CORPORATE FINANCE

Money Markets: What They Are, How They Work, and Who Uses Them

What Is the Money Market?

The money market refers to trading in very short-term debt investments. At the wholesale level,
it involves large-volume trades between institutions and traders. At the retail level, it includes
money market mutual funds bought by individual investors and money market accounts opened
by bank customers.

In all of these cases, the money market is characterized by a high degree of safety and relatively
low rates of return.

KEY TAKEAWAYS

 The money market involves the purchase and sale of large volumes of very short-term
debt products, such as overnight reserves or commercial paper.
 An individual may invest in the money market by purchasing a money market mutual
fund, buying a Treasury bill, or opening a money market account at a bank.
 Money market investments are characterized by safety and liquidity, with money market
fund shares targeted at $1.
 Money market accounts offer higher interest rates than a normal savings account, but
there are higher account minimums and limits on withdrawals.

Understanding the Money Market

The money market is one of the pillars of the global financial system. It involves overnight
swaps of vast amounts of money between banks and the U.S. government. The majority of
money market transactions are wholesale transactions that take place between financial
institutions and companies.

Institutions that participate in the money market include banks that lend to one another and to
large companies in the eurocurrency and time deposit markets; companies that raise money by
selling commercial paper into the market, which can be bought by other companies or funds;
and investors who purchase bank CDs as a safe place to park money in the short term. Some of
those wholesale transactions eventually make their way into the hands of consumers as
components of money market mutual funds and other investments.

Who Uses the Money Market?

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In the wholesale market, commercial paper is a popular borrowing mechanism because the
interest rates are higher than for bank time deposits or Treasury bills, and a greater range of
maturities is available, from overnight to 270 days.1 However, the risk of default is
significantly higher for commercial paper than for bank or government instruments.

Individuals can invest in the money market by buying money market funds, short-term
certificates of deposit (CDs), municipal notes, or U.S. Treasury bills. For individual investors,
the money market has retail locations, including local banks and the U.S. government's
TreasuryDirect website. Brokers are another avenue for investing in the money market.

The U.S. government issues Treasury bills in the money market, with maturities ranging from a
few days to one year.2 Primary dealers buy them in large amounts directly from the government
to trade between themselves or to sell to individual investors. Individual investors can buy them
directly from the government through its TreasuryDirect website or through a bank or a broker.
State, county, and municipal governments also issue short-term notes.

Money market funds seek stability and security with the goal of never losing money and
keeping net asset value (NAV) at $1. This one-buck NAV baseline gives rise to the phrase
"break the buck," meaning that if the value falls below the $1 NAV level, some of the original
investment is gone and investors will lose money. However, this scenario only happens very
rarely, but because many money market funds are not FDIC-insured, meaning that money
market funds can nevertheless lose money.

Types of Money Market Instruments

Money Market Funds

The wholesale money market is limited to companies and financial institutions that lend and
borrow in amounts ranging from $5 million to well over $1 billion per transaction. Mutual
funds offer baskets of these products to individual investors. The net asset value (NAV) of such
funds is intended to stay at $1. During the 2008 financial crisis, one fund fell below that
level.4 That triggered market panic and a mass exodus from the funds, which ultimately led to
additional restrictions on their access to riskier investments.

Money Market Accounts 

Money market accounts  are a type of savings account. They pay interest, but some issuers offer
account holders limited rights to occasionally withdraw money or write checks against the
account. (Withdrawals are limited by federal regulations. If they are exceeded, the bank
promptly converts it to a checking account.) Banks typically calculate interest on a money
market account on a daily basis and make a monthly credit to the account.

In general, money market accounts offer slightly higher interest rates than standard savings
accounts. But the difference in rates between savings and money market accounts has narrowed
considerably since the 2008 financial crisis. Average interest rates for money market accounts
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vary based on the amount deposited. As of August 2021, the best-paying money market account
with no minimum deposit offered 0.56% annualized interest.

Important: Funds in money market accounts are insured by the Federal Deposit Insurance
Corporation (FDIC) at banks and the National Credit Union Administration (NCUA) in credit
unions.

Certificates of Deposit (CDs)

Most certificates of deposit (CDs) are not strictly money market funds because they are sold
with terms of up to 10 years. However, CDs with terms as short as three months to six months
are available.

As with money market accounts, bigger deposits and longer terms yield better interest rates.
Rates in August 2021 for 12-month CDs ranged from about 0.50% to 0.70% depending on the
size of the deposit. Unlike a money market account, the rates offered with a CD remain constant
for the deposit period. There is usually a penalty associated with an early withdrawal of funds
deposited in a CD.

