Money markets are used by the Treasury operations of Central banks, international banks and corporations to manage their short-term cash requirements and obligations - so-called liquidity management. The market is highly sophisticated and almost exclusively professional and, for the private investor, exposure to it is usually only possible through managed investment funds.
For banks and large corporates, liquidity management is about getting a fine return on cash which they may need at short notice. They do this by borrowing and lending between each other - using either money market securities or deposits and loans - in what is called the interbank market.
Just as the interbank market allows commercial banks to engage in liquidity management, Central Banks too use money markets to manage their reserves, and in doing so can affect prevailing money market rates. This is commonly achieved by manipulating the one market segment over which they have direct control, the Treasury bill market.
Open market operations
Commercial banks are required to hold a sufficient proportion of their assets in the form of relatively riskless instruments for monetary control purposes. (To hold reserve assets, and to maintain their reserve asset ratio). Historically, Central Banks’ changed the level of minimum reserve requirements to directly affect levels of liquidity and the price of short-term funds. But such legislative intervention has largely been replaced by open market operations - a process of manipulating the level of liquidity available to commercial banks by buying and selling short-term instruments.
If the Central Bank is buying Treasury bills the increased demand in the market will cause bill yields to fall (there is an inverse relationship between price and yield).This fall in bill yields makes other instruments relatively more attractive and encourages substitution into those assets, thus causing a general fall in money market yields.
The purchase of bills by the Central Bank also increases commercial banks operational reserves. This increase in liquidity - an increase in the supply of money - causes the interbank rate to fall and leads to a general increase in loans extended and in securities purchased. This is because the availability of funds has increased and their cost has decreased.
This supply effect accentuates the reduction in yields on all securities caused by the Central Bank’s initial increase in demand for bills.
By selling Treasury Bills the Central Bank stimulates the reverse price effect. The increased supply of bills in the market will cause bill yields to rise. This rise in bill yields makes other instruments relatively less attractive and leads to substitution out of these instruments and into bills, thus causing a general rise in money market yields. This in turn curtails loans and reduces demand for other instruments thus accentuating the general rise in yields in the money market.
The process of substitution stimulated by Central Bank open market operations spreads to capital markets as borrowers and lenders reevaluate the relative attractiveness of longer term instruments.
This is a fundamental mechanism through which the fine tuning of domestic interest rates - which affects all borrowing and investment decisions - is achieved in domestic money markets.
