They give lenders and borrowers a way to meet their urgent financial needs.
Money markets were frequently taken for granted as basic, low-volatility components of the financial system UNTIL issues emerged during the global financial crisis.
Banks, money managers, and retail investors can typically make secure, liquid, short-term investments through money markets, and borrowers including banks, broker-dealers, hedge funds, and non-financial firms can get low-cost capital through them. The word “money market” is an umbrella term that encompasses a variety of market types that differ based on the requirements of lenders and borrowers.
One effect of the financial crisis has been to draw attention to the variations across distinct money market segments, some of which have proven to be fragile while others have shown considerable resilience.
For the short term
These exchanges are referred to as “money markets” because the assets that are purchased and sold have short maturities—ranging from one day to one year—and typically may be converted into cash with ease. Bank accounts, including term certificates of deposit, interbank loans (loans between banks), money market mutual funds, commercial paper, Treasury bills, securities lending and repurchase agreements (repos), and other financial instruments are all included in money markets. According to the Federal Reserve Board’s Flow of Funds Survey, these markets make up a sizable portion of the financial system in the United States, accounting for nearly one-third of all credit.
These money market instruments, many of them securities, differ in how they are traded and are treated under financial regulatory laws as well as in how much a lender relies on the value of underlying collateral, rather than on an assessment of the borrower.
The most familiar money market instruments are bank deposits, which are not considered securities, even though certificates of deposit are sometimes traded like securities. Depositors, who are lending money to the bank, look to the institution’s creditworthiness, as well as to any government programs that insure bank deposits.
Since collateral is not used to secure interbank loans, a lender must solely rely on a borrower’s creditworthiness to determine the likelihood that they will be repaid. The interbank market in England, where the London interbank offered rate (LIBOR), which reflects the average price at which large banks are ready to lend to one another, is the one that receives the most attention. During the crisis, that market did not prove to be a dependable source of funding. Once the credibility of banks was questioned, LIBOR rates jumped significantly in compared to other money market rates. Additionally, lending volume considerably reduced as banks struggled to fund their current assets and showed less enthusiasm in making new loans. Central banks’ emergency lending assisted in making up for this funding source’s contraction.
The integrity of the pricing methodology used to calculate LIBOR has also come under scrutiny in recent regulatory inquiries.
Commercial paper is a promissory note (an unsecured debt) issued by some sizable nonfinancial firms and highly rated institutions. Investors rely exclusively on the trustworthiness of the issuer to repay their savings because the instrument is unsecured (basically just a promise to pay, hence the name). Like a security, commercial paper is issued and traded. However, it is exempt from most securities rules because it is short-term in nature and not bought by individual investors. Here in the United States,For instance, commercial paper is issued in denominations that are judged too big for retail investors (usually $1 million, but occasionally as low as $10,000) and with maturities ranging from 1 to 270 days.
The safest investment
Government-issued securities with maturities of less than a year are known as Treasury bills. The safest investment for short-term savings is U.S. Treasury bills, which are actively bought and traded once they are issued and are sold at a discount from face value. The trading is governed by securities rules and takes place on a deep and liquid market. US Treasury bills can be used to settle transactions as well as serve as a savings instrument. Electronically issued Treasury Bills can be transferred through the payments system much like cash.
The money markets include a significant, although more intricate, section known as repos. Repos provide affordable interest rates for short-term borrowing and lending—typically no more than two weeks and frequently overnight. In exchange for cash, a borrower sells a security it owns with the promise to buy it back from the buyer—effectively a lender—at a later date and for a price that represents the interest paid for borrowing during the time period. The transaction’s central security acts as collateral for the lender.
Repo and other securities loan markets are essential to short-selling, which is when a trader agrees to sell a security they do not own, in addition to making it feasible for secure short-term borrowing and lending in money markets. The short-seller must temporarily borrow or purchase such a securities through a repo transaction. The short seller must once more purchase or borrow the security when it is time to return it to the lender. The short-seller benefits from the deal if the price has declined.
Companies that invest in various money market products, such as commercial paper, certificates of deposit, Treasury bills, and repos, sell securities known as money market mutual funds (MMMFs). In the United States and the European Union, money market mutual funds are governed as investment firms. They provide enterprises, institutional investors, and ordinary investors with a low-risk return on a short-term investment. A typical MMMF makes investments in highly rated, liquid, short-term instruments. The fund is managed to keep the price constant, or, in terms of securities, maintains a consistent net asset value, which is typically $1 per share, despite the fact that the price is neither fixed nor guaranteed. (This contrasts with other mutual funds, whose per share value fluctuates daily and invest in stocks or bonds)
The difference is paid as interest if the underlying MMMF assets’ value increases over $1 per share. A money market fund with a net value of less than $1 per share, or “breaking the buck,” was practically unheard of prior to the financial crisis. The fund’s investment managers utilized their own funds to maintain the price at $1 per share the few times it occurred.
However, losses on commercial paper and later notes issued by Lehman Brothers (the broker-dealer that filed for bankruptcy in September 2008) put money market funds at risk during the financial crisis. The U.S. government took measures to avert a panic that may have led the credit contraction to spread because MMMFs are significant players in other critical money markets. To help MMMFs fend off an investor run, the U.S. Treasury guaranteed the principal and the Federal Reserve established a special lending facility for commercial paper.
Dysfunctional markets
The money market has other segments that are less straightforward. They include certain triparty repo agreements and asset-backed commercial paper (ABCP).
A company that has illiquid (difficult to sell) financial assets like loans, mortgages, or receivables may use ABCP to borrow money at a reduced rate of interest or to get rid of these assets from its balance sheet. It establishes a special purpose business that buys the firm’s illiquid assets and pays for the transaction by issuing ABCP, which, in contrast to standard commercial paper, is “backed” or secured by the underlying assets. If the assets are rated well and the special facility has enough capital and credit lines, this sort of commercial paper can get a high credit rating. The lines of credit account for the difficulties of selling the underlying assets to meet financial needs, and the capital is meant to cover unforeseen losses on the assets.
During the crisis, there were issues in several segments of the ABCP market. Investors can easily evaluate an issuer’s credit condition because standard commercial paper issuers—almost entirely major nonfinancial firms and banks—file quarterly financial statements. The special purpose entity’s structure, its credit improvements, its liquidity backup, and the value of the underlying assets, among other factors, all of which were likely to be less transparent and more complicated than those of the plain commercial paper, all affected the credit risk on ABCP. Between August and November 2008, the ABCP market in the US shrank by 38%.
More than one-third of all outstanding commercial paper is held by the MMMF market, which was impacted by this. The money in MMMFs abruptly shifted away from ABCP and into government and agency assets when investors started to withdraw their money.
For Treasury and agency assets, the triparty repo market turned out to be substantially less dependable than the regular repo market. When a loan is repaid, ownership of the collateral is transferred from the borrower to the lender and back again by one or two clearing institutions, which control the triparty repo market.
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