Money Market and Types of Money Market Instruments

Money Market is the part of financial market where instruments with high liquidity
and very short-term maturities are traded. The money market is used by participants
as a means for borrowing and lending in the short term, from several days to just
under a year. It's the place where large financial institutions, dealers and government
participate and meet out their short-term cash needs.

They usually borrow and lend money with the help of instruments or securities to generate
liquidity. Due to highly liquid nature of securities and their short-term maturities, money
market is treated as safe place.

Role of Reserve Bank of India: The Reserve Bank of India (RBI) plays a key role of
regulator and controller of money market. The intervention of RBI is varied curbing crisis
situations by reducing key policy rates or curbing inflationary situations by rising key policy
rates such as Repo, Reverse Repo, CRR etc.

Money Market Instruments: Money Market Instruments provide the tools by which one
can operate in the money market. Money market instrument meets short term requirements
of the borrowers and provides liquidity to the lenders. The most common money market
instruments are Treasury Bills, Certificate of Deposits, Commercial Papers, Repurchase
Agreements and Banker's Acceptance.

a) Treasury Bills (T-Bills): Treasury Bills are one of the safest money market
instruments as they are issued by Central Government. They are zero-risk
instruments, and hence returns are not that attractive. T-Bills are circulated by both
primary as well as the secondary markets. They come with the maturities of 3-month,
6-month and 1-year. The Central Government issues T-Bills at a price less than their
face value and the difference between the buy price and the maturity value is the
interest earned by the buyer of the instrument. The buy value of the T-Bill is
determined by the bidding process through auctions. At present, the Government of
India issues three types of treasury bills through auctions, namely, 91-day, 182-day
and 364-day.

b) Certificate of Deposits (CDs): Certificate of Deposit is like a promissory note issued

by a bank in form of a certificate entitling the bearer to receive interest. It is similar to
bank term deposit account. The certificate bears the maturity date, fixed rate of
interest and the value. These certificates are available in the tenure of 3 months to 5
years. The returns on certificate of deposits are higher than T-Bills because they carry
higher level of risk.

c) Commercial Papers (CPs): Commercial Paper is the short term unsecured

promissory note issued by corporate and financial institutions at a discounted value on
face value. They come with fixed maturity period ranging from 1 day to 270 days.
1
 These are issued for the purpose of financing of accounts receivables, inventories and
meeting short term liabilities. The return on commercial papers is is higher as
compared to T-Bills so as the risk as they are less secure in comparison to these bills.
It is easy to find buyers for the firms with high credit ratings. These securities are
actively traded in secondary market.

d) Repurchase Agreements (Repo): Repurchase Agreements which are also called as

Repo or Reverse Repo are short term loans that buyers and sellers agree upon for
selling and repurchasing. Repo or Reverse Repo transactions can be done only
between the parties approved by RBI and allowed only between RBI-approved
securities such as state and central government securities, T-Bills, PSU bonds and
corporate bonds. They are usually used for overnight borrowing. Repurchase
agreements are sold by sellers with a promise of purchasing them back at a given
price and on a given date in future. On the flip side, the buyer will also purchase the
securities and other instruments with a promise of selling them back to the seller.

e) Banker's Acceptance: Banker's Acceptance is like a short term investment plan

created by non-financial firm, backed by a guarantee from the bank. It's like a bill of
exchange stating a buyer's promise to pay to the seller a certain specified amount at a
certain date. And, the bank guarantees that the buyer will pay the seller at a future
date. Firm with strong credit rating can draw such bill. These securities come with the
maturities between 30 and 180 days and the most common term for these instruments
is 90 days. Companies use these negotiable time drafts to finance imports, exports and
other trade.

Call money market

The call money market deals in short term finance repayable on demand, with a maturity
period varying from one day to 14 days. Commercial banks, both Indian and foreign, co-
operative banks, Discount and Finance House of India Ltd.(DFHI), Securities trading
corporation of India (STCI) participate as both lenders and borrowers and Life Insurance
Corporation of India (LIC), Unit Trust of India(UTI), National Bank for Agriculture and
Rural Development (NABARD)can participate only as lenders. The interest rate paid on call
money loans, known as the call rate, is highly volatile. It is the most sensitive section of the
money market and the changes in the demand for and supply of call loans are promptly
reflected in call rates. There are now two call rates in India: the Interbank call rate and the
lending rate of DFHI. The ceilings on the call rate and inter-bank term money rate were
dropped, with effect from May 1, 1989. The Indian call money market has been transformed
into a pure inter-bank market during 200607. The major call money markets are
in Mumbai, Kolkata, Delhi, Chennai, Ahmedabad.

