Money Markets: What They Are, How They Work, and Who Uses Them (2024)

What Is the Money Market?

The money market refers to trading in very short-term debt investments. At the wholesale level, it involves large-volume trades between institutions and traders. At the retail level, it includes money market mutual funds bought by individual investors and money market accounts opened by bank customers.

In all of these cases, the money market is characterized by a high degree of safety and relatively low rates of return.

Key Takeaways

  • The money market involves the purchase and sale of large volumes of very short-term debt products, such as overnight reserves or commercial paper.
  • An individual may invest in the money market by purchasing a money market mutual fund, buying a Treasury bill, or opening a money market account at a bank.
  • Money market investments are characterized by safety and liquidity, with money market fund shares targeted at $1.
  • Money market accounts offer higher interest rates than a normal savings account, but there are higher account minimums and limits on withdrawals.

Understanding the Money Market

The money market is one of the pillars of the global financial system. It involves overnight swaps of vast amounts of money between banks and the U.S. government. The majority of money market transactions are wholesale transactions that take place between financial institutions and companies.

Institutions that participate in the money market include banks that lend to one another and to large companies in the eurocurrency and time deposit markets; companies that raise money by selling commercial paper into the market, which can be bought by other companies or funds; and investors who purchase bank CDs as a safe place to park money in the short term. Some of those wholesale transactions eventually make their way into the hands of consumers as components of money market mutual funds and other investments.

Who Uses the Money Market?

In the wholesale market, commercial paper is a popular borrowing mechanism because the interest rates are higher than for bank time deposits or Treasury bills, and a greater range of maturities is available, from overnight to 270 days. However, the risk of default is significantly higher for commercial paper than for bank or government instruments.

Individuals can invest in the money market by buying money market funds, short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury bills. For individual investors, the money market has retail locations, including local banks and the U.S. government's TreasuryDirect website. Brokers are another avenue for investing in the money market.

The U.S. government issues Treasury bills in the money market, with maturities ranging from a few days to one year. Primary dealers buy them in large amounts directly from the government to trade between themselves or to sell to individual investors. Individual investors can buy them directly from the government through its TreasuryDirect website or through a bank or a broker. State, county, and municipal governments also issue short-term notes.

Money marketfunds seek stability and security with the goal of never losing money and keepingnet asset value(NAV) at $1. This one-buck NAV baseline gives rise to the phrase "break the buck," meaning that if the value falls below the $1 NAV level, some of the original investment is gone and investors will lose money. However, this scenario only happens very rarely, but because many money market funds are notFDIC-insured, meaning that money market funds can nevertheless lose money.

Types of Money Market Instruments

Money Market Funds

The wholesale money market is limited to companies and financial institutions that lend and borrow in amounts ranging from $5 million to well over $1 billion per transaction. Mutual funds offer baskets of these products to individual investors. The net asset value (NAV) of such funds is intended to stay at $1.

During the 2008 financial crisis, one fund fell below that level. That triggered market panic and a mass exodus from the funds, which ultimately led to additional restrictions on their access to riskier investments.

Money Market Accounts

Money market accounts are a type of savings account. They pay interest, but some issuers offer account holders limited rights to occasionally withdraw money or write checks against the account. (Withdrawals are limited by federal regulations. If they are exceeded, the bank promptly converts it to a checking account.) Banks typically calculate interest on a money market account on a daily basis and make a monthly credit to the account.

In general, money market accounts offer slightly higher interest rates than standard savings accounts. But the difference in rates between savings and money market accounts has narrowed considerably since the 2008 financial crisis.

Average interest rates for money market accounts often vary based on the amount deposited. As of June 2023, the best-paying money market account with a no minimum deposit offered 5% annualized interest.

Given today's high interest rate market, money market accounts have become more popular because of their perceived their safety when compared to more volatile investments, such as stocks.

Funds in money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC) at banks and the National Credit Union Administration(NCUA) in credit unions.

Certificates of Deposit (CDs)

Most certificates of deposit (CDs) are not strictly money market funds because they are sold with terms of up to 10 years. However, CDs with terms as short as three months to six months are available.

As with money market accounts, bigger deposits and longer terms yield better interest rates. Rates in June 2023 for 12-month CDs ranged from about 4.90% to 5.15% depending on the size of the deposit. Unlike a money market account, the rates offered with a CD remain constant for the deposit period. There is usually a penalty associated with an early withdrawal of funds deposited in a CD.

