U.S. bank failures in the spring of 2023 prompted an exodus from savings and cash accounts at U.S. banks and brokerages. Canada also saw money move out of savings accounts even though their banks are widely viewed as relatively safer. And most of that money found its way into money market investments.
So, let’s explain what the money market is and why money market investments have been long used as a cash alternative.
What is the money market?
The money market is an organized marketplace where participants — mostly governments, banks, and large institutions — borrow and lend short-term, high-quality debt securities with maturities of (mostly) one year or less. The money market enables the efficient sale of short-term securities to fund near-term cash flow needs.
Money market transactions will typically be in one of several types of securities, including short-term Treasuries (T-bills), certificates of deposit (CDs), commercial paper, bankers’ acceptances (BAs), overnight reserves, and repurchase agreements (repos).
Money markets also enable individuals to invest smaller personal amounts, by way of money market funds that invest in these high-quality, short-term instruments.
Money market funds
Money market mutual funds were designed and launched during the 1970s in the U.S. They quickly became popular with investors because they were an easy and low-risk way to earn more than the posted interest rates available from most of the standard interest-bearing bank accounts.
Money market funds hold high-quality, short-term debt securities that allow them to offer higher payout levels versus most deposit accounts. The underlying investments are usually a mix of cash, cash equivalents, and highly-rated debt securities with maturities of typically one year or less.
This enables money market funds to be highly liquid with very low investment risk. But, money market funds are offered by investment companies and not banks, so there is no guarantee of principal.
These days, a money market fund could be a mutual fund or an ETF (exchange traded fund) structure, both of which are widely available in Canada and the U.S., but not covered by deposit insurance through the CDIC or FDIC.
Money market funds work like a typical mutual fund by issuing redeemable units or shares to investors, and they are required to follow the industry rules and guidelines adopted by financial regulators.
Money market accounts
The terms money market deposit account and money market savings account are used interchangeably to describe a type of bank account available in the U.S. These accounts were introduced in the 1980s during a period of intentional deregulation of U.S. bank deposits.
Money market accounts blend certain features of chequing and savings accounts and balances are FDIC insured.
Depositors have ready access to their money compared to savings accounts and money market funds, as these accounts often come with a debit card and/or cheques — features not widely offered on traditional savings accounts.
Money market accounts let people grow their savings more quickly than traditional bank accounts with higher interest rates, but fewer transactions are allowed. So, it’s definitely not the ideal substitute for an everyday bank account.
Money market accounts tend to have higher minimum balance requirements and the rates are often tiered so the highest APY (annual percentage yield) is only available on higher balances. This could prevent those with smaller balances from earning enough interest to make opening these accounts worthwhile.
Just like money market funds, money market accounts generate interest income, but no capital gains.
Money market funds saw huge inflows in Q1 2023; mostly from bank deposits, which plunged while fund assets rose. It’s important to clarify that the level of fund assets rising is not the same as fund prices rising.
Short maturities and high credit quality lead to minimal price volatility for money market instruments. Limited fluctuation in underlying asset prices means money market fund prices also change very little, if at all, and many money market funds actually have stable or fixed pricing.
“Breaking the buck”
The term “breaking the buck” relates to the common practice of setting American money market mutual fund prices or NAVs at $1 and what happens when investors sustain losses on holdings in a money market fund.
Most recently, the Reserve Primary Fund “broke the buck” in 2008 when its NAV fell to 97 cents after Lehman Brothers failed. This was only the second time in U.S. history that a money market fund failed to maintain its set NAV of $1 per unit.
Money market funds are sold as being extremely safe and they generally are, but the Reserve Primary Fund situation during the Global Financial Crisis (GFC) had an adverse effect on investors’ faith in them as a cash alternative.
As a result, the U.S. Securities and Exchange Commission (SEC) announced new rules for money market funds to enhance their stability and resilience, especially in times of crisis. These included greater restrictions on fund holdings and giving fund companies the ability to suspend redemptions.
Money market fund vs bank account
Although they are not quite as safe as cash (given the absence of any guarantee or insurance feature), money market funds are still considered extremely low risk investments.
And the shift away from deposit accounts to money market funds following bank failures is understandable. But it doesn’t suddenly make money market funds safer than bank deposits, so it’s important to understand insurance coverage and the specifics of any money market funds before investing.