The Indian Money Market: Structure and Instruments

Take them in turn.

1. Call money, notice money and term money

• Call money is lent for one day, repayable on demand.
• Notice money is for 2 to 14 days.
• Term money is for 15 days to one year.

The market is between banks and primary dealers. The rate at which they deal is the call money rate, the most closely watched short term rate in the country, because the Reserve Bank's operating target is to keep it close to the policy repo rate.

2. Treasury bills

Short term instruments of the Central Government, issued by the Reserve Bank on its behalf in tenors of 91, 182 and 364 days. They are zero coupon: issued at a discount and redeemed at face value, so the return is the difference rather than a stated interest.

Why they matter beyond their size. They are the safest rupee instrument there is, so their yield is the risk free rate against which every other short term rate is measured, and they are the collateral most often used in repo transactions.

3. Repo and reverse repo

Section 45U(c) defines a repo as an instrument for borrowing funds by selling securities with an agreement to repurchase them on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.

Section 45U(d) defines a reverse repo as an instrument for lending funds by purchasing securities with an agreement to resell them at an agreed price including interest for the funds lent.

Two things follow from those definitions and both are examinable. First, the same transaction is a repo for one party and a reverse repo for the other; the name depends on which side you stand. Second, a repo is in substance a secured loan, because the securities are collateral, and that is why it has largely replaced uncollateralised call money as the main way banks borrow overnight.

Tri party repo interposes a third party which handles collateral selection, valuation and margining, which removes the operational burden and has made the segment the largest in the Indian money market by volume.

4. Certificates of deposit

A negotiable instrument issued by a bank against a deposit, in dematerialised form, at a discount to face value. The maturity is up to one year. It lets a bank raise bulk funds at a market rate, and it lets the holder sell before maturity, which an ordinary fixed deposit does not permit.

5. Commercial paper

An unsecured promissory note issued by a corporate, primary dealer or financial institution with a good credit rating, in dematerialised form, at a discount. It is how a large creditworthy company borrows short term without going to a bank, and its rate is therefore a direct measure of what the market thinks of that company's credit.

6. Commercial bills, or commercial usance bills

A bill of exchange drawn by a seller on a buyer for goods sold on credit and accepted by the buyer. The seller can hold it to maturity or discount it with a bank and get the money at once. It is the oldest money market instrument in the world and, in India, the least developed: the absence of a genuine bill market is one of the standing defects treated in the next chapter.

The instruments compared

A worked example: a bank's Friday afternoon

Sahyadri Bank finds at four o'clock that its balance with the Reserve Bank will fall short of the cash reserve requirement by 300 crore rupees tonight.

Option one: call money. Borrow 300 crore overnight from another bank at the call rate. Uncollateralised, quick, and the rate is whatever the market is charging that afternoon, which in a tight market can be well above the policy rate.

Option two: tri party repo. Sell 300 crore rupees of government securities it already holds with an agreement to repurchase them tomorrow. Cheaper than call money, because the lender has collateral, and this is why most overnight borrowing now happens here.

Option three: the Reserve Bank's own window. Borrow from the central bank under the liquidity adjustment facility at the repo rate, or, if it has already exhausted that, at the marginal standing facility rate, which is higher. [Recent Trends in the Indian Money Market] describes the corridor these rates form.

Option four: sell a treasury bill. Realise cash by selling from its holding, which is possible only because a liquid secondary market exists.

What the example teaches. The money market's function is to let a bank correct a one day mismatch without disturbing a single loan to a customer. And the fact that the bank has four choices, at four different prices, is what makes the policy rate effective: raise it and every one of those options becomes dearer, so the bank lends less.

What beginners get wrong

"The money market is for companies to borrow." It is dominated by banks. Corporates enter it mainly as issuers of commercial paper, and only large and well rated ones.

"A repo is a sale." In form it is a sale with an agreement to repurchase; in substance it is a secured loan, and section 45U(c) describes the repurchase price as including interest for the funds borrowed.

"Repo and reverse repo are different instruments." They are the same transaction seen from the two sides.

"Treasury bills pay interest." They are zero coupon: issued at a discount, redeemed at face value, and the return is the difference.

"Commercial paper is secured on the company's assets." It is an unsecured promissory note, which is why only highly rated issuers can sell it.

Limits

Access is narrow. The minimum transaction sizes exclude everybody except institutions and very large firms, so the money market's benefits reach a household or a small enterprise only at second hand, through their bank.

It is a wholesale market with no physical location, so its rates are visible to specialists and to nobody else.

Its instruments are unevenly developed. Repo and treasury bills are deep; the commercial bill market has never developed, which is the subject of the next chapter.

