Getting Started!

3.1 MONEY MARKET CONCEPTS

The term “Money Market” refers to the

network of corporations, financial
institutions, investors and governments
which deal with the flow of short-term
capital. When a business needs cash for a
couple of months until a big payment arrives,
or when a bank wants to invest money that
depositors may withdraw at any moment, or
when a government tries to meet its payroll
in the face of big seasonal fluctuations in tax
receipts, the short-term liquidity transactions
occur in the money market.

The money markets have expanded significantly in recent years as a result of the general outflow of money
from the banking industry, a process referred to as disintermediation. Until the start of the 1980s, financial
markets in almost all countries were centered on commercial banks. Savers and investors kept most of their
assets on deposit with banks, either as short-term demand deposits, such as checking accounts, paying little
or no interest, or in the form of certificates of deposit that tied up the money for years. Drawing on this
reliable supply of low-cost money, banks were the main source of credit for both businesses and consumers.

Financial deregulation and the ease of moving money electronically caused banks to lose market share in
both deposit gathering and lending. Investors can place their money on deposit with investment companies
that offer competitive interest rates without requiring a long-term commitment. Many borrowers can sell
short-term debt to the same sorts of entities, also at competitive rates, rather than negotiating loans from
bankers. The money markets are the mechanism that brings these borrowers and investors together without
the comparatively costly intermediation of banks. They make it possible for borrowers to meet short-run
liquidity needs and deal with irregular cash flows without resorting to costlier means of raising money.

The money markets do not exist in a particular place to operate according to a single set of rules. Nor do
they offer a single set of posted prices, with one current interest rate for money. Rather, they are webs of
borrowers and lenders, all linked by telephone and computers. At the center of each web is the central bank
whose policies determine the short-term interest rates for that currency. Arrayed around the central bankers
are the treasurers of tens of thousands of businesses and government agencies, whose job is to invest any
unneeded cash as safely and profitably as possible and, when necessary, to borrow at the lowest possible
cost. The connections among them are established by banks and investment companies that trade securities
as their main business. The constant soundings among these diverse players for the best available rate at a
particular moment are the force that keeps the market competitive.

WHAT MONEY MARKETS DO?

There is no precise definition of the

money markets, but the phrase is
usually applied to the buying and
selling of debt instruments maturing
in one year or less. The money
markets are thus related to the bond
markets, in which corporations and
governments borrow and lend based
on long-term contracts. Similar to
bond investors, money-market
investors are extending credit,
without taking any ownership in the
borrowing entity or any control over management.

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Yet the money markets and the bond markets serve different purposes. Bond issuers typically raise money
to finance investments that will generate profits – or, in the case of government issuers, public benefits –
for many years into the future. Issuers of money-market instruments are usually more concerned with cash
management or with financing their portfolios of financial assets.

A well-functioning money market facilitates the development of a market for longer-term securities. Money
markets attach a price to liquidity, the availability of money for immediate investment. The interest rates
for extremely short-term use of money serve as benchmarks for long-term financial instruments. If the
money markets are active, or “liquid”, borrowers and investors always have the option of engaging in a
series of short-term transactions rather than in longer-term transactions, and this usually holds down longer-
term rates. In the absence of active money markets to set short-term rates, issuers and investors may have
less confidence that long-term rates are reasonable and greater concern about being able to sell their
securities should they so choose. For this reason, countries with less active money market, on balance, also
tend to have less active bond markets.

3.2 INVESTING IN MONEY MARKETS

Short-term instruments are often unattractive to small investors, because the high cost of learning about the
financial status of a borrower, can outweigh the benefits of acquiring a security with a life span of three
months. For this reason, investors typically purchase money-market instruments through funds, rather than
buying individual securities directly.

MONEY-MARKET FUNDS

The expansion of the money markets has been fueled by

a special type of entity, the money-market fund, which
pools money-market securities, allowing investors to
diversify risk among the various company and
government securities held by the fund. Retail money-
market funds cater for individuals, and institutional
money-market funds serve corporations, foundations,
government agencies and other large investors. The
funds are normally required by law or regulation to
invest only in cash equivalents, securities whose safety
and liquidity make them almost as good as cash.

Money-market funds are a comparatively recent innovation. They reduce investors’ search costs and risks.
They are also able to perform the role of intermediation at much lower cost than banks, because money-
market funds do not need to maintain branch offices, accept accounts with small balances and otherwise
deal with the diverse demands of bank customers. Also, unlike banks, money-market funds typically are
not required to set aside a portion of investors’ funds to cover possible losses on investments, enabling them
to pay higher interest rates to investors than banks can. The spread between the rate money-market funds
pay investors and the rate at which they lend out these investors’ money is normally a few tenths of a
percentage point, rather than the spread of several percentage points between what banks pay depositors and
charge borrowers.

