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Lesson 3: Money markets

Flows of money and securities
Money markets

  • What is liquidity?
  • IMF 2008
  • Cleveland & Ohio 2008

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    European Central Bank in Frankfurt, Germany



    Flows of money and securities

    In every country, the general flows of funds through the financial system can be represented like this:

    (adapted from Mishkin, The Economics of Money, Banking and Financial Markets, Addison Wesley, 8th ed., 2007, p. 24)

    (Note: sometimes the counterpart to a (blue) security flow can also be a security flow rather than (yellow) money.)

    The above flows represent only financial investments. They are funneled directly by financial markets, and indirectly by banks and other financial intermediaries, from lenders to borrowers.

    The lenders are also called:

    • the investors
    • the buyers of financial securities
    • the savers

    Conversely, the borrowers are also called:

    • the sellers
    • the issuers of financial securities
    • the spenders

    The other big flows
    There are several other big pictures of flows, of an economic nature, in society:

    1. the flows of purchases of goods and services by households:
      • money: households -> firms
      • goods and services: firms -> households
    2. the flows of work, sold by individuals to firms (in other words, the labor market)
      • work: individuals -> firms
      • salaries (money): firms -> individuals
    3. the flows of other purchases by firms
    4. the flows of physical investments by firms
    5. the flows of repayments of loans by borrowers to lenders
    6. the flows of taxes of various sorts (VAT, indirect taxes)
    7. etc.

    Flows of liabilities
    The characteristic of the flows of funds and of financial securities (as counterparts) is that there is no tangible goods or services or any other tangible values involved. It is only a flow of liabilities. (It is also the case of items 5 and 6 in the above list.)

    Liabilities are financial securities and have value
    When studying financial markets, one must keep in mind this fundamental fact: money and other financial securities are only signs of liabilities between economic agents. When I owe you $100 (or whatever, for that matter) to be paid in some specified future, it is a liability (linking me to you), which is an asset for you (an asset of a financial nature) and a pure liability for me.

    The role of money, financial products, and financial markets is to distribute these liabilities (by definition, involving time) among economic agents, to make the economic system function.



    Money markets (from Levinson, chapter 3)

    Maturity less than one year
    We call "money markets" the financial markets of securities the maturity of which is less than or equal to one year. In other word, it is the markets for short term money needs. Since these markets are in reality one big worldwide market, henceforth we shall use the singular: the money market.

    Issuers have short term needs, often seasonal
    Typically this market is used by agents which experience short delays between expenditures and revenues. For instance, a local government which pays monthly salaries to civil servants, and has tax revenues with a yearly seasonality, will need to finance its monthly expenditures preceding its revenues. A business which expects the payment of a large invoice in only two months but needs the cash right now will use the money market. The money market is also used for other financial operations, investments, speculation, etc. We shall study them in detail.

    Big development since 1980
    Like all other financial markets, the money market developed significantly since 1980 and the deregulation, disintermediation, and removal of barriers in the banking and financial sector. Banks have lost market shares in both gathering deposits and lending money. The US Monetary Control Act of 1980 allowed market forces rather than regulators to determine interest rates.


    Table 3.1 Domestic money-market instruments worldwide ($billion, end of year)    
    1994 1996 1998 2000 2002 2004
    Treasury bills 1 993,2 1 965,4 1 826,2 1 888,2 2 318,3 3 413,2
    Commercial paper 857,6 1 072,7 1 473,3 2 089,4 1 911,4 2 015,0
    Other short-term paper 1 385,7 1 610,6 1 860,1 1 930,8 2 064,1 2 743,9
    Total 4 236,5 4 648,7 5 159,6 5 908,4 6 293,8 8 172,1
    Source : Bank for International Settlements            

    Source: Levinson p. 42


    Difference between the money market and the bond market:

    Long term projects
    The bond market, which we shall study in the next lesson, is a market for financing long term projects with financial instruments having a corresponding long maturity. The money market is only for short term.

    Money market instruments are safer than longer term instruments.

    Money markets help bond markets. Price of liquidity
    The money market helps the development of a bond market. It gives a price to liquidity, "the availability of money for immediate investment". The interest rates for extremely short-term use of money serve as benchmarks for longer-term financial instruments. If the money markets are active, or "liquid", borrowers and investors always have the option of engaging in a series of short-term transactions rather than in longer-term transactions, and this usually holds down longer-term rates.



