Comparison of Money Markets in the United States and Europe
The focus of this paper is the operational structures, functions and management of the money markets in both the United States and Europe. The paper will explore the features of the money markets in the United States alongside those of Europe. Thus, a comparative analysis will be drawn based on the peculiar features that the money markets have and the aspects that are similar in the two monetary and economic zones. The first part of the paper focuses much on the money markets of the United States while the second part delves into the nature of European money market. This dissection enhances clear understanding of the aspects that are similar in the European market as well the United States.
Money market is a group of institutions, conventions and practices with the sole interest of facilitating money exchange. This involves buying, selling, lending and borrowing of money. Usually, it is on a short time basis because it is expected not to exceed 13 months. The money market is only a subsection of the financial market. The highest rate of business on the money market occurs between banks where they borrow and lend money to each other. It is for a reason that they are the suppliers and users of money. This is termed as interbank lending market (Twomey, 2012). The money market involves players who are concerned with meeting the short-term to medium term financial needs of borrowers. Through the market, the investors provide liquidity to the lenders. The short term and the reinvestible funds that are at the disposal of the financial institutions are bid by the borrowers targeting the money. In this case, the borrowers can be individuals, institutions, organizations or even the government.
The transfer of funds usually occurs through the money market instruments. These instruments are short term debt securities. They are highly liquid and have equivalence with cash. It is for a reason that they have low costs and are easy to sell on the market. Transaction is normally done over the counter. Belke and Polleit (2009) maintained that trading on the money market involves interaction between borrowers and lenders. They are able to trade through this network in all debt securities within a range from some few days to approximately one year. This trade is perceived to have low risks due to the market’s liquidity and the short period of time within which the securities must be traded-off.
The modes of exchange include commercial paper, re-purchase instruments, treasury bills and foreign exchange swaps among other instruments. In most countries, these instruments are standardized by what is called the benchmark rates. The major ones are the London Interbank Offered Rate otherwise abbreviated as LIBOR for the United Kingdom, the Euribor which operates in the Euro zone and the Federal Funds Rate for the United States of America.
Functions of the Money Markets
One of the most essential tools in a modern economy is a well-developed money market. It is for a reason that it plays a significant role in the development of the economy of a country. Money market is also known to have boosted the industrial development of many countries. Thus, the functions of the money market are dynamic and far-reaching in every economy that has functional structures of it (Carbaugh, 2011).
Money market is a tool for financing trade. It is through money market and other avenue of funding that trade within an economy is financed. This also goes a long way in stepping up to fund international trade. Commercial traders are allocated finance by means of bills of exchange. These bills are discounted by the bill market. Foreign trade is greatly financed by the discount markets. Thus, the economy of a country significantly grows by means of money market since it forms the foundations of critical foreign exchange and international trade between countries (Choudhry, 2001).
As far as financing industry is concerned, the role of money market in the growth of industries comes in two ways. First, through money market industries; moreover, they are able to secure short term loans in order to help them meet their working capital requirements (Friedman & Schwart, 1971). This is made available by issuing of commercial papers and finance bills. Furthermore, this enables investors to run their enterprises continuously and expand their regional market share. Secondly, even though industries access long term loans through the capital market, it is the money market that dictates the prevalent conditions of the capital market. The general meaning of this is that the interest rates charged in the capital market are influenced by the interest rates charged on the money market. However, this is viewed as an indirect influence since conditions might change overnight (Belke & Polleit, 2009).
Through the money market, financial institutions or organizations with surplus funds can use them to make a profit. It is for a reason that money market enables them to transfer the money to other organizations which have a deficit of the same. In the process, they can make a profit out of their lending to other organizations. Commercial banks for example invest their surplus reserves in near money assets like bills of exchange. These assets are highly liquid, therefore can be turned into cash in an easy way. Through these sales, the banks make a profit and in the process do not lose their liquidity (Belke & Polleit, 2009).
Money market also helps in bringing about self-sufficiency in commercial banks. However, this is only possible if the money market is well developed and the commercial banks have invested in it. Commercial banks during emergency ought to recall their investments on the money market instead of taking loans from the central banks. This helps them from incurring costs by paying higher interest rates to the central bank.
Central banks also function in a smoother way if the money market is well developed. Since the central banks can function without money market, its presence helps the central banks in increasing the efficiency (Carbaugh, 2011). The money market indicates the financial conditions of a country. This helps the central bank to develop and adopt a banking policy that is appropriate to the industry. When the money market is sensitive and integrated, the central bank can efficiently influence the sub-market in a quick and widespread way. This in turn aides the central bank in implementing its policy.
