Money market
What is it?
The money market is a bit like a very large current account used by banks, investors and companies alike. On one hand, investors place their cash in the money market as a safe place to store it during difficult times (a bit like a bank account used to be). On the other hand, companies and banks use the money market to borrow and exchange money on a very short-term basis - always less than a year, but typically overnight, or less than three months.
The really big thing about the money market is that it's supposed to be very liquid - ie, the financial products traded on it can be easily exchanged for cash in a very short time period.
The money market is home to various players. They include money market funds - namely mutual funds (ie, funds which raise capital by buying and selling their shares), which buy and sell 'money market instruments'. Money market funds are always priced at $1 a share. The interest paid on these shares varies.
There are also banks which exchange cash in all kinds of different currencies between themselves in the giant 'interbank market'. The interbank market is crucial to ensuring that banks have cash when necessary. Banks borrow from one another either overnight, or for up to six months.
And there are the companies. Big corporations, like General Electric or AT&T, issue 'commercial paper', effectively IOUs promising to pay back money they borrow within a specified time period. This is usually 30-90 days.
Interest paid on money market instruments is usually stated in terms of LIBOR, or the average rate at which key banks are able to borrow from each other on the London money market.
What's it got to do with the financial crisis?
The money market is essential to providing the world's financial system with short-term cash when it needs it. It's also seen as a nice safe place to park cash. Unsurprisingly, therefore, money markets have proven rather popular with investors as the credit crunch as has worsened. In September 2008, they managed a record $3.5 trillion of cash.
When money market funds start losing money, it's therefore fairly catastrophic. This, however, is what happened following the collapse of Lehman Brothers, when the Reserve Fund, a big player in the money market game, got caught holding Lehman's short-term debt.
Investors in the Reserve Fund tried to pull their money out and invest it in government bonds instead. This caused its share price to fall below $1 (known as 'breaking the buck') and creating fears that investors in other money market funds would rush to remove their cash, too. This was only the second time in the history of money market funds that the buck had been broken (normally, funds in danger of breaking it receive cash from their parent).
Panic withdrawal of funds from the money market and widespread breaking of the buck would signify that the global financial system was truly broken. The money market is widely used by companies that need to borrow money to pay their staff, for example. No money market = no pay = meltdown.
As a result, the US government introduced a 'money market guarantee programme' for up to $3.4 trillion of money market funds, for three months from September 2008. However, the guarantee was not entirely successful - money market borrowing remained frozen, LIBOR soared, and banks became almost totally reliant on money from central banks' discount windows for their short-term funding needs.
In August 2009, former Federal Reserve chairman Paul Volcker argued that money market funds were "free-riders," a threat to the US financial system and should be regulated like banks. The Securities and Exchange Commission, the top US financial regulator, is writing rules to regulate money-market funds.
Last updated on 7 September 2009.
