BASICS OF MONEY MARKET

The financial system of any country is a conglomeration of sub-market, viz. money, capital and forex markets. The flow of funds in these markets is multi-directional depending upon liquidity, risk profile, yield pattern, interest rate differential or arbitrage opportunities, regulatory restrictions, etc. The role of money market in the overall financial system is prime in as much as the market acts as an equilibrating mechanism for evening out short term surpluses and deficits and provides a focal point for Central Bank's intervention to bring out variations in liquidity profile in the economy. Money Market is the market for short-term funds, generally ranging from overnight to a year. It helps in meeting the short-term and very short-term requirements of banks, financial institutions, firms, companies and also the Government. On the other hand, the surplus funds for short periods, with the individuals and other savers, are mobilised through the market and made available to the aforesaid entities for utilisation by them. Thus, the money market provides a mechanism for evening out short-term liquidity imbalances within an economy. Hence, the presence of an active and vibrant money market is an essential pre-requisite for growth and development of an economy. 

As the Indian economy gets integrated with the global economy, the demand for borrowing and lending options for the corporates and the financial institutions increases everyday. Known as the money market instruments, mutual funds, money market mutual funds, government bonds, treasury bills, commercial paper, certificates of deposit, repos (or, ready-forward purchases) offer

various short-term alternatives. The major players in the money market are the Reserve Bank of India and financial institutions like the UTI, GIC, and LIC.

While the call money rates have been deregulated and left to the demand and supply forces of the market, the RBI intervenes in the repos through its subsidiaries. The RBI also acts in the foreign exchange market, where it sells US dollars to stabilise the rupee-dollar exchange rate.

Discussion Points

In context of Money Market we shall attempt to answer following questions in this chapter and elsewhere in this Book.

•  What is this money market?
• Who are the participants?
•  What are the instruments used?
•  How are the interest rates determined ? What is call money?
•  What is meant by the term repos?
•  What are the inter linkages between the money market and the foreign exchange market?
• What are the money market mutual funds (MMMFs), and how are they different from ordinary mutual funds (MFs) as they exist today?
• Conceptual Framework

The money market is market for short-term financial assets which can be turned over quickly at low cost. It provides an avenue for equilibrating the short-term surplus funds of lenders and the requirements of borrowers. It, thus, provides a reasonable access to the users of short term money to meet their requirements at realistic prices. Short term financial asset in this context may be construed as any financial asset which can be quickly converted into money with minimum transaction cost within a period of one year and are termed as close substitute for money or near money.

The money market thus may be defined as a centre in which financial institutions congregate for the purpose of dealing impersonally in monetary assets. In a wider spectrum, a money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost.

This is a market for borrowing and lending short-term funds. Banks, financial institutions, investment institutions, and corporates attempt to manage the mismatch between inflow and outflow of funds by lending in or borrowing from the money market.

The Distinct Features of Money Market 

(i) It is one market but collection of markets, such as, call money, notice money, repo’s, term money, treasury bills, commercial bills, certificate of deposits, commercial papers, inter-bank participation certificates, inter-corporate deposits, swaps, futures, options, etc. and is concerned to deal in particular type of assets, the chief characteristic is its relative liquidity. All the sub-markets have close inter-relationship and free movement of funds from one sub- market to another. There has to be a network of large number of participants which will add greater depth to the market. 

(ii) The activities in the money market tend to concentrate in some centre which serves a region or an area; the width of such area may vary considerably in some markets like London and New York which have become world financial centres. Where more than one market exists in a country, with screen-based trading and revolutions in information technology, such markets have rapidly becoming integrated into a national market. In India, Mumbai is emerging as a national market for money market instruments. 

(iii) The relationship that characterises a money market should be impersonal in character so that competition will be relatively pure. 

(iv) In a true money market, price differentials for assets of similar type (counterparty, maturity and liquidity) will tend to be eliminated by the interplay of demand and supply. Even for similar types of assets, some differential will no doubt continue to exist at any given point of time which gives scope for arbitrage. 

