Structure of the Financial system

Money Market

The money market is a segment of a financial market in which financial instruments with high liquidity and very short maturities are traded. The users borrow or lend for a short term which varies from several days to maybe just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers' acceptances, U.S. Treasury bill, commercial paper, municipal notes, federal funds, and repurchase agreements.

A bearish market is considered risky by investors for their savings. High returns always expose an investor to high risk. For many investors, the money market offers an alternative to these higher-risk investments.

Financial Market

Financial markets such as money markets, foreign exchanges and capital markets are an essential part of a financial system.

Following are the main functions of these financial markets.

The money markets: they provide financial intermediaries, i.e. banks, non-bank financial institutions, a way by which to borrow and lend in the short term and square their respective positions.

The foreign exchange markets: They provide a working environment for international trade.

Capital markets: They provide long-term finance, both equity and debt, for government and the corporate sector.

All these markets work in close collaboration with each other. The performance of one market affects that of any other, in one way or another. These markets play an important role in sending monetary policy signals to the national economy. In fact, monetary policy communications are initiated by the financial markets, particularly money and Forex markets, which then impose an impact on the other financial intermediaries (banks, non-bank financial institutions), firms and households and then finally affect inflation and economic growth.

Difference between Money Market and Stock Market

The main difference between the money market and the stock market is that most money securities transactions take place on a very large scale, whereas stocks are dealt in small proportions. Due to the large size of the transactions, it becomes difficult for the individual investor to gain access to the money market, whereas it facilitates firms to buy and sell securities in their own accounts, at their own risk. In a stock market, a broker receives a commission to act as an agent, and the investor takes the risk of holding the stock. Another difference is that a money market lacks a central trading floor for transactions; deals are transacted over the phone or through electronic systems, while the stock market has a trading floor for transactions.

The money market is accessible for mutual funds or through a money market bank account. These accounts and funds collect the assets of thousands of investors in order to buy money market securities on their behalf. It is possible to purchase some money market instruments, like treasury bills, directly; otherwise, they can be obtained through large financial institutions with direct access to these markets.                      

The primary role of the Money Market

The primary role of the money market is to encourage trading of money in short-term financial instruments called "paper". This makes it different from the capital market which allows investment for shorter as well as longer periods in the form of bonds and shares.

The main function of the money market is interbank lending, that is, banks borrowing and lending to each other using T-bills, commercial paper, repurchase agreements, and similar instruments. The price of these instruments is determined according to the benchmark, i.e. 'London Interbank Offered Rate (LIBOR).' In Pakistan also there are companies with strong credit ratings who issue commercial papers/bonds, debentures, etc to meet their financial needs.

Framework followed by the money market in Pakistan

Banks operating in the money markets are required to ensure monetary and financial stability. Some of these operations are designed basically to implement the monetary policy decisions of the central bank and others are designed mainly to provide liquidity for the banking system. The SBP's operating framework costs a number of elements, including policies on access rights to central bank facilities; collateral policies; and an operating system.                                                                                                    

The basic tools of this framework are:

The demand for reserves

The demand for reserves can change for a number of reasons. During pressurize/stressed times, the interbank market may not work effectively and a bank that is short of liquidity may find it more difficult than usual to borrow money. The central bank uses reserves as a tool to check the money market.

Monetary policy implementation by setting interest rate

Central banks communicate the stance of monetary policy by setting a short-term interest rate. Their operations in money markets are conducted with the objective that the interest rates at which banks transact for short periods of time are close to this policy rate.

Open Market Operations (OMO) is a multilateral transaction in which the central bank at its own initiative deals in the market and thus affects the banking system as a whole.

The interbank money market

The interbank money market is the market in which banks borrow and lend short-term funds to each other; the duration is usually no longer than a week. These transactions have to be settled via banks' accounts with the central bank. If payment flows leave one bank with a surplus of reserves and another with a shortage of reserves, they have an incentive to trade with each other at a market-determined rate.

The interbank market forms the center of a wider money market in which non-bank financial institutions often participate. Overnight liquidity and transparent pricing help to maintain efficient working of the financial markets.

Performance of Money Market in Pakistan

An efficient money market provides a mechanism for meeting the short-term liquidity needs of the lenders and borrowers and facilitates financial intermediation at efficient costs without undue delays. The money market also provides an instant response to the central bank's policy actions for influencing and short-term interest rates in the economy.

International money market (IMM)

International trade, financing, and investments, and related cash and credit transactions developed at a very fast pace in the 1960's and 1970's. The international monetary system has continued to develop to accommodate the need for foreign-currency-denominated transactions and in the process has been provided with opportunities for its continuing onward development.

The International Monetary Market (IMM) was introduced in December 1971 and started to function in May 1972. The very first future trading contracts were made against the U.S. dollar with other currencies such as the British pound, Swiss franc, German Deutschmark, Canadian dollar, and Japanese yen. In 1992, the German Deutschmark/Japanese yen pair was introduced as the first futures cross-rate currency.

There were two major challenges faced by IMM. The first and foremost challenge was to connect values of IMM foreign exchange contracts to the interbank market and the second way to allow the IMM to be the free-floating exchange image for the money markets. To solve these problems, clearing member firms were incorporated to act as a link between banks and the IMM to facilitate orderly markets between bids and ask spreads. The Continental Bank of Chicago was later hired as a delivery agent for contracts.