The Money Market in the United States of America
The United States is known as the only country in the world with the largest domestic money market. It is for a reason that it has the largest volume of transactions (Belke & Polleit, 2009). The money market is less centralized as compared to the money market of other countries. Furthermore, the country also has authorized a wide range of money substitutes. In addition, the country has a very wide range of institutions involved with great diversity.
Since the Second World War, local government units and non-financial business concerns in the United States have attained and gained importance on the money market. This is considered as probably the most unusual and unique composition of the money market in the United States. Further, unlike other countries, state treasurers, corporate treasurers and political authorities prefer managing their own liquid holdings (Belke & Polleit, 2009). In other countries included Euro zone, commercial banks do the management. As a result, the dealers have received more funding from these banks than from the banks in New York City. The other illustration of the nationwide character of the money market is the participation of about 200 banks on the federal funds market. These banks are spread among all Federal Reserve Districts. However, much of the transactions are still done through the infrastructure available in New York.
Consequently, inasmuch as there is a national picture of the money market, a final clearance center is still of cardinal importance. This place can be used as the ultimate point of balancing adjustments of the market. Also, this center can be used as the place where the net impact of changes in total supply or demand converges. This in turn maintains New York as the central point. This coordination is key and critical for the success of the money market and the contribution towards expansion of the financial market and industry within an economy.
The Unit Banking System
The onset of the unit banking system in the United States came with major changes on the country’s money market arrangements. These changes indicate big differences in the way money markets in the United States operate as compared to other countries. As a matter of fact, even the smaller banks and financial institutions need to be fed with credit which they in turn trade off with other institutions as lenders. It is for a reason that there is movement of deposits from one bank to another within the country. These banks, therefore, have the privilege of borrowing money from their federal reserve bank as a way of providing temporary relief to the banks. However, this is only possible if the banks are members of the federal system.
There are big banks which are part of the depositories of the liquid reserves that are meant for the smaller credit institutions and facilities like banks. These big banks are at times unable to meet the demands converging on them. It is for a reason that the demands are greater than the expectations. The big banks also have temporary access to loans from the Federal Reserve Bank. Nonetheless, this is possible for them if there is the inadequacy of funds in other money market facilities. This kind of borrowing is not put at severe penalty level by the federal bank (Carbaugh, 2011). It is for a reason that the borrowing is not viewed as a result of poor management. Rather it is perceived as a result of frequent and unavoidable borrowing needs from the already large unit banking system. Therefore, the federal banks do not have constant interest rates on these kinds of loans. This is a record contrary to practice in the countries in Europe where the central banks maintain their interest rates above the prevailing money market interests. However, the Federal Reserve banks have continuous surveillance duties on the borrowing banks as a measure against abuse of the loans (Carbaugh, 2011).
The other unique practice that emerged on the money market in the United States is the development of the federal funds. It is a special part of the money market that makes it possible for balances on the books of a federal reserve bank be directly transferred to a member bank. This is always done in return for payment of a variable rate of interest. Moreover, this rate is known as the federal funds rate which is always available; a member bank immediately puts an application for the balances. They also provide for transactions through the clearing house funds. These are funds that are on deposit in commercial banks usually through loans between banks or between two large depositors. The name clearinghouse funds came up because it is a rule for such funds to be collected through a clearing process.
Money Market Instruments in the United States
The most frequently used instruments of exchange during transaction in the United States are government securities. The use of government securities gained momentum after the Second World War to extent that it dominated over the other money market elements. Governments always had dealers who would sell or buy instruments for their own account. The prices are only quoted if an interested party requests.
Even though, the dealers represent governments in other parts of the country, their offices are majorly located in New York. This kind of transaction arrangements has positive side effects though. The main one is that it has led to the daily indicator of the pressure of supply and demand. On the other hand, financing dealer uses the repurchase agreement as a funding instrument. It is for a reason that process where dealers temporarily sell parts of their inventory with a repurchase agreement.
The certificate of deposit (CD) is another significant money market instrument. It is usually given out in large volume by commercial banks and is always given out within a particular time period that is negotiated before it is issued (Rochon & Rossi, 2007). Consequently, the owner of the certificate of deposit is denied the right to withdraw his or her deposit before the initially agreed upon date matures. None the less, the owner is at liberty to sell the CD at any time to a secondary market. However, the market must be one that is conducted by government security dealers. Other money market instruments are the bank drafts, commercial paper and bills of exchange.
The Federal Reserve System, on its own initiative, is obligated to carry out daily operation on the money market. This is done in a bid in order to ensure that there is a smooth operation in the country’s financial machinery. The Reserve system also aims to influence economic growth and bolstering economic stability (International Monetary Fund, 2006).
