What is a Money Market
The money market is where financial instruments with high liquidity and very short maturities are traded. It is used by participants as a means for borrowing and lending in the short term, with maturities that usually range from overnight to just under a year. Among the most common money market instruments are eurodollar deposits, negotiable certificates of deposit (CDs), banker's acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).
BREAKING DOWN Money Market
Money market transactions are wholesale, meaning that they are for large denominations and take place between financial institutions and companies rather than individuals. Money market funds offer individuals the opportunity to invest smaller amounts in these assets.
Institutions that participate in the money market include banks that lend to one another and to large companies in the eurocurrency and time deposit markets; companies that raise money by selling commercial paper into the market, which can be bought by other companies or funds; and investors who purchase bank CDs as a safe place to park money in the short term.
The U.S. government issues Treasury bills in the money market, and the bills have maturities that range from a few days to one year. Only primary dealers can buy them directly from the government; dealers trade them between themselves and sell retail amounts to individual investors. State, county and municipal governments also issue short-term notes.
Commercial paper is a popular borrowing mechanism because it is exempt from SEC registration requirements. It's attractive to corporate investors because rates are higher than for bank time deposits or Treasury bills, and a range of maturities is available, from overnight to 270 days. However, the risk of default is significantly higher for commercial paper than for bank or government instruments.
Money Market Funds
The money market itself is limited to companies and financial institutions that lend and borrow wholesale amounts, which range from $5 million to well over $1 billion per transaction. Mutual funds offer baskets of these instruments, which are generally considered to be safe, to individual investors. The net asset value (NAV) of such funds is intended to stay at $1, but during the 2008 financial crisis, one fund fell below that level. That triggered market panic and a mass exodus from the funds, which ultimately led to restrictions on them holding higher-yielding investments in order to raise returns.
Money Market vs. Capital Market
The money market is different from the capital market, which is the sale and purchase of long-term debt and equity instruments. A discussion of the differences between the two markets is available in the articles Financial Markets: Capital vs. Money Market and Getting to Know the Money Market.
Money Market Accounts
Money market accounts are high interest rate accounts targeted at retail investors that also allow limited withdrawal facilities, meaning you can write checks from the account and, in some instances, also get a debit card linked to it. The accounts are meant to incentivize customers to save money for important purposes, such as down payment for a home. They can also be used for overdraft protection in some cases. Thus, funds from your money market accounts are used if you overdraw on your regular accounts. Funds in money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC) at banks and the National Credit Union Administration (NCUA) in credit unions.
In typical money market accounts, banks calculate interest for an account holder on a daily basis and make a monthly credit to his or her account. Average interest rates for money market accounts vary based on the amount deposited. Typically, larger deposit amounts beget higher interest rates. For example, interest rates for Jumbo money market accounts are high because they require a larger deposit amount, such as $100,000.
In the majority of cases, money market accounts require a minimum deposit. Depending on the mode of withdrawal, Regulation D limits the number of such transactions to six. If an account holder passes the transaction limit, banks charge them a fee or convert their account to checking.
Money Market Accounts Vs. Savings Accounts Vs. Certificates of Deposit
The concept and design of money market accounts is similar to that of savings accounts. Both offer higher yields as compared to standard checking accounts and have limited to no withdrawal facilities. In general, money market accounts have better interest rates. But the difference in rates between savings and money market accounts has narrowed considerably since last decade’s financial crisis. The latter also require higher minimum deposit amounts. You can also see a discussion of the differences between the two types of accounts in the video Money Market Accounts Vs. Savings Accounts.
Certificate of Deposits (CDs) are another investment instrument frequently compared to money market accounts. They offer higher interest rates as compared to money market accounts but there is a penalty associated with early withdrawal of funds before the CD term ends. For savings accumulated over a longer period, however, CDs offer better returns as compared to money market accounts.
A drawback of money market accounts in relation to certificates of deposit is that their interest rates are subject to revision. With a CD, the interest rate remains constant and does not change throughout the duration of the deposit period.