Short-Term Debt (Money) Markets
Table of Contents
Money market securities are debt securities with a maturity of one year or less. Remembering the definition of money:
Money is anything that (1) is a medium of exchange, and (2) a store of value.
We call them money market securities because they function as money in the economy. Because they have little interest rate risk they are a good store of value.
1. Specific Money Market Securities
1.1. Treasury Bills (T Bills)
T Bills are short-term debt securities issued by the US Treasury. They are the closest thing to a risk-free asset: backed by the full faith and credit of the US government and with maturities of one year or less, they carry essentially no default risk and minimal interest rate risk. You can read about T-Bills at TreasuryDirect here.
1.1.1. Issuance and Maturities
T-Bills are sold at auction by the Treasury. Current regular auction maturities are:
- 4-week (1-month)
- 8-week (2-month)
- 13-week (3-month)
- 17-week (4-month)
- 26-week (6-month)
- 52-week (1-year)
T-Bills are zero-coupon (discount) instruments: they pay no periodic interest. Instead, investors buy them at a price below face value and receive face value ($1,000 minimum, $100 increments) at maturity. The return is the difference between the purchase price and face value.
1.1.2. Pricing: Bank Discount Yield
T-Bills are quoted on a bank discount yield basis, which uses face value (not price) as the denominator and assumes a 360-day year:
Bank Discount Yield (BDY) = [(Face - Price) / Face] × (360 / Days to Maturity)
Example: A 91-day T-Bill with face value $10,000 is priced at $9,875.
BDY = ($10,000 - $9,875) / $10,000 × (360/91)
= 0.0125 × 3.956
= 4.945%
The BDY understates the true return because it uses face value rather than the (lower) price actually invested. A better measure is the bond equivalent yield (BEY), which uses price as the denominator and a 365-day year:
BEY = [(Face - Price) / Price] × (365 / Days to Maturity)
Continuing the example:
BEY = ($125 / $9,875) × (365/91)
= 0.01266 × 4.011
= 5.078%
Because of these adjustments the BEY is always greater than the BDY for the same T-Bill.
1.1.3. T-Bill Rates and Monetary Policy
T-Bill rates track the Federal Funds rate closely and serve as a benchmark for risk-free short-term borrowing costs throughout the economy.
1.2. Federal Funds
The federal funds market is where commercial banks lend reserves to each other overnight. Banks that have excess reserves at the Fed lend to banks that are short of their required (or desired) reserve balances. These are typically unsecured, overnight loans.
The federal funds rate is the interest rate on these overnight interbank loans. It is the primary tool of US monetary policy: the Federal Open Market Committee (FOMC) sets a target range for the fed funds rate and the Fed uses open market operations to keep the rate within that range.
The chart below shows the historical effective federal funds rate:
Because fed funds loans are unsecured and overnight, they carry minimal credit risk. The fed funds rate serves as the floor for most other short-term interest rates—lenders will not accept less than what they could earn lending overnight to another bank.
1.3. Commercial Paper
Commercial paper is short term borrowing (less than 270 days) by corporations. Because these are corporate borrowers there is default risk, however the risk is generally minimal for most Commercial Paper. In fact, the chart below shows the rate on AA Commercial paper versus Federal Funds.
Commercial paper rated lower than AA may have a higher interest rate however. Ratings for commercial paper are summarized here.
When valuing/rating commercial paper we care about short-term solvency measures such as the current or quick ratios.
1.3.1. Why Less Than 270 Days?
Commercial paper with a maturity of 270 days or less is exempt from SEC registration requirements under the Securities Act of 1933. This makes issuance much faster and cheaper. Registration is costly and time-consuming, so issuers keep maturities below this threshold. Most commercial paper has maturities of 1 to 45 days.
1.3.2. Asset-Backed Commercial Paper (ABCP)
A significant portion of the commercial paper market consists of asset-backed commercial paper, where the paper is backed by a pool of assets (mortgages, auto loans, trade receivables) held in a special purpose vehicle (SPV). ABCP played a central role in the 2007–2008 financial crisis when investors lost confidence in the quality of the underlying assets and the ABCP market froze.
1.4. Repurchase Agreements (Repos)
Repos are the most important security that you have never heard of. They are simply collateralized loans, however these loans can be very useful for managing cash and a firm's balance sheet.
A repo (repurchase agreement) works as follows:
- Party A (the borrower/seller) sells a security (usually a Treasury) to Party B and simultaneously agrees to repurchase it at a higher price on a specified future date.
- The difference between the repurchase price and the sale price is the repo rate—the cost of borrowing.
- From Party B's perspective this is a reverse repo: they buy the security and agree to resell it.
Repos are effectively secured (collateralized) overnight or short-term loans. Because the lender holds collateral, the credit risk is very low and repo rates are just above the fed funds rate.
1.4.1. Repo Use by the Fed
The Fed often uses repos to make short-term adjustments to monetary policy. See the Fed's use of reverse repos in the chart below. Note, in a reverse repo you are just taking the other side of a repo—so you are buying an asset with an agreement to resell the asset at a set price. The Fed uses reverse repos to temporarily drain reserves from the banking system (reducing the money supply). In the chart below you can see the dramatic expansion of Fed reverse repos from near zero to over $2 trillion between 2021 and 2024, as the Fed mopped up excess liquidity created during the COVID-19 era.
