Money markets

Money markets are a source of short-term finance for governments, corpora­tions and other organisations. There are times when these organisations are in need of funds for merely a day, a week or the next three months.

At other times an organisation may have surplus funds and instead of keeping that money as cash or in current accounts at banks, earning little or no interest, it chooses to lend it out to those needing short-term funds by purchasing money market instruments from them.

While we, as individuals, borrow to make up shortfalls or lend surpluses (e.g. by withdrawing or depositing money in our bank accounts) and do so in tens, hundreds or maybe thousands of pounds or euros, governments and com­panies borrow or lend in millions of pounds or euros. Thus the money markets are termed wholesale markets rather than retail markets.

Interest often comes from discount pricing

When manufacturing firms, financial institutions, governments, etc. find themselves in need of short-term funds they often sell an instrument which carries the promise to pay, say, £10 million in 30 days from now. For many of the money market instruments the purchaser of that promise will not pay as much as £10 million because they want to receive an effective interest rate for lending. So they might pay, say, £9.9 million. Thus the security is sold for less than face value. The discount is the difference between face value and purchase price. The yield, the rate of interest gained by the holder, occurs when the instrument reaches maturity and the face value is paid by the issuer to the holder. In this case the return, if the instrument is held to maturity, i.e.

(Note that while most money market securities are issued at a discount, this is not true of all of them. Certificates of deposit and interbank deposits (banks lending for short periods to each other), for example, are issued at their face value and then redeemed at a higher value.)

Secondary trading in the money markets

With many money market instruments the original purchaser is able to sell the instrument in the secondary market on to another investor before maturity if they want to raise some cash themselves; thus these securities are said to be liquid or negotiable. So, staying with the example, after 20 days the original lender might sell this promise to pay £10 million in a further 10 days for, say, £9.96 million. Thus a profit can be made by trading the instruments on the secondary market before they reach the redemption date - in this case £60,000.

However, it must be noted that a loss may be incurred by selling in the secondary market. If, say, the original lender can only attract buyers at a price of £9.87 million then it makes a £30,000 loss. This low price may occur if, say, interest rates on similar financial instruments with 10 days to maturity are now yielding a higher rate of return because lenders have become more wary and are demanding higher rates of return to compensate for higher risk - a lot can change in the financial markets in 20 days. The potential secondary market purchaser would be silly to pay a price higher (receive a lower yield) than the going market rate for this particular issue when there are better deals to be had - i.e. the potential buyer has an opportunity cost (the return on the best alternative use of their investment money) and so the best the original lender can get is £9.87 million, if it has to sell.

The discount and rate of interest (yield) earned are dependent on the risk level and the maturity of the instrument. The maturity is the length of time between issue of the instrument (start of borrowing) and the time it is redeemed when money due is paid (original maturity), or the length of time between when a security is priced or purchased in the secondary market and the date of redemption (current maturity). The maturity length can vary from overnight (borrowing for just 24 hours) to 3 months to 1 year (or more, occasionally). Interest is measured in percentage points, which are further divided into basis points (bps). One basis point equals 1/100 of a percentage point.

There are various types of money market instruments:

• Treasury bills are government-issued money market instruments. Most governments round the world issue Treasury bills, often at government-run auctions, and some countries' bills are regarded as ‘risk-free', better defined as the lowest chance of default compared with all other financial securities. There is a strong secondary market in these bills, and their secondary market price (and hence their yield) will fluctuate according to current conditions. (There is more on Treasury bills in Chapter 9.)

• Commercial paper is a very popular way of raising money for large, well-regarded companies. For example, a corporation wishes to borrow £100 million for two months. It issues commercial paper with a face value of £101 million, payable in 60 days' time. A purchaser is prepared to accept the promise of the company to pay out in 60 days and so buys some of the commercial paper, paying £25 million for one-quarter of the total issue at a discount to the face value. In 60 days' time, the purchaser collects £25.25 million from the corporation. It has earned £250,000 in return for lending the corporation £25 million.

• Repurchase agreements (repos) are a way of borrowing for a few days using a sale and repurchase agreement in which securities (e.g. government bonds) are sold for cash at an agreed price with a promise to buy back the securities at a specified (higher) price at a future date. The interest on the agreement is the difference between the initial sale price and the agreed buy-back, and because the agreements are usually collateralised (secured) by government-backed securities such as Treasury bills, the interest rate is lower than a typical unsecured loan from a bank. If the borrower defaults on its obligations to buy back on maturity the lender can hold on to or sell the securities. Banks and other financial institutions use repos very regularly to borrow money from each other. Companies do use the repo markets, but much less frequently than the banks. (There is more on repos in Chapter 10.)

• Local authority issues are short-term instruments issued by local authorit­ies to finance capital expenditure and cash flow needs. They tend to be regarded as relatively safe investments. There is a strong market in local authority bills and bonds in many European countries, notably France, Italy and Germany, where individual federal states issue them regularly. There are also many bill issues by companies close to governments, e.g. the French railway, SNCF, or the German postal service, Deutsche Bundespost.

• Certificates of deposit (CDs) are issued by banks when funds are deposited with them by other banks, corporations, individuals or investment compa­nies. The certificates state that a deposit has been made (a time deposit) and that at the maturity date the bank will pay a sum higher than that originally deposited. The maturities are typically one to four months and can be nego­tiable or non-negotiable. (You can find more on this in Chapter 10.) There is a penalty on the saver withdrawing the money before the maturity date (they are term securities).

• Bills of exchange and banker's acceptances are commercial financial instruments, often linked to international trade (exports), which enable corporations to obtain credit or raise money and to trade with corporations at low risk of financial inconvenience or loss. Once issued, they may be traded on the secondary markets. (There is more on these instruments in Chapter 11.)

The markets in short-term money

Money markets exist all over the world as a means of facilitating business. Domestic money market means that the funds are borrowed and lent in the country's home currency and under the authority of the country's regulators. There are also money markets outside the jurisdiction of authorities of the currency of their denomination - these are the Euro money markets. This is nothing to do with the currency in Europe: they were termed ‘Euro markets' long before the euro was dreamed up.

Money markets are used by a wide variety of organisations, from treasury departments of corporations to banks and finance companies (e.g. raising large sums in the money markets to then provide hundreds of loans to people wanting to buy cars on hire purchase deals). Pension funds and insurance companies maintain a proportion of their investment funds in liquid, low-risk form (they lend on the money markets) to meet unpredictable cash outflows, e.g. following a hurricane. These markets are also used by central banks to influence interest rates charged throughout the economy - for example, changing base rates at banks through the central bank conducting repo deals in the market will have a knock-on effect on mortgage rates or business loan rates.

In the modern era, rather than having one or a few market locations or buildings in which money market instruments are bought and sold, we have organisations arranging deals over the telephone and then completing them electronically.

Some of the trades are simply private deals with legal obligations to be enforced by each side, but some are conducted through a central clearing house, with each party responsible for reporting the deal to the clearing house, which set­tles the deal by debiting the account of the buyer and crediting the account of the seller. The clearing house then holds the security on behalf of the buyer. The risk of a counterparty reneging on the deal (counterparty risk) is reduced by trading through a clearing house because the clearing house itself usually becomes a guarantor to each party.