Concept of Repo Rate and Reverse Repo Rate

2
Repo (Repurchase) Rate: Repo rate also known as 'Repurchase rate' is the rate at which
banks borrow funds from the RBI to meet short-term requirements. RBI charges some
interest rate on the cash borrowed by banks. This interest rate is called 'repo rate'. If the RBI
wants to make it more expensive for the banks to borrow money, it increases the repo rate;
similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse Repo Rate: Reverse Repo rate is the rate at which Reserve Bank of India (RBI)
borrows money from banks. This is the exact opposite of repo rate. RBI uses this tool when
it feels there is too much money floating in the banking system. If the reverse repo rate is
increased, it means the RBI will borrow money from the bank by offering lucrative rate of
interest. Banks feel comfortable lending money to RBI since their money would be in safe
hands and with a good interest. It is also a tool which can be used by the RBI to drain excess
money out of the banking system.

Money Market & Capital Market:

Money Market is a place for short term lending and borrowing, typically within a
year.
It deals in short term debt financing and investments. On the other hand, Capital
Market refers to stock market, which refers to trading in shares and bonds of
companies on recognized stock exchanges.
Individual players cannot invest in money market as the value of investments is
large, on the other hand, in capital market, anybody can make investments through
a broker.
Stock Market is associated with high risk and high return as against money market
which is more secure.
Further, in case of money market, deals are transacted on phone or through
electronic systems as against capital market where trading is through recognized
stock exchanges.

Benefits and functions of Money Market:

Money markets exist to facilitate efficient transfer of short-term funds between
holders and borrowers of cash assets.
For the lender/investor, it provides a good return on their funds.
For the borrower, it enables rapid and relatively inexpensive acquisition of cash to
cover short-term liabilities.
One of the primary functions of money market is to provide focal point for RBIs
intervention for influencing liquidity and general levels of interest rates in the
economy. RBI being the main constituent in the money market aims at ensuring
that liquidity and short term interest rates are consistent with the monetary policy
objectives.

Functions of the money market

3
The money market functions are

transfer of large sums of money

transfer from parties with surplus funds to parties with a deficit
allow governments to raise funds
help to implement monetary policy
determine short-term interest rates

Participants
Participants in the call money market are
scheduled commercial banks,
non-scheduled commercial banks,
foreign banks,
state, district and urban,
cooperative banks,
Discount and Finance House of India (DFHI) and
Securities Trading Corporation of India (STCI).
The DFHI and STCI borrow as well as lend, like banks and primary dealers, in the
call market. At one time, only a few large banks, particularly foreign banks,
operated in the call money market.

Short essay on Indian Money Market

In India the money market plays a vital role in the progress of economy. But, it is not well
developed when compared to American and London money markets. In this market short-term
funds are borrowed and lent among participants permitted by RBI.
Money Market ensures that institutions which have surplus funds earn certain returns on the
surplus. Otherwise these funds will be idle with the institutions. Similarly, the money market
ensures funds for the needy at reasonable interest. This way liquidity position is assured by
money market operations.
Let us now discuss the various money market instruments in India. In India the Money Market
is regulated by RBI. Hence, the instruments traded and the players in the market require to be
approved by RBI. The instruments currently traded are as follows:
(i) Call Money:
Call money is a method of borrowing and lending for one day. This is also called overnight
money. The rate of interest used to be decided by RBI earlier. After 1989, the interest rate was
deregulated and now the liquidity position (availability of funds) determines the rate of
interest.
The lender issues a cheque or pay order or its account maintained with RBI in favour of
borrower. Accordingly, RBI transfers funds by debit to lender's account to the borrower's
account.
On repayment, the process is reversed through RBI. In times of tight money, situation or
liquidity crunch, the call money interest rate goes up even beyond 50 per cent per annum.

