In the present day financial system, money is a commodity that is nominal in nature even though backed by physical assets. As a result, it can be traded just like any other commodity. Just like other commodities are traded in designated commodities exchanges, money i.e. cash and cash equivalent instruments are traded in a designated exchange termed the “money market”. Money market is a key component of national financial market and comprises various types of instruments designed to perform specific functions. Key functions performed by various instruments traded in money markets include borrowing (short term), lending as well as buying and selling instruments with an initial maturity of up to 1 year. The following are some of the key characteristics and functions of money markets as well as the various money market instruments currently available in India.
Key Features of Money Markets
Just like any other market operating in the financial sector, money markets have some key characteristics that set it apart from other types of financial markets such capital markets:
Over the Counter
Money markets across the world essentially operate over the counter, which essentially means that these trades cannot be made online. Therefore investments in these markets are made physically by authorized representatives or in person and a physical certificate is issued to the buyer of the money market instrument.
This essentially means that money markets are designed to provide and accept bulk orders, thus few retail investors have enough capital to directly participate in money markets. However, individual investors can choose to invest in debt mutual funds that invest in money markets in order to invest in this market.
Unlike capital markets which usually trade in one single type of instrument such as securities, money markets trade is multiple instruments. These instruments feature different maturities, debt structure, credit risk and even currencies to name a few. As a result of this diversity, money market instruments are ideal for diversification through distribution of exposure.
The main feature that makes money markets unique is the high level of liquidity that they offer. It is easy to make money market trades across currencies, maturities, debt structure as well as credit risk, which makes it ideal for institutions seeking to borrow or invest for the short term.
Key Money Market Participants
As mentioned earlier, money markets are not technically open to individual investors as they deal with bulk orders and the trades are carried out over the counter. As a result a range of institutional investors participate in buying and selling money market instruments. Key players in money markets thus include financial institutions as well as dealers looking to borrow or lend money in the short term. The typical duration of these instruments is up to 13 months. Money market instruments as a group are termed as “papers” in contrast to “bonds” and “shares” that are traded on capital markets and refer to long term borrowing instruments.
One of the core drivers of money markets is inter-bank lending. Inter-bank lending refers to banks lending to and borrowing from other banks using money market instruments such as repurchase agreements and commercial papers. The LIBOR or London Interbank Offered Rate usually forms the benchmark for these instruments. India the RBI regulated REPO rate performs a similar function for domestic banks lending and borrowing from one another.
Finance companies operating in money markets usually fund themselves through issue of various asset backed commercial papers (ABCP) which are secured by pledge of various eligible assets. Common examples of such eligible assets include mortgages (residential/commercial), mortgage-backed securities, etc. However, this format of money markets currently exists only in developed economies such as the US.
Money Market in India
The Indian money market is not as developed at present as those of many advanced economies. However, money market instruments in India do have varying maturities from overnight to one year, which can be used for short term lending and borrowing. In India, the Reserve Bank of India controls and regulates money markets which are considered a focal point of its power over the wider financial market. Money markets in India serve the important purpose of providing liquidity to borrowers and providers of funds over the short term, while maintaining a balance between the demand and supply of short term funds. Some of the key money market instruments in India today include treasury bills, call money, commercial papers, certificates of deposit, repos, forward rate agreements and interest rate swaps.
In terms of structure, money markets in India unlike most developed economies comprise elements of both organised and unorganised sectors. Key players in India’s unorganised money market sector include indigenous bankers, money lenders as well as unorganised NBFCs such as Nidhis and chit funds. Key players in the organised money market of India include co-operatives (banks and societies), IDBI (Industrial Development Bank of India), the International Finance Corporation, various RBI regulated NBFCs (e.g. LIC of India), development banks, private and public sector banks as well as the Reserve Bank of India. As per the existing structure of the Indian money market, the RBI can only influence the organised sector and the smaller unorganised sector is largely beyond its control. However due to the considerably larger size of this organised sector, regulatory actions taken by the RBI can produce substantial impact on the way in which this entire market operates.
Types of Money Market Instruments in India
The money market in India is considered to be an agglomeration of multiple sub markets each featuring a different instrument that can differ based on maturity interval, risk level, etc. The following are some key money market instruments available in India:
Traded in a sub-market termed as the call money market, call money essentially represents a short term loan with maturities ranging from 1 day to 14 days and is repayable on demand. The main uses of this instrument include providing short term loans to banks primarily for the purpose of making stock exchange transactions and bullion deals. Key participants in this market include NABARD, UTI mutual fund and LIC mutual fund who are only engaged in lending to the other participants. The call money market participants are allowed to both lend and borrow using the call money instrument are STCI (Securities Trading Corporation of India), DFHI (Discount and Finance House of India), co-operative banks as well as Indian and foreign commercial banks.
Call money loans feature a fixed interest rate, termed as call rate, which being closely related to changes of demand and supply, is quite volatile. Due to the high level of volatility, call money market is considered to be the most sensitive section of India’s money market. At present two separate call rates are in use in India – the DFHI lending rate and interbank call rate. India’s major call money markets are located at Ahmedabad, Chennai, Delhi, Kolkata and Mumbai.
Treasury Bills are by far the oldest of money market instruments and they are still used heavily not just in Indian money markets but also the world over. Treasury Bills or T-Bills in India are short term borrowing instruments issued by the Government of India that do not pay any interest but are available at a discount from their face value at the time of issue. The difference between the discounted issue price and the face value at which these bills are redeemed provide the “interest” payout to the buyer of the bill i.e. the lender. As T-Bills are issued by the government, the returns are guaranteed and they are considered to be zero default risk investments.
