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Sub-sectors of the non-bank financial system
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with a money market fund that invests within money market instruments issued by a wide range
of counterparties. Switching from the former to the latter pattern of holdings transforms
concentrated counterparty exposures (to a handful of banks) into diversified exposures (across the
aforementioned banks and a wide range of issuers of money market instruments).
MMFs are compensated for carrying out money market investment activities on behalf of
investors because investors face resource constraints in carrying out these tasks unilaterally,
including assessing credit risks (to distinguish relatively strong from relatively weak banks) and
operational issues (for example, matching the term of fixed deposits with cash flow needs, and
rolling those deposits).
Investors in MMFs therefore, to some degree, outsource the risk management function, which is
beneficial insofar as investors would otherwise be investing at suboptimal levels in money market
instruments (due to their resource constraints), to their detriment and to the detriment of issuers
of money market instruments.
Investors in MMFs can broadly be split into two types, retail (or individual) investors and
institutional investors, such as bank trust departments, corporations and hedge funds. Due to
state guarantees of retail deposits, retail investors face lower counterparty risk exposures through
bank deposits than institutional investors, whose bank deposits are either uninsured or
incompletely insured by state guarantees. For this reason, institutional investors and businesses
rely on money market funds to a greater extent than retail investors.
MMFs also play an important role in facilitating demand for money market instruments because
investors would invest at sub-optimal levels in their absence, as abovementioned. MMFs therefore
facilitate liquidity provision to issuers of commercial paper and counterparties to repurchase
agreements.
MMFs, through investments in commercial paper, play an important role in the economy. By
providing short-term funding to commercial and municipal borrowers, MMFs enable an important
alternative channel for credit to borrowing from banks thereby lowering the cost of capital
(Macey, 2011).
MMFs also play an important role in the economy through the market for repos. From the
perspective of the MMF, a repurchase agreement involves the purchase of securities from and
resale of the same securities to a counterparty at a fixed price in exchange for an interest payment
for the use of funds in the period in between asset purchase and resale. In effect, a repo is a short-
term interest-bearing secured loan (Macey 2011), which is valuable to counterparties to repo
transactions as a source of liquidity.
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