Demystifying Economic Terms with Maggu-Bhai Volume 22 (June)

Money Market –

There are two kinds of markets where borrowing and lending of money takes place
between fund scarce and fund surplus individuals and groups. The market which
cater to the need of short term funds are called Money Markets while the markets
that cater to the need of long term funds are called Capital Market .

Thus, money market is that segment of financial markets where borrowing and
lending of the short-term funds takes place. The maturity of the money market
instruments is one day to one year. In India, Money Markets are regulated by RBI.
Money markets are also sometimes called discount markets.

The different types of money market in India are –

 Call Money
 Treasury Bills
 Ready Forward contracts (repos)
 Money market mutual funds
 Cash Management Bills
 Certificate of Deposits
 Commercial Papers
 Commercial Bills
 Collateralized Based Lending obligations

Commercial Paper –

Commercial Paper (CP) is an unsecured money market instrument issued in the

form of a promissory note. It was introduced in India in 1990 with a view to enabling
highly rated corporate borrowers to diversify their sources of short-term borrowings
and to provide an additional instrument to investors.

Following are eligible to issue a cp

 Corporate
 Primary dealers (PDs)

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 Financial Institutions (FIs)

A corporate would be eligible to issue CP provided –

 the tangible net worth of the company, as per the latest audited balance
sheet, is not less than Rs. 4 crore
 Company has been sanctioned working capital limit by bank/s or all-India
financial institution/s; and
 The borrowal account of the company is classified as a Standard Asset by the
financing bank/s/ institution/s.

Rating- All eligible participants shall obtain the credit rating for issuance of
Commercial Paper either from Credit Rating Information Services of India Ltd.
(CRISIL) or the Investment Information and Credit Rating Agency of India Ltd.
(ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India
Pvt. Ltd. or such other credit rating agency (CRA) as may be specified by the
Reserve Bank of India from time to time, for the purpose.

The minimum credit rating shall be A-2 [As per rating symbol and definition
prescribed by (SEBI)].

Duration of CP- CP can be issued for maturities between a minimum of 7 days and a
maximum of up to one year from the date of issue. However, the maturity date of the
CP should not go beyond the date up to which the credit rating of the issuer is valid.

Denomination- CP can be issued in denominations of Rs.5 lakh or multiples thereof.

Who can invest in CP- Individuals, banking companies, other corporate bodies
(registered or incorporated in India) and unincorporated bodies, Non-Resident
Indians (NRIs) and Foreign Institutional Investors (FIIs) etc. can invest in CPs.
However, investment by FIIs would be within the limits set for them by (SEBI) from
time-to-time.

CP can be issued either in the form of a promissory note or in a dematerialised form

through any of the depositories approved by and registered with SEBI. Banks, FIs
and PDs can hold CP only in dematerialised form.

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CP are issued at a discount to face value as may be determined by the issuer.

Are CP’s Tradable? CP’s are actively traded in the OTC market. Such transactions,
however, are to be reported on the FIMMDA reporting platform within 15 minutes of
the trade for dissemination of trade information to market participation thereby
ensuring market transparency.

Certificate of Deposit –

Certificate of Deposit (CD) is a negotiable money market instrument and issued in

dematerialised form or as a Usance Promissory Note against funds deposited at a
bank or other eligible financial institution for a specified time period. It was introduced
in India in 1989.

The CDs are issued at a discount on face value. Return on them is difference
between the issue value and face value. There is no lock-in period for certificates of
deposit. Banks/FI’s cannot grant loans against CDs. They also cannot buy back their
own CD before maturity.

Who can issue CD–

 All schedule commercial banks excluding regional rural banks (rrb) and local
area banks (LABs)
 Selected All India Financial Institutions permitted by RBI.

