Short term markets play a major role behind overall financial stability in the financial system. That’s because they provide short term funding as well as liquidity for the financial institutions. Even large-scale corporations and governments rely on this liquidity.
However, you need to understand that excessive reliance on short term markets can have negative effects as well. This becomes significant during durations of financial stress.
Read on and let’s explore more on it.
What are Short Term Markets?
Short term markets refer to markets that provide funding or meet short term liquidity needs ranging from overnight to up to one year.
Key short-term markets include:
- Commercial Paper Market – Companies issue commercial paper, which are short term unsecured promissory notes, to raise capital for working capital and operational needs. Maturities range from overnight to 270 days.
- Repo Market – A repurchase agreement (repo) is a short-term collateralized borrowing where one party sells securities to another and agrees to repurchase them at a slightly higher price. Most repo loans range from overnight to two weeks.
- Money Markets – Money markets are markets for short term lending and borrowing of funds, ranging from overnight to one year. This includes certificates of deposits, Treasury bills, commercial paper, and short-term municipal notes.
Role in Providing Liquidity
A key role of short-term markets is to allow financial institutions, companies, and governments meet short term liquidity needs. For example, financial institutions rely on short term money markets to fund their day-to-day operations and manage liquidity. Companies raise working capital through issuing commercial paper. Repo markets allow institutions to borrow against collateral like Treasuries. By serving as a source of ready, short-term liquidity, short term markets ensure the overall smooth functioning of the financial system.
Serving as Benchmark for Risk-Free Rates
In addition to providing liquidity, short term rates like Libor, SOFR, the Federal Funds rate also serve as key benchmark rates for the pricing of loans, bonds, derivatives and other financial instruments.
As risk-free rates, they serve as the foundation for pricing risk across financial markets. Disruptions in short term markets during the 2008 Financial Crisis led to interest in developing alternative risk-free rates like SOFR.
Transmission of Monetary Policy
As key money markets, short term lending rates also serve as an important transmission channel for central bank monetary policy. For instance, the Federal Reserve influences short term interest rates through adjusting bank reserve requirements, setting interest rates on excess reserves, and controls the Fed Funds rate through open market operations.
Lower short-term rates allow easier access to credit and liquidity for the economy. Higher short-term rates restrict liquidity and credit. Thus, short term markets serve as means for central banks to transmit monetary policy stance to the broader economy.
Procyclicality and Financial Stability Risks
However, short term markets lending though beneficial for liquidity during normal economic environments, also introduces procyclicality and financial stability risks during periods of stress. In times of uncertainty, lenders in short term markets can rapidly withdraw funding or refuse to roll over loans to borrowers.
For example, during 2008, risk aversion and uncertainty led to run on money markets and a seizing up of the commercial paper market. Such massive flight of liquidity and credit exacerbated the financial crisis.
Regulatory reforms after 2008 have focused on reducing reliance on short term wholesale funding to improve system resilience. This includes introduction of liquidity coverage ratios, net stable funding ratios, and closer monitoring of risks from asset managers and hedge funds in short term lending. Striking the right balance between reaping the liquidity benefits of short-term markets while limiting their risks remains an ongoing regulatory priority for maintaining financial stability.
The COVID Crisis and Short Term Markets
The critical role of short term markets in financial stability was again highlighted during the extreme volatility unleashed by the COVID-19 crisis during March-April 2020.
As the pandemic rapidly escalated, investors scrambled to dump risky assets and raised cash holdings, fueling massive demand for US dollars globally. Short term funding markets were in the eye of the storm. Money market funds facing redemptions had to sell assets, including commercial paper, in fire sales to raise liquidity. Corporate borrowers unable to rollover commercial paper amidst cratering demand added to pressures.
The repo market was also severely strained. To raise much needed dollars, foreign central banks heavily borrowed in the US repo market using Treasuries as collateral. This however drained collateral in the repo market, seen in the drastic climb in Treasury repo rates. Adding to funding stresses was rapid withdrawal of cash by hedge funds from prime brokers financed in short term repos.
The seizing up triggered the Federal Reserve to launch a raft of liquidity measures – cutting interest rates to zero, unlimited asset purchases, standing repo facilities to broker-dealers, purchase of commercial paper, municipal debt and corporate bonds. The Fed Swap lines with global central banks also provided dollar liquidity. This strong policy response calmed short term funding markets and fulfilled the Fed’s critical lender of last resort function to prevent deeper financial instability.
The crisis underscored the risks of high leverage, credit risk transmission and opacity that can lurk unseen during normal times but get rapidly amplified in short term markets during periods of stress with damaging spillovers. This calls for ongoing policy efforts to reduce fragility, alongside reforms that improve resilience of core short term funding markets.
Final Words
As you can see, short term funding markets fulfill the vital role of greasing the wheels of the financial system, allowing smooth transfer of liquidity between borrowers and lenders, facilitating commerce and economic activity. However, short term lending involves inherent risks arising from investor confidence and perceptions of counterparty creditworthiness. Managing these risks by reducing excessive dependence on short term volatile funding, while retaining its benefits remains crucial for policymakers seeking to uphold financial stability.
