The Indian Money Market: Structure and Instruments

In one line

The money market is where banks, the Government and large companies borrow and lend for periods from one night to one year, and the Reserve Bank sits in the middle of it.

In the wording a student can write in an exam: the money market is the market for short term funds of original maturity up to one year, in which the Reserve Bank of India, commercial banks, primary dealers, mutual funds, insurance companies and large corporates borrow and lend through instruments such as call and notice money, term money, treasury bills, commercial paper, certificates of deposit, repurchase agreements and commercial bills, its principal functions being to provide liquidity, to enable the management of short term surpluses and deficits, and to transmit the monetary policy of the central bank.

What it is for

Four functions, and an answer should give all four.

1. Liquidity. A bank that finds itself short of cash today, because withdrawals exceeded deposits or because it must meet its reserve requirement, borrows for a night. A bank with a surplus lends. Neither has to disturb its longer term assets.

2. Short term financing. A company finances the gap between paying its supplier and being paid by its buyer; the Government finances the gap between spending and tax collection.

3. Transmission of monetary policy. This is the function that matters most for Module III. The Reserve Bank sets its policy rate and operates in this market; the rate it sets moves the overnight rate, the overnight rate moves other short term rates, and those eventually move deposit and lending rates. [What Determines the Money Supply, and How the RBI Controls It] follows the chain.

4. A benchmark. The overnight rate is the base on which nearly every other interest rate in the economy is built.

The structure

The organised sector, which is what the syllabus means by the money market:

• The Reserve Bank of India, which is both a participant and the regulator.
• Commercial banks, the largest participants on both sides.
• Co-operative banks.
• Primary dealers, licensed to deal in government securities and to underwrite issues.
• Mutual funds and insurance companies, usually lenders of surpluses.
• Large corporates, as issuers of commercial paper.
• Clearing and settlement infrastructure, principally the Clearing Corporation of India, which is what makes tri party repo possible.

The unorganised sector: indigenous bankers, moneylenders, chit funds and unregistered lenders, described in [The Financial System: Two Markets, One Job]. It is outside the Reserve Bank's reach and it is where a large part of small borrowing actually happens.

The instruments, from the statute

Section 45U(b) of the RBI Act 1934 defines money market instruments to include call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper, and such other debt instrument of original or initial maturity up to one year as the Bank may specify. Section 45W gives the Bank power to regulate transactions in derivatives, money market instruments and securities.