4
Only permitted organizations like scheduled commercial banks, large co-operative banks,
DHFI, Primary dealers, NABARD are permitted to borrow funds through call money market.
However, funds can be provided or lent even by other entities like LIC, GIC, large corporate,
big mutual funds, etc.
(ii) Notice Money / Short-term Money:
Under Notice/Short-term Money Market, funds are borrowed and lent for a maximum period
of 14 days. Repayment requires a formal notice or demand from the lender. Interest rate is
decided by the market forces. The market is similar to call money market explained above.
(iii) Treasury Bills:
It is the most important money market instrument for the central government. Treasury Bills
are short-term promissory notes issued by RBI on behalf of Central Government for raising
funds to meet shortfalls in revenue collections, i.e., to meet revenue expenditure.
These are issued at discount to face value. RBI auctions these Treasury Bills at regular
periodical intervals, i.e., weekly and fortnightly. These days' five types of Treasury Bills
depending upon their maturity are auctioned by RBI.
These are 14-day Treasury Bills; 28-day Treasury Bills, 91-day, 182 day and 364 day Treasury
Bills. Any person can invest in Treasury Bills. These are very high liquid and safe instruments.
Treasury Bills are approved securities for investment by banks under SLR requirement.
(iv) Commercial Bills:
Banks are discounting Commercial Bills drawn by business entities/organisations. Banks can
get such discounted bills rediscounted in Money Market. It is not necessary for banks to
rediscount each and every discounted bill.
Banks can certify the large number of bills intended to be rediscounted through a single
document known as "Derivative Usance Promissory Note" (DUPN). In other words, 'DUPN' is
a money market instrument backed by genuine commercial bills.
Banks can get the value of DUPN discounted and obtain funds. This way banks can borrow
funds without transferring the bills. It is necessary that the original bills in the portfolio of
banks should not be drawn for period exceeding 120 days. The maturity of DUPN, however,
should not exceed 90 days.
(v) Commercial Paper:
Commercial Paper (C.P.) is a short-term money market instrument issued by eligible
corporates for raising funds to meet working capital needs. It was introduced in 1989. The C.P.
is in nature of negotiable usance promissory notes issued at a discount to face value.
The C.P. should have fixed maturity period of not less than 30 days and not more than one
year. Corporates having fund-based working capital facility of Rs. 4 crore or more from banks
are only eligible to issue C.Ps. Aggregate value of C.Ps. which can be issued by a corporate is
limited to the maximum working capital facility fixed by the banks.
Investors in C.Ps. should have a minimum investment of Rs. 10 lakh and multiples of Rs. 5
lakh thereafter. The RBI decides about the eligibility criteria for corporates to raise funds
through C.Ps. on the basis of working capital fund limit (Rs. 4 crore or more); minimum
current ratio (1.33); and minimum credit rating (P2 of CRISIL or A2 of ICRA, etc.).
Primary Dealers are also recently permitted to issue C.Ps. Funds raised through C.Ps. should
normally be cheaper as compared to bank funds. Hence, corporates raise funds through issue
of C.Ps. only when the money market interest rates are fairly low.
(vi) Certificate of Deposits:
It is another form of short-term time deposit. The receipt issued for such a deposit is called
Certificate of Deposit. Banks can raise short-term funds, say for 3 or 6 months at rate of
interest different from its normal Time Deposit rate through issue of C.Ds. Interest is paid
from the date of purchase till maturity.

5
Banks issue C.Ds. to manage liquidity and to raise funds at marginally varying rate of interest
as compared to short-term deposit rates. As per RBI regulations C.Ds. can be issued for a
minimum maturity of 3 months and a maximum period of 1 year.
Minimum investment should be of Rs.10 lakh and further investments should be in multiple of
Rs. 5 lakh. These are issued at discount to face value. In India this instrument was first
introduced in 1989. Individuals, Corporates, Trusts and any persons can invest in Certificate of
Deposits.
(vii) Inter-Bank Participation Certificates:
Inter-Bank Participation Certificates or simply Participation Certificates (PC) are short-term
papers issued by scheduled commercial banks to raise funds from other banks against big loan
portfolios.
When banks are short of liquidity to carry on their immediate operations and need short-term
funds, they may approach other banks to share/participate in their lending portfolios. In other
words, part of the specified loans and advances of the borrowing bank will be passed on to the
lender-bank against cash.
This will have the effect of reducing the exposure of borrower-bank on its particular loan
portfolio and increase in the portfolio of lender-bank when the participation is without
recourse basis.
Borrower-banks can have access to the facility only, up to certain percentage (currently 40%)
of their standard or performing assets, i.e., Loans and Advances which are being serviced
without default. PCs. can be issued only for a maximum period of 180 days and not less than a
90-day period.
(viii) Inter-Corporate Deposits:
Inter-Corporate Deposits or ICD is another money market instrument for corporate to park
their temporary surplus funds with other corporate. What a participation certificate for banks
is an inter-corporate deposits between corporate.
Under ICD, corporate lend temporary funds generally to their own group companies;
otherwise the credit risk will be higher. Any corporate can issue the instrument without there
being any prescription about minimum size of such lending and borrowings. This market is not
well-regulated for want of adequate information.
(ix) 'Repo' Instruments:
'Repo' or Repurchase Transactions have been explained in Chapter 14. RBI conducts 'Repo'
transactions to influence short-term interest level in money market. By Repo operation the RBI
transmit interest rate signals to the market. When it announces a fixed rate Repo for certain
number of days/period it conveys its intention to the market about the desirable level of a
short-term interest rate.
Due to greater level of integration among money market, foreign exchange market and
Treasury Bill Market, the Repo transactions ensure stability of short-term rates in all the three
markets. At the same time Repo transactions of RBI provide an opportunity to banks to part
their surplus funds with a minimum rate of return.
You may understand that when RBI conducts 'repos', the short-term interest rate in the money
market may not go below the RBI repo rate as, if rate of interest is lower in other markets,
holders of funds may go for 'Repos' with RBI. The RBI also provides liquidity support, i.e.,
infusion of funds into the market by conducting reverse Repo transactions with Primary
Dealers against Government Securities.