A commercial bank can issue Certificate of Deposit as per its own requirements. A
financial institution can issue Certificate of Deposit within a limit prescribed by RBI. A
thumb rule for FI is that CD together with other instruments, viz. term money, term
deposits, and commercial papers and inter- corporate deposits should not exceed
100 per cent of its net-owned funds, as per the latest audited balance sheet.

To whom can it be issued to– It can be issued to individuals, corporations,

companies, trusts, funds, associations etc. The Non resident Indians are also eligible
for CDs provided they don’t repatriate the fund.

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Minimum amount for Certificate of Deposit - Minimum amount for Certificate of

Deposit has been fixed at Rs. 1 Lakh, to be accepted from a single subscriber.
Larger amounts have to be in the multiples of Rs. 1 Lakh.

Tenure of CDs- Certificates of Deposit are money market instruments and their
maturity period is between seven days to one year for commercial banks. For
Financial Institutions, the maturity is not less than a year and not more than three
years.

Call Money–
One of the toughest jobs for a central bank is to provide sufficient liquidity in the
system. If financial institutions including banks need immediate money, there are few
arrangements for them to borrow for very small periods. Such loans are provided
from the money market.

What is money market- According to the RBI, “the money market is a market for
short-term financial assets that are close substitutes of money”.

Call money market- The facility where overnight (one day) loans can be availed by
banks to meet liquidity. Banks who seek to avail liquidity approach the call market as
borrowers and the ones who have excess liquidity participate there as lenders. The
CMM is functional from Monday to Friday. Banks can access CMM to meet their
reserve requirements (CRR and SLR) or to cover a sudden shortfall in cash on any
particular day.

Effectively, the Call Money Market is the main market oriented mechanism to meet
the liquidity requirements of banks.

Notice money market- The call money is usually availed for one day. If the bank
needs funds for more days, it can avail money through notice market. Here, the loan
is provided from two days to fourteen days.

Participants- Participants in the call money market are banks and related entities
specified by the RBI. Scheduled commercial banks (excluding RRBs), co-operative
banks (other than Land Development Banks) and Primary Dealers (PDs), are
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permitted to participate in call/notice money market both as borrowers and lenders.

As per the new regulations, Payment Banks are also allowed to participate in CMM
as both lenders and borrowers.

Banks are the dominant participants in the CMM and hence it is often known as
interbank call money market. Surplus banks will give loans to other banks. Deficit
banks that need funds will purchase it.

Functioning of Call Money Market- Loans are availed through auction/negotiation.

The auction is made on interest rate. Highest bidder (who is ready to give higher
interest rate) can avail the loan. Average interest rate in the call market is called call
rate. Dealing in call money is done through the electronic trading platform called
Negotiated Trading System (NDS). This call money rate is an important variable for
the RBI to assess the liquidity situation in the economy. The CMM is known as the
most sensitive segment of the financial system.

Since the participants are banks, the call money rate tells about the overall liquidity
position in the economy. Higher call rate indicates liquidity stress in the economy. In
this case, the RBI may follow up with liquidity support measures by through its
monetary the call policy instruments – cutting CRR or allowing more repos. Hence,
money rate is taken as the operating target of monetary policy.

Interest Rate Swap –

An Interest Rate Swap is a financial contract between two parties exchanging or

swapping a stream of interest payments for a `notional principal’ amount on multiple
occasions during a specified period. Such contracts generally involve exchange of a
`fixed to floating’ or `floating to floating’ rates of interest. Accordingly, on each
payment date – that occurs during the swap period – cash payments based on fixed/
floating and floating rates, are made by the parties to one another.

The Forward Rate Agreement (FRA)/IRS were introduced in July 1999 to help banks
and PDs to better manage their interest rate risk in the wake of deregulated interest
rate regime. Scheduled commercial banks (excluding RRBs), PDs and all- India FIs

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are permitted to participate in the market for both balance sheet management and
market making. Non-financial corporations can use IRS/FRA for hedging balance
sheet exposures subject to one of the counterparties being an RBI regulated entity.
Mutual Funds and Insurance companies have been permitted to participate in IRS
for hedging purpose only. Major Benchmarks used for IRS currently are - Mumbai
Interbank Outright Rate (MIBOR), Mumbai Interbank Forward Offered Rate (MIFOR)
and Indian Benchmark Yield Curve (INBMK).

