The money market is a short-term debt market. The purpose of the money market is closely related to the purpose of money itself. The money market provides liquidity and a store of value for funds. Most investors use the money market to keep funds readily available for spending and to keep funds safe from risk. Short-term is debt instruments with maturity of one year or less. Some money market instruments have maturities of weeks or months. Some are overnight.

Money market mutual funds (MMMFs or MMFs) invest in money market instruments. Money market funds offer cash-like shares that are redeemable on demand. This is an interesting intersection of equity and money because the investors buy shares in the mutual fund but the shares function like cash. Prime money market funds invest in relatively illiquid securities, such as commercial paper (CP) and negotiable certicates of deposit (CDs).

The central bank’s overnight interest rate is the core of a sovereign currency’s money market. The federal funds rate is the benchmark interest rate in the money market for the U.S. dollar. The Federal Reserve sets the federal funds rate as an instrument on monetary policy. Other U.S. money market interest rates adjust accordingly.

Treasury bills are the government debt component of the money market. Common maturities are 1 month, 2 month, 3 month, 6 month, and 1 year.

There are a number of other interest rates that characterize the money market.

LIBOR is the London Inter-Bank Offer Rate. Historically, LIBOR was a global reference rate for short-term floating interest rates. This has changed due to a LIBOR scandal involving rate-setting by British banks. LIBOR is being replaced by the Secured Overnight Financing Rate (SOFR).

Commercial paper is the main money-market instrument for corporations. It is the alternative to a bank line of credit for large corporations. There is financial and non-financial commercial paper and it comes in different credit ratings (e.g., A1/P1). Asset-backed commercial paper (ABCP) is a form of secured commercial paper.

Large Certificates of Deposit (CDs) are tradable in the money market.

One key distinction in the money market is whether the instrument is secured or unsecured. Secured means that a security is backed by collateral. If the borrower defaults, the lender retains the collateral to mitigate the losses. Federal funds are unsecured, meaning there is no collateral. The primary example of a secured money market instrument is the repo. Repo is the informal name for a repurchase agreement. A repo is a short-term financial transaction backed by a financial security as collateral. A reverse repo is the opposite side of a repo transaction

Money market instruments are typically sold at a discount to par. This means that investors buy the security for a price less than the par value. Because money market instruments are short-term, it would be inefficient to have interest payments. The difference between the purchase price and par value functions as interest. This is “discount yield.”

Money markets can come under significant strain during a financial crisis. In normal times, money markets operate smoothly and efficiently in the background of the financial system. They are designed to be relatively insensitive to the credit risk associated with typical business cycle fluctuations. However, a financial crisis is often a form of liquidity crisis, because financial institutions begin hoarding liquidity. The high levels of uncertainty cause institutions to hold cash against potential short-term cash flow problems. This means that institutions are unwilling to lend short-term funds and money market rates can rise sharply.

The failure of Lehman Brothers in September 2008 prompted a crisis in the money market. The Reserve Primary Fund was forced to “break the buck.” Prime money market funds invest in relatively illiquid securities, which means that they provide a form of liquidity transformation. This liquidity transformation makes them susceptible to runs, just like a bank that takes liquid deposits and invests in illiquid loans.

Signs of distress in money markets often necessitate the creation of a “liquidity backstop” by central banks. In the financial crisis of 2008-2009, the Federal Reserve created several liquidity facilities to support money markets. A number of these facilities were used again in 2020 in response to the COVID pandemic. Under section 13(3) of the CARES Act and together with the Treasury Department, the Federal Reserve set up the Commercial Paper Funding Facility, or CPFF, and the Money Market Mutual Fund Liquidity Facility, or MMLF. Both of these facilities have equity provided by the Treasury Department to protect the Federal Reserve from losses. In testimony before Congress in May 2020, Federal Reserve Chairman Jerome Powell stated that “Indicators of market functioning in commercial paper and other short-term funding markets improved substantially and rapid outflows from prime and tax-exempt money market funds stopped after the announcement and implementation of these facilities.”