Understanding Money Markets

  • By AFP Staff
  • Published: 5/13/2024
Money Markets Article Header

Money markets refer to a global marketplace where highly liquid (i.e., easily converted to cash) short-term financial investments are traded.

Money market securities have a maturity of one year or less and are typically debt instruments, such as negotiable certificates of deposit, banker’s acceptances, government securities (e.g., U.S. Treasury bills, municipal securities), commercial paper, municipal notes and repurchase agreements.

Participants in money markets include banks, corporations, governments and institutional investors, who borrow and lend money for short periods to meet short-term funding needs, manage liquidity or earn returns on surplus cash.

Money markets are important to treasury professionals as they play a crucial role in providing liquidity to the financial system and facilitating the efficient allocation of short-term funds. They serve as a key resource of short-term financing when flexibility and quick access to cash are needed.

Types of Money Market Instruments

Money markets differ across regions in terms of size, liquidity and types of investment instruments available — which are influenced by local economic conditions and investor preferences. Government securities and bank obligations are most commonly traded, but the availability of instruments depends on the issuers' borrowing needs and the capacity of local investors to support them. The most common money market instruments are described below.

Commercial Paper

Commercial paper (CP) refers to unsecured (i.e., lacking collateral) promissory notes representing an issuer’s debt obligation. CP is typically issued at a discount to its face value, with the difference influencing its yield — both the credit rating of the issuer and the specific issue of CP affect its discount and yield. Interest isn’t paid on CP; instead, the face value is redeemed at maturity. While CP is generally held until maturity, it can be traded on the secondary market prior to its maturity date.

The benefits of CPs include their range of maturities, liquidity (especially for investment-grade CP) and diversification opportunities. One key drawback is their lack of asset backing, which is often mitigated by credit enhancement, such as backup lines of credit.

Asset-backed commercial paper (ABCP), as the name implies, is CP secured by specific assets such as short-term trade receivables. Unlike traditional CP, which is issued through companies, ABCP is issued through a financial conduit and is either backed by assets from a single institution (single-seller) or multiple issuers (multi-seller). As of October 2021, ABCP accounted for 22% of U.S. commercial paper.

One key benefit of ABCP is the fact that it offers enhanced security as it's backed by tangible assets, with credit enhancements from sponsoring banks, thereby ensuring timely repayment. That said, its complex structure makes risk assessment challenging, often requiring third-party credit monitoring. The ABCP market is smaller than the standard CP market, which also increases liquidity risk; however, this is offset by slightly higher returns.

The market-specific characteristics of CP are shaped by securities legislation, regulation and market conventions. In the U.S., the maturity time for CP ranges from overnight to 270 days for public issuance and up to 397 days for private placements. In the U.K., the maximum maturity time is 364 days. Minimum investment amounts and market sizes vary globally, with the U.S. hosting the largest CP market. Europe also boasts significant markets, including an international euro CP market catering to non-U.S. investors with issuance in multiple currencies.

Bank Obligations

Banks raise funds in money markets using various instruments, including time deposits, banker's acceptances and repurchase agreements, collectively known as bank obligations. Time deposits include savings accounts, certificates of deposit (CDs) and negotiable CDs. Negotiable CDs are high-value time deposits traded on the open market, typically in multiples of $100,000 or more. They have a fixed maturity and an active secondary market. Nonnegotiable or retail CDs lack a secondary market and impose penalties for early redemption.

Non-U.S. banks and foreign branches of U.S. banks raise funds through global money markets using Eurodollar deposits, i.e., USD-denominated deposits held outside the U.S. These deposits can be negotiable or nonnegotiable and typically attract foreign investors as they offer higher interest rates than comparable U.S. bank securities. They also come with fewer regulations and a lack of U.S. reserve requirements.

Yankee CDs are USD-denominated CDs sold by U.S. branches of non-U.S. banks, often through New York branches. These, too, historically offer higher interest rates due to regulatory differences. They also provide geographic diversification in investment portfolios.

In many locations, including the United States, time deposits and investments in CDs are protected by deposit insurance; however, their limits are often too low to provide significant protection against credit risk for most business investors. Alternatively, private services can distribute cash investments among a network of banks to receive full FDIC insurance coverage on amounts up to $50 million, thereby offering greater protection and convenience.

Banker's acceptances (BAs) come from commercial trade. They are time drafts accepted by a bank and guarantee payment at maturity. Holders can wait for maturity or sell the BA at a discount before maturity, benefiting from the accepting bank's guarantee.

Government Paper

Government agencies raise funds in the money market by issuing short-term promissory notes called government paper. These are issued at the national, provincial and local levels and include U.K. Treasury bills, U.S. T-bills, German Bubills and Japanese Treasury discount bills. Only those maturing within a year are classified as money market instruments.