    US money markets

    US money markets


    US capital markets

    US capital markets


    US intermediaries

    Source: Mishkin


    The investors/lenders in the money market:

    Short-term instruments are often unattractive to investors because of the high cost of learning about the financial status of a borrower. For this reason, investors typically purchase money-market instruments through funds.

    Money-market funds
    They developed in the US beginning in the 70's. They reduce the investors' search costs and risks. And they perform the intermediation, like a bank, at a lower cost: their spread (difference between borrowing and lending rates) is a few tenth of a percentage point rather than 2 to 4% for banks.

    Investors in US money market funds had $1800 billion in assets, in these funds, in 2005. This represented appromitaly 20% of the world money market assets.

    Individual sweep accounts
    These are accounts managed by financial institutions, for depositors who wish their invested cash to remain very liquid.

    Institutional investors
    All sizeable banks maintain trading departments that actively speculate in short-term securities.

    Investment trusts (= mutual funds), which hold a portfolio of bonds and equities, keep a part of their assets in money market instrument. The idea is to be able to meet the demands of investors to redeem their shares without having to liquidate long term assets.


    Types of instruments, and their issuers/borrowers

    Commercial paper

    It is a short-term debt obligation issued by a private-sector firm or by a government sponsored corporation.

    Its maturity is usually between 90 days and 270 days.
    There are regulatory reasons for that. Above 270 the issuance of a bond must meet more stringent requirements. It must be registered, in the US, with the Securities and Exchange Commision (SEC) prior to issuance.

    Commercial paper is usually unsecured.
    No specific asset guarantees it. (A guarantee is an asset that would be transfered to the investor, should the commercial paper not be refunded.)

    Dates from the XIXth century
    Commercial paper was first introduced in the US in the late 19th century. But of course many forms of similar debts were issued long before that.

    Less costly, for the borrowers, than banks
    Its main advantage for firms borrowing, was that if they were sound they could meet their financial needs at a lower costs than what banks offered. Before the insurance of bank accounts by the FDIC, in 1933, lending to a large and sound corporation was no riskier than to a bank. After the Great depression, commercial paper declined. But in the 1980, it became very popular again when money-market funds began to be important and bought commercial paper.

    Decline when the short rates were very low. Investors less interested
    Between 2001 and 2005, the growth of the money market in the US stopped because the short term rates were very low, and investors shifted their assets towards longer term instruments.

    Financial firms in the US have become the main issuers of commercial paper:

    Table 3.2  Commercial paper outstanding in the United States    
                      ($ billion, seasonally adjusted, end of year)      
    Financial issuers Non financial issuers Total
    1990 421   150   571  
    1992 407   146   553  
    1994 444   165   609  
    1996 601   187   788  
    1998 936   227   1 163  
    2000 1 206   398   1 604  
    2002 1 101   269   1 370  
    2004 1 268   120   1 388  
    Source : Federal Reserve Board          

    Roll over
    Many large companies have continual commercial paper programs, bringing new short-term debt on to the market every few weeks or months. They "roll over" their paper, using the proceed of a new issue to repay the principal of the previous one.

    Beneficial for issuer, but dangerous
    This is beneficial when short term rates are lower than longer term rates, but it is dangerous too: if market conditions or its credit ratings change, a firm used to rolling over its paper may find itself unable to pursue this operation and have to repay a principal at an unexpected time. Several major American and European companies experienced this in 2001 and 2002. Some of them were able to avert bankruptcy by obtaining last minute expensive loans from banks, others were forced to declare themselves bankrupt.


    Bankers' acceptances

    Before the 1980's, bankers' acceptances were the main way for firms to raise short-term funds in the money markets. An acceptance is a promissory note issued by a non-financial firm to a bank in return for a loan. Acceptances usually have a maturity of less than six months.

    Bankers' acceptances differ from commercial paper in significant ways. They are usually tied to a specific commercial transaction. Examples:

    • a European importer wants to pay at 30 days a Japanese exporter for goods to be received tomorrow. The importer will go to its bank, ask to be able to issue a draft guaranteed ("accepted") by the bank, to give to its Japanese supplier. The bank will open a credit to its client and record in its assets a "banker's acceptance". This financial instrument held by the bank can be resold on the secondary market.

    • conversely, a European exporter exports some goods for which the proceeds will be received in two or three months. He will be paid with "bank-guaranteed draft".

    Bankers' acceptances do not bear interest (for the buyer, on the secondary market); instead, an investor purchases the acceptance at a discount from face value, and then gets back its face (from the initial issuer) at maturity. Investors rely on the strength of the guarantor bank, rather than of the issuing company, for their security.