Tripartite Repo –

Tri-Party repo is a financial market instrument where a repo transaction between two
parties is administered by a triparty agent which is a licensed financial institution.
According to the RBI, “Tri-party repo is a type of repo contract where a third entity
(apart from the borrower or lender), called a Tri-Party Agent, acts as an intermediary
between the two parties to the repo to facilitate services like collateral selection,
payment and settlement, custody and management during the life of the transaction.”

In the case of triparty repo, ‘an investor places its money with a custodian bank,
which in turn lends it to another institution, and then assets are pledged as collateral
for the loan.’

The RBI has notified the introduction of triparty repo in India in its April 11, 2017,
Draft Directions. The triparty repo is a financial market instrument like the market
repo and not like the Central Bank repo (RBI’s repo). This means that it may not
have a monetary policy significance rather will have financial market significance.

The role of the tri-party agent - The differentiating factor in the case of triparty repo,
from the market repo is the presence of the third party which is known as triparty
agent. In the case of usual market repo, there is not such an entity.

Job of the tri-party agent is to administer the transaction between the lender and the
borrower. Here, the agent does some post-trade processing-collateral selection,
payment and settlement, custody and management during the life of the transaction.

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Actually, the tri-party agents are custodian banks who have the license to do the
activity at the insistence of the central bank.

Once a lender or borrower notifies about transactions, the agent matches the
transaction amount, conditions and, if successful, processes the transaction. The
agent automatically select from the securities account of the seller, sufficient
collateral that satisfies the credit and liquidity criteria set by the buyer.

Besides initiating the deal, the tri-party agent continues to manage the transaction by
making revaluation of the collateral, margining, making income payments on the
collateral etc.

The triparty agent doesn’t change the relationship between the parties, and he does
not participate in the risk of transactions. In case of default by one party, the impact
still falls entirely on the other party. This means that the level of involvement of the
agent is less.

Eligibility of collateral-

Eligible collateral for tri-party repo shall be securities under repo directions.

 Government Securities
 Corporate securities - Listed corporate debt securities of original maturity of
more than one year which are rated ‘AA’ or above
 Commercial Papers (CPs), Certificates of Deposit (CDs) and Non-Convertible
Debentures (NCDs) of original maturity upto one year which are rated A2 or
above.
 Bonds which are rated ‘AA’ or above, which are issued by multilateral financial
institutions like the World Bank Group (e.g., IBRD, IFC), the Asian
Development Bank or the African Development Bank and other such entities
as may be notified by the Reserve Bank of India from time to time.

Participants- Participants in the existing Market Repo Transactions in Government

Securities Market and Corporate Debt Securities Repo market are generally eligible
to participate in the Tri-party Repo market as well

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Trading Venue- Tri-party repo can be traded Over-the-counter (OTC) including on

electronic platforms.

Reporting of Trade- All tri-party repos shall be reported within 15 minutes of the trade
to the tri-party agent.

Tenor, Settlement, Haircut and Disclosures- The tenor, settlement mechanism,

minimum haircut, and disclosure requirements for tri-party repos will be identical to
those applicable to normal repos, as permitted by RBI.

Tri-Party Agent: Eligible Tri-Party Agents are-

 All tri-party agents need authorization from RBI to act in that capacity, before
they commence operations.
 Scheduled commercial banks are eligible to be tri-party agents.
 Other entities regulated by RBI or SEBI subject to meeting the following
criteria

Money Supply in India - M0, M1, M2, M3, (Reserve, Narrow

and Broad money) –

Reserve Money –

The reserve money represents the base level for money supply or it is the high
powered component of money supply. To understand reserve money, we have to
look into the components of it.

