Friday, January 30, 2015

Money Market - Part I

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Money Market
It generally provides investment avenues of short time tenor, by definition for a maximum one year. Money market transactions are generally used for funding the transactions in other markets including Government securities market, Capital market and meeting short term liquidity mismatches.

The one year tenor can be classified into -
  1. Overnight market - tenor of transactions is one working day (also called Call Money market)
  2. Notice Money market - tenor from 2 days to 14 days
  3. Term Money market - tenor from 15 days to 1 year

Instruments used
Money market instruments include Call Money, Repos, T-Bills, Commercial Papers (CP), Certificate of Deposits (CD), and Collateralized Borrowing and Lending Obligations (CBLO).

Borrowing money from RBI
Banks can borrow money from RBI with or without securities, and for 1 day to 1 year period. Depending on these, there are 3 ways to borrow money from RBI, and hence 3 rates -

1.  Repo (Repurchase) rate
This is a type of collateral lending by RBI. Here, banks sells securities (gov. securities) to RBI with a repurchase agreement (meaning banks will buy back those securities at future date with extra interest). The rate charged by RBI is known as Repo rate.

It comes under Liquidity Adjustment Facility (LAF) of RBI monetary policy (i.e., a way to adjust market liquidity, along with reverse repo).

Banks borrow money by repo to meet their daily mismatches. Repo auctions are conducted by RBI on a daily basis, except Saturdays. Here, minimum bid size is of Rs. 5 crore and multiple. All commercial banks (except RRBs) can borrow through repo facility. Repo borrowings have a tenure of 1 day to 90 days.

2.  Marginal Standing Facility (MSF) - 
Now think what will happen if banks are not able to maintain their daily mismatches even with repo (it happens!). Hence RBI provided (from 2011) one more facility to banks - Marginal Standing Facility (MSF). Albeit its a penalty rate (because banks are not able to maintain their mismatches with repo), and always higher than repo rate (currently 100 basis point higher).

In this scheme, banks borrow money with minimum bid size of Rs. 1 crore and multiple. The tenure is of 1 day only, and banks can borrow 1 % of their respective NDTL under this scheme.

3. Bank Rate -
For the long term, i.e., 90 days to 1 year, banks can borrow money from RBI with bank rate. As it is a long term borrowing, the rate is higher than repo rate

Banks doesn't need any collateral or security, while borrowing for a long term under Bank Rate. It is not used as a monetary policy to adjust the market, rather used to re-discount Bills of Exchange (refer our previous article on Discounting Bills of Exchange), or other Commercial Paper.

Lending money to RBI
Now come to the lending part. Now think, what is the purpose of Reverse Repo? Why banks will lend money to RBI, and when?

If a bank is able to maintain its money requirements properly, and has surplus money, then it would be better for the bank to lend to RBI, rather than keeping it with itself. Because, lending money will give the bank interests in reverse repo rate.

Its again a collateralized lending to RBI with repurchase agreement, as repo (works as opposite to repo).

Liquidity Adjustment Facility (LAF)
Repo and Reverse Repo together forms the Liquidity Adjustment Facility. It is a very essential and efficient tool of RBI to adjust the market liquidity. Since raising or reducing the rates, will make the banks raise or reduce its own rates to its customer (public), and of a short term tenure.

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