The following points highlight the five main conditions of money market. The conditions are: 1. The Market Segments 2. Treasury Bills 3. Commercial Bills 4. Certificates of Deposit 5. Commercial Paper (CP).
Condition # 1. The Market Segments:
In this market funds are borrowed and lent for one day (call) and for a period up to 14 days (notice) without any collateral security. The participants in this market are commercial and cooperative banks who can borrow and lend funds. Mutual funds and all-India financial institutions approved by the RBI, can participate in this market as lenders only.
On lending deposit receipt is issued to the lender. When funds are recalled the lender discharges the receipt and gives it back to the borrower and the borrower repays the amount together with interest for the period fund is used.
From May, 1989 the interest rates in the call and notice market are market-determined. Before that there was a ceiling on the interest rate in this market fixed by the Indian Banks Association. For a long time the ceiling was 10% p.a. Interest rates in this market are highly sensitive to the demand and supply forces.
Interest rate shot up to as high as over 100% during 1991, as the banking system were suffering from liquidity crisis. The rate fell thereafter. It hovered around 2%-3% in November-December, 1993, as banks were flushed with fund. Indeed, large intra-day variations are common in this market segment.
Condition # 2. Treasury Bills:
A treasury bill is basically an instrument of short-term borrowing by the Central Government. In our country these bills were first introduced in October, 1917. At the beginning, treasury bills were issued by the Government in the form of promissory notes at a discount generally for a period between 91 days and 364 days.
Though 91 days treasury bills were introduced in 1932, from July 1965, these bills are made available on tap basis at a fixed discount rate of 4.60% per annum. The low yield on these bills was out of alignment with other interest rates in the system., The banks made use of these bills essentially for parking surplus funds for very short periods.
These 91 days bills are rediscounted by the Reserve Bank of India. However, from November 1986, the RBI has been charging an “additional early discounting fee” for rediscounting these bills within 14 days from the date of purchase. In view of the low-yield and the rigidness, this instrument has ceased to be of relevance to the money market.
The need for widening the short term money market has long been felt with its low yield, the 91 days bills could not serve the function of smoothening liquidity requirements.
It is pertinent to note here the remarks of Chakravarty Committee: “If its yield is substantively raised, not only institutional investors and banks but also other corporate bodies, local government agencies and trusts who presently have no attractive outlet for short-term investment of their surplus funds could together constitute a sizeable market for Treasury Bills.”
With a view to attaining that objective as also to provide a financial instrument with intermediate maturities between the dated securities on the one hand and the 91 days treasury bills on the other, 182 days treasury bills were introduced on auction basis in November 1986 and the longer maturity 364 days treasury bills in April 1992.
The two essential characteristics of these bills are:
(a) There is no pre-determined target amount to be raised—as these are specifically tailored to meet the requirements of holders of short-term liquid funds;
(b) There is no reserve price.
These bills are eligible securities for maintaining Statutory Liquidity Ratio (SLR) purpose as also for borrowing under Stand-by Refinance facility. These are issued at a discount to face value for a minimum of Rs. 1 lakh and multiples thereof. The bills can be purchased by any person resident in India (except State Government and Provident Funds).
Every fortnight the RBI holds auctions and invites bids for the sale of treasury bills of varying maturities up to 364 days. The bids are then scrutinised by a committee which decides the cut-off price. All bids quoting price equal to or higher than the cut off price are accepted for allotment, while other bids are rejected.
With regular fortnightly auctions, maturities that can be regarded almost as a continuum are now available in the market which is conducive to the development of an active secondary market.
Since treasury bills can be acquired by any investor having short-term surplus fund, this instrument has the potentiality of providing a link between various segments of the financial markets through shift of funds from cash to treasury bills and vice-versa.
From January 9, 1993, treasury bills of 91 days maturity are issued on weekly auction basis with pre-announced notified amounts. The initial response to the auctions was continuous.
Condition # 3. Commercial Bills:
The RBI introduced the Bill Market Scheme in 1952. Its thrust was to induce banks to provide finance against bills. Bills of exchange are drawn by the seller (called drawer) on the buyer (called drawee) for the value of goods delivered to him. Such bills are called trade bills; on acceptance by commercial banks trade bills are called commercial bills. If the bills are payable at a future date, the bills are called usance bills.
As payment of accepted usance bills are assured on due dates, they are self-liquidating in character. If the seller is in need of funds before due date, he may approach his banker for discounting the bill, at a discount rate, fixed by the RBI. The Bank on due date would receive the face value (maturity value) from the drawee.
In 1970, the RBI introduced the Bills Rediscounting Scheme under which all licensed scheduled commercial banks were made eligible to rediscount with the RBI at the rate specified by the latter, genuine trade bills arising our of sale or despatch of goods. The maturity date of bill eligible for such rediscounting should not be more than 90 days from the date of rediscounting.