Reserve money = Currency in Circulation + Bankers’ Deposits with RBI + ‘Other’

Deposits with RBI

Currency in circulation’ includes notes in circulation, rupee coins and small coins.
Rupee coins and small coins in the balance sheet of the Reserve Bank of India
include ten-rupee coins issued since October 1969, two rupee-coins issued since
November 1982 and five-rupee coins issued since November 1985. Currency with
the public is arrived at after deducting cash with banks from total currency in

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circulation, as reported by RBI. Bankers’ Deposits with the RBI represent balances
maintained by banks in the current account with the Reserve Bank mainly for
maintaining Cash Reserve Ratio (CRR) and as working funds for clearing
adjustments. Other Deposits with the Reserve Bank for the purpose of monetary
compilation includes deposits from foreign central banks, multilateral institutions,
financial institutions etc.

Reserve money holds the topmost position in the RBI’s monetary policy. Since it is
mostly currency in circulation with the people, reserve money decides the level of
liquidity and price level in the economy. Management of reserve money is thus very
important to manage liquidity and price level (inflation).

Narrow Money – At any point of time, the money held with the public has two most liquid
components Currency Component: This consists of all the coins and notes in the circulation.

Demand Deposit Component: Demand Deposit component is the money of the general public
with the banks, which can be withdrawn by them using cheques, withdrawals and ATMs.

M1 = Currency with public + Demand Deposits with the banking system + other
deposits with RBI.

M2 = M1+ Saving Deposits of post office savings bank.

Broad Money – Narrow money is the most liquid part of the money supply because
the demand deposits can be withdrawn anytime during the banking hours. Time
deposits on the other hand have a fixed maturity period and hence cannot be
withdrawn before expiry of this period. When we add the time despots into the
narrow money, we get the broad money, which is denoted by M3 by RBI

M3 = M1+ Time deposits of Banking System

the Broad money does not include the interbank deposits such as deposits of banks
with RBI or other banks. At the same time, time deposits of public with all banks
including the cooperative banks are included in the Broad Money. In short the M3 is
the treatment of “Time Deposits” of the public.

When you add the Post Office Savings money also into the M3, it becomes M4.

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M4 = M3 + All deposits with Post office savings bank (Excluding National saving
certificate with the post office).

There was a time when the Reserve Bank used broad money (M3) as the policy
target. However, with the weakened relationship between money, output and prices,
it replaced M3 as a policy target with a multiple indicators approach. RBI started
using the Multiple Indicator Approach since 1998. Currently Narrow Money (M1) and
Broad Money (M3) are relevant indicators of money supply in India.

Liquidity of the measures of money supply - The liquidity means how fast an
instrument can be converted into cash. The liquidity of these measures are in order
M1>M2>M3>M4 i.e. M1 is most liquid and M4 is least liquid.

Money Multiplier – It is the relationship between monetary base and money supply in
economy. The amount money that banks generates with each unit (Rs in case of
India) of money. It is the ratio of deposits to the reserves in the banking system.

1
𝑀𝑜𝑛𝑒𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑖𝑒𝑟 =
𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑎𝑡𝑖𝑜

For example

 Say you deposit 100 Rs with a bank. Banks are required to maintain a
percentage of deposits collected as cash reserves with central bank.
 The central bank imposes this reserve on the bank to manage liquidity
situation in an economy. In India we call this Cash reserve ratio (CRR).
 So let us assume CRR is 10%. Then Bank deposits Rs 10 with RBI and lend
the Rs 90 to another customer X.
 X takes the loan and say buys a machinery from Y. Y takes the payment and
deposits the money in his bank.
 The bank again gives the money for credit after netting out the reserves. And
the cycle goes on this manner. So 100 Rs of deposit with a bank leads to
multiplies of the same amount. This is called money multiplier.

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