Government paper is backed by the respective government, making the market liquid and active. It has varying maturities to match investor liquidity needs. Government paper is typically issued at a discount and offers lower yields due to lower default and liquidity risk compared with other instruments. U.S. Treasuries are considered risk-free and serve as a benchmark for interest rates, but sovereign risk varies among countries, with some governments having defaulted on their debt in the past.

  • U.S. government paper: T-bills are short-term money market instruments sold at a discount from their face value, with original maturities of four to 52 weeks. Issued through sealed-bid auctions, bids can be competitive or noncompetitive and are typically bid on by banks and broker-dealers. Because the U.S. Treasury market is highly liquid and has low transaction costs, T-bills are easily tradable in high volumes without significantly impacting market prices or yields.
  • Non-U.S. government paper: In other T-bill (or their equivalent) markets, governments or central banks operate similar processes with the maturity, minimum investment amount and denomination varying depending on the issuing government. For example, the German government mainly issued Bubills with a six-month maturity, but since April 2020, they have issued Bubills with a twelve-month maturity. Similarly, the U.K. Debt Management Office regularly issues Treasury bills with maturities of one, three and six months.
  • Other public instruments: Governments and related entities raise money for short-term financing of projects or working capital needs in the money market through municipal notes (aka munis), variable-rate demand obligations (VRDOs) and tax-exempt commercial paper. These offerings are often tax-free and typically mature anywhere from 270 days (CPs) to one year (munis). VRDOs (can be either tax-exempt or taxable) are long-term bonds with a short-term liquidity feature, allowing investors to sell them back at par value, supported by a credit facility like a bank LOC.

Floating-Rate Notes

Firms, banks, governments and agencies raise longer-term funds through floating rate notes (FRNs) in the money market. FRNs have large minimum denominations, maturities of a year or more and pay a regular coupon tied to a reference rate, such as the U.S. Fed funds rate. They are attractive in interest-rate environments that are uncertain due to their flexibility and relatively higher yields and have published credit ratings for easier assessment of creditworthiness. However, their capital value can fluctuate between rate resets, and their bid-offer spread is wider compared to other instruments, which can erode yield advantages.

Repurchase Agreements

In a repurchase agreement (repo), a security owner, typically a bank or securities dealer, sells a security to an investor with an agreement to repurchase it later at a slightly higher price. This arrangement functions as short-term borrowing for the original owner and a way for the investor to invest short-term cash (often called a reverse repo). Repos usually involve government debt but can be based on any security and come in one of three types: overnight, term (two or more days) or open (no maturity).

Term repos can be tailored to specific maturities and yields, determined largely by market repo rates. Repos can be sold if the selling counterparty defaults (settling risk), and transactions are often overcollateralized to mitigate this risk. Bilateral repos involve direct exchange, while tri-party repos — two-thirds of U.S. repo volume, but only 10% in Europe, according to the International Capital Markets Association — are held and managed by a broker-dealer, which is considered the safest method.

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Money Market Funds

Money market funds (MMFs) are managed, pooled investments offered by financial institutions and managed by financial experts. Investors purchase shares, representing ownership in the fund. To ensure compliance and investor protection, MMFs are subject to regulation by authoritative bodies, including the SEC in the U.S., ESMA in the EU, and the China Securities Regulation Commission.

In the U.S., MMFs are tailored to specific investment objectives and include U.S. Treasury funds, government funds, institutional prime funds, institutional municipal/tax-exempt funds and retail funds designed for individual investors. Similarly, in the EU, MMFs are categorized as short-term MMFs or standard MMFs based on their maturity limits, ensuring clarity and consistency in the market.

MMFs provide a number of benefits to treasurers including principal security, daily liquidity, diversification and economies of scale with minimal transaction costs. Professionally managed by financial experts, MMFs provide a hassle-free and cost-effective investment solution in addition to reduced risk through diversification, making them accessible and efficient short-term investment options.

Short-Duration Mutual Funds

Short-duration mutual funds invest in securities with maturities typically ranging from one to three years, which exceeds those of traditional money market instruments. While the potential returns are higher, these funds also carry increased price volatility due to their sensitivity to interest rate changes, measured by duration.

The portfolios of short-duration mutual funds are tailored to specific maturity profiles and primarily consist of government issues, CDs or CP. Unlike MMFs, these funds do not maintain a fixed unit currency value.

Short-duration mutual funds are strategically used to match investments with expected cash flow needs. For example, treasury professionals could allocate cash to MMFs for immediate liquidity and invest additional funds in short-duration mutual funds with targeted average maturities (e.g., 15 months or 24 months) to align with future cash flow requirements.

The Role of Treasury in Money Markets

In money markets, treasury professionals play a dual role as both buyers and sellers. They act as sellers when issuing securities to borrow short-term funds and as buyers when investing excess cash in money market securities.

Money market participants are often simultaneously issuers and investors, adjusting their positions based on their immediate liquidity requirements. For treasury professionals, this dynamic reflects the flexibility and liquidity management inherent in money market activities.

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