Unit 1
Overview of financial market in India
Money market is a part of financial market where near money assets are traded for short period i.e. for less than one year or one year. Money market transactions facilitates to maintain the liquidity position of the economy through dealing in financial instruments like treasury bills, commercial papers, certificate of deposits, repo, certificate of deposits etc. It is regulated by the Reserve Bank of India.
Some of the significant characteristics are Indian money market are-
Figure: Features of financial market
1. High Liquidity
One of the key features of these financial assets is high liquidity offered by them. They generate fixed-income for the investor and short term maturity makes them highly liquid. Owing to this characteristic money market instruments are considered as close substitutes of money.
2. Deals with near money assets:
It deals with near money assets like treasury bills, commercial papers, certificate of deposits, repo, certificate of deposits etc. Such financial instruments are called as near money assets because it involves some amount of money.
3. Secure Investment
These financial instruments are one of the most secure investment avenues available in the market. Since issuers of money market instruments have a high credit rating and the returns are fixed beforehand, the risk of losing your invested capital is minuscule.
4. Fixed returns
Since money market instruments are offered at a discount to the face value, the amount that the investor gets on maturity is decided in advance. This effectively helps individuals in choosing the instrument which would suit their needs and investment horizon.
5. Fixed returns
Since money market instruments are offered at a discount to the face value, the amount that the investor gets on maturity is decided in advance. This effectively helps individuals in choosing the instrument that would suit their financial needs and investment horizon.
6. Physical trading
Money markets across the world essentially operate over the counter, which implies that the trading of these funds cannot be made online. Hence, investments in the money market are made physically by authorized representatives or in person. Later, a physical certificate is issued to the buyer of the money market instrument.
7. Wholesale Market
Money markets are designed to provide and accept bulk orders. Thus, retail investors who have enough capital can directly participate in money markets, while individual investors must invest in debt mutual funds that invest in money markets in order to benefit from this market.
8. Multiple Instruments
Unlike capital markets which usually trade in one single type of instrument, money markets trade is multiple instruments. These instruments differ in terms of maturity periods, debt structure, credit risk, currency, among others. Money market instruments are therefore considered ideal for diversification through exposure.
9. Key Money Market Participants
Since money markets deal with only bulk orders, they are not open to individual investors. As a result of which, multiple institutional investors such as financial institutions and dealers looking to borrow or lend money for a short term participate in the trading of these instruments.
10. Regulated by RBI
The Indian money market is controlled and regulated by the Reserve Bank of India. RBI is the only institution that can influence the organised sector, while the smaller unorganised sector is largely beyond its control. However, due to the considerably larger size of this organised sector, regulatory actions taken by the RBI can produce a substantial impact on the way in which this entire market operates.
Money market instruments
The following are some key money market instruments to be considered while investing in India-
Figure: Money market instruments
Treasury bills or T-bills are issued by the Reserve Bank of India on behalf of the Central Government for raising money. T-bills do not pay any interest but are available at a discount to the face value at the time of issue. At maturity, the investor gets the face value amount. This difference between the initial value and face value is the return earned by the investor. Treasury Bills are by far the oldest of money market instruments and are considered to be the safest short term fixed income investments as they are backed by the Government of India. Since T-bills are issued by the government, they offer guaranteed returns and are known to be zero default risk investments. Additionally, T-bills have a short maturity period of up to 1 year. T-Bills are commonly classified on the basis of their maturity period and their type.
2. Commercial Papers
Large companies and businesses issue promissory notes to raise capital from investors in order to meet their short term business needs. These promissory notes are known as Commercial Papers (CPs). The firms issuing commercial papers have a high credit rating, owing to which they are unsecured, with the company’s credibility acting as security for the financial instrument. Corporates, primary dealers (PDs) and All-India Financial Institutions (FIs) can issue CPs. CPs have a fixed maturity period ranging from 7 days to 270 days. However, investors can trade this instrument in the secondary market, wherever they offer relatively higher returns compared to that from treasury bills.
3. Certificate of Deposit (CD)
Certificates of deposit are financial assets issued by banks and financial institutions, offering a fixed interest rate on the invested amount, similar to a fixed deposit. The primary difference between a CD and a Fixed Deposit is that of the principal amount. A certificate of deposit is issued only for large sums of money (1 lakh or in multiples of 1 lakh thereafter). Because of the restriction on the minimum investment amount, CDs are more popular among organizations than individuals who are looking to park their surplus for short term and earn interest on the same. The maturity period of Certificates of Deposits ranges from 7 days to 1 year if issued by banks. However, other financial institutions also issue a CD with a maturity period of 1 year to 3 years.
