The money market can initially be defined in two ways:
Macroeconomic: In this sense, the money market consists of supply and demand between banks and companies or consumers. Thus, all conventional banking transactions such as time deposit accounts or consumer credit to the money market are of macroeconomic importance.
Institutional: In this sense, the money market is part of the financial market and is characterized primarily by short-term trading in money. In the foreground is the interbank trade with the money of the central bank. The interest rate for trading is set by the central bank. It is called the money market rate or key interest rate. On the one hand, banks can provide capital and credit to other banks. And secondly, credit institutions in the money market can buy so-called “money market instruments” from other banks. These are special securities with short maturities.
Actors of the money market
Credit institutions: They act together in the so-called “interbank trade”.
Financial Intermediaries: These are insurance companies or investment companies.
Large companies: You can borrow money or spend money at short notice via the money market.
Central Bank: It provides the money for trading on the money market and sets the interest rate. In this way, the central bank controls the creation of money and can influence lending by banks. The central bank thus has a security function for the entire financial sector.
Tasks and functions of the money market
Refinancing: The refinancing of banks is an important function of the money market. For example, refinancing enables banks to finance lending to end customers.
Managing liquidity risk: Banks and large companies can control their liquidity through the money market. If they have short-term surpluses, they lend money to the money market. If you have a shortfall, you can borrow money. The surpluses arise, for example, when many consumers have invested their capital in the bank. Deficits, in turn, can result from an increase in the number of consumer credits awarded.
Regulation of the financial sector: Money market interest rates allow the central bank to partially control the financial markets. In this case, we also talk about “money market policy”.
The economic significance of the money market
The money market with its short-term financial instruments plays an important role in balancing banks’ liquidity. Thus, banks have the opportunity to borrow money at short notice to avoid liquidity bottlenecks. At the same time, there is an opportunity to quickly build up a liquidity reserve with surpluses. Thus, the money market has a major impact on the ability of banks to operate.
Financial instruments of the money market
Daily and time deposits: These are investment products with maturities of one day to one year.
Transactions in repurchase agreements (repurchase agreements ): In this financial transaction, the sale of a security is immediately combined with the purchase. For the buyback, a sum is agreed immediately. For the duration of the term, which is not longer than one year, the security is given to the buyer. Afterward, the seller repurchases his securities back at the agreed price.
Borrowing or Securities Lending: In this case, a security will be lent and the use made available to the lending institution. At the end of the term, the lender receives a fee. In English, securities lending is also referred to as “securities lending”.
Money market paper: These are short-term securities with a maximum term of one year. As a rule, these are bonds or bills of exchange. The purchase price or selling price of the Notes is calculated in excess of the notional amount less interest accrued during the term.
Facilities of the Central Bank: These are formed by the overnight loans and the deposit facility. The deposit facility allows banks to invest overnight excess capital with the central bank.
Money market derivatives: These products are predominantly forward rate agreements, overnight index swaps, and money market futures.
Much of the money market turnover is achieved through so-called “overnight loans”. These are loans that creditors have to pay back the next day. For these loans, interest is usually paid according to the EONIA (Euro Overnight Index Average). This is a special interest rate that banks charge for unsecured loan overnight.
Control of the money market by the central bank
The central bank has the opportunity to control the money market. An important instrument for this control is the money market interest rates. These interest rates are divided into the main refinancing rate, the marginal lending rate, and the deposit rate.
Refinancing rates are those interest rates that a bank has to pay for lending money in the money market. The deposit rate covers the interest that banks and large companies receive when they invest money with the central bank. The money market interest rates allow the central bank to encourage other banks to borrow at short notice. Finally, the banks can again pass on the money that has been made available to consumers in the form of the best unsecured personal loans for 2018 the gadcapital.com.
The effects of the monetary policy of the European Central Bank can be seen, for example, in the current low-interest phase (as of November 2016) for mortgage lending.
Characteristics of trading in the money market
Money market trading is off-market. Most transactions are carried out by telephone or electronically via so-called “money traders”. The minimum denomination on the money market is usually one million euro.
Characteristic of trading on the money market is the high credit rating and a high degree of institutionalization of the players. As institutions usually trade with each other, the transactions are impersonal.
Money supply definitions
The European Central Bank divides the money stock of the financial market into four different groups. The classification is required to answer the question of how much money there is. In each case, the group M1 is a subset of the money M2 and M2 is a subset of the money M3. The abbreviation “M” comes from the English term for money, money.
M0: This is cash that is in circulation. This amount of money is held by both non-banks and central bank money stock with banks.
M1: This money is made up of sight deposits from non-banks, including cash in circulation. Sight deposits include, for example, bank balances of consumers on the passbook or checking account.
M2: This money supply includes M1 and, in addition, deposits with a maturity of up to two years and a statutory notice period of up to three months. The main components are savings or fixed-term deposits. In compliance with the period of notice, savings deposits can be paid out and therefore counted against the money stock M1. Savings deposits cannot be converted into cash at any time compared to sight deposits.
M3: M2 counts for this money supply. In addition, other short-term investments such as bank bonds or money market fund shares as well as repurchase agreements are counted.
In general, monetary claims on the money market are given to M1 and M2.
The difference to the interbank market
The interbank market is the trade in financial products that take place between banks. Inter-bank trading is an important part of the money market and largely consists of lending and lending central bank money.
These are the taking and issuing of short-term loans among banks. In addition, foreign exchange, securities or derivatives can be traded in interbank trading.
Risks for the actors of the money market
Default risk: There is always a risk of default for participants in the money market. This risk is that a borrower can not repay the short-term money market loan on time. The default risk is reduced by so-called “counterparty limits”. In each case, a limit is set for the respective market participants up to the limit of which they may borrow central bank money from another market participant. At the same time, any transaction can be based on collateralization through repo transactions. For example, fixed repurchase agreements for securities are made. As is usual with investments, the investment portfolio is also split into many positions to reduce the risk of default.
Interest rate risk: Due to the very short maturities on the money market, the interest rate risk is very low.
Liquidity risk: The purpose of the money market is to ensure sufficient liquidity among the players. For this reason, the liquidity risk should be minimized. Nevertheless, activities in the money market can weaken the liquidity of an actor through careless economic activity.
The difference to the capital market
The fundamental difference between the capital market and the money market is the maturities. Short-term funds are traded on the money market. By contrast, the capital market is long-term or medium-term funding.
Private investors can participate in both the money market and the capital market. On the capital market, they can invest directly in stocks or bonds in companies or states. At the same time, various markets, such as the gray market, can be used within the capital market. Basically, the capital market offers higher returns than the money market. However, the default risk is higher.
Money market accounts allow investors to invest money in the money market at short notice. However, the chance of high yields is very low, as the current low-interest rates of the European Central Bank (ECB) provide for low capital growth.