 |  Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace, 8/e Peter Rose,
Texas A & M University
Money Market Instruments: Treasury Bills, Repurchase Agreements, Federal Funds and Bank CDs
Chapter SummaryIn this chapter we have examined some of the most important of all securities markets—
the marketplaces where Treasury bills, repurchase agreements (RPs), federal funds, and
bank CDs are traded.
- The U.S. Government securities market began about 200 years ago when the first Secretary
of the Treasury, Alexander Hamilton, organized the market and began to sell debt
securities to selected individuals and financial houses. This market grew with tremendous
speed during and after World War II in response to high government borrowing
needs and the needs of savers for highly liquid, readily marketable financial instruments,
though its growth slowed appreciably as the twentieth century drew to a close
and the new century opened. Most recently the federal government has reduced the volume
of its deficit spending and begun to repay a portion of its debt.
- It is difficult to underestimate the importance of the government securities market in anchoring
the world’s financial system. This market sets the tone for the whole financial
system in terms of interest rates, security prices, and the availability of credit to both
governments and private borrowers. It is an indispensable tool for the government to finance
its large volume of debt, and interest rates on government securities serve as reference
rates for thousands of private loan contracts.
- Moreover, investors all over the globe rely upon government securities as a safe haven
for their cash reserves. This is especially true of Treasury bills, which are direct government
debt obligations with an original maturity of a year or less. And it is in this
same market today that most government economic policy changes begin, in the form
of Treasury and government agency issues of new securities and in central bank operations
in the open market.
- At the heart of the government security market are dealer houses that actively make
markets for a broad range of government, agency, and private security issues. These
dealers actively raise funds to support their purchases of government and other securities
from their customers. Among their most important funds sources are demand loans
from banks and other lenders and repurchase agreements negotiated with financial and
nonfinancial corporations. Demand loans can be canceled at any time by borrower or
lender and carry daily posted interest rates. Repurchase agreements are collateralized
loans, using high-quality securities as loan collateral.
- Security dealers active in the money market generate income through such sources as
commissions and fees charged for carrying out transactions or giving advice, gains on
their security positions if interest rates move favorably, and carry income based on the
spread between their borrowing costs and the yields on the securities they hold as assets.
- Security dealers are in a risky position. Interest rates and security prices are constantly
changing, exposing their security holdings and sources of profit to rapid and sometimes
drastic changes. Many have failed over the years and today these institutions are making
increasing use of hedging tools, such as trading in financial futures contracts, to protect
the value of their assets and profitability.
- Banks are among the most important financial institutions in the money market, providing
credit to security dealers, industrial firms, and other money market participants.
Banks are also the principal channel for making payments in the money market, acting
as guarantors of payments and as custodians for the safekeeping of financial instruments.
Finally, banks serve as a key channel for government economic policy, particularly
in regulating the supply and cost of money and credit.
- Two of the most important sources of funds in the money market to support the activities
of banks are federal funds and negotiable CDs (certificates of deposit). Federal
funds represent “immediately available” money in the form of large-denomination deposits
that can be wired the same day from lenders to borrowers and then back again.
Negotiable CDs are savings deposits with fixed or variable interest rates that are issued
in denominations of $100,000 or more.
- Both federal funds and negotiable CDs help banks meet the legal reserve requirements
that the central bank (in the United States, the Federal Reserve System) imposes upon
their deposit holdings. Bankers must continually compare the cost and availability of
federal funds, CDs, and other sources of bank funds in order to secure the reserves they
require.
- Finally, interest rates attached to money market instruments are key barometers of credit
conditions and have a powerful impact on the strength of the economy. One of these
money market interest rates, the daily federal funds interest rate, has become a key indicator
and channel for the impact of government economic policy upon the U.S. economy.
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2003 McGraw-Hill Higher Education