Commercial Paper

The commercial paper market is for buying and selling unsecured loans for corporations in need
of a short-term cash infusion. Only highly creditworthy companies participate, so the risks are
low.

Banker's Acceptances

The banker's acceptance is a short-term loan that is guaranteed by a bank. Used extensively in

foreign trade, a banker's acceptance is like a post-dated check and serves as a guarantee that an
importer can pay for the goods. There is a secondary market for buying and selling banker's
acceptances at a discount.

Eurodollars

Eurodollars are dollar-denominated deposits held in foreign banks, and are thus, not subject to
Federal Reserve regulations. Very large deposits of eurodollars are held in banks in the Cayman
Islands and the Bahamas. Money market funds, foreign banks, and large corporations invest in
them because they pay a slightly higher interest rate than U.S. government debt.

Repos
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The repo, or repurchase agreement (repo), is part of the overnight lending money market.
Treasury bills or other government securities are sold to another party with an agreement to
repurchase them at a set price on a set date.

Money Markets vs. Capital Markets

The money market is defined as dealing in debt of less than one year. It is primarily used by
governments and corporations to keep their cash flow steady, and for investors to make a
modest profit.

The capital market is dedicated to the sale and purchase of long-term debt and equity
instruments. The term "capital markets" refers to the entirety of the stock and bond markets.
While anyone can buy and sell a stock in a fraction of a second these days, companies that issue
stock do so for the purpose of raising money for their long-term operations. While a stock's
value may fluctuate, unlike many money market products, it has no expiration date (unless, of
course, the company itself ceases to operate).

Advantages and Disadvantages of Money Markets

There are several pros and cons of money market investments. Most money market securities
are considered extremely low-risk, due to the protection of FDIC insurance, backing by a
government or bank, or the high creditworthiness of the borrowers. They are also very liquid,
meaning that they can readily be exchanged for cash at short notice.

The tradeoff of having low risk is that these investments also have low returns. Not only do
money markets underperform other asset classes, they often don't even keep pace with inflation.
In addition, any fees associated with an account can easily eat into those slim returns.

Moreover, these advantages do not extend to all money market securities. Some of them are not
FDIC insured, and there is a (small) chance that even the most trustworthy borrowers may
default. Some money market accounts have minimum balance requirements or restrictions on
withdrawals.
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Pros and Cons of Money Market Accounts

Pros

 Extremely low risk.

 May be insured by FDIC.
 Highly liquid.
 Higher returns than most bank accounts.

Cons

 Low returns that may not keep pace with inflation.

 Not all money market securities are insured.

 May have high minimum investments or withdrawal restrictions.

Why Is It Called the Money Market?

The money market refers to the market for highly liquid, very safe, short-term debt securities.
Because of these attributes, they are often seen as cash equivalents that can be interchangeable
for money at short notice.

Why Is the Money Market Important?

The money market is crucial for the smooth functioning of a modern financial economy. It
allows savers to lend money to those in need of short-term loans and allocates capital towards
its most productive use. These loans, often made overnight or for a matter of days or weeks, are
needed by governments, corporations, and banks in order to meet their near-term obligations or
regulatory requirements. At the same time, it allows those with excess cash on hand to earn
interest.

What Are Some Examples of Money Market Instruments?

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The money market is composed of several types of securities including short-term Treasuries
(e.g. T-bills), certificates of deposit (CDs), commercial paper, repurchase agreements (repos),
and money market mutual funds that invest in these instruments. The money market funds
typically have shares that are always priced at $1.

Can You Lose Money in the Money Market?

For depositors, most money market accounts are insured by the FDIC up to $250,000 per
institution. Because money market instruments are very low risk, there is virtually no chance
you will lose your money by owning a CD or T-bill either. During periods of extreme financial
stress, for example, during the height of the 2008 financial crisis, some money market funds did
"break the buck" and briefly incur losses, but this was quickly corrected.

What Are the Downsides of Money Markets?

Because they are virtually risk-free, money market investments also come with very low interest
rates - often the risk-free rate of return. As a result, they will not provide substantial capital
gains or investment growth compared to riskier assets like bonds or stocks. Some types of
money market accounts, like CDs, furthermore can lock your money up until it matures, which
can range from months to years.

The Bottom Line

Money market accounts and money market funds are considered among the safest ways to
invest one's money. They also have much lower returns than other investments, often even less
than inflation. Because they are so low risk, many people and businesses use money markets as
a short-term investment for their cash reserves.