Money Market is the part of financial market where instruments with high liquidity and very short-term maturities are traded. 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.
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.
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.
Commercial Papers (CPs):
Commercial Paper is the short term unsecured promissory note issued by corporates and financial institutions at a discounted value on face value. They come with fixed maturity period ranging from 1 day to 270 days. 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.
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.
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.
(Also read: Concept of Repo Rate and Reverse Repo Rate)