What Is the Money Market?
The money market refers to trading in very short-term debt investments. At the wholesale level, it involves large-volume trades between institutions and traders. At the retail level, it includes money market mutual funds bought by individual investors and money market accounts opened by bank customers.
In any case, the money market is characterized by a high degree of safety and a relatively low return in interest.
- The money market involves the purchase and sale of large volumes of very short-term debt products, such as overnight reserves or commercial paper.
- An individual may invest in the money market by purchasing a money market mutual fund, buying a Treasury bill, or opening a money market account at a bank.
- Money market investments are characterized by safety and liquidity, with money market fund shares targeted to $1.
Understanding the Money Market
On the widest scale, the money market is one of the pillars of the global financial system and involves overnight swaps of vast amounts of money between banks and the U.S. government. An individual may invest in the money market by buying money market funds, short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury bills, among other examples.
Traders and institutions are more commonly the buyers for other money market products such as eurodollar deposits, banker's acceptances, commercial paper, federal funds, and repurchase agreements. In all cases, they are low-risk investments that have maturities ranging from overnight to just under one year. That short life makes them almost as liquid as cash. That is, the principal is safe and the money is not inaccessible for long.
The money market also has retail locations. Your local bank is one retail location, and the U.S. government's TreasuryDirect website is another. Your broker is yet another source. However, most money market transactions are wholesale, meaning they are for large denominations and take place between financial institutions and companies rather than individuals.
The money market is defined as dealing in debt of less than one year. The borrowers keep their cash flows steady, and the lenders make a modest profit.
Money Market Participants
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. Some of those wholesale transactions eventually make their way into the hands of consumers as components of money market mutual funds and other investments.
The U.S. government issues Treasury bills in the money market, with maturities that range from a few days to one year. Primary dealers buy them in large amounts directly from the government to trade between themselves or to sell to individual investors. Individual investors can buy them directly from the government through its TreasuryDirect website or through a bank or a broker. State, county, and municipal governments also issue short-term notes.
In the wholesale market, commercial paper is a popular borrowing mechanism because the interest rates are higher than for bank time deposits or Treasury bills, and a greater 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 seek stability and security with the goal of never losing money and keeping net asset value (NAV) at $1. This one-buck NAV baseline gives rise to the phrase "break the buck," meaning that if the value falls below the $1 NAV level, some of the original investment is gone and investors will lose money. However, this scenario only happens very rarely, but because many money market funds are not FDIC-insured, meaning that money market funds can nevertheless lose money.
Types of Money Market Instruments
Money Market Funds
The wholesale money market is limited to companies and financial institutions that lend and borrow in amounts ranging from $5 million to well over $1 billion per transaction. Mutual funds offer baskets of these products to individual investors. The net asset value (NAV) of such funds is intended to stay at $1. 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 additional restrictions on their access to riskier investments.
Money Market Accounts
Money market accounts are a type of savings account. They pay interest, but some issuers offer account holders limited rights to occasionally withdraw money or write checks against the account. (Withdrawals are limited by federal regulations. If they are exceeded, the bank promptly converts it to a checking account.) Banks typically calculate interest on a money market account on a daily basis and make a monthly credit to the account.
In general, money market accounts offer slightly higher interest rates than standard savings accounts. But the difference in rates between savings and money market accounts has narrowed considerably since the 2008 financial crisis. Average interest rates for money market accounts vary based on the amount deposited. As of mid-2019, the best-paying money market account with no minimum deposit offered 2.25% annualized interest. The best with a minimum deposit of $10,000 paid $2.45%.
Certificates of Deposit (CDs)
Most certificates of deposit (CDs) are not strictly money market funds because they are sold with terms of up to 10 years. However, CDs with terms as short as three months to six months are available.
As with money market accounts, bigger deposits and longer terms yield better interest rates. Rates in mid-2019 for six-month CDs ranged from about 0.02% to 0.65% depending on the size of the deposit. Unlike a money market account, the rates offered with a CD remain constant for the deposit period. There is a penalty associated with early withdrawal of funds deposited in a CD.
This is where we get into the professional market for institutions and traders who deal in large-volume transactions. The commercial paper market is for buying and selling unsecured loans for corporations in need of a short-term cash infusion. Only highly creditworthy companies participate, so the risks are low.
Another professional money market trade, the banker's acceptance is a short-term loan that is guaranteed by a bank. Used extensively in foreign trade, a banker's acceptance is like a post-dated check and serves as a guarantee that an exporter can pay for the goods. There is a secondary market for buying and selling banker's acceptances at a discount.
These are not to be confused with the euro currency. Eurodollars are dollar-denominated deposits held in foreign banks and thus not subject to Federal Reserve regulations. Very large deposits of eurodollars are held in banks in the Cayman Islands and the Bahamas. Money market funds, foreign banks, and large corporations invest in them because they pay a slightly higher interest rate than U.S. government debt.
The repo, or repurchase agreement, is part of the overnight lending money market. Treasury bills or other government securities are sold to another party with an agreement to repurchase them at a set price on a set date.
Money Markets vs. Capital Markets
The money market is defined as dealing in debt of less than one year. It is a means for governments and corporations to keep their cash flow steady, and for investors to make a modest profit.
The capital market is dedicated to the sale and purchase of long-term debt and equity instruments. The term encompasses the entire stock and bond markets. Certainly, anyone can buy and sell a stock in a fraction of a second these days. However, the company issued the stock for the purpose of raising money for its long-term operations. Its value fluctuates but it has no expiration date unless the company itself ceases to operate.