    When banks were able to borrow money at a lower cost than other types of firms, bankers' acceptances allowed manufacturers to take advantage of bank's superior credit standing. This advantage has largely disappeared, as many other big corporate borrowers are considered at least as creditworthy as banks.

    They no longer play a significant role in the US. They amounted to $4 billion in 2005, one tenth of their value outstanding in 1980.


    Treasury bills

    They are securities with a maturity of one year or less, issued by national governments.
     Treasury bills issued by a government in its own currency are generally considered the safest of all possible investments in that currency. Table 3.1 showed that T-bills are the most important money market instrument, representing, in 2004, 42% of the total world domestic money markets.

    The mix of money-market and longer-term debt issuance varies considerably from government to government and time to time. The US government sought to reduce the average length of its borrowing, starting in 1996, to reduce interest costs, but then announced in 2005 that it would resume issuance of 30-year bonds to finance an increased national debt.

    National particularities
    Japan, until recently, preferred long-term bonds. So do the Germans and the British. The French emphasized short-term government debt in 2004, but then replaced much of it with longer-term debt in 2005.

    In cases where a government is unable to convince investors to buy its longer-term obligations, treasury bills may be its principal source of financing.

    Emerging-market countries
    Some emerging-market countries have issued treasury bills denominated in foreign currencies, mainly dollars, in order to borrow at lower rates than prevail in their home currency. This strategy requires frequent refinancing of short-term foreign-currency debt. When a sudden decline in the value of the currency raises the domestic-currency cost of refinancing that debt, the government may not be able to meet its obligations unless foreign investors are willing to purchase new treasury-bill issues to repay maturing issues. This caused debt crises in Mexico in 1995, Russia in 1998 and Brazil in 1999.

    Thanks to rise in oil and commodity prices, Brazil is now, as of 2008, a country with sound finances.


    Government agency notes and local government notes

    Table 3.4  Short-term debt issuance by US government agencies    
    $ billions    
    1990 581      
    1992 817      
    1994 2 098      
    1996 4 246      
    1998 5 757      
    2000 8 745      
    2002 9 236      
    2004 10 422      
    Source : Bond Market Association      


    Interbank loans

    Banks constantly lend money, on a very short term basis, to one another
    Banks lend money to one another, mostly to meet legal reserve requirements, but also to face large and sudden demands of cash from clients. Many of these loans are across international boundaries.

    Tightening up of this market
    Following the subprime crisis of 2007 and 2008, the interbank loan market became tighter than it used to be: banks are wary of lending to another bank that may go bankrupt. For this reason the Fed as well as the ECB injected huge amounts of money into their financial systems (several hundred billion dollars, and several hundred billion euros, injected by opening new central bank credits, at lower rates than commercial rates) between July 2007 and early 2008.

    Three articles on ECB cash injection (Telegraph, December 2007):

    1. Central banks give biggest liquidity boost ever
    2. ECB mind-numbing cash injection
    3. Huge ECB cash injection dwarfs BoE auction

    Overnight loans

    Overnight loans are short-term unsecured loans from one bank to another.

    Leading interest rates
    The interest rates at which banks extend short-term loans to one another have assumed international importance.

    1. LIBOR: London Inter-Bank Offer Rate
    2. EURIBOR: the rate at which European banks lend to each other
    3. EONIA
    4. etc.

    US federal funds rate
    In the US, the Federal funds rate is the rate at which commercial banks can lend to one another the funds that they keep as reserves at the banks members of the Federal Reserve (the Federal Reserve is a system of 12 banks, equivalent to one central bank). It is the primary policy lever of the Federal Reserve Board, and hence a closely watched economic indicator.


    Time deposits

    Also called Certificates of deposit, or CDs. They are interest bearing deposits, but cannot be withdrawn before maturity without a penalty. Although they can last as long as 5 years, most of them qualify as money market instruments because they have less than one year maturity.

    Large time deposits are often used by corporations, governments and money-market funds to invest cash for brief periods.


    International agency paper

    The World Bank, the Inter-American Development Bank and other organizations owned by member governments issue this type of paper, denominated in many different currencies.



    Combination of two transactions
    Repos are financial contracts, signed at time t, combining two transactions:

    1. at time t, a securities dealer, such as a bank, sells securities it owns to an investor, agreeing to repurchase the securities at a specified higher price at a later date T
    2. at time T, it repurchases its securities as agreed.

