Economic concepts: Money Markets

It is the market in which high liquidity instruments are traded for a short term(less than 1 year) period. It is a part of financial markets. It can be classified into three

overnight market – for one day

notice money market – 2 to 14 days

term money market – 15 days .

Reserve bank of India being the apex body uses various tools to control the money supply(liquidity) in the money market, for ensuring effective demand for money, bearable rate of inflation and steady economic growth.

The various tools that are used are as follows

Liquidity adjustment facility.

It is the options by which RBI adjusts the liquidity available in the system and there by influences the interest rate prevailing in the system. As of now, RBI uses three tools under the LAF. They are Repo , Reverse repo and MSF.

Repo:

These are basically short term lending tools. Repo means repurchase options. Generally, in India, 1 day Repo is only used. But RBI reserves the decision of using more day Repos and uses them occasionally.

Repo stands for repurchase option. In repo, the scheduled commercial banks (including RRB and LAB) and primary dealers(specialized dealers who acts as intermediaries in trading government securities) can sell their Government securities to the RBI, with a repurchase clause. The banks and the RBI have to repurchase the securities in the specific time period as mentioned in the clause. Generally it will be one day. Whenever the banks need money immediately at night for ending that day's transactions and when the call money interest rate are higher or there is very high liquidity deficit in the system, the banks and dealers will prefer this option to borrow money. The rate at which repo transactions are done is known as Repo rate.

Repo is used by the RBI to inject liquidity into the system and there by reduce the inter – bank interest rates. In India, repo auctions are conducted by RBI twice a day. The first time repo(in a day) is called as LAF-REPO and the second time repo (in a day) is known as SLAF – REPO.

Reverse repo:

It is the reverse of the previous thing. Whenever there is a liquidity surplus, the banks and the dealers lend the money to the RBI, by buying the government securities from the RBI with a clause of reselling them back after a specific time period. The rate at which the reverse repo transactions are done is known as Reverse repo rate.

Marginal Standing Facility:

All scheduled commercial banks can avail overnight up-to one percent of their net demand and time liabilities(NDTL) outstanding at the end of the second preceding fortnight.

The rate is always 100 basis points above the LAF- repo rate. The MSF rate dependent on LAF – REPO rate ans varies dependent on variations in repo rate.(from MAY 2011)

 

Liquidity Corridor or Interest Corridor:

The difference between the interest rates of Reverse Repo rate and the MSF rate is known as liquidity corridor.(Now after May 2011) RBI has fixed the corridor as 200 basis points(always) and Repo rate comes in the middle of the corridor. And the Repo rate is the only independent varying LAF policy rate of RBI as reverse repo rate is always set 100 basis points below repo rate and the MSF rate is fixed always 100 basis pts above the Repo rate.

Significance of the liquidity corridor:

Consider today's rates (as of January 26, 2012) MSF rate is 9.5% and reverse repo is 7.5%

If there is surplus liquidity in the system, the call money rate (the rate at which the interbank overnight money transaction takes place) goes below 7.5% and hence for banks using reverse repo tool is profitable than lending to other banks. Similarly, if there is a liquidity deficit in the system, the call money rate goes above 8.5% and subsequently banks starts to use repo tool than call money option as repo tool becomes profitable now. But, when the money required is very high than that is auctioned through the LAF - REPO tool, then the banks use MSF tool to borrow money. Hence the call money is not preferred even in very difficult circumstances, which stops the call money interest rate to float above the MSF rate, that is 9.5%.

The major significance of the narrow corridor like 200 basis points is that it provides more stability (less variation of call money rates) in the system. Hence, LAF becomes a important a important monetary tool and not just a liquidity supplier or a absorber tool(like CRR).

The accepted 'system deficit' or 'liquidity deficit' in the system is +/- 1% of net deposit time liability(NDTL).

Note: repo can also be undertaken in corporate debt securities (all SCB)

CRR:

It is a statutory requirement for all scheduled banks to maintain a particular amount of cash reserves with the Reserve bank of India. It is a fixed percentage of their net demand and time liabilities as fixed by RBI. Reduction of CRR injects one time liquidity into the system. It is basically a liquidity tool rather a monetary tool.

Statutory Liquidity Ratio:

It is a minimum amount of liquid assets (cash, gold , government securities and SDL) that has to be maintained by scheduled banks among themselves. It is generally fixed as a percentage of NET DEMAND AND TIME LIABILITY of that particular bank by RBI. The present rate of SLR is 24%. but most banks maintain maintain it at 28% on a average.