The transactions of the Federal Reserve System are quite a number. They comprise the purchase or sale of government securities and purchase of bankers’ acceptances which is smaller than the government securities. It transacts loans made to dealers in government securities and also makes acceptances in the form of repurchase agreements. As a result, the dealers have received more funding from these banks than from the banks in New York City (Kakes, 2000). The other illustration of the nationwide character of the money market is the participation of about 200 banks on the federal funds market. These banks are spread among all Federal Reserve Districts. However, much of the transactions are still done through the infrastructure available in New York. Consequently, although, there is a national picture of the money market, a final clearance center is still of cardinal importance. This place can be used as the ultimate point of balancing adjustments of the market. In addition, this center can be used as the place where the net impact of changes in total supply or demand converges. This in turn maintains New York as the central point (International Monetary Fund, 2006).
Money Market Funds
Money market funds can be termed as open ended mutual funds that are used to invest in the short term debt securities. It can also be termed as virtual banking system. These debt securities include treasury bills for the United States and commercial paper. They are generally considered being secure and realizing more profit. The funds are the significant providers of liquidity to financial intermediaries.
The main purpose of money market funds is to reduce possible losses that can be incurred due to market and liquidity risks. In the United States, the Securities and Exchange Commission regulates the money market funds. The investment company act of 1940 allows the fund to buy the highest debt. The debt is also stipulated to mature any time before the end of 13 months plus a weighted average maturity of at most 60 days (Rochon & Rossi, 2007). The investors are only allowed up to 5% of investment in any one issuer. Exceptions are only applicable for government securities and repos.
Polishing Your Writing to Make it Shine
The revelation of the riskiness of the money market funds emanated with the collapse of the Lehman brothers. This incident caused anxiety among investors thus leading them to redeem their funds. This in turn brought about the forcing of liquidation of assets or imposed restrictions on redemption. In just three days, major institutional funds had been redeemed. This crisis caused an almost run on the money funds. It is for a reason that the redemptions resulted in an acute fall in the demand for commercial paper. This brought about a serious liquidity crisis by preventing companies from rolling over their short term debts. Therefore, the buyers went into the strike since it was impossible to buy commercial paper by means of money funds. This in turn drove up the yields from 2% to 8% just within a week (International Monetary Fund, 2006).
In a bid to avert this crisis, the Department of Treasury came up with an optional insurance program to holdings that could purchase the commercial paper. The insurance provided for the restoration of covered funds if by any chance they break the buck. Following that financial crisis, the money market funds have received consideration as of significance to financial stability. However, this is only important in given situations which are usually depicted by market uncertainty and instability. International Monetary Fund (2006) indicates that money market funds include the market situation and investor sentiments among others. Moreover, the significance of the funds is felt and appreciated certain parts of the financial market like corporate commercial paper and covered bond markets.
The Money Market in Europe
The European money market is not very integrated. It is for a reason that as much as there is the European Union, there are different policies governing the money market in every country. This in turn has led to the viewing of the money market as being insecure. The only segments of the market that are considered to be secured and well developed are the forward rate agreement and the cross currency swap segments. They form the greatest percentage of the money market share.
Structure of the Euro Money Market
The institutional organization of the money market in the European Union is in four phases. The first one is the central banks of the different countries. These banks act as the providers of macro monetary policy and general policy strategies. They also serve as a link between the local banks and the European central bank. Second is the operational framework whose responsibility is to implement the monetary policy. The operational framework also implements liquidity management by their central banks. They in particular manage the monetary policy instruments like an open market operations, standing facilities and reserve requirements among others.
Private traders come in third. This also includes traded instruments such as deposits, derivatives and repurchase agreements among other instruments. Also, it entails facilities used for trading and the organization of the market (Twomey, 2012). These include electronic brokering and information systems for trading facilities then organized exchange and over the counter exchange for the kind of market organization. Finally, we have the payment and settlement infrastructure. This includes the big value payment systems, securities settlement systems, clearing and netting facilities among others. The products are just like in the United States, short time deposits; furthermore, repurchase deposits and foreign exchange swaps among others.
The European Central Bank and the Money Market
This is the central bank for the euro. It is mandated to monitor the monetary policy of the Euro zone which is a 17 member state of the European Union. The European central bank is termed as one of the most important central banks since monitors one of the largest currency areas in the world. The European central bank has the mandate of maintaining the stability of prices in the Euro zone. This implies that their primary objective is to make sure that there is an all-time low inflation rate, possibly below or around 2% (Perron, 2004). One of the striking differences between this bank and the Federal Reserve System is that it has one major objective; other functions are just but subordinate functions.
The main duty of the European Central Bank is to define and implement of the monetary policy within the Euro zone. The ECB also conducts foreign exchange operations and caters for international reserves of the Euro System of central banks. It is finally mandated with the duty to ensure smooth operation of the financial market infrastructure.
