Remaking the Money Market

CAMBRIDGE – Last month, at a US Federal Reserve Bank conference on the money market, officials lamented the market’s enduring fragility. Indeed, six years after a run on the money market nearly brought the United States – indeed, global – financial system to its knees, critical risks that underpinned that crisis still have not been brought under control.

At its core, the money market serves the need of a firm or nonprofit institution to store cash that it can access on a moment’s notice. A university, for example, must set aside a portion of students’ tuition payments to cover unexpected expenses. But the sum is larger than $250,000 – the maximum that the government insures in a single account. Seeking more security for its cash, the university may turn to US Treasury bonds.

The process is simple. The university deposits the money in a bank for a short period – often just one day – with the bank providing a US Treasury bond as collateral. If the bank does not return the cash the next day, the university can sell the bond, keep the cash it is owed, and return any excess to the bank. It is almost as safe as a government-insured bank deposit.

If only universities engaged in such practices, the money market would not have grown large enough to damage the economy so deeply in 2008 and 2009. But large businesses waiting to invest excess cash make the same types of cash deposits with banks – millions of dollars at a time – owing to the same unwillingness to rely solely on a bank’s promise to safeguard anything over $250,000.