Money Market and Capital Market in India – UPSC Economy Notes

The financial landscape is segmented into two primary components based on the duration of funds needed: the money market for short-term requirements (less than one year) and the capital market for longer durations (a year or more). The demarcation is not defined by the amount but by the time frame. The money market caters to immediate financial needs, such as working capital, loan servicing, and short-term consumption.

Money Market:

The money market facilitates the exchange of short-term funds, encompassing maturities from overnight to one year. Transactions in the money market can be either secured, involving collateral, or unsecured, conducted without collateral. Various entities participate in the money market, including banks, financial institutions (e.g., LIC), mutual funds, foreign institutional investors (FIIs), companies, individuals, and the government (RBI). Additionally, an informal market exists outside RBI control, involving small-scale moneylenders and other players.

Money Market Instruments:

1. Call Money:
   • Call money represents short-term loans with maturities typically overnight.
   • Lenders and borrowers in the call money market include banks, financial institutions, and other entities.
2. Bill Market:
   • The bill market encompasses both commercial bills and treasury bills.
   • Commercial bills are short-term credit instruments issued by businesses to meet immediate financial needs.
   • Treasury bills, issued by the government, serve as a short-term borrowing instrument.
3. Certificates of Deposit (CD):
   • Certificates of Deposit are negotiable money market instruments issued by banks with a specific maturity date.
   • They offer a higher interest rate than regular savings accounts.
4. Commercial Paper (CP):
   • Commercial Paper is an unsecured, short-term debt instrument issued by corporations to raise funds.
   • It provides companies with a cost-effective means of financing short-term obligations.

Capital Market:

In contrast to the money market, the capital market addresses long-term financing needs, extending beyond one year. It serves as a platform for raising funds for capital-intensive projects, business expansions, and investment in securities.

Key Differentiation:

• Duration: Money market deals with short-term financial instruments (less than one year), while the capital market focuses on long-term instruments (one year or more).
• Participants: Both markets involve various participants, including financial institutions, corporations, and government bodies.

Conclusion: Understanding the dynamics and instruments of the money market and capital market is crucial for participants in the financial ecosystem. These markets play distinct yet complementary roles in meeting the diverse funding requirements of entities, contributing to the overall functioning and liquidity of the financial system.

Call Money

Call or Notice money refers to funds borrowed or lent for a very short duration. The distinction between “Call money” and “Notice money” lies in the time frame: if the period extends from one day up to 14 days, it is termed “Notice money”; otherwise, it is referred to as “Call money.” These transactions do not necessitate collateral security, with promissory notes being sufficient.

Key Features:

1. Duration:
   • Call Money: Borrowed or lent for a period of one day.
   • Notice Money: Involves a period exceeding one day but up to 14 days.
2. Collateral Requirement:
   • No collateral security is mandated for these transactions.
   • Promissory notes serve as the legal instrument.
3. Participants:
   • Commercial banks, including both Indian and foreign banks.
   • Co-operative banks.
   • Financial entities such as the Discount and Finance House of India Ltd. (DFHI) and Securities Trading Corporation of India (STCI).
   • Life Insurance Corporation of India (LIC), Unit Trust of India (UTI), and National Bank for Agriculture and Rural Development (NABARD) can only participate as lenders.
4. Purpose:
   • The call money market allows banks and financial institutions to manage their day-to-day fluctuations in money surpluses and deficits.
5. Interest Rates:
   • Interest rates in the call and notice money market are determined by market forces.
   • Market-driven interest rates reflect the supply and demand dynamics in the short-term funding market.

Conclusion: Call money serves as a vital component in the financial system, providing flexibility for institutions to address short-term mismatches in liquidity. The absence of collateral requirements streamlines the lending and borrowing process, making it a convenient avenue for managing immediate funding needs in the financial landscape.

Bill Market: Treasury Bills

Introduction: The bill market encompasses various instruments, including Treasury Bills (T-Bills), which are a category of government securities. Government securities comprise bonds issued for a year or more by the Government of India and state governments, along with T-Bills issued by the Government of India for periods up to 364 days. The Reserve Bank of India (RBI) acts as the agent of the government, managing and servicing these securities through its public debt offices.

