Money market aims and objectives PDF

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Money market aims and objectives,nature, participants...

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UNIT IV

LESSON

10 MONEY MARKET CONTENTS 10.0

Aims and Objectives

10.1

Introduction

10.2

Money Market

10.3

Nature of Money Market in India

10.4

Constituents of Money Market

10.5

Participants of Money Market 10.5.1

Participants in Call Money Market

10.5.2

Participants in Treasury Bills Market in India

10.5.3

Participants in Commercial Bill Market in India

10.6

Role of Money Market in India

10.7

Let us Sum up

10.8

Lesson End Activity

10.9

Keywords

10.10 Questions for Discussion 10.11 Suggested Readings

10.0 AIMS AND OBJECTIVES After studying this lesson, you should be able to: z

Define Money Market

z

Discuss the Nature of Money market in India

z

Understand the Constituents of Money Market

z

Explain the Participants of Money Market

z

Describe the Role of Money market in India

10.1 INTRODUCTION A financial market is a market where variety of financial assets are traded directly or indirectly to cater to the diverse saving notions of the savers and numerous investment preferences of the investors, and where financial institutions buy the financial claims of those who have surplus funds and sell their own claims. In view of a large number of different types of financial investments of diverse maturity issued by financial institutions and trading of wide range of securities, there exist different types of financial markets in a developed economy. Each market deals with a somewhat different type of securities in terms of instruments, maturity and the assets backing it. Also, different markets serve different parts of the country. A fair understanding of

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these financial markets provides insight into conceptual model of the financial system and intricate interrelationships that exist among various intermediaries. This, in itself, hones the decision-making skills of the market participants. Broadly speaking, financial markets can be classified according to maturity structure and kind of securities traded in the markets. It is noteworthy that in view of financial liberalisation and concomitant expansion and diversification of operations and increased financial interdependencies, ironclad distinctions among markets are blurred and are of academic interest. It has been rightly observed that “you should recognise big differences among types of market, but do not get hung up trying to distinguish them at the boundaries”. According to maturity of claims traded, financial markets can be grouped into two broad categories, viz. Money Market and Capital Market. We will discuss here only money market as capital market has already been discussed in lesson 4.

10.2 MONEY MARKET Money market is a market where near money assets and not currency are traded. Near money assets are characterised by their liquidity, high marketability and low risk. Money market is distinct from other financial markets because of the short-term maturity of money market instruments, large denomination of transactions, low default risk, innovation and flexibility.

10.3 NATURE OF MONEY MARKET IN INDIA Money market typically trades in short-term securities having an original maturity of one year or less. Because of short-term maturity, adverse price movements resulting from interest rate fluctuations are smaller in money market securities which, in turn, lead to low risk. Another redeeming characteristic of money market is that money market instruments are generally sold in large denominations. The size of these transactions prevents most individual investors from participating directly in the money markets. Instead, dealers and brokers operating in the trading rooms of large banks and brokerage houses, bring customers together. Individuals generally invest in money market securities indirectly, with the help of financial intermediaries. Low default risk is another feature of money market securities. The risk of late or nonpayment of principal and/or interest is generally small. As cash lent in money markets must be available for quick repayment to the lender, money market instruments are usually issued by high-quality borrowers having low default risk. Innovation and flexibility are the hallmark of the money market. Despite the wholesale nature of the money market, innovative securities and trading methods have been developed to provide opportunity to small savers to access to money market securities. Money market securities are used to ‘warehouse’ funds until needed. The returns earned in these investments are low due to their low risk and high liquidity. It is important to note that money market does not represent a single physical location. Money market transactions do not take place in any one particular place or building. Usually, traders arrange purchases and sales between participants over the phone and complete them electronically. Dealings may be conducted with or without the help of brokers. In view of this unique characteristic, money market securities typically have an active secondary market. An active secondary market makes it easy to find buyers

who will purchase the security sold initially in the future. This provides flexibility to the instruments to use them for meeting short-term financial needs.