    This is equivalent to lending/borrowing, guaranteed with financial securities (in French, "prêt sur gage" où le gage est un actif financier)

    Specifities of repos
    Besides their general belonging to secured financial instruments, repos have the following specificities:

    1. the investor lends less money than the market value of the securities at t, so the lending is rather secure
    2. a large investor whose investment is greater than the amount covered by bank insurance may deem repos safer than bank deposits
    3. if the investor believes the price of the securities will fall, he can sell them a bit after t and buy them back a bit before T, in order to sell them back to the dealer at T, at the price agreed upon at t.
    4. for the dealer it brings cash in a quick and easy way, and the dealer can make it work


    Repos serve to keep the markets highly liquid, which in turn ensures that there will be a constant supply of buyers for new money-market instruments.

    Any type of security can be used, although in practice the overwhelming majority of repos involve national governments notes.

    In a reverse repo, the roles of the investor and of the dealer are switched.


    Nowadays, repos, rather than open market operations, are used by governments to control the money supply (in other words, the amount of liquidities in the system).

    The average maturity of a repo is only a few days.


    Historically, until 1993, repos have been discouraged in France, where the legal basis for them was unclear. But since 1993, the market for repos became quite large. (French repos.)

    In Germany, banks were forced to set aside reserves for repo transactions until 1997, making such transactions uneconomic.


    Watching short-term interest rates

    Central banks, governments and investors pay close attention to short-term interest rates.


    Spreads (= the differences in interest rates on different instruments) are highly sensitive indicators of market participants' expectations.

    Uncollateralized loans and repos
    One important set of spread is that between uncollateralized loans and repos. As repos are fully collateralized, there is almost no risk that repayment will be disrupted. Uncollateralized loans among banks, however, are at risk if a bank should fail. The spread between these two types of lending thus reflects perceived creditworthiness.

    Comparing spreads in various countries is instructive. During the winter 1998, for example, the average spread between uncollateralized three-month loans and three-month repos were

    • UK: 21 basis points (on basis point = one hundredth of a percentage point)
    • US: 5,6 basis points
    • France: 8 basis points
    • Japan: 58 basis points

    The general view was that many Japanese banks were extremely weak.

    The spreads between different categories of commercial paper are also closely watched.

    The spread between AA paper and weaker A2-P2 rating is usually 15 to 20 points. A widening may indicate that investors are worried about a deteriorating economy, which would be more likely to cause financial distress for issuers of A2-P2 paper than for issuers of stronger AA-rated paper.

    Signs of markets anxiety
    A spread between top-rated commercial paper issued by financial companies and that issued by non-financial companies also indicates anxiety in the markets, as in good times both bear similar interest rates.



  • What is liquidity? Can bank regulators and central banks prevent future liquidity crises? (The Economist, March 6, 2008)
  • IMF 2008: An interview with the new general manager of the IMF on the monetary and budgetary ways to fight the current world crisis. (Le Monde, March 4, 2008)
    Exercise : develop your own opinion on what should be done at a monetary, financial and budgetary level, by governments and international financial institutions to address the present world financial crisis.
  • Cleveland & Ohio 2008: Ohio is suffering, Cleveland is dying
  • Le Monde, 6 March 2008

    by Sylvain Cypel

    "It is Main Street against Wall Street", people against moneymakers which choke it. With an innate sense of the formula, Barack Obama used this sentence during the debate which opposed him to Hillary Clinton in Cleveland, the largest city of Ohio [the state capital being Columbus], where a primary election was held Tuesday March 4, to designate the state democratic delegates for the nomination of the national party candidate in the November elections.

    A punchy sentence which here the senator of Illinois knew would resonate instantly. Without the brilliant rhetoric, Hillary Clinton did in fact play the same score. "To understand which factors drove people's votes here, said Edward Hill, rector of the College of Urban Affairs at the state university of Ohio, one must consider the rising insecurity which reaches our middle class, and on top of which now weighs the subprime mortgage crisis." This insecurity comes from a long time ago, from the 1970's and 1980's. Like the Lorraine region of France, Ohio was the "steel heart" of the United States: the steel industry dominated it. And here too it sank.

    The biggest players - US Steel, Memphis Steel, Republic Steel - delocalized or changed activities. The deterioration of employment was aggravated in the 1990's by the crisis of the automotive sector. Ohio was the main subcontractor to Michigan, "the car state" just across the state border. Out of fifty subcontractors to the auto industry twenty years ago, only eleven remain today. On February 27, Honda announced it was closing its motorbike plant in Marysville. The Japanese manufacturer had already moved its off-road vehicles division to North Carolina in 1997. In 2007, 93 small businesses closed their doors.