CDs have also gained in popularity recently due to their safety and currently high rates.

Commercial Paper

The commercial paper market is for buying and selling unsecured loans for corporations in need of a short-term cash infusion. Only highly creditworthy companies participate, so the risks are low.

Banker's Acceptances

The banker's acceptance is a short-term loan that is guaranteed by a bank. Used extensively in foreign trade, a banker's acceptance is like a post-dated check and serves as a guarantee that an importer can pay for the goods. There is a secondary market for buying and selling banker's acceptances at a discount.

Eurodollars

Eurodollars are dollar-denominated deposits held in foreign banks, and are thus, not subject to Federal Reserve regulations. Very large deposits of eurodollars are held in banks in the Cayman Islands and the Bahamas. Money market funds, foreign banks, and large corporations invest in them because they pay a slightly higher interest rate than U.S. government debt.

Repos

The repo, or repurchase agreement (repo), is part of the overnight lending money market. Treasury bills or other government securities are sold to another party with an agreement to repurchase them at a set price on a set date.

Money Markets vs. Capital Markets

The money market is defined as dealing in debt of less than one year. It is primarily used by governments and corporations to keep their cash flow steady, and for investors to make a modest profit.

The capital market is dedicated to the sale and purchase of long-term debt and equity instruments. The term "capital markets" refers to the entirety of the stock and bond markets. While anyone can buy and sell a stock in a fraction of a second these days, companies that issue stock do so for the purpose of raising money for their long-term operations. While a stock's value may fluctuate, unlike many money market products, it has no expiration date (unless, of course, the company itself ceases to operate).

Advantages and Disadvantages of Money Markets

There are several pros and cons of money market investments. Most money market securities are considered extremely low-risk, due to the protection of FDIC insurance, backing by a government or bank, or the high creditworthiness of the borrowers. They are also very liquid, meaning that they can readily be exchanged for cash at short notice.

The tradeoff of having low risk is that these investments also have low returns. Not only do money markets underperform other asset classes, they often don't even keep pace with inflation. In addition, any fees associated with an account can easily eat into those slim returns.

Moreover, these advantages do not extend to all money market securities. Some of them are not FDIC insured, and there is a (small) chance that even the most trustworthy borrowers may default. Some money market accounts have minimum balance requirements or restrictions on withdrawals.

Pros and Cons of Money Market Accounts

Pros

  • Extremely low risk.

  • May be insured by FDIC.

  • Highly liquid.

  • Higher returns than most bank accounts.

Cons

  • Low returns that may not keep pace with inflation.

  • Not all money market securities are insured.

  • May have high minimum investments or withdrawal restrictions.

Why Is It Called the Money Market?

The money market refers to the market for highly liquid, very safe, short-term debt securities. Because of these attributes, they are often seen as cash equivalents that can be interchangeable for money at short notice.

Why Is the Money Market Important?

The money market is crucial for the smooth functioning of a modern financial economy. It allows savers to lend money to those in need of short-term loans and allocates capital towards its most productive use. These loans, often made overnight or for a matter of days or weeks, are needed by governments, corporations, and banks in order to meet their near-term obligations or regulatory requirements. At the same time, it allows those with excess cash on hand to earn interest.

What Are Some Examples of Money Market Instruments?

The money market is composed of several types of securities including short-term Treasuries (e.g. T-bills), certificates of deposit (CDs), commercial paper, repurchase agreements (repos), and money market mutual funds that invest in these instruments. The money market funds typically have shares that are always priced at $1.

Can You Lose Money in the Money Market?

For depositors, most money market accounts are insured by the FDIC up to $250,000 per institution. Because money market instruments are very low risk, there is virtually no chance you will lose your money by owning a CD or T-bill either. During periods of extreme financial stress, for example, during the height of the 2008 financial crisis, some money market funds did "break the buck" and briefly incur losses, but this was quickly corrected.

What Are the Downsides of Money Markets?

Because they are virtually risk-free, money market investments also come with very low interest rates - often the risk-free rate of return. As a result, they will not provide substantial capital gains or investment growth compared to riskier assets like bonds or stocks. Some types of money market accounts, like CDs, furthermore can lock your money up until it matures, which can range from months to years.

The Bottom Line

Money market accounts and money market funds are considered among the safest ways to invest one's money. They also have much lower returns than other investments, often even less than inflation. Because they are so low risk, many people and businesses use money markets as a short-term investment for their cash reserves.