10.4 CONSTITUENTS OF MONEY MARKET Money market is composed of different constituents, each specialising in a particular credit operation. 1. Call/Notice money market: It represents a segment of money market that deals in money at call and short notice. Loans given by banks can be called back at a very short notice. Such loans are provided without any collateral security. Call money market provides high liquidity with low return to the banks. The rate of interest in this market is very low and highly volatile and susceptible to changes in demand and supply of funds and at times changes taking place several times during the course of the day. Call/Notice money market, as noted earlier, is a market where the day-to-day surplus funds, mostly of banks are traded. In India, there does not exist short-term money market. Call loans in India are provided: (i) to the bill market, (ii) for the purpose of dealing in the bullion markets and stock exchanges, (iii) between banks, and (iv) frequently to individuals of high financial status in Mumbai for ordinary trade purposes in order to save interest on cash credits and overdrafts. Among these uses, interbank loan has been the most predominant. Banks borrow from other banks to meet a sudden demand for funds, make large payments, large remittances, and to maintain cash with the RBI. To the extent, call loans that are given in India to security brokers. To the extent call money is used in India, it is akin to federal funds in the US and to the extent the call money is provided to security brokers, it tantamounts to call loans proper in the US. Maturity period of call loans varies between one day and a fortnight while notice money deals in funds for 2–14 days. Call loans are unsecured in India, unlike in other countries. Further, trading on the call money market is seasonal in character as is reflected in the volume of money at call and short notice. Thus, demand of money at call market is less during slack season as compared to that during busy season in a year. It is generally found that borrowings from call market tend to be highest around March every year ostensibly due to withdrawals of deposits in March to meet year-end tax payments and withdrawals of funds by financial institutions to meet their statutory obligations. Call money markets are located mainly in high industrial and commercial centres like Mumbai, Kolkata, Chennai, Delhi and Ahmedabad. Among these, the Mumbai call market is the biggest both in terms of size and buoyancy. This is primarily because head offices of all the premier banks, the RBI, LIC and UTI are situated there. It has also the biggest stock exchange and highly developed communication system. The call money markets at Delhi, Kolkata, Chennai and Ahmedabad are geographically dispersed due to which different call rates prevail in these markets. In addition to the above, there exists a large number of local call markets developed and operated by indigenous local bankers. 2. Term Money Market: The term-money market is another segment of the uncollateralised money market which deals with financial transactions of shortterm duration ranging from 15 days to one year. This market has been somewhat dormant in India. It was also a strictly regulated market upto the late 1980s with the ceiling rates of interest (10.5–11.5%) across the various maturity periods. Historically, statutory pre-emptions on interbank liabilities regulated interest rate

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structure, cash credit system of financing, high degree of volatility in the call money rates, availability of sector-specific refinance, inadequate Asset Liability Management (ALM) discipline among banks and scarcity of money market instruments of varying maturities were cited as the main factors that inhibited the development of the term money market. 3. Collateral loan market: This is a market that deals in collateral funds. Collateral funds refer to loans granted against the securities. The collateral loans are generally provided by commercial banks mostly to brokers and dealers in stocks and bonds. Collateral loans are given for a short period lasting for a few months. The collateral is returned to the borrower on repayment of loans. In case of default, the collateral becomes the property of the lender. 4. Acceptance Market: It deals with bankers’ acceptances involved in trade transactions both within and outside the country. Banker’s acceptance refers to a draft drawn by a business firm upon a bank and accepted by it. The bank is required to pay to the order of a particular party or to the bearer a certain specific amount at a specific date in future. The banker’s acceptance is different from a cheque in that the former is payable at a specified future date while the latter is payable on demand. What is important to note is that in banker’s acceptance, bank funds are not involved. The bank merely adds its guarantee to the draft. 5. Discount market: It is concerned with discounting of short-term instruments such as commercial bills arising out of commercial transactions. The seller draws a bill on the buyer who accepts it promising to pay the stipulated amount at a specified date. The seller, instead of waiting for the maturity of the bill, gets it discounted with commercial bank that makes the payment of the bill after charging discount. On the date of maturity, the bank will claim the amount of the bill from the person who accepted the bill. The Chore Working Group to review the system of cash credit also looked into, in 1979; the question of setting up of a discount house in India. The Chore Group was of the considered view that discount houses along the pattern of the U.K. could be profitably adopted in India. It recommended that: i.

The proposed discount house should be the sole depository of the surplus liquid funds of the banking system as well as the non-banking financial institutions.

ii. It should use surplus funds to even out the imbalances in liquidity in the banking system subject to the RBI guidelines. iii. It should create ready market for commercial banks, treasury bills and government securities by being ready to purchase from and sell to the banking system such securities. iv. The discount house should be sponsored by the commercial banks, LIC, UTI, GIC with participation by the IDBI, ICICI and SFCs. v. The discount house should be an autonomous body which should be run strictly on commercial principles. vi. The RBI should have powers to issue directives to the proposed discount house. 6. Bill market: This represents that segment of money market where short-term bills, viz. commercial bills and treasury bills are traded. While commercial bills arise out of business transactions, treasury bills are short-term government securities issued by the central bank on behalf of the government for raising funds.

Treasury bill market deals with instruments of short-term borrowing of the government. It plays a vital role in cash management of the government. Being risk-free, their yields at varied maturities serve as short-term benchmarks and help pricing varied floating rate products in the market. Treasury Bills market has been most preferred by central banks for market interventions to influence liquidity and short-term interest rates, generally combined with repos/reverse repos. There was an active Treasury Bills market in India’s bank’s history before the 1960s when 91-days Treasury Bills were auctioned weekly and the bills were widely held in the market. In the mid-1950s, the system of ad hoc 91-days Treasury Bills was introduced to replenish on automatic basis, the Central Government’s cash balance with the RBI to restore to its minimum required level which opened up the era of uncontrolled monetization of the central government’s deficit. In mid-1960s, the auction system for issue of 91-days Treasury Bills to the market was replaced by the Tap sale of bills. Though the Tap bill rates were varied in sync with changes in the Bank Rate till 1974, the discount rate on ad hoc and tap bills continued unchanged since then at the uniform rate of 4.6 per cent. Combined with the regime of administered interest rates, there was no congenial environment for Treasury Bills market to develop. However, the interest in development of Treasury Bills market came up with the introduction of 182-days Treasury Bill on auction basis in November, 1986 and the constitution of Discount and Finance House of India (DFHI) as a money market institution in March 1988. At present, the Treasury bill market in India deals in the treasury bill issues of weekly, 14-day and 91-day bill auctions and 364-day bill auctions on a fortnightly basis combined with 14-day intermediate bills available for state governments and foreign central banks. Check Your Progress 1 State whether the following statements are true or false: 1. A financial market is a market where variety of financial assets are traded directly or indirectly 2. Money market is a market where near money assets and not currency are traded. 3. Money market typically trades in short-term securities having an original maturity of one year or less. 4. Call money markets are located mainly in high industrial and commercial centres. 5. Lateral funds refer to loans granted against the securities.

