can be interchangeable
for money at short notice. Why is the money market important? The money market
is crucial for the smooth functioning of a modern financial economy. It allows
savers to lend money to those in need of short-term loans and allocates capital
towards its most productive use. These loans, often made overnight or for a
matter of days or weeks, are needed by governments, corporations, and banks in
order to meet their near-term obligations or regulatory requirements. At the
same time, it allows those with excess cash on hand to earn interest. What are
some examples of money market instruments? The money market is composed of
several types of securities including short-term Treasuries (e.g. T-bills),
certificates of deposit (CDs), commercial paper, repurchase agreements (repos),
and money market mutual funds that invest in these instruments. The money
market funds typically have shares that are always priced at $1. Can you lose
money in the money market? For depositors, most money market accounts are
insured by the FDIC up to $250,000 per institution. Because money market
instruments are very low risk, there is virtually no chance you will lose your
money by owning a CD or T-bill either. During periods of extreme financial
stress, for example during the height of the 2008 financial crisis, some money
market funds did "break the buck" and briefly incur losses, but this
was quickly corrected. What are the downsides of money markets? Because they
are virtually risk-free, money market investments also come with very low
interest rates - often the risk-free rate of return. As a result, they will not
provide substantial capital gains or investment growth compared to riskier
assets like bonds or stocks. Some types of money market accounts, like CDs,
furthermore can lock your money up until it matures, which can range from
months to years.
|
|