Money Markets: What They Are, How They Work, and Who Uses Them (2024)

FAQs

Money Markets: What They Are, How They Work, and Who Uses Them? ›

The primary purpose of a money market fund is to provide investors with a safe avenue for investing in secure and highly liquid, cash-equivalent, debt-based assets using smaller investment amounts. In the realm of mutual-fund-like investments, money market funds are characterized as low-risk, low-return investments.

What are money markets and how do they work? ›

Money market accounts are a type of savings account. They pay interest, but some issuers offer account holders limited rights to occasionally withdraw money or write checks against the account. (Withdrawals are limited by federal regulations. If they are exceeded, the bank promptly converts it to a checking account.)

What is money market answer? ›

money market, a set of institutions, conventions, and practices, the aim of which is to facilitate the lending and borrowing of money on a short-term basis. The money market is, therefore, different from the capital market, which is concerned with medium- and long-term credit.

Why do people use money market? ›

A money market account typically earns a higher interest rate than a regular savings account, so you can grow your money while building your savings. And, unlike a regular savings account, there are typically more ways to access your money when you need it.

What is the main function of money markets? ›

Money markets serve five functions—to finance trade, finance industry, invest profitably, enhance commercial banks' self-sufficiency, and lubricate central bank policies.

What is the money market quizlet? ›

Money Market. The part of the global financial market that deals with financial instruments that are easily converted to cash (highly liquid) and have very short maturities, usually one year or less.

How much will $10,000 make in a money market account? ›

Currently, money market funds pay between 4.47% and 4.87% in interest. With that, you can earn between $447 to $487 in interest on $10,000 each year. Certificates of deposit (CDs). CDs are offered by financial institutions for set periods of time.

Who uses the money market? ›

For the most part, money markets provide those with funds—banks, money managers, and retail investors—a means for safe, liquid, short-term investments, and they offer borrowers—banks, broker-dealers, hedge funds, and nonfinancial corporations—access to low-cost funds.

What is money market in simple words? ›

The money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities with average maturities of one year or less. It enables governments, banks, and other large institutions to sell short-term securities to fund their short-term cash flow needs.

Is the money market good or bad? ›

While money market funds aren't ideal for long-term investing due to their low returns and lack of capital appreciation, they offer a stable, secure investment option for individuals looking to invest for the short term.

What is the downside of a money market account? ›

Disadvantages of money market accounts

For example, you often won't earn as much with a money market account as you would with a traditional CD because the CD has a time commitment: The bank will pay you more in exchange for locking up your funds longer.

How much money should you keep in a money market account? ›

Some money market accounts come with minimum account balances to be able to earn the higher rate of interest. Six to 12 months of living expenses are typically recommended for the amount of money that should be kept in cash in these types of accounts for unforeseen emergencies and life events.

What is an example of a money market? ›

The institutions that offer money market instruments to the lenders (investors) include commercial banks, corporations, government, non-banking financial institutions, etc. Some of the examples of money market instruments include commercial papers, treasury bills, certificates of deposits, etc.

How do I buy money market funds? ›

Investors can purchase shares in money market mutual funds directly from brokerage companies or mutual fund firms, just as they would purchase shares in a stock or equity mutual fund.

What is the best money market account right now? ›

Best Money Market Account Rates
  • Northern Bank Direct – 4.95% APY.
  • All America Bank – 4.90% APY.
  • Redneck Bank – 4.90% APY.
  • First Foundation Bank – 4.90% APY.
  • Sallie Mae Bank – 4.65% APY.
  • Prime Alliance Bank – 4.50% APY.
  • Presidential Bank – 4.37% APY.
  • EverBank – 4.30% APY.

What are the advantages and disadvantages of the money market? ›

While the money market offers high liquidity, low risk, competitive interest rates, and diversification, it also comes with relatively low returns and a lack of potential interest rates and credit risks on which investors can base their financial goals and risk tolerance.

Can money market funds lose value? ›

All investments are subject to market risk, including possible loss of principal. Retail Money Market Funds: You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so.

Can you withdraw money from a money market account? ›

Usually you can make unlimited withdrawals and payments by using an ATM or by making the withdrawal in person, by mail, or by telephone. A money market account might require a minimum amount to be deposited.

How does a money market work for dummies? ›

MMAs are like savings where they earn interest; like CDs and/or Bonds, they are a safe and low-risk investment. MMAs generally pay a higher interest rate and can boost your returns by investing differently from regular savings accounts. They are vital to a diverse financial portfolio.

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