Chances are you've heard the term before, but what exactly is the money market? It is the organized exchange on which participants can lend and borrow large sums of money for a period of one year or less. While it is an extremely efficient arena for businesses, governments, banks, and other large institutions to transact funds, the money market also provides an important service to individuals who want to invest smaller amounts while enjoying perhaps the best liquidity and safety found anywhere. Here we look at some of the most popular types of money market instruments and the benefits they offer to the individual investor.
Purposes of the Money Market
Individuals will invest in the money market for much the same reason that a business or government will lend or borrow funds in the money market: sometimes the need for funds does not coincide with having them. For example, if you find you have a certain sum of money that you do not immediately need (to pay down debt, for example), then you may choose to invest those funds temporarily, until you need them to make some other, longer-term investment, or a purchase. If you decide to hold these funds in cash, the opportunity cost that you incur is the interest that you could have received by investing your funds. If you do invest your funds in the money market, you can quickly and easily secure this interest.
The major attributes that will draw an investor to short-term money market instruments are superior safety and liquidity. Money market instruments have maturities that range from one day to one year, but they are most often three months or less. Because these investments are associated with massive and actively-traded secondary markets, you can almost always sell them prior to maturity, albeit at the price of forgoing the interest you would have gained by holding them until maturity.
The secondary money market has no centralized location. The closest thing the money market has to a physical presence is an arbitrary association with the city of New York; although, the money market is accessible from anywhere by telephone. Most individual investors participate in the money market with the assistance (and experience) of their financial advisor, accountant or banking institution.
Types of Money Market Instruments
A large number of financial instruments have been created for the purposes of short-term lending and borrowing. Many of these money market instruments are quite specialized, and they are typically traded only by those with intimate knowledge of the money market, such as banks and large financial institutions. Some examples of these specialized instruments are federal funds, discount window, negotiable certificates of deposit (NCDs), eurodollar time deposits, repurchase agreements, government-sponsored enterprise securities, shares in money market instruments, futures contracts, futures options, and swaps.
Aside from these specialized instruments on the money market are the investment vehicles with which individual investors will be more familiar, such as short-term investment pools (STIPs) and money market mutual funds, Treasury bills, short-term municipal securities, commercial paper, and bankers' acceptances. Here we take a closer look at STIPs, money market mutual funds, and Treasury bills.
Short-Term Investment Pools (STIPs) and Money Market Mutual Funds
Short-term investment pools (STIPs) include money market mutual funds, local government investment pools, and short-term investment funds of bank trust departments. All STIPs are sold as shares in very large pools of money market instruments, which may include any or all of the money market instruments mentioned above. In other words, STIPs are a convenient means of cumulating various money market products into one product, just as an equity or fixed income mutual fund brings together a variety of stocks, bonds, and so forth. STIPs make specialized money market instruments accessible to individual investors without requiring an intimate knowledge of the various instruments contained within the pool. STIPs also alleviate the large minimum investment amounts required to purchase most money market instruments, which generally equal or exceed $100,000.
Of the three main types of STIPs, money market mutual funds are the most accessible to individuals. These funds are offered by brokerage companies and mutual fund firms, which sell shares in these funds to their individual, corporate and institutional investors. Short-term investment funds are operated by bank trust departments for their various trust accounts. Local government investment pools are established by state governments on behalf of their local governments, allowing investors to purchase shares of local government investment funds.
Money market mutual funds are further divided into two categories: taxable funds and tax-exempt funds. Taxable funds place investments in securities such as Treasury bills and commercial papers that pay interest income that is subject to federal taxation once it is paid to the fund purchaser. Tax-exempt funds invest in securities issued by state and local governments that are exempt from federal taxation. These two categories of money market mutual funds provide different patterns of growth, each of which attracts different types of investors. (For more, see Money Market Mutual Funds, The Money Market: A Look Back and The Money Market tutorial.)
Treasury Bills (T-Bills)
Treasury bills, commonly known as "T-bills," are short-term securities issued by the U.S. Treasury on a regular basis to refinance earlier T-bill issues reaching maturity, and to help finance federal government deficits. Of all money market instruments, T-bills have the largest total dollar value outstanding--a sum that as of 2004 exceeded $650 billion. In addition to scheduling regular sales of T-Bills, the Treasury also sells instruments called cash management bills on an irregular basis, by re-opening the sales of bills that mature on the same date as an outstanding issue of bills.
When T-bills were initially conceived, they were given three-month maturities exclusively; but bills with six-month and one-year maturities were subsequently added. Three-month and six-month bills sell in the regular weekly auctions, and another bill auction takes place every four weeks for the sale of one-year bills.
T-bills are sold through the commercial book-entry system to large investors and institutions, which then distribute those bills to their own clients, which may include individual investors. An alternative is Treasury Direct, which is run as a non-competitive holding system designed for small investors who plan to hold their securities until maturity. Individual bidders on Treasury Direct have their ownership recorded directly in book-entry accounts at the Department of the Treasury. If an investor purchases T-bills through the Treasury Direct system and wishes to sell them prior to maturity, he or she must transfer them to the commercial book-entry system. The transfer can be arranged only through a depository institution that holds an account at a Federal Reserve Bank; the person making the transfer is required to pay applicable transfer fees.
When an individual investor builds a portfolio of financial instruments and securities, he or she typically allocates a certain percentage of funds towards the safest and most liquid vehicle available: cash. This cash component may sit in his or her investment account in purely liquid funds, just as it would if deposited into a bank savings or checking account. However, investors are much better off placing the cash component of their portfolios into the money market, which offers interest income while still retaining the safety and liquidity of cash. Many money market instruments are available to investors, most simply through well-diversified money market mutual funds. Should investors be willing to go it alone, there are other money market investment opportunities, most notably in purchasing T-bills through Treasury Direct.