    From beacon of the "American dream", Cleveland (900 000 inhabitants in 1950, 430 000 today) has become its nightmare. The city is at the same time younger and older than the national average: a gaping hole is in the middle range, in the 25-50 years old. "The American dream: it is a stable job, together with good social protection, which allows the children to receive good schooling, and, most important, which gives access to home ownership", says Robert Triozzi, director of the city hall legal department. In the state, however, 160 000 "stable" industrial jobs were lost since 2001, which represent 17% of the total. The number of people receiving unemployment financial help grew by 20%.

    With the deindustrialization, the dream went to rags. With the subprime mortgage crisis it collapsed altogether. "More and more people are hurt in their flesh by the bad sides of our system, the extreme deregulation of the economy", summarizes Frank Jackson, the Democratic city mayor. Named "poorest city of the United States" in 2004, Cleveland ranks fourth for the number of insolvent borrowers. From 182 in 2003, the number of home seizures jumped to 1926 in 2005, and then to 7800 in 2007. The city hall forecasts 13 000 this year. Courts order 200 to 300 new seizures a week. Approximately 12% of the flats are currently vacant, their ex-owners having found refuge, suitcase in hand, at some relatives, or having left the Cleveland area. Entire city districts are falling apart.

    "Men lose their jobs. Then the whole family loses its medical coverage, it can longer pay for the kids studies, and if we are indebted that's it. And here, everybody is indebted." This simple summary is given by Anita Williams, a 52 year old black housewife from Mount Pleasant. Blacks, in Cleveland, make up 3/4 of the insolvent borrowers. Like Slavic Village or East Cleveland, where 40% of the tenements are under threat of seizure, the sector of Mount Pleasant is mostly inhabited by black people. Around Kinsman Avenue, in some streets, a fourth of the small wooden houses, typical of industrial cities were seized. Sealed front doors, windows boarded with planks.

    Conmen abound

    On numerous front sides, a large post says: "No copper, all PVC plumbing". A message to robbers. Bands of them scout these districts in search of seized flats, to tear off whatever can be taken. The petty criminals look first of all for metals which they resell to scrap metal dealers. They operate at night, "and sometimes even in daylight. Before we have the time to arrive, they are gone", say the police. "Not true, reply the residents, the police no longer bother to come." The truth is in between: the police are overworked. "If nothing is done, 2009 is going to be worse", forecasts Mr. Hill

    The city provides two services to families, one legal and one financial, so that they don't fall victims of a "second rip-off". Because conmen abound. Some of them are well known and advertise their activity. With ads on tv they vaunt their fabulous offers. To insolvent borrowers they propose to refinance their mortgage or to simply buy their house, under conditions they don't specify because they are outrageous. To potential buyers, these "flippers" (speculators) promise free houses at "unheard off" prices.

    It is sufficient for "flippers" to resell three out of ten to be profitable", complains Mr. Triozzi. The mayor, Mr. Jackson pushed for a plan entitled "Don't Borrow Trouble", and two services, legal and financial, to help refinance the loans by "clean" banks. But "once the seizure has been pronounced, we are powerless; and banks multiply their demands for seizure". According to him, only a "large scale federal plan" will be able to put an end to the new real estate speculation which thrives on the misery of indebted families. "A city can do nothing, says Mr. Jackson, only a state can impose a moratorium", and Ohio, with a Republican house, will not vote it.

    It is in this context that Hillary Clinton and Barack Obama were soliciting Democratic voters bulletins. Cleveland is not Ohio. In a state as large as French Brittany, other places are less desolate. But Cleveland is the standard bearer of the state, its speaker. This is why both candidates called for a "renegotiation" of the commercial agreements signed between the United States and Third world countries, which blue collars hold massively responsible for the deindustrialization of their state.

    Moreover, Cleveland presents the specific feature of being inhabited 52% by Blacks, whereas the proportion in the whole Ohio state is less than the national average. And to be "for Clinton" in Cleveland has become "very hard, one is considered a traitor in his community", explained Jerry Brandon, a 26 year old black student who supports the senator of New York. On the other hand, she got the massive support of the white population of the state in general (60%) et of white women in particular (70%, and 78% among those over 65 years old). The senator of Illinois was rallying under his banner 65% of the people below 35, and 85% of Black Americans. He won Cleveland. But she won Ohio. It is to her that old blue collars and white collars, desperate, and often retired, gave their votes.


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