4. Repurchase Agreements or Ready Forward Contract (Repo)
Also known as repos or buybacks, a Repurchase Agreement is a formal agreement between two parties, where one party sells a security to another, with the promise of buying it back at a later date. It is also called a Sell-Buy transaction. The seller buys the security at a predetermined time and amount which also includes the interest rate at which the buyer agreed to buy the security. The interest rate charged by the buyer for agreeing to buy the security is called Repo rate. Repos come-in handy when the seller needs funds for the short-term, s/he can just sell the securities and get the funds to dispose of. The buyer gets an opportunity to earn decent returns on the invested money. Repo rate, fixed by the RBI may be defined as the rate at which domestic Indian banks borrow from other Indian banks or from the RBI. A decreasing repo rate makes it cheaper for banks to borrow money from other banks or the central bank. This, ultimately allows the bank to pass on the lower rate benefit to customers in the form of loans provided at reduced rates
5. Banker’s Acceptance
This is a financial instrument produced by an individual or a corporation in the name of the bank, wherein the issuer must pay a specified amount to the instrument holder on a predetermined date, between 30 and 180 days, starting from the date of issue of the instrument. Banker’s Acceptance is issued at a discounted price, and the actual price is paid to the holder at maturity. The difference between the two is the profit made by the investor. Banker’s acceptance is a secure financial instrument as the payment is guaranteed by a commercial bank
6. Call Money
Call money essentially represents a short term loan for the purpose of making stock exchange transactions with maturities ranging from 1 day to 14 days and is repayable on demand. The call money market participants are allowed to lend and borrow using the call money instruments such as STCI (Securities Trading Corporation of India), DFHI (Discount and Finance House of India), co-operative banks and Indian and foreign commercial banks. Call money loans feature a fixed interest rate, termed as call rate, which being closely related to changes in demand and supply, is quite volatile. Due to this high level of volatility, the call money market is considered to be the most sensitive section of India’s money market
7. Interest Rate Swaps
Interest rate swap is referred to a financial transaction in which two parties sign a deal wherein one pays a fixed rate of interest, and the other pays a floating rate of interest. The fixed rate of interest payable is calculated using a notional principal amount, while the floating rate of interest is paid on the actual principal lent out/borrowed with the rate varying on the basis of market conditions. In India, interest rate swaps are mainly used by commercial banks. However, these are separate products that are not directly linked to the bank’s assets such as money lent to customers in the form of loans. This money market instrument protects the borrower from interest rates changes even though the borrower is on the hook for any variable mark-up payments not covered by the interest rate swap agreement.
The money market structure is broadly divided as organisational structure and institutional structure. The further sub-classifications are discussed below-
Figure: Constituents/Structure of Money market
A) Organisational structure
1. Call Money Market:
The most important component of organised money market is the call money market. It deals in call loans or call money granted for one day. Since the participants in the call money market are mostly banks, it is also called interbank call money market. The banks with temporary deficit of funds form the demand side and the banks with temporary excess of funds form the supply side of the call money market.
2. Treasury Bill Market:
The treasury bill market deals in treasury bills which are the short-term (i.e., 91, 182 and 364 days) liability of the Government of India. Theoretically these bills are issued to meet the short-term financial requirements of the government. But, in reality, they have become a permanent source of funds to the government. Every year, a portion of treasury bills are converted into long-term bonds. Treasury bills are of two types: ad hoc and regular. Ad hoc treasury bills are issued to the state governments, semi- government departments and foreign central banks. They are not sold to the banks and the general public, and are not marketable. The regular treasury bills are sold to the banks and public and are freely marketable. Both types of ad hoc and regular treasury bills are sold by Reserve Bank of India on behalf of the Central Government. The treasury bill market in India is underdeveloped as compared to the treasury bill markets in the U.S.A. and the U.K.
3. Commercial Bill Market:
Commercial bill market deals in commercial bills issued by the firms engaged in business. These bills are generally of three months maturity. A commercial bill is a promise to pay a specified amount in a specified period by the buyer of goods to the seller of the goods. The seller, who has sold his goods on credit draws the bill and sends it to the buyer for acceptance. After the buyer or his bank writes the word ‘accepted’ on the bill, it becomes a marketable instrument and is sent to the seller. The seller can now sell the bill (i.e., get it discounted) to his bank for cash. In times of financial crisis, the bank can sell the bills to other banks or get them rediscounted from the Reserved Bank. In India, the bill market is undeveloped as compared to the same in advanced countries like the U.K. There is absence of specialised institutions like acceptance houses and discount houses, particularly dealing in acceptance and discounting business.
4. Collateral Loan Market:
Collateral loan market deals with collateral loans i.e., loans backed by security. In the Indian collateral loan market, the commercial banks provide short- term loans against government securities, shares and debentures of the government, etc.