European Central Bank’s Monetary Policy
In the Eurosystem, approximately 1500 banks are eligible to transact the bidding of short term repurchase agreements. The duration can be at least two weeks and at most three months. The banks that need the funds borrow and are under obligation to pay back within the stipulated time period. This short duration also gives room for the interest rates to change with the changes in time. This is contrary to the way the federal reserve bank of the United States operates. The federal banks supply the economy by purchasing treasury bonds instead of transacting the repos.
Bidding by participating banks takes place again when the repos are due. In this system, the liquidity in the economy increases with the growth in the quantity of notes auctioned. A decrease in the quantity of the notes has a negative effect on the liquidity. The asset side of the European Central Bank’s balance sheet carries all contracts. The member banks only get to carry the resulting deposits as liability. This means that the member banks get an increase in funds since the resulting deposits are in the form of cash. Therefore, the economy gets an injection of more money. Banks that have the need to participate in the auction have to be qualified (Carbaugh, 2011). Proof of needed collateral is a key and the collateral must be in terms of loans given out to other entities. However, a variety of private banking securities can also be taken in. All in all, an asset can qualify as bank collateral if it is in good condition and is well protected from inflation risks.
Transactions on the Euro money market occur via electronic means. This is contrary to the United States where transactions are carried out over the counter. Therefore, the lenders and the borrowers of securities on the Euro money market are able to trade by means of visas, swipes and other electronic systems. In the United States, although trading in securities is well advanced, the trading is still through the counter. This is yet another aspect in which the Euro zone money market differs from the money markets in the United States (Carbaugh, 2011).
Future of the Euro Money Market Interest Rates
Following the financial crisis that the Euro zone underwent in the recent past, banks that tool loans from the Central Bank have been worried about the all-time high interest rates of the central bank. The governing authorities are contemplating on reducing the interest rates. This move could reduce the profit that the Central Bank was supposed to make. This will in turn shrink the balance sheet of the Central Bank and bring about an automatic drop in the future of money market interest rates. Therefore, the Euro whose value has been on the rise is threatening to go low. The money market is an important tool in the making of the value of the euro. Thus, this possible low dive of the euro could see it being dragged down towards the dollar in the near future.
The month of January saw the euro in an almost lock step with the Eonia rate that has been prevalent for two years. This is a clear indication that traders are very much expecting the overnight interest rates to experience changes. This correlation, which came to 0.8 has come out as the strongest. This condition has come barely a year since the flooding of the market with long term loans. The early repayment of loans by the European banks to the Central Bank helped the euro gain dominance over the dollar. Moreover, this move led to the increase in the rate of the money market. This is a condition that was hailed by the staff of the Central Bank because it improved the financial condition. However, it significantly led to the shrinking of the balance sheet of the Central Bank (Mathieson et al., 2001).
It is interesting to explore the differences between the United States and European monetary market in terms of the transmission of shocks and spillover effects. Studies that have been conducted on this aspect reveal very interesting distinctions between the United States and Europe. Whereas the strongest international transmission of shocks occurs within the various classes of assets, the international cross-market spillovers are quite conspicuous in the European and the American economies (Dufey & Giddy, 1994). In the United States monetary markets, short-term interest rates exert a substantial influence on the Euro financial market. This often affects the equity markets, bond yields and securities on the European money markets and other global financial institutions and structures. This probably explains why the financial shockers of the United States often affect all the money markets across the globe. In essence, it is this far-reaching effect of fluctuations on the United States’ monetary market that has always been pointed to as the cause for the global financial crises that have often had global consequences. The shocks on the United States’ monetary market always has a 10 per cent impact overall in the Euro bond and securities market operations and movements. Thus, the Euro zone money market does not steady and seldom withstand the changes in the United States monetary market.
The transmission of shocks from the money market in the United States into Europe often flow in the opposite direction. Although, the Euro money market is not very consistent and stable, the United States money market is also occasionally unsteady. Though in the short term, short-term interest rates on the Euro market has had a significant impact on the United States monetary market, especially the bond and equity markets. In terms of the variances, statistics indicate that more than 25% of the Euro financial market fluctuations were a consequence of movements on the United States monetary market (Lieberman & Hall, 2008). On the contrary, Euro monetary market had 8% impact on the United States monetary markets.
The United States and European monetary markets have similarities in various aspects and differences from several fronts. Whereas the United States monetary market seems to be more developed and stable, the securities still trade over the counter. This is not the case with the Euro zone monetary markets. The Euro monetary market is founded on trading through visas and other online approaches. Nonetheless, the instruments of trading in both the monetary markets seem to be similar with slight differences but the similarity in principle and policy. The structure of the European monetary market may be slightly different from the United States structure given that the Euro market brings together several nations that have had their economies and their currencies harmonized under the Euro.