An Introduction to the Money Market Instruments Inside Your Account
Here at Investment U, we mainly cover stocks, bonds, options and other capital securities. To be sure, these are important. They allow investors to grow their wealth, and help companies raise funds. But capital instruments only make up half of our financial markets. The other half is made of poorly-understood securities like commercial paper, short-term loans and CD’s. They’re called money market instruments, and our economy couldn’t function without them.
The money market is a highly technical and sometimes shadowy part of our financial system. In the simplest terms, it facilitates short-term borrowing and lending. These activities are essential to our way of life. A simple bank account couldn’t exist without them.
Yet the public is much less informed about money market instruments than capital market instruments. Let’s learn more about the obscure short-term markets that make capitalism as we know it possible.
What Are Money Markets?
Our economy runs on debt. Companies, governments and institutions constantly run into situations where they need more money than they currently have on hand.
Sometimes, market participants meet these financial obligations through long-term borrowing. To do this, they issue conventional bonds. But if you could only borrow money by setting up a multi-year payment plan, the economy would move a lot slower than it actually does. Sometimes, your company just needs to borrow a bit of cash until next month. Or tomorrow.
That’s where money market instruments come in. They’re short-term debt securities which mature in less than a year. And they’re sold over-the-counter, hence their relative obscurity.
Most investors only interact with these instruments through money market funds and accounts. They’re retail investment products which leverage the money market to earn a fixed interest rate. But in truth, the money market is much vaster.
An ordinary savings account earns interest because it’s tied into the money market. Banks are always lending eachother money with short-term securities called promissory notes. They use these loans to cover day-to-day expenses like payroll. And they pay them back with a small but fixed amount of interest. It’s called the overnight rate, and it’s set by the central bank.
That’s why this system is called the money market. It’s where your bank deposits live.
Investing in Money Market Instruments
Given the fixed returns and short turnaround on money market instruments, you might be tempted to buy them yourself. Unfortunately, it’s not so easy to do that.
Money markets are designed for lending between banks, governments, and other large institutions. They trade extremely high-denomination securities which aren’t accessible to most individual investors. And since they trade on informal OTC exchanges, most brokers aren’t equipped to deal in them.
One exception to the inaccessibility of money market instruments is treasury bills. “T-bills” are short-term U.S. government debt notes. They range in value between $1000 and $5 million. You can buy them directly from the government through auction sites like TreasuryDirect.
As we mentioned earlier, you can also access money markets indirectly through special mutual funds and accounts. These give you a piece of the fast-paced action. But like other broad-market funds, they tend to earn a smaller return than specific securities.
It’s understandable why the public is so uninformed about money market instruments. They’re complicated little pieces of paper which reside within our banking system. They represent astronomical amounts of money. Yet they pop in and out of existence without most people noticing.
Yet without the money market, banks would collapse. Governments would default. And big companies would constantly be going under. Our economy would grind to a halt. We hope this article has helped you learn something about this essential part of our financial system. Whether or not you’re aware of it, you use it every day.