Money Market – Definition, Features and Instruments

As per the definition of Reserve Bank of India, money market is “a market for short terms financial assets that are close substitute for money, facilitates the exchange of money in primary and secondary market”.

Indian money market was highly regulated and was characterized by limited number of participants. The limited variety and instruments were available. Interest rate on the instruments was under the regulation of Reserve Bank of India. The sincere efforts for developing the money market were made when the financial sector reforms were started by the government.

Money markets are the markets for short-term, highly liquid debt securities. Examples of these include bankers’ acceptances, repos, negotiable certificates of deposit, and Treasury Bills with maturity of one year or less and often 30 days or less. Money market securities are generally very safe investments, which return relatively; low interest rate that is most appropriate for temporary cash storage or short term time needs.

The Nature of Money Markets

In this we define money markets broadly to include all financial instruments easily converted to means of payment that are used by governments, financial institutions and non-financial institutions for short-term funding or placements. By convention, we limit our scope to instruments of less than one year maturity.

The most important function of a money market is to provide a means whereby economic units can quickly adjust through cash positions. For all economic units (business, household’s financial institutions or governments) the timing of cash inflows is rarely perfectly synchronized or predictable in the short run. In addition to facilitating the liquidity management of economic actors, money markets fulfill a number of additional economic functions:

  1. Interest rates on money market instruments serve as reference rates for pricing all debt instruments;
  2. Governments or central banks use money market instruments as tools at monetary policy;
  3. Short-term interbank markets, finance longer-term lending when financial intermediaries transform maturities.

Features of Money Market

  • It is a market purely for short-terms funds or financial assets called near money.
  • It deals with financial assets having a maturity period less than one year only.
  • In Money Market transaction cannot take place formal like stock exchange, only through oral communication, relevant document and written communication transaction can be done.
  • Transaction has to be conducted without the help of brokers.
  • It is not a single homogeneous market, it comprises of several submarket like call money market, acceptance & bill market.
  • The components of Money Market are the commercial banks, acceptance houses & NBFC (Non-banking financial companies).
  • It is not a single market but a collection of markets for several instruments.
  • It is a need-based market wherein the demand & supply of money shape the market.
  • Money market is basically over-the-phone market.
  • Dealing in money market may be conductive with or without the help of brokers.
  • It is a market for short-term financial assets that are close substitutes for money.
  • Financial assets which can be converted into money with ease, speed, without loss & with minimum transaction cost are regarded as close substitutes for money.

The Major Players of Money Market

  • Reserve Bank of India
  • Acceptance Houses
  • Commercial Banks, Co-operative Banks and Primary Dealers are allowed to borrow and lend.
  • Specified All-India Financial Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice money market only as lenders
  • Individuals, firms, companies, corporate bodies, trusts and institutions can purchase the treasury bills, CPs and CDs.

Money Market Instruments

Money market instruments take care of the borrowers’ short-term needs and render the required liquidity to the lenders. The varied types of India money market instruments are treasury bills, repurchase agreements, commercial papers, certificate of deposit, and banker’s acceptance.

  1. Treasury Bills (T-Bills) – Treasury bills were first issued by the Indian government in 1917. Treasury bills are short-term financial instruments that are issued by the Central Bank of the country. It is one of the safest money market instruments as it is void of market risks, though the return on investments is not that huge. Treasury bills are circulated by the primary as well as the secondary markets. The maturity periods for treasury bills are respectively 3-month, 6-month and 1-year. The price with which treasury bills are issued comes separate from that of the face value, and the face value is achieved upon maturity. On maturity, one gets the interest on the buy value as well. To be specific, the buy value is determined by a bidding process, that too in auctions.
  2. Repurchase Agreements – Repurchase agreements are also called repos. Repos are short-term loans that buyers and sellers agree upon for selling and repurchasing. Repo transactions are allowed only among RBI-approved securities like state and central government securities, T-bills, PSU bonds, FI bonds and corporate bonds. Repurchase agreements, on the other hand, are sold off by sellers, held back with a promise to purchase them back at a certain price and that too would happen on a specific date. The same is the procedure with that of the buyer, who purchases the securities and other instruments and promises to sell them back to the seller at the same time.
  3. Commercial PapersCommercial papers are usually known as promissory notes which are unsecured and are generally issued by companies and financial institutions, at a discounted rate from their face value. The fixed maturity for commercial papers is 1 to 270 days. The purposes with which they are issued are – for financing of inventories, accounts receivables, and settling short-term liabilities or loans. The return on commercial papers is always higher than that of T-bills. Companies which have a strong credit rating, usually issue CPs as they are not backed by collateral securities. Corporations issue CPs for raising working capital and they participate in active trade in the secondary market. It was in 1990 that Commercial papers were first issued in the Indian money market.
  4. Certificate of Deposit – A certificate of deposit is a borrowing note for the short-term just similar to that of a promissory note. The bearer of a certificate of deposit receives interest. The maturity date, fixed rate of interest and a fixed value – are the three components of a certificate of deposit. The term is generally between 3 months to 5 years. The funds cannot be withdrawn instantaneously on demand, but has the facility of being liquidated, if a certain amount of penalty is paid. The risk associated with certificate of deposit is higher and so is the return (compared to T-bills). It was in 1989 that the certificate of deposit was first brought into the Indian money market.
  5. Bankers Acceptance – A banker’s acceptance is also a short-term investment plan that comes from a company or a firm backed by a guarantee from the bank. This guarantee states that the buyer will pay the seller at a future date. One who draws the bill should have a sound credit rating. 90 days is the usual term for these instruments. The term for these instruments can also vary between 30 and 180 days. It is used as time draft to finance imports, exports.

It depends on the economic trends and market situation that RBI takes a step forward to ease out the disparities in the market. Whenever there is a liquidity crunch, the RBI opts either to reduce the Cash Reserve Ratio (CRR) or infuse more money in the economic system. In a recent initiative, for overcoming the liquidity crunch in the Indian money market, the RBI infused more than Rs 75,000 crore along with reductions in the CRR.

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