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4.3. Money market

The financial system and its securities may be depicted as in Figure 1. There are two broad categories of securities (excluding PIs):

• Debt and deposits (we place them together because deposits are debt, i.e. claims on banks).

• Shares.

Debt (and deposits) include:

• The securities issued by the ultimate borrowers:

- Marketable debt (MD) such as CP, TBs and PNs.

- Non-marketable debt (NMD) such as overdrafts from banks.

• The deposit securities of the banks:

- Negotiable certificates of deposit (NCDs).

- Non-negotiable certificates of deposit (NNCDs)

- Notes and coins (central bank)

- Central bank securities (CBS - which we regard as deposits for the sake of simplicity).

The debt (and deposit) market is usually also categorized into the money market and the bond market. The line demarcating the money and bond markets is usually drawn on the basis of term to maturity of the securities traded, and is arbitrarily determined to be one year. Broadly speaking then, the bond market is defined as the market for the issue and trading of long-term securities, while the money market is the market for the issue and trading of short-term securities.

These definitions are not very helpful. The demarcation line of a year is useful but the definitions are too simple. A more useful elucidatory approach is to split the debt and deposit market into:

• Long-term debt (and deposit) market (LTDM).

• Short-term debt (and deposit) market (STDM).

The LTDM comprises all forms of long-term debt, marketable and non-marketable. The bond market is the marketable instrument arm of the LTDM. The rest of the LTDM is made up of long-term instruments such as mortgages (which can have terms of up to 20 years). Thus in the LTDM we find MD (= bonds) and NMD.

It is notable that price discovery of long-term debt takes place in the bond market and the rates discovered here are used in the pricing of NMD (if they are fixed-rate instruments). Thus the bond market is the price-maker in the LTDM while NMD is a price-taker.

The STDM can be split into the market for marketable short-term debt and the market for non-marketable short-term debt, and many scholars subscribe to this and use the former as the definition for the money market. We have a different view and it is based on the significance of the short-term NMD (and deposit) market in monetary policy and in price discovery.

Thus in our view the money market should be described as being comprised of the short-term MD (and deposits) and NMD (and deposit) markets. Examples of MD in the money market are TBs, CP, NCDs and so on, and examples of NMD in the money market are short-term NNCDs and loans such as overdrafts.

However, this simple definition ignores two significant parts of the money market and these are money creation by the banks (by making new loans), and the interbank markets where interest rates have their genesis. And these two parts of the money market are closely related. There are three interbank markets:

• Bank-to-bank interbank market (b2b IBM).

• Bank-to-central bank interbank market (b2cb IBM)

• Central bank-to-bank interbank market (cb2b IBM).

Banks are required to settle amounts owed to one another (as a result of deposit shifts) at the end of each business day. This occurs over accounts held with the central bank (which are usually called settlement accounts - SAs). It should be evident that the amounts will balance out, because what one bank loses another gains. This is the b2b IBM.

The bank-to-central bank interbank market (b2cb IBM) does not apply to all countries and an interest rate is not applied in this market (in most cases). It is the cash reserve requirement (RR), in terms of which banks are required by statute to hold deposits (called cash reserves or reserves - R) with the central bank equal to a certain proportion of their deposits (or liabilities). In some countries the accounts in which these RR are held are called reserve accounts, and in some these RR balances are held in the SAs.

The central bank operates in the money and foreign exchange markets and its actions (called open market operations - OMO) lead to amounts being owed to it and amounts owing to the banks at the end of the business day. Most central banks bring about a situation where the banks owe the central bank [called money market shortage (MMS) or liquidity shortage (LS)] funds on a permanent basis, and they lend the funds (R) to the banks in order to make up the deficit. This market is called the cb2b IBM, and this is where monetary policy is played out.

A crucial part of monetary policy is to bring about this LS and to lend the funds to the banks at the central bank's accommodation rate (called by various names such as repo rate, Bank rate, base rate, discount rate and so on), which we call the key interest rates (KIR). This is a fixed rate and it is determined "administratively" by the central bank's Monetary Policy Committee (MPC).

It will be clear that the wider interbank market (i.e. the b2b IBM and the cb2b IBM) does balance out, i.e. clear effectively, but the central bank "recycles" the funds to the relevant banks at a different rate to the b2b IBM rate, i.e. at the KIR. This rate is the genesis of interest rates for short-term money (in the cb2b IBM funds are provided for 1-day or a little longer in some markets).

Thus, the KIR is made effective by the existence of a LS and this rate has an immediate impact on the b2b IBM rate (as the banks compete for deposit funds). This is called the interbank rate (federal funds rate in the US). This rate in turn affects the banks' deposit rates to the public and in turn these deposit rates affect their lending rates. The latter has a major impact on the demand for loans - a target of the central bank as this is largely the counterpart of the money stock (this will be explained in more detail later). And, the growth rate in the money stock has an important bearing on inflation, the ultimate target of monetary policy. Inflation is important in that a low rate of inflation is one of the significant factors in a stable economic environment.

It will now be evident that the definition of the money market is not straightforward. A proper definition is that the money market encompasses:

• The markets in the marketable and non-marketable securities of ultimate borrowers.

• The markets in the marketable and non-marketable securities of financial intermediaries.

• The interbank market between the private sector banks.

• The interbank markets between the central bank and private sector banks.

The money market may be depicted as in Figure 2.

money market

Figure 2: money market

If the reader likes, the money market derivatives market can be added to this list.

The dominant players in the money market are the private sector banks, the central bank, the retirement funds and the money market unit trusts. Generally the money market is of the OTC variety. In some countries certain of the instruments are listed on exchanges.

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