With a view to augmenting the facilities for rediscounting and making a pool of resources available for the purpose, the RBI has progressively enlarged the number of institutions eligible for rediscounting of bills; thus, other financial institutions which have short-term surplus resources and which look forward to their gainful employment can now rediscount commercial bills.
To facilitate successive rounds of rediscounting, the earlier procedure of endorsing and delivering to the re-discounter at every-time of rediscounting has been done away-with.
Now a derivative usance promissory note is to be issued by the discounter on the strength of the underlying bills which have a tenor corresponding to or less than the tenor of the derivative usance promissory note and in any case not more than 90 days. These derivative notes have been exempted from stamp duty and a proforma which will facilitate successive rounds of rediscounting has also been specified.
In the context of the Bill market being a vital segment of the money market, the Working Group on Money Market made a set of recommendations aimed at developing bill financing and developing bill culture.
Progressively inland credit sales should be effected by drawing usance bills since such bills could be discounted with banks, the Group observed that the RBI accepted the major recommendations of the committee report.
Bill culture can develop if Government, public sector undertakings and large industrial organisations accept it as a basis for financing business transactions.
Banks should also persuade their large customers to fall in line with the credit discipline and provide bill acceptance and bill discounting limits while fixing the overall working capital limits. Since amount and date of repayment are known in the case of bills, bill financing would enable banks to plan their cash management efficiently.
Condition # 4. Certificates of Deposit:
Conceptually, certificates of Deposit (CD) is a document of title to a time deposit. It is distinguished from a conventional time deposit in respect of its free negotiability and hence marketability. CDs were first introduced in USA in the sixties by the Banks to help their depositors tide over problem of illiquidity of bank time deposits prior to maturity. Because of free negotiability CDs are marketable before maturity.
Recognising that CD is intended to widen the range of money market instruments offering investors greater flexibility in the employment of their short term surpluses and following the rationalisation of interest rates on short term deposits.
In June 1989, the RBI issued guidelines for issue of CDs, permitting scheduled commercial banks (excluding regional rural banks) to issue CDs at a discount on face value for a period from- 3 months up to one year. The discount rate could be freely determined.
On maturity, face value of the CDs are paid to the last holder by the issuing banks. CDs are issued in the form of usance promissory notes payable on a fixed date without any grace period. They attract stamp duty.
The minimum size of the issue should be Rs. 1 crore, the minimum amount of subscription is fixed at Rs. 25 lakh (face value) to a single investor in the minimum denomination of Rs. 5 lakh. Being a negotiable instrument, CD can be transferred by endorsement and delivery but only after the expiry of 45 days from the date of issue to the primary investor.
Banks are not permitted to grant loans against CDs nor to buy back before maturity. The issue amount of CDs are included in the issuing banks demand and time liabilities for reckoning of reserve requirements.
Condition # 5. Commercial Paper (CP):
CPs are negotiable money market instrument issued by well-related companies to raise short-term working capital requirements directly from the market instead of borrowing from the banks. CPs are issued as unsecured usance promissory notes on a discount to face value basis. The issuer promises to pay the buyer some fixed amount on some future date but pledges no assets.
The promise to pay is backed by his earning power and liquidity. CPs can be issued directly through banks/merchant banks (called dealers). “CPs differ from other short-term money market instruments such as commercial bills in that they are not tied to a specific transaction and that they are an obligation of the issuer only, whereas commercial bills are obligations of both the drawer and the accepting bank.”
CP is not a new instrument; in the USA it dates back to early nineteenth century. The CP market in USA developed in 1920s. The development of consumer finance companies in the twenties and the high cost of bank credit resulting from the incidence of (non-interest bearing) compulsory reserve requirements in the sixties have contributed to the popularity of this instrument in the US market.
Most of the CP market in Europe are modelled on the lines of the US market. In USA as well as most other countries, the major investors are banks and non-banks financial institutions. Secondary market has not been active, as the paper is nearly always held to maturity.
Commercial paper has come into being in India on January 1, 1990. According to the guidelines issued by the RBI (in the liberalised monetary policy announced on October 11, 1993), highly rated companies with a net worth of at least Rs. 4 crores having (fund-based) working capital limit of Rs. 4 crore and listed on the stock -exchange would be permitted to issue CPs.
Minimum size of CP will be Rs. 25 lakh, though the amount to be invested by any single investor shall be a minimum of Rs. 1 crore (face value). The maturity period of the CPs could 56 range from 91 days to less than one year. Any person, bank, company, other registered incorporated bodies as well as unincorporated bodies can invest in CPs. The outstanding issue of CPs as at the end of September 1993 was over Rs. 2000 crore.