Concept
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Depositing money in the bank is a simple financial agreement that stipulates that the money will be returned upon the client’s request to withdraw it and is therefore based on a financial instrument. This creates both an asset for the depositor, and a liability for the bank. As such, depositing money into a bank account can be viewed as both lending and purchasing a simple financial instrument (or the corresponding asset). Of course, borrowing and lending can take place for terms longer than a year, which cause the underlying loans or instruments to be classified as instruments that belong to the bond (or fixed- income) markets. Comparing the long-term loans in the bond markets to the short-term loans in money markets reveals the rationale behind the term ‘money markets’ — as the term of the loan becomes shorter, the asset held by the lender increasingly resembles money or cash (that is, highly liquid capital that can spent immediately by its holder). In the very short-term, such as the overnight lending that takes place with bank deposits, the asset is virtually indistinguishable from cash, as the lender can simply withdraw their money if they wish to spend it.
A similar but slightly more formal money-market instrument is a certificate of deposit, where a deposit of money is formally documented in a contract which is issued to the depositor as a certificate. This certificate explicitly states the deposit agreement (the way in which the borrower will return the borrowed amount to the depositor). To buy a certificate of deposit is to give, (or in effect, lend) one’s money to a counter-party; the counter-party, who are borrowing the money, are said to have sold a particular financial instrument, namely the certificate of deposit. This certificate of deposit is not strictly tied to the money market, as the instruments conditions may also specify that it can be sold on the secondary market; that is, the lender who has bought the certificate might be allowed to sell it to a third party, who would then obtain the right to receive the repayment from the borrower.
It is not surprising that money markets exist — many parties in the economy have money but do not have to spend it in the short term, and many parties do not have money available but nevertheless require it. As described in Module 1, necessity is the crucial prerequisite to financial
markets, regardless of the type of market. Money markets serve the natural, economic requirement of connecting short-term lenders and borrowers, to their mutual benefit.