Money markets an arena for liquidity management

Written by Sunil K Parameswaran | Updated: Nov 16 2012, 09:19am hrs
The money market is a market for securities with an original term to maturity of one year or less. Securities with an original term to maturity of greater than a year are referred to as capital market securities. Quite obviously, money market securities must be debt securities, since equity shares do not have a stated maturity date.

On the other hand, capital market securities may be equity or debt securities. In the context of debt securities, there are two terms used in the context of their tenure, which differ in meaning. The original term to maturity of a security is its term to maturity as of the date of issue. Obviously, it will not change subsequently.

However, the actual term to maturity of a security is its current term to maturity, which will decline with the passage of time. Money market securities will, consequently, have an actual term to maturity of one year or less.

The money market is for managing imbalances between inflows and outflows. For any economic agent, be it a private business or a government entity, the times at which inflows are realised will rarely, if ever, be perfectly synchronised with the times at which expenditure is scheduled. Take the Indian government for instance. It collects income tax once a quarter. Thus, inflows are lumpy. However, expenditure on account of wages, salaries, fuel bills and other items will be incurred on virtually a daily basis.

Consequently, even if the government were to have a budget surplus for the financial year as a whole, which is rare, most of the time, it will have a deficit. Same is true for corporate entities. There will be points in time where their currency accounts will have a healthy surplus. At other times, however, they will have low or nil balances and may even have to take recourse to an overdraft facility.

The money market is the arena where economic agents source cash for bridging their temporary deficits and is also the venue for their short-term investments. Governments borrow by issuing short-term debt securities, termed as treasury bills or T-bills.

Corporations borrow by issuing short-term unsecured promissory notes known as commercial paper (CP). Banks borrow by issuing negotiable certificates of deposit (CDs), which are essentially fixed deposit receipts which can be traded before maturity. Other forms of transactions in the money market include repurchase agreements or repos, which are referred to as ready-forward (RF) transactions in India, and bankers acceptances, which are bills of exchange that have been accepted by a commercial bank.

The capital market, on the other hand, is an arena for raising long-term capital to fuel investments. If a business wants to set up a factory or build a new office, it will seek recourse to the capital market. Similarly, governments issue medium-to-long-term bonds known as treasury notes or T-notes and treasury bonds or T-bonds, respectively.

However, while the economic functions of the two markets are different, as is the nature of the securities that trade in them, money markets may, at times, be used for raising bridge financing. For instance, interest rates in India are currently on the higher side. Let us assume that a company is contemplating the issue of bonds with 15 years to maturity for funding an investment project.

If it were to do so under the current conditions, it would have to pay a high coupon. However, if the CFO is of the belief that the rates are likely to ease within the foreseeable future, he may well decide to raise the required funds in the money market, and retire the securities subsequently by raising money in the capital markets when the anticipated rate decline materialises. Thus, while the money market is primarily meant for current account and not capital account transactions, there could be exceptions.

Why is there such a strong focus on liquidity management Money is an extremely perishable asset. If it is not productively invested even for a day, the loss can be enormous, and income lost can never be recouped.

For instance, consider a company that keeps R10 million un-invested for six days. If we assume that the interest rate is 7.50% per annum, the interest income foregone will be R12,500, assuming that the year consists of 360 days, which is the common assumption in most money markets.

Similar examples of perishable assets can be given from other industries. If Jet Airways were to fly from Mumbai to Delhi on a given day with 10 empty seats, then the revenue lost is lost forever because on a subsequent flight, they cannot accommodate two passengers on every seat. Similarly, if the Taj in Mumbai were to have 10 empty rooms on a given day, they, obviously, cannot put up multiple guests in a room on a subsequent day.

Money markets may be securities dominated or bank dominated. Western markets are securities dominated in the sense that most transactions involve transfers of securities between lenders and borrowers. Asian markets on, the other hand, are largely bank dominated, implying that most transactions involve borrowing and lending by commercial banks.

It is believed that the latter are more vulnerable to government pressures. We have seen evidence of this in India, where in the early 1980s, public sector banks were asked to conduct Loan Melas and offer unsecured loans to borrowers, mostly connected to the ruling party. Most of this money, as expected, was never repaid.

The writer is the author of Fundamentals of Financial Instruments published by Wiley, India