T-Bills as Money Market Instruments: Treasury bills serve as short-term investment instruments with maturities typically up to one year. They play a crucial role in managing short-term liquidity. The Government of India issues three types of T-Bills through auctions, with durations of 91 days, 182 days, and 364 days. Unlike bonds, T-Bills are zero-coupon securities, meaning they do not pay regular interest.

Key Features:

1. Types of T-Bills:
   • 91-day T-Bills
   • 182-day T-Bills
   • 364-day T-Bills
2. Minimum Investment:
   • T-Bills are available for a minimum amount of ₹25,000 and in multiples of ₹25,000.
3. Issuance and Redemption:
   • T-Bills are issued at a discount and redeemed at par.
   • The difference between the maturity value (face value) and the issue price constitutes the return to investors.
4. Zero-Coupon Securities:
   • T-Bills do not pay periodic interest but are issued at a discount, and the return is realized at maturity.
5. Market Stabilization Scheme (MSS):
   • T-Bills can be issued under the Market Stabilization Scheme, contributing to liquidity management.
6. Investors:
   • Typical investors in T-Bills include banks, insurance companies, financial institutions, etc.
7. Auctions:
   • T-Bill auctions are conducted on the Negotiated Dealing System (NDS), where members electronically submit their bids.

Conclusion: Treasury Bills, as part of the bill market, provide short-term investment avenues for investors while aiding the government in managing its short-term funding requirements. The discount-based issuance and par redemption structure make T-Bills distinctive in the realm of money market instruments. The electronic auction system enhances efficiency and transparency in T-Bill transactions.

Cash Management Bills (CMBs):

Introduction: Cash Management Bills (CMBs) share similarities with Treasury Bills (T-Bills) but are distinguished by their shorter maturities, specifically less than 91 days. These bills serve as short-term debt instruments issued by the government to meet its immediate cash flow needs. Similar to T-Bills, CMBs are issued at a discount and redeemed at face value (par) upon maturity.

Key Characteristics:

1. Short-Term Maturity:
   • CMBs have maturities of less than 91 days, making them suitable for addressing short-term cash management requirements of the government.
2. Discount Issuance:
   • Similar to T-Bills, CMBs are issued at a discount, allowing the government to raise funds at a lower upfront cost.
3. Redemption at Face Value:
   • At maturity, CMBs are redeemed at their face value, ensuring that investors receive the full nominal value of the instrument.
4. Immediate Cash Flow Needs:
   • CMBs are strategically employed by the government to address immediate cash flow needs, offering a flexible instrument for short-term funding.
5. Government Debt Instrument:
   • CMBs represent a form of government debt and contribute to the spectrum of money market instruments.
6. Complement to T-Bills:
   • While T-Bills cover a broader range of maturities (up to 364 days), CMBs cater to the very short-term funding requirements, providing a complementary tool in the government’s cash management toolbox.

Conclusion: Cash Management Bills (CMBs) emerge as a specialized category within the realm of government debt instruments. Their distinctive feature lies in the ultra-short maturities, allowing the government to swiftly address immediate cash flow needs. The discount issuance mechanism aligns with the broader principles of money market instruments, providing an efficient means of short-term funding for the government.

Interbank Call Money Market:

Overview: The Interbank Call Money Market serves as a crucial component of the money market where major financial institutions engage in short-term borrowing and lending activities among themselves. In this market, transactions occur at interbank rates, representing the interest rates at which banks lend or borrow funds from each other.

Key Features:

1. Short-Term Nature:
   • The loans in the interbank call money market are extremely short-term, often having a duration of no more than a week. This reflects the immediate and temporary nature of the funds borrowed or lent in this market.
2. Reserve Requirements:
   • Financial institutions, including banks, utilize the interbank call money market to manage their short-term liquidity needs and meet reserve requirements. This market plays a vital role in helping institutions maintain the necessary reserves.
3. Participants:
   • While the term “interbank” suggests transactions primarily between banks, the market is not exclusive to banks alone. Various financial entities participate, including other financial institutions, mutual funds, large corporations, and insurance companies. This diverse participation enhances the market’s liquidity and functionality.
4. Interest Rates:
   • Interbank rates, which determine the cost of borrowing or the return on lending, are influenced by factors such as prevailing market conditions, central bank policies, and the overall demand and supply dynamics in the financial system.
5. Liquidity Management:
   • Institutions engage in call money market transactions as a means of effectively managing their liquidity on a short-term basis. The flexibility and immediacy of these transactions make them instrumental in responding to sudden changes in liquidity needs.

