Money Market Instruments and Short-Term Funds

The difference between money market investments and capital market investments is that money market investments usually have a term of one year or less, while capital market transactions have a duration that exceeds one year. A further definition is that money market instruments can be converted to cash rather quickly and have a low risk profile due to the short maturity.

There is both a primary market (first issue) and secondary market for money market instruments, however there is no formal Exchange for the listing and trading of money market instruments. Rather, the primary participants in the money market consist of commercial banks, governments, corporations, government-sponsored enterprises (Farm Credit System, Federal Home Loan Bank System, Federal National Mortgage Association, Government National Mortgage Association), money market mutual funds, futures market exchanges, brokers and dealers, and the Federal Reserve.

Money market transactions can be done by "name give-up" / introducing broker or through an intermeidiary. In a name give-up transaction, all portions of the transaction are anonymous through an OTC electronic screen-based system until the very end when the two parties identify themselves for the purpose of settling the transaction. It is at that point that credit risk is assumed between the two participants. In an intermediary transaction the operator or broker in an OTC screen-based system will be the counterparty to other parties (who remain anonymous) and will then match back-to-back transactions.

Federal Funds / Federal Funds Rate

The Federal Funds Rate is often utilized by the Board of Governors of the Federal Reserve, Open Market Committee, to either stimulate or curtail economic expansion. For instance, in response to the tightening of the credit markets and growing recession during 2008, the Fed Funds Rate was reduced six times.

Recent Fed Funds Rates
DateFed funds Rate
December 16, 20080.00% - 0.25%
October 29, 20081.00%
October 8, 20081.50%
April 30, 20082.00%
March 18, 20082.25%
January 30, 20083.00%
January 22, 20083.50%


Some depository institutions are reguired to maintain a reserve account with its district Federal Reserve Bank. Every two weeks there is a Reserve Account Settlement Day when each bank must reconcile the actual amount in its reserve account with the reserve requirement from the previous two weeks. In order to comply with that requirement the bank must have sufficient reserves in the account or arrange for a short-term, overnight loan deposited into the reserve account. Thus, Federal funds are overnight, unsecured loans between two financial institutions used to satisfy Federal Reserve overnight reserve requirements. Banks that have excess funds in their reserve account are lenders to those banks that have a reserve deficiency. These funds are normally transferred within the time frame of a single business day in order to meet reserve requirements (usually a debit to the lending bank's account at the district Federal Reserve Bank and a credit to the account of the borrowing bank). There are also broker banks that consolidate excess reserves from several banks and then arrange to lend the balance to those banks that require additional reserves. Fed funds can be borrowed by only those depository institutions that are required by the Monetary Control Act of 1980 to hold reserves with Federal Reserve Banks. The interest rate at which banks lend these funds to each other is the Federal Funds Rate, which is set by the Federal Reserve (as a part of monetary policy). These overnight transactions are usually unsecured between banks that already have correspondent banking relationships. Longer term federal funds loans (term loans with a fixed maturity and continuing contract, which are perpetually rolled over until either parties terminate) usually have formal written agreements. In the event that a bank has a reserve deficiency and perhaps it is too late in the day to arrange for a loan at the Federal Funds rate or the rate has increased to an unacceptable level, the bank may then borrow from the Federal Reserve Discount Window (see next).

In addition to bank to-bank federal funds, some banks will also issue overnight repurchase agreements (take in cash and issue an acceptable security as collateral, which the bank repurchases the following day and returns the cash) in order to obtain funds from corporate and municipal treasury departments that have extra liquidity but are structurally barred from being participants in the fed funds market. As many banks are all competiting for funds at the same time in order to satisfy reserve account requirements, this non-bank overnight funds market is essential and the Repurchase Agreement Rate closely mirrors the Fed Funds Rate (the repurchase rate is slightly lower due to the collateralized structure of a repurchase agreement transaction).

Why is the actual Daily Fed Funds rate often lower than the Target Fed Funds rate? When banks have excess reserves over their required minimum amount, which does not earn interest, they lend the extra cash and that activity places downward pressure on the federal funds rate.