(v) Due to greater flexibility in the regulatory framework, there are constant endeavours for introducing new instruments/innovative dealing techniques; and 

(vi) It is a wholesale market and the volume of funds or financial assets traded in the market are very large. 

(vii) The Indian money market has a dichotomic structure. It has a simultaneous existence of both the organized money market as well as unorganised money markets. The organised money market consists of RBI, all scheduled commercial banks and other recognised financial institutions. However, the unorganised part of the money market comprises domestic money lenders, indigenous bankers, trader, etc. The organised money market is in fully controlled by RBI. However, unorganised money market remains outside the RBI control. 

(viii) The demand for money in Indian money market is of a seasonal nature. India being an agriculture predominant economy, the demand for money is generated from the agricultural operations. During the busy season i.e. between October and April more agricultural activities takes place leading to a higher demand for money. 

(ix) In the Indian money market, the organized bill market is not prevalent. Though the RBI tried to introduce the Bill Market Scheme (1952) and then New Bill Market Scheme in 1970, still there is no properly organized bill market in India.

(i) In our money market the supply of various instruments such as the Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. is very limited. In order to meet the varied requirements of borrowers and lenders, it is necessary to develop numerous instruments. 

Pre–Conditions for an Efficient Money Market 

A well developed money market– 

(a) uses a broad range of financial instruments (treasury bills, bills of exchange etc). 

(b) channelises savings into productive investments (like working capital), 

(c) promote financial mobility in the form of inter sectoral flows of funds and 

(d) facilitate the implementation of monetary policy by way of open market operations. 

The development of money market into a sophisticated market depends upon certain critical conditions. They are: 

(i) Institutional development, relative political stability and a reasonably well developed banking and financial system. 

(ii) Unlike capital market or commodity markets, tradings in money market are concluded over telephone followed by written confirmation from the contracting parties. Hence, integrity is sine qua non. Thus banks and other players in the market may have to be licensed and effectively supervised by regulators. 

(iii) The market should be able to provide an investment outlet for any temporarily surplus funds that may be available. Thus, there must be supply of temporarily idle cash that is seeking short-term investment in an earning asset. There must also exist a demand for temporarily available cash either by banks or financial institutions for the purpose of adjusting their liquidity position and finance the carrying of the relevant assets in their balance sheets. 

(iv) Efficient payment systems for clearing and settlement of transactions. The introduction of Electronic Funds Transfer (EFT), Depository System, Delivery versus Payment (DVP), High Value Inter-bank Payment System, etc. are essential pre-requisites for ensuring a risk free and transparent payment and settlement system. 

(v) Government/Central Bank intervention to moderate liquidity profile. 

(vi) Strong Central Bank to ensure credibility in the system and to supervise the players in the market. 

(vii) The market should have varied instruments with distinctive maturity and risk profiles to meet the varied appetite of the players in the market. Multiple instruments add strength and depth to the market; and 

(viii) Market should be integrated with the rest of the markets in the financial system to ensure

perfect equilibrium. The funds should move from one segment of the market to another for exploiting the advantages of arbitrage opportunities. 

(i) In India, as many banks keep large funds for liquidity purpose, the use of the commercial bills is very limited. RBI should encourage banks to make use of commercial papers instead of making transactions in cash. 

The money market in India has been undergoing rapid transformation in the recent years in the wake of deregulation process initiated by Government of India/Reserve Bank of India. The institutions of Primary Dealers (PDs) and Satellite Dealers have been set up as specialised institutions to facilitate active secondary market for money market instruments. New money market instruments have been introduced and more institutions have been permitted as players in the market. Interest rates in respect of all money market instruments have been completely freed and are allowed to be fixed in terms of market forces of demand and supply. 

