Money market: meaning, features, components and the Indian money market

1. Meaning and definitions

The money market is the market for short-term funds, that is, loans and financial instruments with a maturity of up to one year. It is not a place but a network of dealings between lenders and borrowers of short-term money, carried on by telephone and electronic platforms.

• Crowther: the money market is “a collective name given to the various firms and institutions that deal in the various grades of near money.”
• RBI: the money market is “the centre for dealings, mainly of a short-term character, in money assets; it meets the short-term requirements of borrowers and provides liquidity or cash to the lenders.”

Money market and capital market distinguished.

2. Features of a money market

1. Short-term funds: deals only in funds up to one year, from overnight upwards.
2. Near-money instruments: the assets traded are close substitutes for money and can be turned into cash quickly at little cost.
3. No fixed place: transactions are by telephone and electronic platforms.
4. Wholesale market: the deals are large and are made by institutions, not individuals.
5. Central bank at the apex: it is the lender of last resort and regulates the market through interest rates and liquidity operations.
6. Commercial banks as the core: they are the main lenders and borrowers.
7. Sub-markets: call money, treasury bill, commercial bill, CP and CD markets.
8. Interdependence: in a developed market the sub-markets are closely linked and interest rates move together.

3. Functions (importance) of the money market

• Provides short-term funds to trade, industry and government.
• Gives banks and institutions a place to invest surplus funds profitably while keeping them liquid.
• Enables the government to borrow short term through treasury bills.
• Makes monetary policy effective: changes in the repo rate and liquidity pass to other rates through the money market.
• Economises the use of cash and promotes the mobility of funds between sectors and regions.
• Helps equilibrium between demand and supply of short-term funds and keeps interest rates stable.

4. Components of the money market

(a) Institutions

• The central bank (RBI);
• commercial banks and co-operative banks;
• primary dealers in government securities and the Discount and Finance House of India (DFHI, set up in 1988);
• financial institutions, mutual funds and insurance companies;
• in the unorganised sector, indigenous bankers (shroffs, chettiars, multanis) and moneylenders.

(b) Sub-markets and instruments

1. Call money market: inter-bank lending repayable on demand, overnight (call money), 2 to 14 days (notice money) or up to one year (term money). The interest rate is the call rate; it is the most sensitive indicator of liquidity.
2. Treasury bills: short-term borrowing instruments of the Central Government, issued at a discount through RBI auctions in 91-day, 182-day and 364-day maturities.
3. Commercial bill market: bills of exchange arising from trade, discounted by banks.
4. Commercial paper (CP): unsecured promissory notes issued by highly rated companies, introduced in India in 1990.
5. Certificates of deposit (CDs): negotiable time deposits issued by banks, introduced in 1989.
6. Repo and reverse repo: sale of securities with an agreement to buy them back, used between banks and between the RBI and banks under the Liquidity Adjustment Facility. Tri-party repo (TREPS) has replaced the older CBLO.
7. Money market mutual funds, which pool small savings into these instruments.

5. The Indian money market: features and defects

The Indian money market has two parts: the organised sector (RBI, banks, financial institutions, primary dealers) and the unorganised sector (indigenous bankers and moneylenders). Textbooks list the following features, most of which are also its traditional defects:

1. Dichotomy: the two sectors work separately, and the RBI’s control reaches only the organised part.
2. Lack of integration between sub-markets, so that interest rates in one do not move with another.
3. Multiplicity of interest rates: rates differ between banks, sectors and regions; the unorganised sector charges far higher rates.
4. Seasonal stringency: demand for funds rises in the busy season (November to April, when crops are harvested and marketed) and falls in the slack season, so rates fluctuate.
5. Underdeveloped bill market: traders preferred cash credit and overdrafts to bills, so the commercial bill market stayed small.
6. Shortage of funds relative to the demand of a developing economy, and limited banking in rural areas.
7. Absence of a fully developed secondary market in some instruments.

Reforms

Following the Chakravarty Committee (1985) and the Vaghul Working Group on the money market (1987), the RBI set up the DFHI (1988), introduced CDs (1989), CP (1990) and 182-day and 364-day treasury bills, freed money market interest rates, turned the call market into a pure inter-bank market for banks and primary dealers, and introduced the Liquidity Adjustment Facility (2000) with the repo rate as the policy rate. The market today is far more integrated, electronic and responsive to RBI policy, though the unorganised sector persists in rural credit.

The RBI’s legal powers over the money market are dealt with in RBI: monetary regulation and credit control.

How this is examined

For the essay, open with the definition and the distinction from the capital market, then the features (sections 2 or 5, depending on whether the question says “Indian”), and close with the reforms. For the six-mark “components” note, give institutions in one line and the seven instruments with their maturities. Do not confuse the money market with the capital market or with the foreign exchange market.