They provide a means for lenders and borrowers to satisfy their short-term financial needs
Money markets were generally taken for granted as plain-vanilla, low-volatility sectors of the financial system until issues arose during the global financial crisis.
Money markets, for the most part, provide those with funds—banks, money managers, and retail investors—with a safe, liquid, short-term investment vehicle, while also providing borrowers—banks, broker-dealers, hedge funds, and nonfinancial corporations—with access to low-cost funds. The phrase “money market” refers to a broad category of secured transactions that vary depending on the demands of lenders and borrowers.
One of the effects of the financial crisis has been to draw attention to the disparities between various areas of money markets, since some have proven to be fragile while others have proven to be quite resilient.
For the time being
Because the assets bought and sold are short-term—with maturities ranging from a day to a year—and typically easily convertible into cash, these exchanges are referred to as “money markets.” Bank accounts, including term certificates of deposit; interbank loans (loans between banks); money market mutual funds; commercial paper; Treasury bills; and securities lending and repurchase agreements are all examples of money markets (repos). According to the Federal Reserve Board’s Flow of Funds Survey, these markets account for a significant portion of the financial system, accounting for around one-third of all credit in the United States.
These money market instruments, many of which are securities, differ in terms of how they are traded and regarded by financial regulatory rules, as well as how much a lender relies on the value of underlying collateral rather than a borrower’s estimate.
Bank deposits are the most common money market products, although they are not considered securities, despite the fact that certificates of deposit are sometimes traded as securities. Depositors consider the bank’s creditworthiness as well as any government programmes that insure bank deposits when lending money to it.
Because interbank loans are not guaranteed by collateral, a lender must rely solely on a borrower’s creditworthiness when determining repayment prospects. The London interbank offered rate (LIBOR), which is established daily and indicates the average price at which major banks are ready to lend to one another, is the most keenly monitored interbank market in the world. During the crisis, that market did not prove to be a trustworthy source of funding. When banks’ creditworthiness was called into doubt, LIBOR rates spiked in compared to other money market rates. Furthermore, lending volume fell dramatically as banks struggled to fund existing assets and were less interested in making new loans. Central bank emergency lending helps compensate for the reduction in this funding source. Recent regulatory investigations have shown severe problems in the integrity of the pricing process that determines LIBOR.
Commercial paper is an unsecured promissory note issued by highly rated banks and large non-financial enterprises. Because the instrument is unsecured (meaning it is nothing more than a promise to pay), investors rely completely on the issuer’s creditworthiness to get their money back. Commercial paper is issued and exchanged in the same way that securities are. However, most securities rules do not apply to it because it is short-term in nature and not purchased by individual investors. Commercial paper is issued in the United States in maturities ranging from 1 to 270 days, and in denominations judged too big for regular investors (usually $1 million, but occasionally as low as $10,000).
The most secure investment
Treasury bills are short-term securities issued by the government having maturities of less than a year. Short-term savings should be placed in US Treasury bills, which are sold at a discount from face value and actively bought and sold after they are issued. Trading is regulated by securities rules, and the markets are deep and liquid. Treasury bills aren’t just for saving; they can also be used to settle transactions. Treasury bills, which are issued electronically, are as easy to send as money through the payments system.
Repos are a big part of the money market, but they’re more difficult. Repos offer low interest rates for borrowing and lending for a short period of time—usually less than two weeks and frequently overnight. A borrower sells a security for cash and promises to buy it back from the purchaser (who is effectively a lender) at a set date and at a price that reflects the interest rate charged over the period. For the lender, the security at the heart of the transaction serves as collateral.
Repo and other securities loan markets are crucial to short-selling—when a trader agrees to sell a security that he or she does not own—in addition to making secure short-term borrowing and lending possible in money markets. To obtain such a security, the short-seller must borrow it or purchase it through a repo transaction on a temporary basis. When it comes time to return the security to the lender, the short-seller must either buy or borrow the security again. The short-seller makes money on the transaction if the price has declined.
Companies that invest in various money market instruments, such as commercial paper, certificates of deposit, Treasury bills, and repos, offer money market mutual funds (MMMFs). In the United States and the European Union, money market mutual funds are regulated as investment businesses. They provide retail and institutional investors, as well as corporations, with a low-risk return on a short-term investment. A typical MMMF invests in highly rated liquid, short-term instruments. Despite the fact that the price is neither fixed or guaranteed, the fund is managed to maintain a constant price—or, in securities speak, a stable net asset value, which is normally $1 per share. (This differs from other mutual funds that invest in stocks or bonds and have a daily per share value.) The difference is paid as interest if the value of the underlying MMMF assets climbs over $1 per share. A money market fund with a net value of less than $1 per share—known as breaking the buck—was nearly unheard of prior to the global financial crisis. The fund’s investment managers used their own resources to hold the price at $1 a share the few times it happened.
Money market funds, on the other hand, were threatened by losses on commercial paper and, later, notes issued by Lehman Brothers during the financial crisis (the broker-dealer that went bankrupt in September 2008). The US government responded to prevent a panic that may have expanded the credit contraction because MMMFs are key players in other critical money markets. To help MMMFs avoid a run by investors, the US Treasury guaranteed principal and the Federal Reserve created a special lending facility for commercial paper.
Markets that don’t work
There are some parts of the money market that aren’t that straightforward. Asset-backed commercial paper (ABCP) and certain triparty repo agreements are examples of these.
ABCP could be used by a company with difficult-to-sell (illiquid) financial assets, such as loans, mortgages, or receivables, to borrow at a reduced rate or to offload these assets from its balance sheet. It establishes a special purpose organisation to purchase the firm’s illiquid assets and finance the transaction by issuing ABCP, which is secured or “backed” by the underlying assets, unlike regular commercial paper. If the assets are highly rated and the special facility has appropriate cash and lines of credit, this sort of commercial paper can achieve a high credit rating. The capital is intended to cover asset losses that occur unexpectedly, and the lines of credit account for the difficulty of selling the underlying assets to meet cash needs.
During the crisis, some areas of the ABCP market faced issues. Investors can easily examine the credit condition of standard commercial paper issuers, which are nearly entirely large nonfinancial firms and banks. The credit risk on ABCP was determined by a variety of factors, including the special purpose entity’s structure, credit enhancements, liquidity backstop, and the value of the underlying assets, all of which were likely to be less transparent and complex than the credit risk on conventional commercial paper. Between August and November 2008, the ABCP market in the United States shrank by 38%.
The MMMF market, which houses more than a third of outstanding commercial paper, was affected hard by this. When investors started withdrawing money from MMMFs, the funds shifted away from ABCP and into government and agency securities.
For Treasury and agency assets, the triparty repo market proved to be far less dependable than the standard repo market. The triparty repo market is based on one or two clearing institutions holding the collateral and transferring ownership from the borrower to the lender and back when the loan is repaid.
The collapse of markets for privately issued securities backed by mortgages roiled the triparty repo market. In the triparty repo market, these securities made up a major portion of the collateral. The triparty market suffered from both the higher haircuts (the percentage by which a lender reduces the value of a security for collateral purposes) needed to offset the volatility in the securitized debt market and the difficulty of pricing collateral that no longer had a market price once the market value and credit ratings of these securities fell and trading in these securities dried up.
The ABCP and triparty repo market crises combined to cause funding problems for banks, securities firms, and hedge funds that relied on these money markets to fund their investments. Those marketplaces have dropped considerably in recent years.