How Do Money Markets Work?
If you’re looking to make a relatively short-term, safe investment, money markets offer plenty of incentive. These markets are very accessible to most people, and participating in them is as easy as opening a special type of savings account. You don’t even need to worry about buying or selling securities—financial institutions do it for you. As a result, they rarely seem like an investment product.
Make no mistake, however: the money market is an investment market. The investments are short-term and low risk, which means they also offer lower reward. They’re more often seen as a type of fixed-income product, akin to bonds. In fact, treasury bonds are one of many financial products within the money market.
Here’s a look at how these markets operate and what their purpose is—as well as how to invest in them.
What is a Money Market?
A money market deals with short term investments that require liquidity. Typically, these products mature in three to 12 months. For this reason, they’re considered “cash” investments—hence the term, money market.
Once vested in the market, those funds become part of cash swaps between banks, companies, governments and anyone else moving large sums on a daily basis. This can assist in everything from financing trade to financing industry. These markets ultimately provide liquidity to the greater financial markets.
Types of Products
Investing in the money market takes place through a variety of mediums. Each offers the opportunity to participate in the broader market through different financial products. For example, some of the most common include:
- Treasury bills: Treasury bills are a short-term financial product issued by the federal government. A type of bond, they come with fixed interest and maturity dates.
- Commercial paper: Paper represents unsecured business loans for cash. Because only prime credit companies participate, it’s considered a very low-risk investment.
- Deposit certificates: Certificates of deposit (CD) are a fixed income financial product. They’re usually issued in three-month increments.
- Bankers’ acceptance: These are short-term loans used in foreign trade. They signify an importer’s ability to pay for goods.
- Money market funds: These funds pool money to leverage higher buying power on short-term, stable financial products.
- Money market accounts: Individual accounts for retail investors that functions as a savings account. They typically come with minimum balance requirements.
There are also more sophisticated products like Eurodollars and repos. These financial products are all short-term, relatively stable. They’re ideal for risk-averse investors and are great for hedging against volatility. By nature, they’re also very accessible, to maintain market liquidity.
How to Invest in a Money Market
For retail investors, these markets are highly accessible. The simplest way is to invest in a money market account. They require a specialized account opened through a brokerage or a bank. The account typically comes with a minimum balance requirement and a higher interest rate than a savings account. Retail investors deposit their money into the account and the financial institution does the rest.
For other products, investment is more direct. For example, investors can buy treasury bills directly from the United States Treasury website. Likewise, you can buy CDs through virtually any banking institution. There are few barriers to obtaining these financial products, although there are stipulations. As mentioned, these accounts require a minimum balance. CDs come with a penalty for early withdrawal. These penalties serve to promote stability by keeping funds vested and liquid.
Key Terms to Know
Money market terms focus more on the products themselves than the market. It’s best to get familiar with the jargon surrounding whatever type of investment interests you. For example, if you invest in repos, get to know terms like “collateralized.” When it comes to broader market terms, here are some of the most common:
- Fixed rate: An interest rate that’s unchanging over the life of the investment.
- Variable rate: An interest rate that fluctuates over the life of the investment.
- Credit rating: The reputability of the money market product or the seller of that product.
- Maturity: The length of time of the product investment (typically under one year).
- Penalty: The forfeiture of profit or principle that comes from pulling an investment early.
Many low-risk investors prefer these markets. Not only are the financial products themselves stable, there’s a much lower barrier to understanding them. In fact, money markets are very straightforward.
The Basic Functions of a Money Market
The chief purpose of the money market is liquidity. Short-term investments play an important role in the liquidity of banks, companies and even the federal government. Cash funneled into these markets becomes part of swaps between banks and the government or banks and companies. While their finances are vested, these institutions rely on the liquidity of money markets to facilitate active capital. In this way, money markets are what keep fund transfers flowing each day.
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For investors, money markets represent very stable investments. The low risk, extremely stable nature of money market funds is enticing. It’s a win-win for investors and money market beneficiaries alike.