3.4 Money Market Instruments

What Makes an Instrument a Money Market Instrument

Money market instruments are short-term debt securities maturing in one year or less. They share four traits the Series 7 tests: very short maturity, high liquidity, low (not zero) risk, and large denominations (often $100,000 and up). Corporations, banks, dealers, and governments use them to park cash and to fund short-term needs. Most are issued at a discount rather than paying a coupon.

Commercial Paper

Commercial paper is an unsecured promissory note issued by large, creditworthy corporations to fund short-term needs such as payroll and inventory. It is sold at a discount and backed only by the issuer's credit, so it carries somewhat more risk than collateralized instruments.

The magic number is 270 days. Commercial paper maturing in 270 days or less is exempt from SEC registration under the Securities Act of 1933, which is why issuers keep maturities at or under that limit; longer paper would trigger registration and lose the speed and cost advantage.

Exam Tip: "Unsecured corporate debt" + "270 days" = commercial paper. It is rated by agencies, and only top-tier (prime) paper is readily marketable.

Bankers' Acceptances (BAs)

A bankers' acceptance is a time draft used chiefly to finance international trade (importing and exporting). An importer's bank "accepts" the draft, stamping its own guarantee onto the obligation, so the instrument carries the credit of the accepting bank rather than the merchant. BAs are sold at a discount and typically mature in 30 to 180 days, and they trade actively in the secondary market.

Exam Tip: Any mention of imports, exports, or international trade points to a bankers' acceptance.

Repurchase Agreements (Repos)

A repurchase agreement (repo) is a collateralized short-term loan. A dealer sells Treasury securities to an investor and simultaneously agrees to repurchase them at a slightly higher price on a set date; the price difference is the interest, called the repo rate. If the dealer defaults, the lender keeps the government collateral, which is why repos are the most liquid and among the safest money market instruments. Maturities run from overnight to several months.

From the investor's side the same trade is a reverse repo (the investor buys securities now and agrees to sell them back). The Federal Reserve uses repos and reverse repos as a primary tool of open-market operations to manage short-term rates.

Negotiable Certificates of Deposit

A negotiable CD (jumbo CD) is a large-denomination time deposit (minimum $100,000, usually $1 million or more) issued by a bank that, unlike a retail CD, can be sold in the secondary market before maturity instead of incurring an early-withdrawal penalty. It pays a fixed rate and matures at face plus interest. FDIC insurance applies only up to $250,000 per depositor per bank, so most of a jumbo CD's balance is uninsured and depends on the issuing bank's credit.

Federal Funds

Federal funds are unsecured overnight loans between banks of reserve balances held at the Federal Reserve, used to meet reserve requirements. The interest rate is the federal funds rate, set by supply and demand in the interbank market within a target range established by the Federal Open Market Committee (FOMC). It is the foundational benchmark from which most other short-term rates take their cue. Do not confuse it with the discount rate, the rate the Fed itself charges banks that borrow directly from it.

Risk and Tax Hierarchy

All money market instruments are low-risk, but there is an order. Safest: T-Bills (full faith and credit) and repos (government collateral). Low risk: bankers' acceptances (bank guarantee) and negotiable CDs (FDIC to limits). Slightly higher: commercial paper and fed funds, both unsecured and dependent on the borrower's credit.

On taxes, the rule is short: only T-Bills among money market instruments are exempt from state and local tax (and taxable federally). Commercial paper, BAs, repos, and negotiable CD interest are taxable at every level.

Exam Tip: If the question asks which money market instrument escapes state and local tax, the answer is the T-Bill, because it is a direct U.S. Treasury obligation.

Money Market Funds vs. Money Market Instruments

Do not confuse the instruments above with a money market mutual fund, which is a pooled vehicle that buys those instruments and seeks to maintain a stable $1.00 net asset value. A retail money market fund is a security registered under the Investment Company Act of 1940; the underlying commercial paper, T-Bills, BAs, and repos are the assets it holds. The fund is not FDIC-insured, unlike a bank deposit, a point examiners like to test against a customer who assumes a money market fund is the same as a bank account.

Why Issuers Use the Discount Structure

Most money market instruments (T-Bills, commercial paper, bankers' acceptances) are issued at a discount rather than paying a coupon because the holding period is so short that a single price-to-par gain is simpler and cheaper to administer than periodic interest. The investor's yield is the annualized difference between the discounted purchase price and par. Negotiable CDs are the main exception: they are interest-bearing, paying a stated rate plus principal at maturity. Recognizing which instruments are discount and which are interest-bearing helps you eliminate wrong answers quickly on yield questions.