Prime Rate

Prime Rate, or the Bank Prime Loan rate, is the rate posted by 75% of top 35 (by assets in domestic offices) insured U.S.-chartered commercial banks. Prime is one of several base rates used by banks to price short-term business loans and is also used in consumer financial products. Prime Rate changes tends to mirror changes in the Federal Funds Rate (Fed Funds + 3.0%)

Recent Prime Rates
DatePrime Rate
December 16, 20083.25%
October 29, 20084.00%
October 8, 20084.50%
April 30, 20085.00%
March 18, 20085.25%
January 30, 20086.00%
January 22, 20086.50%
December 11, 20077.25%
October 31, 20077.50%
September 18, 20077.75%
June 29, 20068.25%
May 10, 20068.00%
March 28, 20067.75%


Discount Window (Federal Reserve Bank) / Discount Rate

Short-term funds lent by the Federal Reserve to banks at the Discount Rate, which is also set by the Federal Reserve (as part of monetary policy). Each depository institution (commercial, community, savings and loan, etc.) located within a respective district of one of the 12 Federal Reserve Banks is required to maintain a reserve account with that District bank. When a depository institution determines that is has a insufficient amount of reserves on-hand, the institution may borrow additional funds from the Federal Reserve Discount Window in order to increase the reserve account to the proper level. Typically, borrowings (which are actually credits to the institution's reserve account with the district Fedral Reserve Bank) from the Discount Window are for an overnight period in order to meet the reserve requirement and then the institution goes into the market to attract deposits, issue CDs or sell securities from its portfolio in order to pay off the borrowings from the Federal Reserve. The term Discount Window is from an earlier period when all advances from the Federal Reserve were collateralized by the "discounted" value of a pledged asset from the borrowing institution. Now, all Discount Window advances are collateralized by an approved list of eligible collateral.

The Federal Reserve Discount Window is suppose to be "Lender of Last Resort" when an institution has insufficient reserves on account with the Federal Reserve. The Discount Rate is usually lower than the Fed Funds Rate and borrowing from the Discount Window is sometime seen as an indication that the financial institution (Borrower) is in some type of trouble. The Fed encourages the bank to have sufficient reserves through deposit inflows and / or borrowing in the Fed Funds market. In addition to depository institutions that offer traditional savings and checking accounts, depository institutions that maintain transaction accounts such as checking and NOW accounts or nonpersonal time deposits may also borrow from the Discount Window if necessary. In addition, the Fed may lend to the U.S. branches and agencies of foreign banks if they hold deposits against which reserves must be kept. In the event that the Board of Governors of the Federal Reserve System determine that there are unusual conditions that have placed the finacial markets under pressure and traditional credit sources are unavailable, then individuals, partnerships, and corporations that are not depository institutions may be granted access to the Discount Window.

As indicated above, borrowings from the Discount Window are normally overnight duration to adjust the reserve account balance. These advances are known as Adjustment credit. The Federal Reserve Discount Window will also provide longer term advances known as Extended credit. Extended credit is only granted to acommodate seasonal financial activities that are naturally occurring within the bank's region (for instance agricultural activity) or when there are conditions beyond the control of the bank that effect capital (for instance natural disasters or adverse economic conditions). The Extended advance is usually for a maximum of 60 days maximum within a 120-day period, and institutions termed undercapitalized by a regulatory agency may only borrow from the Discount Window for a maximum of 5 days.

Financial institutions are not permitted to borrow from the Federal Reserve Discount Window lower Discount Rate to obtain sufficient funds to meet reserve requirements and simultaneously lend excess funds to other institutions at the higher Fed Funds Rate.

Eurodollar / LIBOR (London Interbank Offer Rate)

Eurodollar deposits are deposits denominated in USD but are deposited outside the legal jurisdiction (and banking regulation) of the United States (the most actively traded offshore deposit). They are sometimes referred to as offshore deposits and can really be any deposits placed outside the country of denomination. The other Euro-deposits are the Japanese yen (¥), U.K. Sterling (£), Swiss francs and Canadian dollars (and the Euro outside of the EU). In the United Kingdom, certain banks accept dollar deposits with set maturities (usually 90 days) and the interest rate is LIBOR (London Interbank Offered Rate).

LIBOR is a notional lending rate quoted and set by 19 commercial banks at 10:00am London, U.K. time under the auspices of the British bankers Association (BBA). The rate quoted is what a partcipating bank would pay to borrow funds at various maturities (1 month, 2 months, 3 months, etc.), and in various currencies, from another participating bank, and is one of the major international bechmark rates.