1.4.2. Repo 105
Repo 105 is an (extreme) example of how banks can use repos to manage their balance sheet. Repo 105 was the name of the repo Lehman used to move poorly-performing assets off their balance sheet prior to taking the balance sheet snapshot. Once the snapshot was taken, Lehman repurchased the bad assets. See more here.
1.5. Negotiable Certificates of Deposit (NCDs)
A certificate of deposit (CD) is a time deposit at a bank—the depositor agrees to leave funds on deposit for a specified term and receives a fixed interest rate. Most retail CDs are non-negotiable (you pay a penalty for early withdrawal).
A negotiable CD is a large-denomination CD (typically $1 million or more) that can be sold in the secondary market before maturity. This secondary market liquidity makes NCDs attractive to corporations and institutional investors managing short-term cash.
Key features:
- Issued at face value and pay face value plus interest at maturity (not discount instruments)
- Maturities from 2 weeks to 1 year
- Subject to FDIC insurance only up to $250,000, so the credit quality of the issuing bank matters
- Rates are slightly above T-Bill rates to compensate for the additional credit risk
NCDs were introduced in 1961 by First National City Bank (now Citibank) and were instrumental in developing the modern money market.
1.6. Banker's Acceptances
A banker's acceptance (BA) is a time draft (a post-dated check) drawn on and accepted (guaranteed) by a bank. They arise primarily in international trade finance.
How a BA works:
- A US importer orders goods from a foreign exporter.
- The importer's bank issues a letter of credit guaranteeing payment.
- The exporter draws a time draft on the importer's bank (e.g., "pay $500,000 in 90 days").
- The bank accepts the draft—stamping it "accepted"—making itself primarily liable for payment.
- The accepted draft (the BA) can then be sold in the money market at a discount.
The bank's guarantee transforms the importer's credit risk into bank credit risk, making BAs marketable. BAs are discount instruments quoted on a bank discount yield basis, similar to T-Bills.
The BA market has shrunk dramatically since the 1980s, largely replaced by other trade finance instruments and letters of credit, but BAs remain an important historical money market instrument and still appear in some international trade contexts.
1.7. Eurodollars
Eurodollars are US dollar-denominated deposits held at banks outside the United States (or at foreign branches of US banks). The "Euro" prefix is historical—the market originated in London and Europe, but Eurodollar deposits exist worldwide.
Key points:
- Eurodollar deposits are not subject to US banking regulations (e.g., reserve requirements), making them slightly more efficient to hold.
- They carry slightly higher credit risk than domestic deposits (less regulatory oversight), so they typically offer higher rates than comparable domestic instruments.
- The Eurodollar market is enormous—trillions of dollars in deposits—and is central to global dollar funding.
1.7.1. LIBOR and SOFR
For decades, the London Interbank Offered Rate (LIBOR)—the rate at which large London banks would lend Eurodollars to each other—served as the benchmark floating rate for hundreds of trillions of dollars in financial contracts (loans, derivatives, mortgages).
Following the 2012 LIBOR manipulation scandal (in which banks were found to have been submitting false rates), regulators mandated a transition away from LIBOR. The US replacement is the Secured Overnight Financing Rate (SOFR), published by the New York Fed. SOFR is based on actual overnight Treasury repo transactions, making it a transaction-based (not survey-based) rate. LIBOR was officially discontinued for most currencies in June 2023.
1.8. Money Market Mutual Funds (MMMFs)
Most individual investors cannot directly access instruments like T-Bills (minimum $100 purchase at auction) or NCDs (minimum $1 million). Money market mutual funds pool small investors' funds to invest in money market instruments, giving retail investors access to money market rates.
Key features:
- MMMFs aim to maintain a stable net asset value (NAV) of $1.00 per share.
- They offer check-writing privileges and same-day liquidity, making them a close substitute for bank deposits.
- Yields track short-term market rates closely (unlike bank savings accounts, which are stickier).
1.8.1. "Breaking the Buck"
Because MMMFs promise a $1.00 NAV, they are perceived as very safe. However, they are not FDIC-insured. If a fund's portfolio loses enough value, the NAV can fall below $1.00—this is called breaking the buck.
The most famous example occurred on September 16, 2008, when the Reserve Primary Fund broke the buck after its holdings of Lehman Brothers commercial paper became worthless following Lehman's bankruptcy. This triggered a run on MMMFs industry-wide, threatening to freeze the commercial paper market. The US Treasury and Federal Reserve intervened with emergency guarantees to stop the panic.
1.8.2. Post-Crisis Reforms
Following the 2008 crisis the SEC implemented major MMMF reforms:
- 2010 reforms: Tightened maturity and liquidity requirements; required stress testing.
- 2016 reforms: Institutional prime MMMFs (those investing in non-government securities) must use a floating NAV rather than the fixed $1.00 NAV; government-only and retail MMMFs may maintain the stable NAV; funds can impose liquidity fees and redemption gates during stress periods.
- 2023 reforms: Eliminated optional redemption gates (which paradoxically encouraged runs as investors rushed to exit before gates were imposed); made liquidity fees mandatory above certain thresholds.