T-Bills are commonly classified in two ways – based on maturity and based on type. The maturity classification of treasury bills names these as 10 day TBs, 91 day TBs, 182 day TBs and 364 day TB. The other classification categories of these government-issued promissory notes include auction bills, tap bills and ad hoc bills. Ad hoc bills are no longer available in India however they were only available to foreign central banks, semi-government departments, central and state government for investment purposes. Auction bills follow a multiple price system in order to ensure fair pricing. Auction bills and tap bills are also termed as regular bills as they are available for investment by banks as well as other participating institutions.
Ready Forward Contract (Repo)
The term repo is derived from the phrase “repurchase agreement” which is essentially an agreement that simultaneously mentions sale and purchase of an asset. In the Indian context, repo agreements are made between banks as well as between a bank and the RBI for short term loans. In case such borrowing agreements are made internationally, the commonly used rate is the LIBOR (London Inter Bank Offered Rate), while in case of a domestic repo agreement between two Indian financial institutions the applicable rate is termed as the repo rate. Repo rate may thus be defined as the rate at which domestic Indian banks borrow from other Indian banks or from the RBI. The repo rate is fixed by the Reserve Bank of India and it is one of the most powerful monetary control tools that the central bank possesses. Decreasing the repo rate makes it cheaper for banks to borrow money from other banks or the central bank. This theoretically allows the bank to pass on the lower rate benefit to customers in the form of loans provided at reduced rates.
Money Market Mutual Funds
This was originally used as an alternate term for liquid funds, which are among the lowest risk debt funds. After reclassification of mutual funds by SEBI, a unique type of mutual fund known as money market funds have emerged and these primarily invest in various money market instruments. Because the money market is largely over the counter and mainly features block deals, it is largely closed off to the general public and this is where liquid funds fill the gap. Individual investors can put their money in a liquid fund, which invests in block over the counter deals carried out on money markets. Though money markets themselves are overseen by the RBI, liquid funds are regulated by SEBI (Securities Exchange Board of India).
As a general rule, liquid funds primarily invest in money market instruments with a maturity of up to 91 days. Because of the potentially low level of risk associated with short maturity money market instruments, liquid funds are considered to be a low risk investment option even though they provide higher returns than bank deposits. Moreover, these funds are highly liquid making them ideal for short term parking of excess funds for not only individual investors but also for institutional investors.
Interest Rate Swaps
This is the newest money market instruments in use in India today. Interest rate swap is a financial transaction in which two parties sign a deal in which one pays a fixed rate of interest, while the other pays a floating rate of interest. The fixed rate of interest payable is calculated using a notional principal amount, while the floating rate of interest is paid on the actual principal lent out/borrowed with the rate varying on the basis of market conditions. In India interest rate swaps are mainly used by commercial banks however, these are separate products that are not directly linked to the bank’s assets such as money lent to customers in the form of loans. This money market instrument protects the borrower from interest rates changes even though the borrower is on the hook for any variable mark up payments not covered by the interest rate swap agreement.
Key Functions of Money Markets
Money Markets have continued to exist in modern economies due to their unique features as well as their ability to carry out some key functions that other financial markets cannot. The five leading functions that a money market carries out in the modern economic system include:
Providing Trade Financing
Modern day money markets play a vital role in ensuring that there is adequate capital available to institutions engaged in domestic as well as international trade. Internationally, short term funding for ventures may be available to traders through “bills of exchange” apart from other routes. These are instruments that are discounted by the bill market. In common practice, discount markets and acceptance houses are engaged in financing overseas trading ventures using these “bills of exchange”.
Ensuring Industrial Financing
Many industries issue bonds on the bond market or shares on the stock market in order to receive long term financing of their operations. However, many industrial houses are actively involved with money markets too. There are two ways in which money markets help with industrial financing – providing short term funding and producing an impact on capital markets. Short term funding from money markets can help industries finance day to day operations and meet working capital requirements using commercial papers, finance bills, etc. Long term capital is obtained by industries through issue of bonds or shares on applicable capital markets. However, capital markets are impacted by money market movements. This is because the rate applicable to short term lending plays a key role in determining the applicable yield of long term capital market instruments such as bonds.
Low Risk – High Liquidity Investment Solution
The money market offers institutions such as commercial banks, a lucrative low risk route to use their excess funds in order to earn additional income. The main reason why commercial banks need to generate this additional income is to ensure that they have sufficient liquidity to meet uncertain demands such as withdrawal of consumer deposits. Usually commercial banks invest their funds in near money assets that have a short maturity period which can be easily converted to cash to provide high liquidity to the investor. This way the banking sector is able to generate additional income while maintaining sufficient liquidity.
Ensuring Self Sufficiency of Banks
Commercial banks operating in developed money markets have ample opportunities to invest and generate further income such that their self sufficiency improves in the long term. Banks can always borrow from central banks when they face a dire cash crunch hence RBI is considered to be the lender of last resort. However, it is always desirable for banks to be able to manage their own monetary requirements in the short term as well as the long term. This, money market can help the bank achieve through availability of funds at rates that are lower than those charged by the central bank. Thus money markets provide a two pronged benefit – helping banks earn additional income and also as a source funds to the bank when required.
Maintaining Money Supply for Central Banks
Central Banks globally are involved in maintaining and controlling markets – both money markets as well as capital markets. Thus even though a central bank such as RBI can influence monetary policy without having to take the help of money markets, the presence of this improves their efficiency by a great deal. As these markets operate using short term interest rates, they serve as an excellent indicator of the country’s overall economic health. Such information can provide accurate guidance to the central bank regarding how it should act to rectify any problems that might be occurring in the current situation. In the present day all markets are linked, therefore actions taken by the central bank in money markets will have an impact on capital markets. Thus, in the presence of a developed money market, the central bank has access to a secure, quick as well as effective way to influence various sub markets without having to overextend itself.