Money Market guide

What is the money market?

Traditionally the money market has been the wholesale arena for financial institutions to either borrow or lend money for periods up to one year. Money markets, which operate in all major global financial centres, have evolved with recent developments in the finance industry and enable a broad range of participants to benefit from the available products. The London money market has been one of the leading players in this sector. London is home to a multitude of financial companies ensuring that an environment of professionalism, efficiency and competition is maintained. This marketplace is now available to businesses and private individuals alike through the utilisation of money market accounts.

What is a money market deposit?

A deposit is a cash placement with a bank for a fixed period from overnight up to one year at a rate of interest determined at the outset of the transaction. Interest is accrued at this rate of interest over the chosen period and paid to the depositor with the original amount on the maturity date of the deposit. 

The ability to deposit cash for a specific period of time offers greater flexibility in the management of both liquidity and interest rate risk. Consequently funds can be invested to match with future cash flow requirements and to 'hedge' against the impact of adverse movements in interest rates. This product is also known as a fixed rate, term or time deposit.

The major difference between a deposit and a standard bank account is the interest rate structure. With a money market account the depositor knows the total return on the investment from the date of the transaction whereas, with a standard bank account, the interest rate will be variable and can change at any time depending on conditions in the money market. 

A change in the level of official interest rates would normally lead to banks adjusting the rates applicable to their variable accounts with immediate effect. The fixed rate on a money market account will remain unchanged until the maturity date of the chosen investment period. Subsequently interest rates applied to any new deposits transacted at maturity will be governed by the rates that are available in the wholesale money market at that time.

What amount of cash is needed to open a deposit account?

It is not necessary to have a substantial amount of cash to be able to transact a money market deposit. Some financial institutions accept a minimum of £10,000 to open an account but this will vary and the depositor should ascertain the terms and conditions of the account prior to proceeding. 

For larger deposits the principal amount does not have to be in set multiples as any amount above the minimum can be accepted. One factor that generally prevails within the money market is that deposits of £1,000,000 or more will attract a slightly better rate of interest than for a smaller amount. 

At maturity of a deposit the original deposit plus accrued interest will be repaid to the investor’s bank account. However, there are other options open to the depositor; these being to reinvest the funds for a further fixed period, either the principal amount only or together with the accrued interest, or to increase the size of the deposit by transferring additional funds to the account. A reduced amount can also be deposited for a further period as long as it does not fall below the minimum amount required. The choice of new investment period is always at the discretion of the client.

What investment periods are available?

The majority of business transacted in the professional wholesale market is for the standard trading periods of 1,2,3,6 or 12 months. However, the flexibility of the market is such that a deposit can be fixed to mature on any value date as long as it is a valid business day. 

Some banks offer this flexibility to their clients, thus allowing the depositor to structure investments that mature on specific dates to match against future cash flow needs. Interest rates for the standard periods are published on a daily basis, with rates for irregular periods being calculated from the money market yield curve that is prevailing at the time. These are provided upon request.

What rate of interest will be applied to the deposit account?

Interest rates in the money market, which fluctuate on a daily basis, are influenced by various factors. The official rate as set by the Central Bank, market expectation of future trends, supply and demand, current volatility and international economic developments. The biggest influence is naturally the official rate, which in the London money market is determined by the Bank of England. Monetary policy is reviewed on a monthly basis and the rate is set to meet the inflation target over the medium term.

Interest rates for deposits in the shorter periods, up to three months, will in normal market conditions be set close to Central Bank rate. Longer term rates up to one year will reflect the other factors as traders endeavour to anticipate moves in the official rate. 

In addition the interest rates quoted by the various financial institutions, who offer these accounts, will also vary for other reasons. There can be many commercial factors influencing the rates that a particular bank might offer at any one time and it is prudent for the depositor to check rates from various sources. The competitive nature of the market should ensure that attractive terms are available.

The depositor has the capacity to adopt a view on interest rate movements to benefit from the fixed returns offered by a money market account.  If the investor thinks that rates are going to rise faster than the market is indicating, a deposit can be fixed for a short period to take advantage of expected higher rates in the future.  Conversely a deposit for a longer period up to 12 months can be transacted if it is anticipated that rates are going to fall.  The choice is the responsibility of the investor and not the bank and it must always be remembered that market forecasts and anticipation are not always fulfilled and that rates can move contrary to expectation.

Daily interest rates are readily available through various channels; direct telephone contact with a bank’s treasury dealers, bank internet websites and financial press and journals being the main ones.

What are the benefits of a money market account?

As funds deposited in a standard variable rate bank account are readily available, the rate will be lower than money market accounts to reflect this accessibility. In some cases current account interest rates can in fact be very low in comparison to those available in the money market.

The main benefit of a money market account is the ability to enhance the interest rate return on a cash investment but the depositor must bear in mind that the funds are fixed for a specific period and cannot be withdrawn until the maturity date. If depositors are sure of current and future cash flow requirements, the potential to achieve a higher yield is offered by a money market deposit. This can be of particular advantage when a fall in interest rates is expected.

In certain cases it is possible to break a fixed deposit before the maturity date but this will lead to penalty charges and administration fees being levied. These charges can be dependent on the difference between the interest rate on the fixed deposit account and those available in the money market at the time the deposit is broken. Other factors may also have to be taken into account and it is advisable that a depositor clarifies with the bank what the procedure is in such circumstances.

Some banks may limit the maximum amount that can be kept in a particular variable rate account but this restriction is not generally applied to money market transactions. A depositor should check the terms and conditions of variable and money market accounts to determine the parameters under which they operate.

What other relevant points are to be considered?

