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What is the Money Market?

definition

The money market is where banks, businesses, and the government can raise money by selling short-term debt, which investors can buy through money market accounts and other investments.

🤔 Understanding money markets

When businesses and banks need short-term capital, they can use the money market to get access to low-cost financing. The government also participates in the money market by issuing Treasury bills. Then, banks and other dealers commonly buy them in large quantities from the government and sell them to investors. Individuals can invest in the money market by opening a money market account at a bank or by purchasing Treasury bills or money market mutual funds. Because they are mostly short-term investments — they’re debt that matures in less than one year — money market investments are typically highly liquid and relatively safe. You can also usually withdraw these investments at any time without hefty transaction fees.

example

Let’s say John is the CEO of a company, and he wants to raise money to fund a few of his everyday operating expenses. He considers selling shares in his company. Instead, he opts to raise short-term capital through the money market by issuing commercial paper. This allows John to raise the money he needs without selling more ownership in his company.

Takeaway

The money market is like a weekend getaway…

It’s easy and quick because it’s not a long-term commitment. Borrowing a long-term loan, on the other hand, is like moving to a new city. It’s typically a longer commitment, more things could go wrong, and you generally can’t just pick up and leave anytime without some loss.

Tell me more...

What are the types of money market instruments?
What is the difference between the money market and the capital market?
What are the advantages and disadvantages of the money market for investors?
Are money market investments a good idea?

What are the types of money market instruments?

There are several different ways that you can invest in the money market. In many cases, individual investors don’t buy and sell money market securities themselves (although there are a few exceptions). Instead, money market securities are typically wrapped up in a fund, and investors buy shares in the fund. Let’s talk about some of the most common money market instruments.

Money market accounts

Money market accounts are perhaps the most accessible way to buy into the money market. A money market account is a bank account that you can get from a bank or credit union. But unlike a traditional checking account, a money market account earns interest. The interest rate is often comparable to — or higher than — what you earn with a high-yield savings account.

Like a checking account, a money market account also lets you access your money via a debit card, check, or bank transfer. But unlike a checking account, there are typically limits on the number of withdrawals and transfers you can do from your money market account each month. This type of account is not for paying multiple bills or purchases — Most often, you should be using these accounts to hold money.

Money market accounts usually have a minimum balance requirement. If the balance of your account falls below this amount, you might have to pay a monthly fee.

As we mentioned, the interest rate you can earn on a money market account is usually comparable to — or higher than — what you can get with a savings account. It varies, though. When overall interest rates go up or down, the rate of money market accounts will move in the same direction. Unlike savings accounts, money market accounts can also invest in other money market instruments, such as Certificates of Deposit (CDs) and commercial paper.

Money market funds

Money market funds are mutual funds that invest in a bundle of money market instruments. These funds work like any other mutual fund, but they are relatively low risk and thus offer low returns.

Money market mutual funds fall into a few different categories depending on where they invest. A prime money market fund can invest in any money market instruments, including commercial paper, CDs, and repurchase agreements, which are securities that banks sell and buy back. A government money market fund invests in cash, Treasury bills, and repurchase agreements that are backed by the government. Finally, tax-exempt money market funds (aka, municipal funds) invest mostly in debt issued by state and local governments.

Treasury bills

A Treasury bill is a short-term security that the U.S. government issues at a discounted rate. Treasury bills are very low-risk investments because the Treasury Department fully backs them. The government typically uses these securities to finance the national debt or infrastructure projects. Treasury bills mature within one year and pay a face value higher than the purchase price, rather than an interest rate.

Certificates of Deposit

A CD is a money market instrument that banks can use to raise capital. A CD works like a savings account, where you are basically loaning money to your bank, and it pays you interest. CDs are typically a very safe investment because the Federal Deposit Insurance Corporation (FDIC) insures them up to $250,000. CDs also usually offer a higher interest rate than savings accounts or money market accounts.