INTEREST RATES AND PRICES

Borrowers in the money markets pay interest for the use of the money they have borrowed. Most money-
market securities pay interest at a fixed rate, which is determined by market conditions at the time they are
issued. Some issuers prefer to offer adjustable-rate (variable rate) instruments, on which the rate will
change from time to time according to procedures laid down at the time the instruments are sold. Because
of their short maturities, most money-market instruments do not pay periodic interest during their lifetimes
but rather are sold to investors at a discount to their face value. The investor can redeem them at face value
when they mature, with the profit on the redemption serving in place of interest payments.

The value of money-market securities changes inversely to changes in short-term interest rates. Because
money-market instruments by nature are short-term, their prices are much less volatile (less unstable) than
the prices of longer-term instruments, and any loss or gain from holding the security in the short time until
maturity is small.
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3.3 TYPES OF MONEY MARKET INSTRUMENTS

There are numerous types of money-market instruments. The best known are commercial paper, bankers’
acceptances, treasury bills, government agency notes, local government notes, interbank loans, time deposits
and paper issued by international organizations. The amount of instruments issued during the course of a
year is much greater than the amount of instruments outstanding at any one time since many money-market
securities are outstanding for only short periods of time.

COMMERCIAL PAPER

Commercial paper is a short-term debt

obligation of a private-sector firm or a
government owned or controlled corporation.
In most cases, the paper has a life or maturity
greater than 90 days but less than nine (9)
months. This maturity is dictated by
regulations. New securities must be registered
with the regulator, the Securities and Exchange
Commission, prior to issuance. Commercial
paper is usually unsecured, although a
particular commercial paper issue may be
secured by a specific asset of the issuer or may
be guaranteed by a bank.

Commercial paper became hugely more

popular in the 1980s. At a time of high inflation
and soaring short-term interest rates,
regulations limited the interest that banks could
pay depositors. Money-market funds enabled
investors to earn higher rates than banks could
offer, and strong non-banking firms discovered
that they could raise money more cheaply by
selling commercial paper to money-market
funds than by borrowing from banks. These
events caused the commercial paper market to
thrive. It has continued to grow rapidly, with
occasional interruptions due to conditions in
the financial markets.

Examples are the Bank of the Philippine Island P100-billion Bond and Commercial Paper Offering last
November, 2019; and the Phoenix Petroleum Philippines P10-billion Commercial Paper Program last July,
2020.

BANKERS’ ACCEPTANCES

Before the 1980s, bankers’ acceptances were the

main way for firms to raise short-term funds in the
money markets. An acceptance is a promissory note
issued by a non-financial firm to a bank in return for
a loan. The bank resells the note in the money
market at a discount and guarantees payment.
Acceptances usually have a maturity of less than six
months.

Bankers’ acceptances differ from commercial paper

in significant ways. They are usually tied to the sale
or storage of specific goods, such as an export order
(international trade) for which the proceeds will be
received in two or three months. They are not issued
at all by financial-industry firms. They do not bear
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interest; instead, an investor purchases the acceptance at a discount from face value and then redeem it for
face value at maturity. Investors rely on the strength of the guarantor bank, rather than of the issuing
company, for their security.

In the era when banks were able to borrow at lower cost than other types of firms, bankers’ acceptances
allowed manufacturers to take advantage of banks’ superior credit standing. This advantage has largely
disappeared, as many other big corporate borrowers are considered at least as creditworthy as banks.

Although bankers’ acceptances are still a significant source of financing for some companies, their
importance has diminished considerably as a result of the greater flexibility and lower cost of commercial
paper.

TREASURY BILLS

Treasury bills, often referred to as t-bills, are securities

with a maturity of one year or less, issued by national
governments such as the Fixed Rate Treasury Bills
issued by the Philippine Government through the
Bureau of Treasury. Treasury bills issued by a
government in its own currency are generally
considered the safest of all possible investments in that
currency. Such securities account for a larger share of
money-market trading than any other type of
instrument.

The mix of money-market and long-term debt issuance

varies considerably from government to government and time to time. Like other borrowers, government
will want to undertake long-term borrowings when the gap between short-term and long-term interest rates
is low, but will prefer shorter-term borrowings when the cost of long-term debt is relatively high.

GOVERNMENT AGENCY NOTES

National government agencies and government owned or controlled corporations are heavy borrowers in
the money market. These include entities such as Land Bank of the Philippines, Home Mutual Development
Fund or Pag-ibig Fund, among others.

LOCAL GOVERNMENT NOTES

Local government notes are issued by provincial or local government, and by agencies of these governments.
The ability of governments at this level to issue money-market securities varies greatly from country to
country. In some cases, the approval of national authorities is required; in others, local agencies are allowed
to borrow only from banks and cannot enter the money markets.

In the Philippines, the Local Government Unit Guarantee Corporation facilitates the LGU Bond floatation.
Among the LGUGC-guaranteed LGU bonds were those issued by the cities of Caloocan, Tagaytay and
Puerto Princesa; and the Municipality of Infanta in Quezon Province.

INTERBANK LOANS

Interbank Loans are loans extended from one bank to another with which it has no affiliation. Many of
these loans are across international boundaries and are used by borrowing banks to re-lend to its own clients.