Rigidities in the Indian Money Market: 

Notwithstanding the deregulation process initiated by the Reserve Bank of India and several innovations, the money market is not free from certain rigidities which are hampering the growth of the market. The most important rigidities in the Indian money market are: 

(i) Markets not integrated 

Money market in India is not well integrated. There is a well-developed secondary market in India, which does not exist in money market. 

(ii) Players restricted 

Only Government, banks, FII and big companies are involved in the money market. Retail investors are rarely interested in the money market making it restricted to only corporates, the Government and the foreign Institutional Investors (Fll’s). 

(iii) Supply based-sources influence uses 

Banks are generally the main sources of fund in the money market. Commercial Banks are main supplier of funds in Money Market Instruments especially RBI which issues Treasury Bills on behalf of the Government of India. 

(iv) Not many instruments 

Unlike European Market, only few money market instruments are available in India i.e. Treasury bill, commercial papers, commercial bill, certificate of deposit and call/notice money in India. 

(v) Reserve requirements 

There are fixed reserve requirements in case of Cash Reserve Ratio (CRR) and Statutory

Liquidity Ratio (SLR) which banks have to maintain at all times. CRR is the reserve which banks have to keep with RBI. Whereas, SLR is the reserve which banks have to keep with themselves, thus, restricting the flow of money market instruments. 

(i) Lack of transparency 

There is lack of transparency in money market because the secondary market is not very well developed. Since, the transactions are done Over the Counter (OTC), there is lack of transparency and public information. 

(ii) Commercial transactions are mainly in cash 

Since most of the transactions are done through cash, the circulation of funds in money market instrument is restricted.

(iii) Heavy Stamp duty limiting use of exchange bills 

In case of issuance of commercial bills, stamp duty is paid in case of bill of exchange, thus, limiting their use. Further, in case of Commercial Paper (CP), the stamp duty rates applicable to non-bank entities are five times higher than those applicable to banks. Moreover, a CP attracts a stamp duty for 90 days irrespective of the tenure. Hence, CP issued for a shorter period attracts higher stamp duty, making it an expensive financial instrument. 

Distinction between Capital and Money Market 

There is, however, basically a difference between the money market and capital market. The operations in money market are for a duration upto one year and deals in short term financial assets whereas in capital market operations are for a longer period beyond one year and therefore, deals in medium and long term financial assets. Secondly, the money market is not a well defined place like the capital market where business is done at a defined place viz. stock exchanges. The transactions in the money market are done through electronic media and other written documents. The major points of distinction are enumerated as below: 

(1) In the Capital Market, there is classification between Primary Market and Secondary Market. While there is no such sub-division in money market, as such. However, slowly a secondary market in greater form is coming up in Money Market also. 

(2) Capital Market supplies fund for long term requirement. In contrast, the Money Market generally supplies fund for short term requirement. 

(3) If the volume of business of Capital Market is considered (both Primary and Secondary Markets), it will lag behind the total value of transaction in Money Market. 

(4) While the number of instruments dealt with in the Money Market are many like 

(a) Interbank Call Money, 

(b) Notice Money upto 14 days

(a) Short-term deposits upto 3 months 

(b) 91-days Treasury Bill 

(c) 182-days Treasury Bill 

(d) Commercial Paper etc. 

The number of instruments in Capital Market are shares and debentures. 

(2) The players in Capital Market are general investors, brokers, Merchant Bankers, Registrar to the issue, underwriters, Corporate Investors, Foreign Financial Institutions (Fll) and Bankers. While in money market the participants are Bankers, RBI and Government. 

(3) Rate of interest in money market is controlled by RBI or central bank of any country. But capital market’s interest and dividend rate depends on demand and supply of securities and stock market’s sensex conditions. Stock market is regulated by SEBI. 

(4) The degree of risk is small in the money market. The risk is much greater in capital market. The maturity of one year or less gives little time for a default to occur, so the risk is minimised. Risk varies both in degree and nature throughout the capital market. 