U.S. Treasury Bills

Treasury Bills (T-Bill) are short-term U.S. Treasury issues of one week to 12 months. They are purchased at a discount to their face value (but pay face value at maturity) in what as known as a yield auction. In a yield auction the potential purchasers indicate the yield / discount to face value that they are willing to pay at that given moment in order to own the T-Bill. The bidder with the least discount of the face value of the T-Bill wins the auction. There is a very active secondary market for the buying and selling of T-Bills, and they are also used as collateral in repurchase agreement transactions.

Banker's Acceptances

The usage of Banker's Acceptances occur primarily in international trade. An Importer (Drawer) enters into an Acceptance Agreement with their primary bank (Drawee) in order to facilitate a transaction in which the Importer cannot obtain financing from an overseas Exporter. A Banker's Acceptance is a time draft drawn on and accepted by a banking institution which substitutes its credit for that of an importer and is guaranteed by a bank as to payment. This is a Documentary Collection payment method (Time Draft / Documents against Acceptance), in which the shipped goods become available before payment, payment is made on the maturity of the draft, the payment of the draft is reliant upon the Importer paying.

  • The Importer has a banking relationship with a bank already
  • The importer arranges for a shipment from an Exporter
  • A bank draft is a draft or a check drawn by a bank on itself, which it marks as Accepted
  • The bank issues the Banker's Acceptance on the behalf of the Importer and if the documentation is correct then the bank pays the Exporter
  • The Banker's Acceptance has a maturity of 30 to 270 days
  • It is the obligation of the Importer to repay the Banker's Acceptance
  • The bank can sell the Banker's Acceptance at a discount to an investor in the secondary market for such instruments in order to obtain the cash today
  • The Importer repays the Banker's Acceptance to the holder
  • There is a very good secondary market in these products with institutional investors and money market funds, however they are beginning to be replaced by alternative methods and products. They typically range in denominations from USD$25,000 to USD$1,000,000. These are sold discounted in actual days based on a 360 day year.

    Commercial Paper

    Commercial Paper is a short-term unsecured promissory note primarily issued by non-financial corporations, while banks issue bank note or bank paper and finance companies issue paper directly to institutional investors or through commercial paper dealers and it is a low cost alternative to bank loans. Interest rates on commercial paper are entirely market derived and are reflective of the credit worthiness of the issuer. Many corporations have 364-day revolving credit facility back-up commitments from banks in order to credit enhance the commercial paper program. In the event that the commercial paper can't be rolled over / funded at a reasonable rate, the comapny will draw on the credit facility to pay off the investors in the commercial paper and the company will then have a substitute bank loan.

    In the United States, the commercial paper market is very large. It is very active as the issuance of commercial paper under the terms of Section 3(a)(3) of the 1933 Securities Act exempts these short-term securities from the expensve and time consuming registration process. Commercial paper may not exceed 270 days in maturity (average maturity is 30 to 35 days).

    The benchmark commercial paper program is from General Electric Capital Corporation (GECC). Tier 1 corporate issuers like GECC obtain the best financing. There is also Asset Backed Commercial Paper (ABCP), which is used to fund (and is collateralized by) a group of assets. Issuers who are rated A2 / P2 by the credit rating agencies have a harder time of obtaining funding at attractive rates.

    Prime Sales Finance Paper: These are promissory notes from finance companies placed directly with the investor. These come in denominations of $1,000 to $5,000,000. There is a minimum order of $25,000. These are issued to mature on any day ranging from 3 days to 270 days. There is no secondary market for these. Under certain conditions, the company will buy back the securities prior to maturity. They will usually adjust the interest rate in this event. These can be either discounted or interest bearing. And they are based on actual days based on a 360 day year.

    Dealer Paper (Finance): These are promissory notes of finance companies sold through commercial paper dealers. Their denominations range from $100,000 to $5,000,000. They are issued to mature on any day from 15 days to 170 days. There is a limited secondary market. Early buyback can usually be negotiated with the dealer. These can be either discounted or interest bearing based on actual days and a 360 day year.

    Dealer Paper (Industrial): These are promissory notes of the leading and largest industrial firms. It is sold through commercial paper dealers. They are sold in denominations of $500,000 to $5,000,000. They mature on certain dates form 30 days to 180 days. There is a limited secondary market. These are discounted based on actual days and a 360 day year.