Interest on a money market deposit in excess of £50,000 will be paid gross to the depositor. It is the responsibility of a UK depositor to declare this source of income to the Inland Revenue as taxpayers are liable for income tax on gross interest received.

The interest rate on a money market deposit is fixed for the chosen period and is the true return on the investment. Rates for variable rate accounts show Annual Equivalent Rates to reflect the compounding effect of interest. This assumes that interest is credited to and remains on the account throughout the period. Accordingly an account that pays interest on a monthly basis will give a better annual rate of return than an account with quarterly interest payments if the variable interest rate is the same on each. AER comparisons for fixed deposits are available but are only valid if the deposit is rolled over for matching time periods and interest rates remain unchanged over a twelve months period. A view on the direction of interest rate movements, in accordance with cash flow considerations, is of more importance for the selection of the deposit period.

Money market deposit accounts are not only available in Sterling but can be opened in various currencies. Currency accounts that are widely available are in US dollars and euros although some banks may also offer the facility to transact deposits in other currencies as well. Some institutions specialise in specific foreign currencies, particularly if they are internationally based or have overseas ownership.

What happened in the UK money market in 2007?

The Bank of England manages monetary policy in the UK by changing its official interest rate to meet the inflation target as set by the British government. The rate is known as the repo rate. 2007 opened at 5.00 percent and closed at 5.50 percent with changes during the year as follows:

It proved to be both an interesting and volatile year for interest rates and the money markets in general. 2007 began with the Bank of England tightening monetary policy in response to the expanding economy, a surging housing market and the threat of consumer price inflation. A 25 basis points hike in official interest rates in January set the tone and the yield curve started to reflect the expectation of even higher interest rates as the year progressed. This proved to be the case as rates were pushed up again in May and July to hit a peak of 5.75 percent.

At that time it was forecast that there would be the need for further tightening and, in an effort to get ahead of the curve, traders forced money market rates higher in the anticipation of the Bank of England rate going to 6.00 percent or above.

Late summer brought the Northern Rock fiasco and this, combined with the problems in the US sub-prime mortgage market, caused the money markets to virtually cease trading. The credit crunch was upon us. Rates in the markets became severely distorted due to the lack of liquidity and conditions remained in an abnormal state throughout the remainder of the year. The Bank of England finally succumbed to market pressures and eased the cost of money in early December.

What was the effect on money market deposit rates in 2007?

For the investor the increase in yields over a number of months would have rewarded short term deposits and penalised any long term deposits placed early in the year. However in the latter part of 2007 it would have been prudent to deposit funds for longer periods to take advantage of the peak in the yield curve. 2008 promises to be another challenging year but, with the economic downturn spreading around the globe, it is anticipated that interest rates will be heading lower.

The following graphs illustrate the effect of interest rate movements on 3 and 12 months fixtures over the course of 2007.

Figure 1: Money Market 3 Month versus Bank of England Base Rate

Figure 2: Money Market 12 Month versus Bank of England Base Rate

What other products are available in the marketplace?

Apart from utilising a money market account to transact cash investments, there are alternative markets and treasury services that can offer businesses and private clients the opportunity to manage their financial affairs.

The foreign exchange market, where currencies are bought and sold by financial institutions throughout the world on a virtual non-stop basis, helps to smooth the transaction of international trade in goods and services, cross border investments in bonds and shares and the purchase and sale of foreign companies and property.  Again this marketplace has evolved to encompass large corporate clients, small to medium sized companies and private individuals alike, providing the stage for currency cash flows to be managed and future commitments covered. Banks are able to offer suitable products, such as spot and forward foreign exchange contracts,  to overcome uncertainty and enable clients to switch between currencies to suit their requirements..

More complex matters, such as hedging or protecting borrowing costs and exchange rate exposure through derivative products, can be considered by the more sophisticated client but the inherent risks of such transactions should be fully understood.

A bank’s treasury department will be able to provide a broader explanation of the range of services and products that are available in today’s marketplace.

If you would like to discuss any of the services or information mentioned in this guide please telephone Les James, Treasury Manager, Butterfield Private Bank 08000 321 311.

The information and expressions of opinion this guide contains are not intended to be a comprehensive study and should not be treated as a substitute for specific advice concerning individual situations.

Money Market Deposit Accounts - Glossary of Terms

AER - This stands for Annual Equivalent Rate. It is quoted to show what the compounding effect on the interest rate on a bank account or deposit would be if interest is calculated only once a year.

Capital - The basic amount of money that has been deposited or invested apart from any interest that is to be received.

Compound Interest - The interest amount paid or earned on the original capital plus accumulated interest added to the deposit.

Cross Border Investments -  Investments in the financial sector which involve the movement of currencies across national borders.

Derivative Products - Financial products that are derived from existing products in the cash, foreign exchange and money markets. These include options, futures and swaps.

Exchange Rate - The value of one currency compared to another.

Fixed (Term) Deposit - An amount of money deposited with a financial institution for an agreed period of time at a rate of interest fixed at the start of the transaction.

Foreign Exchange Contract - A transaction between two counter-parties for the exchange of one currency for another at an agreed exchange rate for settlement on an agreed value date. 

Forward Contract - A foreign exchange transaction where the delivery of the specified currencies is agreed for settlement  on a specified date in the future.

Interest Rate Risk - The potential for losses or reduced income arising from adverse movements in interest rates.

Interpolation - The process of determining a rate that lies between a series of known rates.

Monetary Policy - Management by a central bank of a country’s money supply to ensure the availability of credit in quantities and at levels consistent with specific national objectives, such as the rate of inflation.

Rollover - The periodic renewal of a deposit, re-priced at current market interest rates.

Spot Contract - A foreign exchange transaction where the delivery of the specified currencies is agreed for immediate settlement.