(5) The money market is closely and directly linked with central bank of the country. The capital market feels central bank's influence, but mainly indirectly and through the money market. 

Distinction between Money Market and Capital Market

Basis	Money Market	Capital Maket
1.      Maturity of Instruments	1 year or less	More than 1 year
2.      Risks	Less	More and varied
3.      Instruments	Treasury bills, CDs, etc	Shares, bonds, etc
4.      Finance	Short term	Long term
5.      Relation with Central Bank	Direct	Indirect

The Participants:

The money market in India, as many other less developed countries, is characterised by two segments -

1. Organised Segment

2. Unorganised Segment

The principal intermediaries in the organised segment are:

a. The commercial and other banks,

a. Non-banking finance companies and

b. Co-operative societies.

The primary activity of these intermediaries is to accept deposits from the public and lend them on a short-term basis to industrial and trading organisations. In recent years, they have extended their activities to rural areas to support agricultural operations. There is also an active inter-bank loan market as part of the organised money market.

The salient features of the organised money market in India are

(i) A significant part if its operations which is dominated by commercial banks, is subject to tight control by the Reserve Bank of India which

(a) regulates the interest rate structure (on deposits as well as loans), reserve requirements and sectoral allocation of credit and

(b) provides support to the banks by lending them on a short term basis and insuring the deposits made by the public.

(ii) It is characterised by fairly rigid and complex rules which may prevent it from meeting the needs of some borrowers even though funds may be available.

(iii) Overall, there is a paucity of loanable funds, mainly because of the low rate of interest paid on deposits.

The principal participants in the unorganised money market are

a. Money Lenders,

b. Indigeneous Bankers,

c. Nidhis (mutual loan associations) and

d. Chit Funds.

They lend, primarily to borrowers who are not able to get credit from the organised money market. The characteristics of the unorganised money market are:

(i) informal procedures,

(ii) flexible terms,

(iii) attractive rates of interest to depositors and

(iv) high rates of interest to borrowers.

The size of the unorganised money market is difficult to estimate, though it appears to be fairly large. However, its importance relative to that of the organised money market is declining. This is a welcome development from the point of view of the Reserve Bank of India because of the existence of a large unorganised market frustrates its efforts to control credit.

Access to call money market was restricted to scheduled commercial banks until 1971 when the RBI permitted the Unit Trust of India (UTI) and the Life Insurance Corporation of India (LIC) to deploy their short-term funds. The list was later expanded to include cooperative banks, term- lending financial institutions (such as IDBI, IFCI, ICICI and SCICI), MFs launched by the public sector banks and investment institutions, and the MFs set up in private sector. The RBI allowed the MMMFs set up in the public and private sectors to participate in the money market. Former finance minister agreed in principle to allow the Department of Posts to invest its short-term funds in the call money market.

While banks and the UTI can lend as well as borrow, financial institutions, General Insurance Corporation (GIC), LIC, MFs, and MMMs can only lend in the call money market. The private sector banks and MFs have been demanding a level playing field vis-a-vis the UTI regarding the facility to borrow from the money market so as to meet their redemption requirements. This facility comes in handy for them, particularly in a declining market, as they can obtain the required short- term funds at a lower cost. This is because of the large difference between the cost of the short- term funds in the organised money market and that in the unorganised, or informal, money market. The participation of LIC, GIC and UTI would increase the availability of short-term funds and enable UTI to meet any large repurchases from unit-holders. MFs have now been permitted to borrow from the money market to meet their dividend, interest and redemption obligations. They can borrow upto 20 per cent of their net assets owned.

MMMFs provide an ideal vehicle for an average investor to reap the benefits of high call money rates and high yields on money market instruments which, hitherto, have been enjoyed only by banks and financial institutions while paying a lower rate of interest on deposits. This is because retail investors can’t invest in money market instruments due to the restrictions in terms of eligibility and the minimum amount of investment despite higher return offered by these securities.