Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. It was introduced in India in 1990 with a view to enabling highly rated corporate borrowers/ to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations.
What is Commercial Paper?
Commercial Paper (CP) is a short-term, unsecured debt instrument issued by corporations, financial institutions, or governments to raise funds for operational needs. It includes inventories, short-term debts, account payables, financing payroll, etc. CP typically matures within 1 to 270 days and is characterized by low risk and high liquidity. It is sold at a discount to its face value and offers investors a competitive yield.
Key Points About Commercial Paper
Issuer: Typically, large and financially stable corporations, financial institutions, and government entities issue CP to meet their short-term funding needs.
Maturity: CP has a short maturity period, usually ranging from a few days to a maximum of 270 days. This short-term nature makes it convenient for companies to obtain funds quickly.
Unsecured: It is usually issued without any collateral backing. Investors rely on the creditworthiness of the issuer when purchasing CP.
Interest Rates: The interest rate on CP is generally lower than other forms of short-term borrowing, like bank loans. The rate is determined based on prevailing market conditions, the issuer’s credit rating, and the maturity period’s length.
Liquidity: It can be easily sold in the secondary market before maturity. It provides investors with liquidity.
Investors: CP is often purchased by institutional investors, such as money market funds, corporations with excess cash, and other entities looking for a short-term investment vehicle.
Regulation:
In India, The Reserve Bank of India regulates the issuance and trading of CP through the Reserve Bank Commercial Paper Directions, 2017, along with operational guidelines from the Fixed Income Money Market and Derivatives Association of India.
In the United States, commercial paper is regulated by the Securities and Exchange Commission (SEC) if offered to the general public. However, many issuers are exempt from SEC registration requirements.
Risk: Commercial paper is relatively safe due to the creditworthiness of reputable issuers. Still, there is a risk of default if the issuer faces financial difficulties.
Denominations: It is typically issued in large denominations. It makes it less accessible to individual investors
Advantages of Commercial Paper
Prior to the introduction of commercial paper in the Indian money market i.e. before 1990, corporate companies used to depend on the crude and traditional method of borrowing working capital from the commercial banks by pledging the inventory of raw materials as collateral security. This is time-consuming for the borrowing companies in availing the short-term funds for day-to-day production activities. Commercial paper has emerged as an effective instrument for all corporate companies to avail the short-term funds from the money market within the shortest possible time limit by avoiding the hassles of direct negotiation with the commercial banks for availing the short-term loans.
Types of Commercial Paper
Promissory Notes
Promissory notes are financial transactions promises from one party (the issuer) to another (the payee) to repay a specific amount of money by a certain date. They are legally binding instruments to formalize loans or debts between individuals, businesses, or financial institutions.
Drafts
Drafts, also known as bills of exchange, are orders from one party (the drawer) to another (the drawee) to pay a specified amount to a third party (the payee). They serve as a form of payment or transfer of funds, often used in international trade transactions.
Checks
Checks are written orders from a bank account holder to their bank, instructing the bank to pay a certain amount of money to the bearer or a specified recipient. They are a common form of payment, allowing individuals and businesses to make secure and convenient transactions.
Certificates of Deposit (CDs)
Certificates of Deposit are time deposits banks and financial institutions offer. Investors deposit a fixed amount of money for a specified period, earning a predetermined interest rate. CDs are considered low-risk investments due to their fixed returns and the assurance of principal repayment upon maturity.
Eligibility for Issuing Commercial Paper
Companies, Primary Dealers (PDs) and Finance Institution (FIs) are eligible to issue commercial paper. Commercial Paper (CPs) can be issued based on the guidelines set by RBI. The following conditions have to be fulfilled by corporates to receive privileges for issuing commercial paper:
- The tangible net worth of the company should not be less than 4 Crores, as per the latest audited Balance-Sheet.
- The companies should have the ‘sanctioned working capital limit’ by the banks or any Financial Institutions (FIs).
- The Financial Institutions or Banks should classify the ‘Borrowal Account’ as a Standard asset.
Issuing Commercial Paper
Commercial paper can be issued into the market by the following members:
- Leasing and Finance Companies
- Manufacturing Companies
- Financial Institutions
FAQs
Who uses commercial paper?
Commercial paper is commonly used by well-established and creditworthy companies. These can include corporations, banks, and financial institutions looking for short-term funds to cover their operational needs.
Is commercial paper safe to invest in?
Generally, commercial paper issued by reputable companies is considered safe due to their creditworthiness. However, like any investment, there’s a level of risk involved. Investors should assess the credit rating of the issuer before investing.