Conclusion: The Interbank Call Money Market plays a pivotal role in the broader money market ecosystem, providing a platform for major financial institutions to engage in short-term lending and borrowing. Its significance lies in facilitating liquidity management, assisting institutions in meeting reserve requirements, and serving as a dynamic arena for short-term financial transactions among diverse participants.

Certificates of Deposit (CD):

Overview: Certificates of Deposit (CDs) are financial instruments issued by scheduled commercial banks and financial institutions (FIs) to raise short-term funds. These instruments represent a secured and negotiable promissory note, providing investors with a means to earn returns over a specified period.

Key Features:

1. Issuers:
   • CDs are issued by scheduled commercial banks and financial institutions. Regional Rural Banks (RRBs) and Local Area Banks do not have the authority to issue CDs.
2. Secured Promissory Note:
   • A CD is a secured negotiable promissory note, implying that it is a written promise to pay a specified sum of money to the holder at a future date.
3. Discounted Issuance:
   • CDs are typically issued at a discount to their face value. The discount rate is determined through negotiations between the issuer and the investor.
4. Maturity Period:
   • The maturity period for CDs issued by banks should not be less than 15 days and should not exceed one year. Financial institutions, on the other hand, can issue CDs with a maturity period of not less than 1 year and not more than 3 years.
5. Minimum Deposit:
   • The minimum deposit required from a single subscriber should be at least ₹1 lakh, and subsequent deposits should be in multiples of ₹1 lakh.
6. Eligible Subscribers:
   • CDs can be issued to a range of entities, including individuals, corporations, companies (including banks and primary dealers), trusts, funds, associations, etc.

Inter Corporate Deposits (ICD) Market:

Apart from CDs, there is an additional avenue known as the Inter Corporate Deposits (ICD) market, which allows corporations to engage in unsecured lending. In the ICD market, one corporate entity extends an unsecured loan to another, providing an alternative financing option, particularly for entities with lower credit ratings.

Conclusion: Certificates of Deposit serve as a valuable instrument for banks and financial institutions to mobilize short-term funds from a diverse set of investors. The discounted issuance, negotiability, and defined maturity periods make CDs an attractive option for both issuers and investors in the money market. Additionally, the Inter Corporate Deposits market provides corporations with a platform for unsecured inter-corporate lending, contributing to the overall dynamism of the financial landscape.

Commercial Paper (CP):

Overview: Commercial Paper (CP) is a short-term financial instrument that serves as an unsecured promissory note. It is typically issued by well-established and top-rated corporations, Primary Dealers (PDs), Satellite Dealers (SDs), and all-India Financial Institutions (FIs) to raise funds for short durations.

Key Features:

1. Issuers:
   • CPs are issued by top-rated corporates, Primary Dealers (PDs), Satellite Dealers (SDs), and all-India Financial Institutions (FIs).
2. Maturity Period:
   • CPs can be issued for maturities ranging from a minimum of 7 days to a maximum of up to one year from the date of issue. However, the maturity date cannot extend beyond the validity period of the issuer’s credit rating.
3. Denominations:
   • CPs can be issued in denominations of ₹5 lakh or multiples thereof.
4. Eligibility Criteria for Issuers:
   • Corporates intending to issue CPs must have a tangible net worth of not less than ₹4 crore.
5. Credit Rating Requirement:
   • All CP issuers are required to obtain a credit rating from a recognized credit rating agency. This rating provides investors with an assessment of the creditworthiness and risk associated with the CP.
6. Minimum Investment:
   • The minimum amount that can be invested by a single investor in CP is ₹5 lakh, and subsequent investments must be in multiples thereof.
7. Discounted Issuance:
   • CPs are issued at a discount to their face value, and the return to investors is derived from the difference between the discounted issuance price and the face value at maturity.

