Commercial paper is
a short-term unsecured promissory note maturing in
less than 270 days issued by banks for a fee on
behalf of corporations and other borrowers to
raise funds from investors with idle cash. It is a
low-cost alternative to bank loans. US issuers are
able to efficiently raise large amounts of funds
quickly and without expensive
Securities and Exchange Commission (SEC)
registration by selling paper, either directly or
through independent dealers, to a large and varied
pool of institutional buyers.
Competitive,
market-determined yields in notes whose maturity
and amounts can be tailored to specific needs, can
be earned by investors in commercial paper.
Commercial paper is usually issued in
denominations of US$100,000 or more. Therefore
smaller investors can only invest in commercial
paper indirectly through money market funds or
their pension funds.
Commercial paper has
become an important debt market because of the
advantages of commercial paper for both investors
and issuers. Commercial paper outstanding grew at
an annual rate of 14% from 1970 to 1991, at the
end of which it totaled US$528 billion. Until its
recent seizure, the commercial paper market was
worth US$3 trillion, with half consisting of
bank-financed ''conduits'' of asset backed
commercial paper (ABCP). The ABCP market shrank
13% in August 2007 as US companies struggled
unsuccessfully to raise short-term funds to roll
over maturing outstanding debts.
Federal
Reserve data showed an ongoing squeeze on credit
that slashed ABCP outstanding by US$194.7 billion
in August (the steepest slump in seven years),
US$54.6 billion in September, and US$13 billion in
the first two weeks of October. The good news was
that the drop has eased with the passage of time.
The bad news was that the squeeze was beginning to
affect companies outside the financial sector.
Outstanding commercial paper totaled
US$1.864 trillion in the week of October 10, off
sharply from a high of US$2.186 trillion hit in
July. Issuance of ABCP was again hardest hit,
since the sector has the greatest potential
exposure to mortgages.
Characteristics
of commercial paper Securities offered to
the public must be registered with the SEC
according to the Securities Act of 1933.
Registration requires extensive public disclosure,
including issuing a prospectus on the offering. It
is a time-consuming and expensive process. Most
commercial paper is issued under Section 3(a)(3)
of the 1933 Act, which exempts from registration
requirements short-term securities with certain
characteristics.
The exemption
requirements have been a factor shaping the
characteristics of the commercial paper market.
The key requirement for exemption is that the
maturity of commercial paper must be less than 270
days. In practice, most commercial paper has a
maturity of between five and 45 days, with 30-35
days being the average. Many issuers continuously
roll over their commercial paper, financing a
more-or-less constant amount of their assets in
this way. The nine-month maturity limit is not
violated by the continuous rollover of notes, as
long as the rollover is not automatic but is at
the discretion of the issuer and the dealer. Many
issuers will adjust the maturity of commercial
paper to suit the requirements of an investor.
Notes must be of a type not ordinarily
purchased by the general public. In practice, the
denomination of commercial paper is large: minimum
denominations are usually US$100,000, although
face amounts as low as US$10,000 are available
from some issuers. Typical face amounts are in
multiples of US$1 million, because most investors
are institutions. Issuers will usually sell an
investor the specific amount of commercial paper
needed.
Proceeds from commercial paper
issues can be used to finance ''current
transactions'', which include operating expenses
and the funding of current assets such as
receivables and inventories. Proceeds cannot be
used to finance fixed assets, such as plant and
equipment, on a permanent basis. The SEC has
generally interpreted the current transaction
requirement broadly, approving a variety of
short-term uses for commercial paper proceeds as
these are not traced directly from issue to use.
Firms are required to show only that they have a
sufficient "current transaction" capacity to
justify the size of the commercial paper program,
a particular level of receivables or inventory for
example. Firms are allowed to finance construction
as long as the commercial paper financing is
temporary and to be paid off shortly after
completion of construction with long-term funding
through a bond issue, bank loan or internally
generated cash flow.
Commercial paper is
typically a discount security, similar to Treasury
bills. The investor purchases notes at less than
face value and receives the face value at
maturity. The difference between the purchase
price and the face value, called the discount, is
the interest received on the investment.
Commercial paper is, occasionally, issued as an
interest-bearing note by request of investors. The
investor pays the face value and, at maturity,
receives the face value and accrued interest. All
commercial paper interest rates are quoted on a
discount basis.
Until the 1980s, most
commercial paper was issued in physical form in
which the obligation of the issuer to pay the face
amount at maturity is recorded by printed
certificates that are issued to the investor in
exchange for funds. A safekeeping agent hired by
the investor held the certificates, until
presented for payment at maturity. The "settling"
of the transactions (the exchange of funds for
commercial paper first at issuance and then at
redemption) each occurs in one day. On the day the
commercial paper is issued and sold, the investor
receives and pays for the notes and the issuer
receives the proceeds. On the day of maturity, the
investor presents the notes and receives payment.
Commercial banks, in their role as issuing, paying
and clearing agents, facilitate the settling of
commercial paper by carrying out the exchanges
between issuer, investor and dealer required to
transfer commercial paper for funds.
When
new paper is not sold to roll over the matured
paper, the bank must pay the investors of the
maturing paper and hold the unsold paper in its
own account until sold. This requires the bank to
record the outstanding paper it holds on its
balance sheet, increasing its liability, which
raises reserve and capital requirements, and
lowering its profit margin.
An increasing
amount of commercial paper is being issued in
book-entry form, whereby entries in computerized
accounts are replacing the physical certificates.
Book-entry systems will eventually completely
replace the physical printing and delivery of
notes. The Depository Trust Company (DTC) is a
clearing cooperative operated by member banks, a
member of the US Federal Reserve System, a
limited-purpose trust company under New York State
banking law and a registered clearing agency with
the Securities and Exchange Commission. In
September 1990 it began to convert most commercial
paper transactions to book-entry form.
The
advantages of a paperless system are significant.
In the long run, the fees and costs associated
with the book-entry system will be significantly
less than under the physical delivery system. The
expense of delivering and verifying certificates
and the risks of messengers failing to deliver
certificates on time are eliminated. As all
transactions between an issuing agent and a paying
agent are settled with a single end-of-day wire
transaction, the problem of daylight overdrafts,
which arise from non-synchronous issuing and
redeeming of commercial paper, are reduced. This
electronic processing also deprives issuers and
creditors of precious hours for remedial response
in a crisis.
CP market
participants Commercial paper is issued by
a wide variety of domestic and foreign firms,
including financial companies, banks and
industrial firms. Finance companies are the
biggest issuers. They provide consumers with home
loans, unsecured personal loans and retail
automobile loans. They provide businesses with a
variety of short- and medium-term loans including
secured loans to finance purchases of equipment
for resale. Some are wholly owned subsidiaries of
industrial firms that provide financing for
purchases of the parent firm's products. For
example, a major activity of General Motors
Acceptance Corporation (GMAC) is the financing of
purchases and leases of General Motor's vehicles
by dealers and consumers. General Electric
Capital, and Ford Motor Credit are two other big
issuers.
Financial issuers also include
securities firms and insurers. Securities firms
issue commercial paper as a low-cost alternative
to other short-term borrowings such as repurchase
agreements and bank loans, and they use commercial
paper proceeds to finance a variety of security
broker and investment banking
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