10.5 PARTICIPANTS OF MONEY MARKET The money market of a country comprises the institutions who are engaged in lending and borrowing of short-term funds. Although institutions comprising money market differ from country to country, central, commercial banks, non-banking financial companies, brokers and dealers are usually operating almost in every money market of the world.

10.5.1 Participants in Call Money Market Players in call money market in India can be grouped into the following categories: 1. Reserve Bank of India

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2. Scheduled Commercial Banks 3. Non-scheduled Commercial Banks 4. Foreign Banks 5. State, District and Urban Cooperative Banks 6. Discount and Finance House of India (DFHI) 7. Securities Trading Corporation of India (STCI) 8. Primary Dealers (PDs) 9. Satellite Dealers (SDs) Commercial banks and cooperative banks are the major participants operating as both lenders and borrowers, while a large number of financial institutions and mutual funds are operating only as lenders. The behaviour among banks in the market has not been found uniform. There are some banks, mainly foreign banks and new private sector banks, which are active borrowers and some public sector banks that are major lenders. Earlier, foreign banks operated in the call money market primarily as lenders. But subsequently, they extended their participation as borrowers for meeting CRR requirements. The problems faced by these banks in garnering deposits through branch expansion and increase in the cost of servicing deposits have also kept depositors away from call market till 1970 whereafter they have been participating in the market on a regular basis. In order to widen the participation of call money market and increase its depth, the RBI permitted special institutions such as GIC, IDBI and NABARD to operate in the market as lenders with effect from May 2, 1989, and 13 more institutions already operating in the bills rediscounting market, were allowed in call money market as lenders from October 1990. The RBI also set up new institutions, viz. DFHI, STC and money market mutual funds (MMMFs).

10.5.2 Participants in Treasury Bills Market in India The participants in the Treasury bills market include the RBI, SBI, Commercial banks, State governments and other approved bodies, DFHI, STCI, other financial institutions such as LIC, UTI, GIC, NABARD, IDBI, IFCI, ICICI, etc. corporate entities and general public and foreign institutional investors. Among the above, the RBI plays predominant role in Treasury bill market buying/holding over three-fourths of the total outstanding bills. Commercial banks are the next important player as subscribers to such treasury bills followed by State governments and others. Treasury bills are least popular among the corporate entities and the general public.

10.5.3 Participants in Commercial Bill Market in India The following are the players of Indian bill market: 1. All Scheduled Commercial Banks 2. LIC and its subsidiaries 3. GIC and its subsidiaries 4. ICICI bank 5. UTI 6. IRCI

7. ECGC 8. IDBI bank 9. SBI Mutual Fund 10. Select UCBs 11. Can bank Mutual Fund 12. IFCI 13. DFHI 14. NABARD 15. NHB 16. SCICI 17. TFCI 18. Exam Bank 19. LIC Mutual Fund 20. SIDBI, etc. Among these, DFHI is a major player in providing rediscounting facility to the institutions discounting trade bills. DFHI obtains refinance from the RBI. The DFHI offers two-way quotes for buying and selling rediscounted bills.

10.6 ROLE OF MONEY MARKET IN INDIA Primary objective of money market is to facilitate the flow of short-term funds. To achieve these objectives, money market performs the following functions: 1. The most important function of money market is to establish linkage between supplies of short-term surplus funds and demanders of funds for meeting their short-term requirements. It provides convenient access to both providers and borrowers of short-term funds to satisfy their lending and investment requirements. In this process, money market provides an equilibrating mechanism to even out short-term liquidity. 2. Money market provides an ideal place for a firm or financial intermediary to ‘warehouse’ excessive holdings of cash balances until they are needed. In the real world, the immediate cash needs of individuals, firms and governments hardly synchronies with cash receipts. Further, corporations’ daily patterns of receipts from sales do not match the pattern of their day-to-day expenses. Since holding surplus cash involves opportunity cost-cost in terms of lost interest income, firms and other economic units use the money market as an interim investment that provides a higher return than holding cash or money in banks. They invest their excess cash funds in money market instruments that can be quickly liquidated in cash in times of need with little risk of loss of value. Thus, through the ‘warehousing’ function, money market provides efficient means to enable large amount of funds to be funneled from suppliers of funds to users of funds for a short period of time. Most investment funds and financial institutions held money market securities to meet investment or depo...