Conclusion: Commercial Paper (CP) serves as a valuable instrument for well-established entities and financial institutions to meet their short-term funding requirements. The discounted issuance, credit rating, and defined maturity periods make CPs an attractive option for both issuers and investors in the money market. The reliance on credit ratings enhances transparency and assists investors in making informed investment decisions based on the perceived credit risk of the issuer.

Ready Forward Contracts (Repos):

Overview: A Ready Forward Contract, commonly known as a Repo (Repurchase Agreement), is a financial instrument that involves a simultaneous agreement for the sale and future repurchase of securities. Repos are widely used in the money market for short-term borrowing and lending transactions, providing flexibility to financial institutions in managing their liquidity needs.

Key Features:

1. Simultaneous Sale and Repurchase Agreement:
   • In a Repo transaction, one party agrees to sell securities to another party with a simultaneous commitment to repurchase the same securities at a future date. This arrangement provides a short-term borrowing mechanism.
2. Lender and Borrower:
   • The party selling the securities is the borrower, and the one buying the securities is the lender. The borrower essentially borrows funds against the collateral of securities.
3. Rate of Interest:
   • The interest rate at which the lender (usually the central bank or other financial institutions) lends money to the borrower in a Repo transaction is called the Repo rate. The Repo rate is often based on government securities.
4. Government Securities as Collateral:
   • Repos are typically backed by high-quality collateral, often in the form of government securities. The lender receives the securities as collateral during the term of the agreement.
5. Short-Term Nature:
   • Repos are short-term financial instruments with maturities ranging from overnight to a few days, weeks, or months. They are commonly used for managing short-term funding needs.
6. Interest Rate Dynamics:
   • The difference between the sale price and the repurchase price in a Repo transaction effectively represents the interest earned by the lender. The interest cost for the borrower is determined by the Repo rate.
7. Liquidity Management:
   • Repos play a crucial role in the liquidity management of financial institutions, allowing them to access short-term funds or deploy excess funds for short-term returns.

Conclusion: Ready Forward Contracts, or Repos, are essential instruments in the money market, facilitating short-term borrowing and lending activities among financial institutions. The use of government securities as collateral enhances the security of these transactions. The Repo rate, which influences the cost of funds for borrowers, is a key monetary policy tool often set by central banks to manage overall economic liquidity.

Commercial Bills:

Overview: Commercial Bills, also known as trade bills or commercial paper, are negotiable instruments that arise from transactions involving the sale of goods or services. These bills of exchange are drawn by the seller (drawer) on the buyer (drawee), representing a commitment to pay a specified amount at a future date.

Key Features:

1. Nature of Commercial Bills:
   • Commercial bills originate from trade transactions, where the seller extends credit to the buyer. The buyer acknowledges the debt through a written instrument, creating a negotiable commercial bill.
2. Discounting of Bills:
   • When a seller needs immediate funds and holds a commercial bill with a future payment date, they can approach a commercial bank or another discounting institution to discount the bill. Discounting involves selling the bill at a value less than its face value to receive immediate cash.
3. Acceptance by Commercial Banks:
   • Commercial bills become “commercial” when they are accepted by commercial banks for discounting. The bank may charge a commission or discount fee for providing liquidity to the billholder.
4. Role of Discount and Finance House of India (DFHI):
   • The Discount and Finance House of India (DFHI), established by the Reserve Bank of India (RBI), plays a crucial role in the bill market. DFHI engages in re-discounting short-term commercial bills, fostering liquidity in the money market.
5. Objective of DFHI:
   • DFHI aims to develop a secondary market for existing money market instruments, ensuring the smooth functioning of the short-term liquidity landscape. It participates in various money market segments, including Treasury Bills, commercial paper, certificate of deposits, and government-dated securities.
6. Integration of Money Market Segments:
   • DFHI’s activities contribute to the integration of different segments of the money market, promoting efficiency and liquidity.
7. Dealing in Various Instruments:
   • In addition to commercial bills, DFHI engages in dealing with Treasury Bills, participating in interbank call money, notice money, term deposits, commercial paper, certificate of deposits, and government-dated securities.