Unlike other money market instruments, CDs are not as liquid — You can’t easily withdraw your money at any time. You have to keep the investment for the life of the CD or risk paying a fee. Investment terms are generally between three months and five years.

Commercial paper

Commercial paper is short-term debt issued by corporations to fund short-term liabilities, like accounts payable. Commercial paper is unsecured debt, meaning it is not backed by collateral. Therefore, only corporations with excellent credit are generally able to take advantage of this type of money market instrument.

Banker’s acceptances

A banker’s acceptance is a short-term loan often used in foreign trade. Because a bank has guaranteed the debt, it is more secure. Companies receiving a banker’s acceptance know they’re going to get their money.

Municipal notes

A municipal note is like a Treasury bill, except it is issued by a state or local government instead of the federal government. Municipal notes usually mature within one year, and they pay out the entire return when they reach maturity — both the interest and the principal amount. Municipal notes help local governments pay for capital projects like infrastructure. Local governments might use a municipal note when they expect the project to help them increase tax or non-tax revenue.

Eurodollars

A eurodollar is a deposit of U.S. dollars into a foreign bank or an overseas branch of an American bank. Eurodollars aren’t subject to the same regulations as deposits in the United States and aren’t covered by FDIC Insurance. Due to the relatively higher risk, they tend to earn a higher interest rate.

Repurchase agreements

A repurchase agreement is when banks sell securities to raise short-term funds, then promise to repurchase them after a very short period of time — usually within a day or two. When banks repurchase the securities, they do so at a slightly higher price than when they sold them. The banks are promising to repurchase the securities right away, while the institutions buying the securities are promising to sell them back.

What is the difference between the money market and the capital market?

The money market is typically made up of debt securities that mature in less than one year. Money market instruments generally provide for low-risk investments with a modest but limited return. They also allow banks, corporations, and governments to maintain a steady cash flow and get access to capital when they need it.

The capital market is made up of longer-term investments, such as the stock and bond markets. Companies generally use the capital market to raise money for long-term capital.

While bonds sold in the capital market typically mature in longer than one year, stocks don’t have an expiration date. They remain on the market until the company buys them back or goes out of business.

What are the advantages and disadvantages of the money market for investors?

Investing in the money market might be the right choice for some, but it’s not for everyone. As with any investment opportunity, there are some pros and cons to consider.

Advantages of the money market

Money market instruments can be a viable option if you have a sizeable amount of money that you need to put somewhere for the short term. Money market accounts usually have a rate of return that is higher than checking accounts and higher than — or at least comparable to — savings accounts.

You might choose to put your money into a money market account if you know you’ll need to access it easily, but don’t want it sitting in a checking account, not earning interest. Money market investments are highly liquid, which makes it easy to get your money out at any time. With a money market account, you can usually use an ATM card, checks, or bank transfers.

Money market investments tend to be very low risk. The FDIC insures bank money market accounts up to $250,000. It’s important to note that this FDIC insurance does not apply to money market mutual funds.

Disadvantages of the money market

Money market investments aren’t for everyone. First, if you’re investing in a money market account, there will probably be a large balance requirement, which could be a big hurdle for some people.

If your balance falls below the minimum requirement at any time, you may end up paying a monthly fee (which is most likely higher than whatever amount you might be earning in interest).

Money market investments aren’t as liquid as checking accounts. While you can easily access the funds in a money market account if you need to, you’re limited to a certain number of withdrawals and transfers each month. This could be inconvenient if you end up needing to access your money more often.

One of the most significant downsides to money market investments is the rate of return. Sure, you can get a better interest rate with a money market account than with a checking account. And if all you need is an account that acts like a bank account, then a money market account might be for you.

Not only is the return rate of many money market investments not enough to keep up with the stock market, but there could also be years when it’s not enough to keep up with inflation. So instead of earning money as you might think you are, your money would be losing value.

Are money market investments a good idea?

At the end of the day, it comes down to what your financial goals are. Consider how soon you’ll need to access the money and decide whether you’re looking for an investment opportunity or just an alternative to a traditional bank account.

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