Money Market Manual

I. INTRODUCTION

Definition

The money market is a wholesale market for low risk, highly liquid, short-term [*] debt instruments. It serves as an avenue through which banks and financial institutions can offload their excess liquidity or meet their short-term funding requirements. To the government an organized money market represents a means for it to implement it's monetary policies in a more efficient manner. Moreover, it provides it with a liquid market for securities through which it can finance it's own borrowing requirements.

Trading in the money market only began in Pakistan in February 1991 with the switchover of the Government from on-tap to auction system. As per the previous system interest rates on T-Bills were fixed at 6% and anyone could buy as many of the securities as one liked through this on-tap system.

This market can be classified into:

A. i. Primary market

i. ii. Secondary Market

Primary Market:

The primary market constitutes the government of Pakistan selling it's securities through the State Bank of Pakistan. This is done through T-Bill auctions held every alternate Wednesday. Through these auctions the government invites bids for its Market Treasury Bills in fixed tenors of 3, 6 and 12 months. Presently all financial institutions are allowed to participate in these auctions either with their own funds or on behalf of a customer, which is usually a corporation. A pre-auction target is announced a day or so in advance to indicate the amount that the SBP intends to pick up. The amount that is eventually picked up depends on both the actual requirement of the government as well as the bidding pattern. The bid at which an institution enters the auction is denoted by the price at which it proposes to purchase a specific amount of T-Bills. The higher the bid the lower the cost of funds to the Ministry of Finance and therefore the greater the chance of the bid being accepted. An institution can submit more than one bid in the same tenor for different prices and amounts.

Secondary Market:

The securities issued in the primary market are then traded in the secondary market, which basically constitutes the various financial institutions trading among themselves through brokers. The two markets are inextricable linked in the sense that the rates at which bids are accepted in the auction have a direct bearing on the rates prevailing in the secondary market. These auction cut-offs also reflect the State Bank's current monetary policy and players in the secondary market develop an interest rate outlook based on their interpretation of the trends found in these rates. Besides this the market rates are also dependant on a number of market fundamentals such as inflation expectations, the foreign exchange situation, budget deficit, the liquidity situation in interbank etc.

Purpose of Money Market

The need for financial institutions to indulge in money market transactions arises primarily from the reserve requirements imposed by the State Bank. All commercial banks are required to maintain 15% of their Demand and Time Liabilities (DTL) [†] in FIBs, T-Bills, KESC Bonds and other specially approved government securities. NBFIs on the other hand have to maintain 14% of their DTL in government-approved securities, which constitute TFCs, NIT Units and WAPDA Bonds, in addition to the securities approved for commercial banks. Commercial banks and NBFIs also have to maintain a certain portion of their DTL in a cash reserve maintained with the SBP at 0% interest. This ratio is known as the CRR (Cash Reserve Requirement) and stands at 5% for commercial banks and 1% for NBFIs.

MAJOR PLAYERS

The State Bank of Pakistan, commercial banks, non-bank financial institutions, corporations and brokers constitute the players in the money market. At present there are 38 commercial banks operating in Pakistan, comprising of 19 foreign banks and 15 local banks. Besides these there are also four nationalized scheduled banks namely National Bank of Pakistan, Habib Bank Ltd., United Bank Ltd and First Women Bank Ltd. It is important to mention at this point that the money market is significantly affected by the decisions of five large banks namely NBP, HBL, MCB, ABL and UBL due to their large deposit base.

II. MONEY MARKET INSTRUMENTS

T-Bills: T-Bills are short term securities issued by the State Bank on behalf of the Ministry of Finance through auctions or OMOs (Open Market Operations). They are zero-coupon bonds issued at a discount, have a par value of Rs 100 and a maturity of three, six or twelve months. Bank borrowing is one of the various measures the government takes to fill it's budgetary deficit and this bank borrowing currently takes place against T-Bills. 30% of the interest earned on T-Bills is retained by SBP as advance income tax.

Price of a T-Bill: Assume a 6 month T-Bill with a par value of Rs. 100 and a yield of 7.23% is to be sold in an auction. It's price would be calculated in the following manner:

= 100

(1+T-Bill yield)tenor

=