FMI book CBCS-1-83

Money Markets

Learning Objectives

  • Understand the following topics after studying this chapter:

    • Financial Markets

    • Segments of Financial Markets

    • Difference between Capital Market and Money Market

    • Money Market Instruments

    • Shortcomings of Indian Money Market

Financial Markets

  • Definition: Markets that channel funds from savers to users in need.

  • Development of financial markets allows efficient allocation of savings to invest in capital projects, enhancing economic growth.

  • Functions:

    • Establish fair prices for securities.

    • Enhance liquidity of financial assets.

    • Minimize transaction costs.

    • Reduce risk by facilitating diversification.

    • Improve the functioning of the payment mechanism.

Segments of Financial Markets

  • Divided into:

    1. Capital Markets: Long-term financial claims (maturities > 1 year).

    2. Money Markets: Short-term financial instruments (maturities < 1 year).

Capital Markets

  • Characteristics:

    • Involve long-term debt and equity.

    • Expected to provide higher returns.

    • Includes primary and secondary markets.

  • Participants: Investors, intermediaries like merchant banks.

Money Markets

  • Definition: Markets for short-term funds (overnight up to 1 year).

  • Role: Provides an equilibrating mechanism for demand and supply of short-term funds, facilitates central bank interventions in monetary policy.

  • Characteristics:

    • Instrument for monetary policy transmission.

    • Helps ensure liquidity in the financial system.

    • Provides avenues for short-term funding for banks and financial institutions.

Difference between Capital Market and Money Market

S.No

Capital Market

Money Market

1

Long-term borrowings (maturity > 1 year)

Short-term borrowings (maturity < 1 year)

2

Instruments: Debentures, derivatives

Instruments: T-bills, commercial papers, etc.

3

Higher risks

Safe, liquid, and less risky

4

Regulated by SEBI

Regulated by RBI

5

Generates funds for fixed capital

Generates funds for working capital

Features of Money Markets

  • Deals with highly liquid and short term securities.

  • Readily transferable securities.

  • Regulated by the Reserve Bank of India (RBI).

  • Transactions occur without a defined physical location.

  • Typically involves maturities from overnight to one week.

  • Instruments: Certificates of Deposit, T-Bills, Commercial Papers, etc.

Objectives/Functions of the Money Market

  1. Facilitate movement of funds from surplus to deficit units.

  2. Inject liquidity through central bank interventions.

  3. Provide access to short-term funds at reasonable prices.

Need for Money Market

  • Essential for businesses needing working capital.

  • Addresses daily operational cash needs and liquidity crises.

  • Transactions are typically high volume and considered low-risk.

Constituents of Money Market

  • Segments:

    1. Borrowers of Funds

    2. Intermediaries

    3. Market Makers

Money Market Participants

  • Includes:

    • Government, banks, financial institutions, corporates, mutual funds, etc.

  • Banks utilize the money market to meet mandatory ratios (CRR, SLR).

Money Market Institutions/Organizations

  • Organized Sector: RBI, mutual funds, public/private sector banks, development banks, etc.

  • Unorganized Sector: Indigenous banks, money lenders, etc.

Money Market Instruments

  • Characteristics: All have maturities < 1 year.

  • Major instruments include:

    1. Certificates of Deposit (CDs): Issued by banks, negotiable and at a discount to face value.

    2. Commercial Paper (CP): Unsecured instrument for corporations, issued for short-term borrowing.

    3. Treasury Bills (T-bills): Government securities issued at a discount, used for short-term borrowing.

    4. Collateralized Borrowing and Lending Obligation (CBLO): Electronic short-term borrowing instrument.

    5. Repo Agreements: Short-term borrowing with a buy-back agreement for securities.

    6. Call/Notice/Term Money: Directly borrowed/lent between banks for very short terms.

Role of a Central Bank

  • The Reserve Bank of India (RBI) controls and supervises the banking and financial system, ensuring economic stability.

  • The main objectives include promoting economic growth, controlling inflation, and reducing unemployment.

  • Functions of RBI:

    1. Issuing bank notes.

    2. Managing government's banking transactions.

    3. Custodian of cash reserves.

    4. Regulating credit through CRR and SLR.

    5. Implementing monetary policy and liquidity management.

Shortcomings of the Indian Money Market

  1. Lack of integration between organized and unorganized sectors.

  2. Inadequate banking facilities lead to underdevelopment in rural areas.

  3. Multiple and inconsistent interest rates across institutions.

  4. Seasonal shortages of funds due to various economic factors.

  5. Insufficient variety of financial instruments available.

Summary

  • Financial markets evolve from a barter system to a money economy, with banks initially dominating, followed later by financial markets and non-banking institutions.

  • Money markets in India have developed considerable depth and efficiency, but continue to face challenges. The RBI plays a crucial role in monitoring and regulating these markets.