Quick revision

1. Four functions: liquidity, short term finance, transmission of monetary policy, and a benchmark rate.
2. Participants: the Reserve Bank, commercial and co-operative banks, primary dealers, mutual funds, insurers, large corporates, and the clearing infrastructure. Plus an unorganised sector outside the Bank's reach.
3. Section 45U(b) of the RBI Act 1934 lists the instruments: call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper, and other debt instruments of original maturity up to one year. Section 45W gives the power to regulate them.
4. Call money 1 day; notice money 2 to 14 days; term money 15 days to 1 year.
5. Treasury bills: Central Government, 91, 182 and 364 days, zero coupon, issued at a discount. The risk free benchmark and the usual repo collateral.
6. Repo, section 45U(c): borrowing by selling securities with an agreement to repurchase at a price including interest. Reverse repo, section 45U(d): the lending side of the same transaction. In substance a secured loan. Tri party repo is now the largest segment.
7. Certificate of deposit: issued by a bank, negotiable, at a discount, up to one year. Commercial paper: unsecured promissory note of a well rated corporate or financial institution, at a discount. Commercial bill: a bill of exchange arising from a trade, discountable with a bank; the least developed segment in India.

Test yourself

1. What is the money market and what functions does it perform? It is the market for short term funds of original maturity up to one year, in which the Reserve Bank, commercial and co-operative banks, primary dealers, mutual funds, insurers and large corporates lend and borrow. Its functions are to provide liquidity, so that an institution with a temporary shortage can obtain funds without disturbing its longer term assets and one with a surplus can employ it; to provide short term finance for working capital and for the mismatch between receipts and payments, including for the Government; to transmit monetary policy, since the central bank operates in this market and the rate it sets there works through to other rates; and to provide the benchmark short term rate on which most other interest rates in the economy are built.

2. Name the money market instruments recognised by the Reserve Bank of India Act, and state the statutory maturity limit. Section 45U(b) of the Act defines money market instruments to include call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill and commercial paper, together with such other debt instrument of original or initial maturity up to one year as the Bank may specify from time to time. The statutory limit is therefore one year of original or initial maturity, which is what separates a money market instrument from a capital market one. Section 45W confers on the Bank the power to regulate transactions in derivatives, money market instruments and securities.

3. Explain repo and reverse repo, and say why a repo is described as a secured loan. Section 45U(c) defines a repo as an instrument for borrowing funds by selling securities under an agreement to repurchase them on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. Section 45U(d) defines a reverse repo as the corresponding instrument for lending funds by purchasing securities under an agreement to resell them at an agreed price including interest for the funds lent. The two are the same transaction viewed from opposite sides, so what is a repo for the borrower is a reverse repo for the lender. It is described as a secured loan because, although it takes the form of a sale and repurchase, the lender holds the securities throughout and can sell them if the borrower fails, so the economic substance is a loan against collateral; the definition itself acknowledges this by describing the repurchase price as including interest for the funds borrowed.

4. Distinguish a certificate of deposit from commercial paper. A certificate of deposit is issued by a bank against a deposit placed with it, is negotiable and held in dematerialised form, is sold at a discount to face value and has a maturity of up to one year; it enables a bank to raise bulk funds at a market determined rate and gives the holder the ability to sell before maturity, which an ordinary term deposit does not. Commercial paper is issued by a corporate, a primary dealer or a financial institution of good credit standing, is an unsecured promissory note, is likewise issued at a discount in dematerialised form for up to one year, and enables a well rated borrower to raise short term funds directly from the market instead of from a bank. The essential differences are the identity of the issuer, a bank in the one case and a non bank borrower in the other, and the fact that commercial paper carries the issuer's credit risk without any security.

5. What are treasury bills and why do they matter beyond their size? Treasury bills are short term obligations of the Central Government, issued by the Reserve Bank on its behalf in tenors of 91, 182 and 364 days. They carry no coupon: they are issued at a discount to face value and redeemed at par, so the return is the difference. They matter beyond their volume for two reasons. Being obligations of the sovereign in its own currency they are the safest rupee instrument available, so their yield serves as the risk free benchmark against which every other short term rate is priced. And because they are safe and liquid, they are the collateral most commonly used in repurchase transactions, which makes them the foundation of the largest segment of the money market.

6. Why has the commercial bill market remained undeveloped in India, and why does that matter? A commercial bill is a bill of exchange drawn by a seller on a buyer for goods sold on credit and accepted by the buyer, which the seller may discount with a bank to obtain payment at once. It has remained undeveloped in India because of the reluctance of buyers to accept bills, the absence of a wide secondary market in which discounted bills can be resold, the preference of banks for cash credit arrangements which are more convenient for them, and the historical prevalence of informal trade credit. It matters because a functioning bill market would convert the trade credit that small suppliers extend into cash immediately, which is precisely the delayed payment problem examined in the chapter on the problems of MSMEs, and it is the reason that a modern substitute, the electronic discounting of trade receivables, has had to be built in its place.