Money Market Instruments: Characteristics and Function

Posted on Dec 28, 2025 in Economy

The term “Money Market” is somewhat of a misnomer. Currency itself is not traded; rather, the securities in the money markets are short-term with high liquidity, making them close substitutes for money.

Money Markets Defined

Key characteristics of money market securities include:

  • Usually sold in large denominations (e.g., $1,000,000 or more).
  • Low default risk.
  • Mature in one year or less from their issue date, though most mature in less than 120 days.

Money Markets Versus Banks

The banking industry traditionally handles short-term needs and possesses an information advantage. However, banks face significant constraints:

  • Banks are heavily regulated.
  • Reserve requirements create additional expenses not borne by money markets.
  • Regulations on the level of interest banks could offer depositors led to significant growth in money markets, especially in the 1970s and 1980s. When interest rates rose, depositors moved funds from banks to money markets.

Cost Advantages

The cost structure of banks limits their competitiveness to situations where their informational advantages outweigh their regulatory costs. Interest rate limitations on banks became a significant issue after the 1950s.

The Purpose of Money Markets

Money markets serve vital functions for both investors and borrowers:

  • Investors: Provide a place for warehousing surplus funds for short periods.
  • Borrowers: Offer a low-cost source of temporary funds.

Corporations and the U.S. government utilize these markets because the timing of cash inflows and outflows is often not well synchronized, and money markets solve these cash-timing problems.

Treasury Bills (T-Bills)

T-bills have maturities ranging from 8 days up to 12 months.

Discounting

Discounting occurs when an investor pays less for a security than its face value at maturity; the price increase provides the return. This method is common for short-term securities that often mature before interest checks can be mailed.

Example Calculation:

  • You pay $996.37 for a 28-day T-bill, maturing at $1,000.
  • Discount Rate Calculation: $I = (1,000 – 996.37) / 1,000 \times 360/28 = 4.67\%$.
  • Investment Rate Calculation: $i = (1,000 – 996.73) / 996.73 \times 366/28 = 4.76\%$.

Treasury Bill Auctions

T-bills are auctioned to dealers every Thursday. The Treasury accepts both competitive and noncompetitive bids, and the price everyone pays is based on the highest yield paid to any accepted bid.

Auction Example Summary:

If the Treasury auctions $2.5 billion par value 91-day T-bills and receives various bids, they accept bids starting from the highest price (lowest yield) until the target amount is met. Both competitive and noncompetitive bidders pay the price corresponding to the highest accepted yield.

Fed Funds

These are short-term funds transferred (loaned or borrowed) between financial institutions, usually for one day. Banks use this market to meet short-term reserve requirements.

Repurchase Agreements (Repos)

Repos function similarly to the fed funds market, but nonbanks can participate. A firm sells Treasury securities and agrees to buy them back later (typically 3–14 days) at a specified price. This setup is essentially a short-term collateralized loan. The Federal Reserve may use this market to conduct monetary policy by purchasing or selling Treasury securities.

Negotiable Certificates of Deposit (CDs)

These are bank-issued securities documenting a deposit, specifying the interest rate and maturity date. Denominations typically range from $100,000 to $10 million.

Commercial Paper

This consists of unsecured promissory notes issued by corporations, maturing in no more than 270 days. Commercial paper volume grew significantly in the early 1980s due to rising bank loan costs, though it fell during recent recessions. The annual market remains large (over $0.85 trillion outstanding).

Asset-Backed Commercial Paper (ABCP)

A special type of commercial paper, ABCP, backed by securitized mortgages, played a key role in the 2008 financial crisis. When the poor quality of underlying assets was exposed, a run on ABCP began, causing runs on many Money Market Mutual Funds (MMMFs) that held it, requiring government intervention.

Banker’s Acceptances

This is an order to pay a specified amount to the bearer on a given date, provided specified conditions (usually delivery of promised goods) have been met. They are often used in international trade.

Advantages of Banker’s Acceptances

  1. Exporter is paid immediately.
  2. Exporter is shielded from foreign exchange risk.
  3. Exporter does not need to assess the importer’s financial security.
  4. The importer’s bank guarantees payment.
  5. Crucial to international trade.

Banker’s acceptances avoid the need to establish the creditworthiness of an overseas customer, and an active secondary market exists until maturity.

Eurodollars

Eurodollars represent U.S. Dollar-denominated deposits held in foreign banks. This market is essential because many foreign contracts require payment in U.S. dollars due to the dollar’s relative stability.

The Eurodollar market has grown rapidly because depositors often receive a higher rate of return than in the domestic market. Multinational banks face fewer regulations restricting U.S. banks and are willing to accept narrower spreads between deposit interest and loan interest.

Birth of the Eurodollar Market

Oddly, the Eurodollar market was fathered by the Soviet Union in the 1950s. Fearing the U.S. might seize their accumulated dollar deposits held in U.S. banks, the USSR transferred those dollars to European banks, initiating the market.

Securities Liquidity

In addition to interest rate and maturity, liquidity is a crucial feature of money market securities, closely tied to the depth of the secondary market.