An Introduction to Money Markets

Money markets do not get as much attention in headlines and everyday press as other markets, e.g., capital markets where bonds and shares are traded. Nevertheless, they are a vital component of a well-functioning financial system and a wider economy as they provide banks, financial and non-financial institutions, or governments with the funds essential to satisfy their short-term financial needs.

The definition of money markets can be as follows: ‘‘a component of the financial markets that consist of assets involved in short-term borrowing and lending with maturities of one year or shorter’’ (Goldman Sachs, 2020) or money market is simply a generic name used to describe the market wherein banks and other financial institutions lend, borrow and trade money, certificates of deposit (CDs) and other financial instruments’’ (Chartered Institute for Securities and Investment: henceforth CISI, 2020). Money market funds have become an integral part of financial markets, which allowed retail investors to invest in cash assets and near-cash assets, in other words - financial securities that are traded in money markets.

In this article, we will cover many concepts with regards to money markets with some including:
1. Money market funds (MMF)
2. Financial instruments traded in money markets
3. Classification of money market funds
4. Benchmarks 
5. Benefits and risks of investing in money market funds

Money market funds

We have already established that money markets are financial markets in which only short-term debt instruments are traded. Individual investors may gain access to money markets by investing in money market funds (MMF), described by Goldman Sachs as ‘‘a mutual fund that invests in short term debt securities… [and] allow investors to participate in a more liquid, diverse and high-quality portfolio than if they were to invest individually’’. MMFs are known as pooled investments, which gather together small amounts of capital from a large number of investors. According to Arnold (2020), the minimum amount of money needed to invest in UK money markets is around £500,000. Thus MMFs are important for retail investors who can invest in such funds even with as little as £1,000. However, the minimum amount required to invest in money market funds will differ from one mutual fund to another.

Money market funds attract investors from all areas of the private sector, i.e., banks, insurers, pension funds, other non-bank financial institutions, corporations, and households (Deutsche Banks, 2015), who invest the surplus of their cash for shares in the fund and receive interest on their investment. Investors are generally allowed to redeem their shares daily. An MMF can charge its investors several fees, ranging from the initial charge, annual management charge, investment adviser’s fees, administrator’s fees to switching and redemption fees. Investment fees are an important consideration for money market funds’ investors as they can seriously affect their returns.

Some prominent benefits of investing in money market funds (or pooled investments in general) rather than individually, are the idea of diversification, a process whereby fund managers invest in a wide range of securities, thus reducing the risk. Besides, MMFs invest in a large proportion of highly liquid securities to offer investors same-day (T+0) or next-day (T+1) liquidity (Goldman Sachs, 2020). Historically, returns generated by MMFs for retail investors showed the potential to be greater than those of deposits while taking on a similar degree of risk.

The Deutsche Bank’s research explained key benefits of investing in MMFs with the following passage:

Money market funds offer investors money market returns and liquidity, while providing the economic benefits of a pooled investment. As opposed to a direct investment in money market instruments, investors benefit from portfolio diversification, economies of scale and the fund manager’s expertise.

Although the risk of losing the capital by investing in MMFs is relatively small, there are some key elements that an investor should consider and understand that any investment in money market products is not entirely risk-free:

First of all, the capital may be lost if a lending institution, usually a bank, becomes insolvent and can no longer repay its investors. One of the biggest financial institutions that went bust in recent years was Lehman Brothers, the fourth-largest investment bank in the United States, filed for bankruptcy in the peak of the 2007-09 global financial crisis.

Another risk associated with money market products is the effect of inflation relative to the size of interest rates. Using a simplified Fisher equation, we can conclude that the positive real rate of return is only possible if the average rate of interest is higher than the inflation within a period.

Fisher equation 

real rate of return = nominal rate of interest – rate of inflation

Another consideration is the liquidity risk. Although one of the key objectives of MMFs is to provide their investors with a portfolio of investment that has a high degree of liquidity, it is a possibility for an investor to hold illiquid assets.

As with any open ended investment vehicle, investors are exposed to the risk of either being unable to sell their holding at a fair price (in the instance of elevated investor redemption
requests) or being unable to sell their holding at all (in the case of a gated/closed fund).
                                           Square Mile Research, 2017

Financial instruments traded in money markets

According to many sources, including the Chartered Institute of Securities & Investment or Arnold (2020): Treasury bills, commercial paper, and certificates of deposits are the main assets traded in money markets in the United Kingdom.

