Money Markets What They Are How They Work and Who Uses Them

Money Markets: What They Are, How They Work, and Who Uses Them

What Is the Money Market?

The money market refers to trading in short-term debt investments. At the wholesale level, it involves trades between institutions and traders. At the retail level, it includes money market mutual funds bought by investors and money market accounts opened by bank customers.

In all cases, the money market is characterized by safety and relatively low rates of return.

Key Takeaways

• The money market involves the purchase and sale of 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 at $1.
• Money market accounts offer higher interest rates than a normal savings account, but there are higher account minimums and limits on withdrawals.

Understanding the Money Market

The money market is one of the pillars of the global financial system. It involves swaps of money between banks and the U.S. government. Most money market transactions are wholesale transactions that take place between financial institutions and companies.

Participating institutions include banks that lend to one another and to large companies, companies that raise money by selling commercial paper, and investors who purchase bank CDs as a safe place to park money. Some of those transactions eventually make their way into the hands of consumers as components of money market mutual funds and other investments.

Who Uses the Money Market?

In the wholesale market, commercial paper is a popular borrowing mechanism because of higher interest rates and a greater range of maturities. However, default risk is significantly higher for commercial paper.

Individuals can invest in the money market by buying money market funds, short-term CDs, municipal notes, or U.S. Treasury bills. The money market has retail locations, including local banks and the U.S. government’s TreasuryDirect website. Brokers are also avenues for investing in the money market.

The U.S. government issues Treasury bills in the money market. Primary dealers buy them directly from the government to trade or sell to individual investors. State and local governments also issue short-term notes.

Money market funds seek stability and security with a goal of never losing money and maintaining a $1 net asset value (NAV). However, some funds are not FDIC-insured and can potentially lose money.

Types of Money Market Instruments

Money Market Funds

Mutual funds offer baskets of short-term debt products to individual investors. The net asset value (NAV) of these funds is intended to stay at $1.

Money Market Accounts

Money market accounts are a type of savings account that pays interest. Some issuers offer limited withdrawal rights to account holders. Interest is calculated daily and credited monthly.

Money market accounts typically offer slightly higher interest rates than standard savings accounts.

Funds in money market accounts are insured by the FDIC or the NCUA.

Certificates of Deposit (CDs)

CDs are time deposits with terms ranging from three months to ten years. Rates depend on deposit size and term length. A penalty may apply for early withdrawal.

Commercial Paper

The commercial paper market enables corporations to buy and sell unsecured short-term loans, with low risks.

Banker’s Acceptances

Banker’s acceptances are short-term loans guaranteed by banks. They are used in foreign trade to guarantee payment for goods.

Eurodollars

Eurodollars are dollar-denominated deposits held in foreign banks. They pay slightly higher interest rates than U.S. government debt.

Repos

Repos are overnight lending agreements in which Treasury bills or other government securities are sold with an agreement to repurchase them at a set price on a set date.

Money Markets vs. Capital Markets

The money market deals with debt of less than one year, while the capital market deals with long-term debt and equity instruments.

Advantages and Disadvantages of Money Markets

Money market instruments are considered low-risk and highly liquid. However, they often have low returns and fees may reduce those returns. Some securities are not insured and may have minimum balance requirements or withdrawal restrictions.

Pros and Cons of Money Market Accounts

• Extremely low risk.
• May be insured by FDIC.
• Highly liquid.
• Higher returns than most bank accounts.
• Low returns that may not keep pace with inflation.
• Not all money market securities are insured.
• May have high minimum investments or withdrawal restrictions.

Why Is It Called the Money Market?

The money market is named so because of its highly liquid and safe nature, with short-term debt instruments being seen as equivalents to cash.

Why Is the Money Market Important?

The money market is crucial for the smooth functioning of the financial economy, allowing savers to lend money and allocate capital toward its most productive use. It provides short-term loans to governments, corporations, and banks, while also allowing those with excess cash to earn interest.

What Are Some Examples of Money Market Instruments?

The money market includes short-term Treasuries, CDs, commercial paper, repos, and money market mutual funds.

Can You Lose Money in the Money Market?

Most money market accounts are insured by the FDIC, and money market instruments are low-risk, so the chance of losing money is very low. In extreme financial stress, some money market funds may incur losses, but these are usually corrected quickly.

What Are the Downsides of Money Markets?

Money market investments have low interest rates, which limits their capital gains and investment growth. Some types of accounts, such as CDs, lock money until maturity.

The Bottom Line

Money market accounts and funds are considered safe investments with low returns. They are popular for short-term cash reserves but offer limited growth compared to riskier assets.