Conclusion: Commercial Bills play a vital role in facilitating trade transactions and providing short-term financing solutions. The involvement of commercial banks and institutions like DFHI enhances liquidity and efficiency in the money market. The discounting process allows businesses to convert future receivables into immediate cash, supporting their working capital needs.

Government Dated Securities (Long-Term Securities):

• Government Dated Securities encompass bonds issued by the Government of India and state governments. These bonds typically have a maturity period of a year or more. They form a crucial part of the government’s borrowing program to fund various developmental activities and meet financial requirements.

London Interbank Offered Rate (LIBOR):

• LIBOR is the average interest rate estimated by leading London banks for interbank borrowing. It has historically served as a benchmark for short-term interest rates globally. However, due to a rigging scandal in 2012 that led to fines and impacted its credibility, the UK Financial Conduct Authority announced the discontinuation of LIBOR by the end of 2021. Financial institutions, mortgage lenders, and credit card agencies have used LIBOR as a reference for setting their interest rates.

Mumbai Interbank Offered Rate (MIBOR):

• The NSE Mumbai Interbank Bid Rate (MIBID) and NSE Mumbai Interbank Offered Rate (MIBOR) were developed by the National Stock Exchange (NSE) for the overnight money market in 1998. MIBOR serves as a benchmark rate for a majority of deals in the Indian financial market, providing an indication of the cost of borrowing in the interbank market.

FAQs

1. What is the Money Market in India?

The money market in India refers to a segment of the financial market where short-term borrowing and lending of funds take place. It comprises various instruments such as treasury bills, commercial papers, certificates of deposit, and call money market transactions. The primary participants in the money market include commercial banks, financial institutions, corporations, and the Reserve Bank of India (RBI).

2. What are the key features of the Money Market in India?

Key features of the money market in India include:

• Short-term nature: Instruments traded in the money market have a maturity period of up to one year.
• High liquidity: Money market instruments are highly liquid, allowing participants to easily buy or sell them at low transaction costs.
• Low risk: Money market instruments are considered low-risk investments due to their short maturity and high credit quality issuers.
• Central bank regulation: The Reserve Bank of India (RBI) regulates the money market to maintain stability and control liquidity in the financial system.
• Diverse instruments: The Indian money market offers a range of instruments catering to the varying needs of investors and borrowers.

3. What is the Capital Market in India?

The capital market in India is a segment of the financial market where long-term securities such as stocks, bonds, and debentures are traded. It provides a platform for companies and governments to raise funds for capital investment and expansion projects. The capital market is divided into two categories: primary market, where new securities are issued, and secondary market, where existing securities are bought and sold among investors.

4. What are the key components of the Capital Market in India?

Key components of the capital market in India include:

• Stock exchanges: Platforms where equities and other securities are traded among investors.
• Securities and Exchange Board of India (SEBI): The regulatory authority overseeing the capital market to ensure transparency, fairness, and investor protection.
• Primary market: Where companies issue new securities through initial public offerings (IPOs) and rights issues to raise capital.
• Secondary market: Where existing securities are traded among investors, facilitating liquidity and price discovery.
• Investment institutions: Entities such as mutual funds, insurance companies, and pension funds that invest in securities on behalf of their clients.

5. How does the Capital Market contribute to India’s economic growth?

The capital market plays a crucial role in India’s economic growth by facilitating:

• Capital formation: Companies raise funds from the capital market to finance long-term investment projects, fostering economic development and industrial expansion.
• Wealth creation: Investors participate in the capital market to invest their savings in stocks and bonds, generating returns and wealth accumulation over time.
• Corporate governance: The capital market promotes transparency, accountability, and good governance practices among listed companies to attract investors and enhance market integrity.
• Economic stability: Efficient capital markets contribute to financial stability by allocating capital to productive investments, reducing systemic risks, and supporting sustainable economic growth.

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