Banks lend far greater sums to other institutions. Overnight loans are short-term unsecured loans from one
bank to another. They may be used to help the borrowing bank finance loans to clients, but often the
borrowing bank adds the money to its reserves in order to meet regulatory requirements and to balance
assets and liabilities.

In the Philippines, the reserve status of banks is normally known after the check clearing results have been
transmitted. Hence, interbank (call) loans are currently done between 4:00 to 5:30 p.m.
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TIME DEPOSITS

Time deposits, another name for

certificates of deposits or CDs, are
interest-bearing bank deposits that
cannot be withdrawn without penalty
before the specified date. Although time
deposits may last for as long as five
years, those with terms of less than one
year compete with other money-market
instruments.

Time deposits with terms as brief as 30

days are common. Large time deposits
are often used by corporations,
governments and money-market funds
to invest cash for brief periods.

INTERNATIONAL AGENCY PAPER

International agency paper is issued by the World Bank, Asian Development Bank and other organizations
owned by member governments. These organizations often borrow in many different currencies, depending
upon interest and exchange rates.

REPOS

Repurchase agreements, known as repos, play a critical role in the money market. They serve to keep the
markets highly liquid, which in turn ensures that there will be a constant supply of buyers for new money-
market instruments.

A repo is a combination of two transactions:

1. First transaction: A securities dealer, such as a bank, sells securities it owns to an investor, agreeing
to repurchase the securities at a specified higher price at a future date.

2. Second transaction: Days or months later, the repo is unwound as the securities dealer buys back
the securities from the investor.

The amount that the investor lends is less than the market value of the securities. Such difference is called
the haircut. The haircut will ensure that the securities still has sufficient collateral if the value of these
securities should fall before the securities dealer repurchases them. The usual buyer of repos in the
Philippines is the Bangko Sentral ng Pilipinas (the investor).

3.4 HOW DOES TRADING OCCURS?

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Trading in money-market instruments occurs almost entirely over computer systems. The money market
instrument dealers could be banks or non-banks. They sign contracts, either with one another or with a
central clearing house, committing themselves to completing transactions on the terms agreed.

When trading occurs, one or both parties is responsible for reporting the event electronically to the clearing
house, which settles the trade by debiting the bank account of the dealer responsible for the purchase and
crediting the account of the selling dealer. Most money-market instruments exist only in electronic book-
entry form and are held by the clearing house at all times; after a trade, the clearing house simply holds the
instrument on behalf of the new owner instead of the previous one. The clearing house thus reduces
counterparty risk – the risk that the parties to a transaction might not live up to their obligations. It generally
does not serve as an investigative or enforcement agency, so if there is a dispute between the putative buyer
and seller as to the terms of a trade it must be resolved by the parties themselves or in the legal system.

Because of the large amounts of money involved, the collapse of an important bank or securities dealer with
many unsettled trades could pose a threat to other banks and dealers as well. For this reason, clearing houses
have been striving to achieve real-time settlement, in which funds and securities are transferred as quickly
as possible after the transaction has been reported.

3.5 CREDIT RATINGS AND THE MONEY MARKET

Ratings agencies are private firms that offer opinions about the creditworthiness of borrowers in the financial
markets. The issuers of treasury bills, agency notes, local government notes, and international agency paper
usually obtain ratings before bringing their issues to market. Some commercial paper issues are rated,
although in many cases the ratings agency expresses its view of an issuer’s multi-year commercial paper
program rather than judging each issue separately. Participants in interbank lending and buyers of bankers’
acceptances look for a rating not of the particular deal, but of the financial institutions involved.

Three firms, Moody’s Investor Services, Standard & Poor’s (S&P) and Fitch, rate money-market issuers
around the world. Their ratings scales from short-term corporate debt appear in the table below. Some of
these agencies maintain separate scales for rating short-term government debt, commercial paper and banks’
strength. Many other ratings agencies specialize in individual industries or countries.

Description of Bond Ratings by Rating Agencies

Moody's Standard Fitch

& Poor's Ratings
Highest credit quality; issuer has strong ability Aaa AAA AAA
to meet obligations
Very high credit quality; low risk of default Aa1 AA+ AA
Aa2 AA
Aa3 AA-
High credit quality, but more vulnerable to A1 A+ A
changes in economy or business A2 A
A3 A-
Adequate credit quality for now, but more likely Baa1 BBB+ BBB
to be impaired if conditions worsen Baa2 BBB
Baa3 BBB-
Below investment grade, but good chance that Ba1 BB+ BB
issuer can meet commitments Ba2 BB
Ba3 BB-
Significant credit risk, but issuer is presently B1 B+ B
able to meet obligations B2 B
B3 B-
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 High default risk Caa1 CCC+ CCC
Caa2 CCC CC
Caa3 CCC- C
Issuer failed to meet scheduled interest or C D D
principal payments

Note: Firms' precise definitions of ratings vary

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