Open Market Operation:

Government from time to time sells and buys government securities and bonds directly from the market. Banks, dealers, corporates, even FIIs can buys these government securities. In fact, it is mandatory for few government institutions to buy government securities

BANK RATE POLICY:

It is the rate at which RBI re-discounts government securities and bills of exchanges or commercial bills. The present rate is 9.5%.

MARKET STABILIZATION SCHEME:

When the rupee appreciates, RBI will normally buy the foreign exchanges and release money which increases the liquidity in the system. As we are aware, too much liquidity would actually induce inflation in the economy. Hence RBI simultaneously would simultameously do open market operations and absorb the excess liquidity. But during 2004 there came a situation where RBI went short of government securities to sell and absorb liquidity. It can also cant ask the govet to issue new securities as it would increase the fiscal defecit as well. Hence came the concept of Market stabilization scheme.

Here the govt securities which is issued by RBI on behalf of the govt would be sold in a separate scheme called MSS. Govt of India maintains money in an seperate account with RBI called MSS account which would will be equal to the sum of the value of all the secuities thus issued. The collected funds will be maintained in the same account and is rotated to buy and sell securities

 and by the way stabilize the market without increasing the fiscal defecit.

 The high liquidity instruments generally traded are government securities, certificates of deposits, commercial papers etc. Certain important terminologies associated with money markets are described below.

GOVERNMENT SECURITIES:

• Treasury bills
• cash management bills
• Dated government securities
  1. Fixed rate bonds
  2. Floating rate bond
  3. Zero coupon bonds
  4. Capital indexed bonds
  5. Bonds with call/put option
  6. Special securities

7. STRIPS(seperate trading of registered interest and principal of securities)

TREASURY BILLS:

• 91 days
• 182 days
• 364 days
• 14days intermediate treasury bills/

Treasury bills are zero coupon securities and they pay no interest. They are generally lesser than the face value of the bills and the difference in the amount gain of the buyers. For example, consider a treasury bill of Rs.100. It is auctioned at a lesser value of only Rs.90. And if the treasury bill is 91 days type, then after 91 days the person who bought the bill for Rs. 90 could get Rs.100.

Cash Management Bills:

Introduced on May 2010 , are same as treasury bills but with a 2 major difference

1. they are given for a period less than 91 days
2. they are not accepted as eligible securities for SLR purpose.

Dated Government securities:

They are long term securities and carry fixed or floating coupon(interest rate) which is paid on face value, payment at fixed time periods(usually half-yearly). The tenure of dated securities can be upto 30 years.

State Development Loans:

State governments also raise loans from the market. SDLs are dated securities issued through market similar to the way as usual by central government.

Sub – Markets

Call money rate:-

Uncollateralized lending and borrowing of funds is predominantly overnight and is open for participants only to SCBs and primary dealers.

Bill Market:-

Bill market or the discount market is the most important part of money market where short term bills are bought and sold. They can be either commercial or treasury bills.

It is also known as bill of exchange. Consider a small manufacturer buys raw materials from a steel firm for Rs.1000. The manufacturer does not have money now. Hence gives a bill of exchange, stating to pay Rs. 1100 at a fixed future date. The steel firm holds the bill in exchange for actual cash. Now if the steel firm runs into liquidity deficit, it can deposit the bill of exchange in any commercial bank and get money at a discount rate i.e, Rs.1050. The Rs.50 difference(1100-1050) is the earning of the bank. Now if the commercial bank wants cash, they can do the same with the RBI. The RBI will re-discount this bill at Bank Rate and give the balance money.

This is a important tool used in western countries, less famous in India.

Treasury Billl Market:-

Same thing can be done with treasury bill too.

Certificate of Deposit:-

It is a negotiable money market instrument. Banks will issue CDs for maturities from 7 days to one year where as FIs can issue maturities one yr to two yr.

They are issued by banks in multiples of Rs.25 lakhs. Now, the minimum value is reduced to one lakh. They are issued at a discount to this face value and the difference is their rate of interest.

Commercial Papers:-

It is issued by corporates, FIs, primary dealers with a net worth of Rs. 5 crore. They are issued in the multiples of 25 lakhs subject to a minimum issue of 1 crore. They are issued to raise funds. They are issued at a discount to the face value and difference is the rate of interest.

Maturity period-- 7days to one year

Collateralized Borrowing and Lending Obligations:-

It is operated by CCIL- Clearing Corporation of India ltd. It lends money on collaterals(government and other securities).