Treasury bills are issued weekly on behalf of the UK Government by the Debt Management Office (DMO). Treasury bills may be issued with a minimum maturity of 1 day and a maximum maturity of 364 days. However, regular weekly tenders are typically for maturities of 1 month (approximately 28 days), three months (approximately 91 days), and six months (approximately 182 days). UK Treasury bills are sold at a discount to par value with the minimum purchase amount of £500,000. It means that an investor does not earn interest; instead, they pay less than the initial value (par value). For example, an investor pays £990,000 for Treasury bills with a par value of £1,000,000 with a maturity date of three months. At the maturity date, the par value of the investment is paid back by the Government, resulting in a £10,000 return for an investor. Treasury bills are usually bought by banks and financial institutions. The list of the Treasury bill primary participants can be accessed here.

Commercial paper is an unsecured short-term instrument of debt. To finance accounts receivables (debtors) and inventories or meet short-term cash needs, corporations issue commercial papers (Arnold, 2012). In some cases, these are also issued by banks and municipalities. Commercial paper promises the holder a sum of money to be paid in a set number of days – it is a promissory note. The buyer, usually other firms, insurance companies, or pension funds, are effectively lenders to a firm issuing commercial paper, which has an average maturity of about 40 days, but it can be as long as 270 days. Commercial papers do not pay interest in a similar way to Treasury bills.

Certificates of deposit (CDs). Banks issue term securities called certificates of deposit (CDs) when funds are deposited with them by other banks, corporations, individuals, or investment companies (Arnold, 2012). A sterling certificate of deposit is a document produced by the UK office of a British or foreign bank, stating that a sterling deposit has been made with a bank which is repayable to the bearer (lender) upon the surrender of the certificate at maturity (source: Bank of England). CDs have an average maturity of 1-4 months but can be any length of time between a week and a year. The document also states the rate of interest and date of repayment. Sterling CDs may be issued in multiples of £10,000 with a minimum of £50,000 and a maximum of £500,000 of investment.

It is important to know other popular instruments traded in money markets:

Repurchase Agreements (REPOS) is an agreement between a seller and a buyer whereby the seller agrees to repurchase the securities at an agreed price and, usually, at a stated time.

Floating Rate Notes (FRN) are debt instruments with variable interest rates.

Asset-backed commercial papers (ABCP) are securities issued by special purpose vehicles (SPV) and secured by assets purchased by the SPV.

Classification of money market funds

Money market funds follow different investment policies and are tailored to the

different needs of potential investors (Deutsche Bank, 2015), and thus classification of money market funds can be categorised by targeted investor group (institutional versus retail) or by investment focus (debt of private or public issuers). In the United Kingdom, there are two basic types of money market funds that are classified with regard to how the accounting techniques are applied. These are constant net asset value (CNAV) and accumulating net asset value. The net asset value (NAV) is a fund’s price per share and is calculated as the difference between the fund’s assets and its liabilities, divided by the number of shares outstanding. Thus, shares in CNAV are issued with an unchanging face value, e.g., £1 per share (CISI, 2020), with the income being accrued daily and either paid out to the investor or used to purchase more units of the fund. Accumulating net asset value share is similar to CNAVs; however, the main difference is that the income is reflected by an increase in the value of the fund share rather than being distributed to an investor.

In variable net asset value (VNAV) funds, the share price depends on the market value of the fund’s assets, in contrast to CNAV, where the net asset value is constant. Note that there is also a low volatility net asset value (LVNAV) money market fund, which is similar to constant net asset value funds; thus, its price can be displayed as constant. These funds, however, operate under strict conditions.

Benchmarks

Money market funds use a range of indices available in the markets as a benchmark to compare the performance of each of the funds under the management. These include:

London Interbank Bid Rate (LIBID) and London Interbank Offered Rate (LIBOR)

One of the traditional income sources for banks is the difference between the income they got from the interest rates they charge borrowers and deposit rates they pay to investors (lenders), e.g., when someone opens a savings account. For any bank to be profitable, the level of income derived from the charges incurred by borrowers must be higher than the number of interest banks would be willing to pay to investors.

Similarly, in money markets, banks make lending and borrowing transactions between each other every day. London Interbank Offered Rate (LIBOR) is the lending rate paid to a borrower, often called the bid-offer spread or the bid-ask in other markets. Thus, this rate indicates the interest that a borrower could incur - charged by the lender. On the other hand, the deposit rate paid to depositors quoted in the markets is called the London Interbank Bid Rate (LIBID). The higher quoted rate is the LIBOR because to be profitable, banks must charge borrowers with higher interests compared to the interest they incur on borrowed money from other banks or institutions. However, LIBOR is gradually being phased out and is most likely to be replaced by an alternative as early as 2021 (CISI, 2020).

