A subset of the fixed income market is the money market. We commonly associate the word “fixed income” with bonds. A bond, in reality, is merely one sort of fixed income security. The money market differs from the bond market in that it specializes in very short-term debt securities (debt maturing in less than a year). Because of their short maturities, money market assets are sometimes known as cash investments.
Governments, financial institutions, and huge enterprises issue money market securities, which are essentially IOUs. These instruments are extremely liquid and are thought to be extremely safe. Money market assets give much lower returns than most other securities due to their severe conservatism.
One of the primary distinctions between the money market and the stock market is that most money market instruments trade in extremely large denominations. Furthermore, because the money market is a dealer market, corporations purchase and sell securities in their own accounts, at their own risk. This restricts the individual investor’s access to the inventory maintained by their broker. In the stock market, a broker receives a commission for acting as an agent, but the investor bears the risk of keeping the stock. Another distinguishing feature of a dealer market is the absence of a central trading floor or exchange. Deals are made over the phone or via technological technologies.
We can easily acquire access to the money market by employing a broker or money market mutual funds. These funds combine the assets of thousands of individuals to purchase money market securities on their behalf. Some money market instruments, such as treasury bills, can, however, be purchased directly.
Understanding the Money Market
The money market is one of the global financial system’s cornerstones. It entails overnight transfers of large sums of money between banks and the US government. The vast majority of money market transactions are wholesale transactions between financial institutions and businesses.
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 purchased by other companies or funds; and investors who buy bank CDs as a safe place to park money in the short term are all participants in the money market.Some of the wholesale transactions end up in the hands of consumers as part of money market mutual funds and other assets.
Types of Money Market Instruments
- Money Market Funds
Companies and financial organisations that lend and borrow in quantities ranging from $5 million to far over $1 billion each transaction are barred from participating in the wholesale money market. Individual investors can purchase baskets of these products from mutual funds. The net asset value (NAV) of such funds is expected to remain constant at $1. One fund dropped below this level during the 2008 financial crisis.
This caused a market panic and a large exodus from the funds, resulting in further limits on their access to riskier investments.
- Money Market Accounts
Savings accounts are money market accounts. They pay interest, but some issuers limit account holders’ ability to withdraw funds or write checks on the account. (Federal regulations limit withdrawals. If they are surpassed, the bank immediately transforms the account to a checking account.) Banks normally compute interest on money market accounts daily and credit the account weekly.
Money market accounts often provide somewhat higher interest rates than conventional savings accounts. However, the spread between savings and money market accounts has shrunk significantly since the 2008 financial crisis. Money market account interest rates vary depending on the amount deposited. The best-paying money market account with no minimum deposit offered 0.56% annualised interest as of August 2021.
- Certificates of Deposit (CDs)
Because they are sold with periods of up to ten years, most certificates of deposit (CDs) are not truly money market funds. However, CDs with periods ranging from three to six months are available.
Larger deposits and longer durations, like with money market accounts, yield higher interest rates. Rates on 12-month CDs varied from roughly 0.50% to 0.70% in August 2021, depending on the size of the deposit. In contrast to a money market account, the rates offered by a CD remain consistent during the deposit period. An early withdrawal of monies invested in a CD is normally subject to a penalty.
- Commercial Paper
The commercial paper market is used to buy and sell unsecured loans for businesses in need of a quick cash infusion. Because only highly creditworthy enterprises join, the risks are minimal.
- Banker’s Acceptances
A banker’s acceptance is a short-term loan that is bank-guaranteed. A banker’s acceptance, which is often used in overseas trade, is similar to a post-dated cheque and acts as a promise that an importer will be able to pay for the products. There is a secondary market for purchasing and selling discounted banker’s acceptances.
- Eurodollars
Eurodollars are dollar-denominated deposits maintained in foreign banks that are not regulated by the Federal Reserve. Banks in the Cayman Islands and the Bahamas have very substantial deposits of eurodollars. They are invested in by money market funds, international banks, and huge enterprises because they pay a somewhat higher interest rate than US government debt.
- Repos
The repo, or repurchase agreement (repo), is a type of overnight lending money market transaction. Treasury bills or other government securities are sold to another party with the promise to repurchase them at a predetermined price on a predetermined date.
Advantages and Disadvantages of Money Market
| Advantages of Money Market Funds | Disadvantages of Money Market Funds |
| 1. They are practically like a bank account with higher interest rates. We can earn considerably higher amounts of interest on a money market fund than on a regular savings account due to the low-risk nature of these funds. | 1. High liquidity also means volatile opportunities. If the instruments that these funds invest in are withdrawn or cancelled in their term, the money market fund could lose the invested money very quickly and customers can even lose their invested capital. |
| 2. Similar to the example above, these funds can be withdrawn almost at a day’s notice like an account with a bank. Because they are involved in short term securities and cash instruments, the liquidity is pretty high in money market funds. | 2. Certain money market funds can request to lock in your money if the investment company wants to change the nature of the fund. Either one can withdraw all their funds or have their money locked in for two to three years at a time. |
| 3. All earnings from the funds along with the fund itself is easily trackable and can be conveniently managed. | 3. Although slow earners, waiting to see your money grow on Money market funds might mean missing out on other categories of mutual funds that can earn interest much quicker and double your investment in a matter of a few years. |
| 4. The Securities and Exchange Commission (SEC) makes sure that the funds available in the market only invest in tried and tested instruments and have a proven track record of making good investment decisions. Any foul play can lead to tax and other penalties for the investment companies. In this sense, these funds are safer than similar funds. | 4. These funds are not insured. For bank accounts and term deposits, FDIC provides for insurance upto $250,000 per customer. However, money market funds are not insured as the funds are not secured for any amount of time. This could be troublesome if the investment company is not able to manage the fund properly. |
| 4. Due to the low-risk nature, these funds have almost a steady rate of interest that keeps growing slowly but steadily over a course of time. Over the course of years, these funds can provide high returns. | 5. Although high returns are possible, these funds might not be able to beat inflation if the investment articles are not regulated often. For long tenures, the fund might earn high returns, but considering the time value of money, it might be on the lower side of returns. |
Pros and Cons of Money Market Accounts
Pros
- Extremely low risk.
- May be insured by FDIC.
- Highly liquid.
- Higher returns than most bank accounts.
Cons
- Low returns that may not keep pace with inflation.
- Not all money market securities are insured.
- May have high minimum investments or withdrawal restrictions.
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