5. Certificate of Deposit and Commercial Paper Markets:
Certificate of Deposit (CD) and Commercial Paper (CP) markets deal with certificates of deposit and commercial papers. These two instruments (CD and CP) were introduced by Reserve Bank of India in March 1989 in order to widen the range of money market instruments and give investors greater flexibility in the deployment of their short-term surplus funds.
B) Institutional structure/participants
1. Central Government:
Central Government is a borrower in the money market through the issue of Treasury Bills (T-Bills). The T-Bills are issued through the RBI. The T-Bills represent zero risk instruments. They are issued with tenure of 91 days (3 months), 182 days (6 months) and 364 days (1 year). Due to its risk free nature, banks, corporates and many such institutions buy the T-Bills and lend to the government as a part of it short- term borrowing programme.
2. Public Sector Undertakings:
Many government companies have their shares listed on stock exchanges. As listed companies, they can issue commercial paper in order to obtain its working capital finance. The PSUs are only borrowers in the money market. They seldom lend their surplus due to the bureaucratic mindset. The treasury operations of the PSUs are very inefficient with huge cash surplus remaining idle for a long period of time.
3. Non-banking financial companies
NBFCs acts as an intermediary in the money market. Some of them are-
Both general and life insurance companies are usual lenders in the money market. Being cash surplus entities, they do not borrow in the money market. With the introduction of CBLO (Collateralized Borrowing and Lending Obligations), they have become big investors. In between capital market instruments and money market instruments, insurance companies invest more in capital market instruments. As their lending programmes are for very long periods, their role in the money market is a little less.
Mutual funds offer varieties of schemes for the different investment objectives of the public. There are many schemes known as Money Market Mutual Fund Schemes or Liquid Schemes. These schemes have the investment objective of investing in money market instruments. They ensure highest liquidity to the investors by offering withdrawal by way of a day’s notice or encashment of units through Bank ATMs. Naturally, mutual funds invest the corpus of such schemes only in money market. They do not borrow, but only lend or invest in the money market.
4. Commercial banks:
Scheduled commercial banks are very big borrowers and lenders in the money market. They borrow and lend in call money market, short-notice market, repo and reverse repo market. They borrow in rediscounting market from the RBI and IDBI. They lend in commercial paper market by way of buying the commercial papers issued by corporates and listed public sector units. They also borrow through issue of Certificate of Deposits to the corporates.
5. Corporates:
Corporates borrow by issuing commercial papers which are nothing but short-term promissory notes. They are issued by listed companies after obtaining the necessary credit rating for the CP. They also lend in the CBLO market their temporary surplus, when the interest rate rules very high in the market. They are the lender to the banks when they buy the Certificate of Deposit issued by the banks. In addition, they are the lenders through purchase of Treasury bills.
The Indian money market is still in its infant stage and still developing. The rent trends in the Indian money market are discussed below-
1. An increase in secured funding
Secured funding provides an alternative source of term liquidity for the Group balance sheet. In the unsecured market, banks' cash borrowings decreased by 44%. And secured funding is increasing rapidly.
2. Changes in the repo market:
The growing gap between where dealer-banks are willing to finance each other through the vast and shadowy "repo" market vs. what investors charge for such collateralized lending shows the negative feedback loop of heightened regulatory pressures on banks. In a repo, one party sells an asset (usually fixed-income securities) to another party at one price at the start of the transaction and commits to repurchase the fungible assets from the second party at a different price at a future date or (in the case of an open repo) on demand. If the seller defaults during the life of the repo, the buyer (as the new owner) can sell the asset to a third party to offset his loss. The asset therefore acts as collateral and mitigates the credit risk that the buyer has on the seller. As banks continue to repay the liquidity facilities provided by the ECB, they have returned to the repo market for funding. The survey reveals that the market share of euro-denominated repos has recovered from 57% in June 2012 to 66% in December last year. As a result, collateral remains in high demand, not only from central bank holdings (due to asset purchases) and capital requirements, but also from banks attempting to secure funding. Investors such as money-market mutual funds have had the option of parking their cash elsewhere at these times when dealers are shunning them, even as rates are lower.
3. Price Formation and Transmission:
This is very popular trends in money market. Price formation is one of the key elements of market economy functioning. The price of a commodity or a service is formed as a result of numerous economic, political and social processes and this is true for traditional commodity relations as well as for financial markets. In business terms, price transmission means the process in which upstream prices affect downstream prices. Upstream prices should be thought of in terms of main inputs prices (for processing / manufacturing, etc.) or prices quoted on higher market levels (e.g. wholesale markets).
4. Low Level of Interest Rates:
Currently many banks are offering Low Level of Interest Rates on home loan, car loan etc. for attraction of people.
5. Increase in investment:
Investment by companies and wealthy individuals in zero-risk treasury bills has been on the rise over the last one year.
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