Sterling Overnight Index Average (SONIA)

In April 2018, the Bank of England took control of the Sterling Overnight Index Average or simply SONIA, which is a weighted average rate of all unsecured sterling overnight cash transactions (a minimum deal of £25 million) brokered in London between midnight and 4.15 pm.

Euro Overnight Index Average (EURONIA and EONIA)

EURONIA is a regulated-data benchmark that provides a weighted average rate of all unsecured lending transactions in the interbank market. Such transactions must be made by panel banks of the EU and European Free Trade Association (EFTA) countries. The rate is calculated and published by the European Central Bank. A UK-based equivalent rate is called EONIA, which is the one-day interbank interest rate for the eurozone.

Secured Overnight Financing Rate (SOFR)

With the LIBOR being gradually phased out, SOFR, which stands for the Secured Overnight Financing Rate alongside Sonia, is a likely measure to replace it. The daily SOFR is based on secured overnight transactions in the US Treasury repurchase market, and it is not estimated on borrowing rates like LIBOR is. SOFR is commonly used to price US dollar-denominated derivatives and loans and was first introduced by the Federal Reserve Bank of New York in April 2018.

Any thoughts?

Money market funds were first introduced in the US in the early 1970s due to the decision by which regulation capped the interest that banks were allowed to pay on deposits at a level below money market yields. According to CISI (2020), the MMFs found their way to European markets in the 1980s, and ever since, it has been an important component of our modern financial markets which allow banks, government, and companies to manage the liquidity of their assets better and meet short-term financial goals. Although the preservation of capital is the primary goal of an MMF, the aforementioned liquidity and competitive, sector-related returns are other key objectives.

A country’s economic strength will be reflected in the value placed by the financial markets on its government-issued borrowing instruments. Similarly the financial strength of a corporation or a bank is indicated by the rates of return it has to offer to borrow in the bond or money markets (Arnold, 2015). 

Investing in money markets is considered a very safe option (although not entirely risk-free). Many money market funds are rated by independent credit rating agencies, such as Standard & Poor's, Moody's, and Fitch Ratings. Each credit rating agency has a unique set of rating criteria. Common themes are the characteristics of the assets in the portfolio, the composition of the portfolio, and the fund's legal and operational framework. Fund providers are required to provide regular reporting to allow the credit rating agencies to undertake continuous surveillance of the ratings (IMMFA, n.d.).

In the United Kingdom and worldwide, the money market has grown exponentially over the last 30 years. The importance of money market funds in short-term funding markets became evident when US funds experienced an investor run during the financial crisis of 2007-09. Those events resulted in increased regulatory scrutiny aimed to mitigate potential risks to financial stability.

The Money Market Funds Regulation (MMFA) requires fund managers to stick to strict regulatory guidelines with regard, e.g., to the liabilities and assets of MMFs or characteristic and portfolio indicators. Fund managers must also report every quarter to a domestic regulator, the Financial Conduct Authority in the United Kingdom. European Securities and Markets Authority (ESMA), which receives information from MMFA, maintains a central database of money market funds. Although the effects of Brexit are still unknown for financial markets, it is important to remember that some regulatory changes in money markets may happen because the UK is no longer part of the European Union.

Further reading

The Institutional Money Market Funds Association (n.d.). About IMMFA [online]. Available at https://www.immfa.org/about-immfa/

The Independent. Financial crisis 2008: How Lehman Brothers helped cause 'the worst financial crisis in history'. Available at https://www.independent.co.uk/news/business/analysis-and-features/financial-crisis-2008-why-lehman-brothers-what-happened-10-years-anniversary-a8531581.html

Bibliography

Arnold, G. (2020). The Financial Times Guide to Investing. 4th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1365862/the-financial-times-guide-to-investing-pdf

Deutsche Bank (2015). Money market funds – an economic perspective [online]. Available at https://www.dbresearch.com/PROD/RPS_EN-PROD/PROD0000000000441776/Money_market_funds_%E2%80%93_an_economic_perspective%3A_Matc.pdf?undefined&realload=Z5ZcAa2kmbhZtbxYgJLjIGq1Nof4tcUjW3Hwgl3DLcvntUr8B~e15cKrK15U2Y7nFiReUcs43aDnCo54~yjwGQ==

Chartered Institute for Securities & Investment (2020). Investment, Risk & Taxation, 11th ed. London: CISI