Certificate of Deposit

A Certificate of Deposit (CD) is a short-term money market instrument issued by commercial banks and select financial institutions to raise funds from individuals, corporations, and institutional investors. It represents a negotiable, interest-bearing time deposit with a fixed maturity period and a specific rate of interest.
In simple terms, a Certificate of Deposit is a document of deposit that certifies that the depositor has placed a certain sum of money with a bank for a fixed period at a predetermined rate of interest. CDs are considered safe, low-risk, and highly liquid investments within the money market.

Meaning and Concept

A Certificate of Deposit is a negotiable instrument issued at a discount to face value (in some cases at par), acknowledging a fixed-term deposit. It is transferable by endorsement and delivery, allowing investors to sell it in the secondary market before maturity.
In India, CDs were introduced in 1989 by the Reserve Bank of India (RBI) to provide banks with an additional tool to manage short-term liquidity and to widen the range of money market instruments available to investors.

Definition

According to the Reserve Bank of India (RBI):

“A Certificate of Deposit (CD) is a negotiable money market instrument issued in dematerialised form or as a Usance Promissory Note for funds deposited at a bank or other eligible financial institution for a specified period.”

Thus, CDs act as tradable time deposits that combine the safety of a bank deposit with the liquidity of a marketable security.

Features of Certificate of Deposit

1. Issuer: Scheduled commercial banks (except regional rural banks and cooperative banks) and select All-India Financial Institutions such as IDBI, SIDBI, and EXIM Bank.
2. Form: Issued in dematerialised form (electronic) or as a Usance Promissory Note.
3. Minimum Amount: ₹5 lakh and in multiples of ₹5 lakh thereafter.
4. Tenure:
   • For banks: 7 days to 1 year.
   • For financial institutions: 1 year to 3 years.
5. Interest Rate: Market-determined (fixed or floating), usually higher than savings deposits but lower than corporate bonds.
6. Transferability: Freely transferable through endorsement and delivery (for physical CDs) or via depository transfer (for demat CDs).
7. No Premature Withdrawal: Cannot be redeemed before maturity; however, they can be sold in the secondary market.
8. Denomination: Issued in multiples of ₹5 lakh, making it suitable for institutional and high-net-worth investors.
9. Regulation: Governed by guidelines issued by the Reserve Bank of India (RBI) under Section 45W of the RBI Act, 1934.

Parties Involved

1. Issuer: The bank or financial institution issuing the CD.
2. Investor: The individual, company, or institution purchasing the CD.
3. Registrar/Depository: Maintains records of ownership (in case of dematerialised CDs).
4. Secondary Market Participants: Brokers or dealers facilitating CD trading.

Objectives of Issuing Certificates of Deposit

• To help banks and financial institutions raise short-term funds.
• To provide investors with a safe and liquid investment option.
• To diversify funding sources beyond traditional deposits.
• To make the money market more flexible and efficient.
• To aid in liquidity management and short-term resource mobilisation.

Advantages of Certificate of Deposit

For Banks and Financial Institutions:

• Enables mobilisation of funds during periods of tight liquidity.
• Diversifies funding beyond savings and term deposits.
• Improves liquidity management in the money market.

For Investors:

• Offers higher returns than savings or current accounts.
• Provides a low-risk investment option as CDs are backed by banks.
• High liquidity — can be sold in the secondary market.
• Fixed maturity ensures predictable income.

Disadvantages of Certificate of Deposit

• No Early Withdrawal: Funds are locked in until maturity.
• Minimum Investment Limit: Restricts small retail investors.
• Interest Rate Risk: If market rates rise after purchase, the CD’s value may fall.
• Limited Return: Offers lower returns than riskier instruments like corporate bonds or equities.
• Taxable Income: Interest earned is subject to tax as per applicable income tax laws.

Types of Certificates of Deposit

1. Bank Certificates of Deposit:
   • Issued by scheduled commercial banks for 7 days to 1 year.
   • Used primarily for short-term liquidity management.
2. Institutional Certificates of Deposit:
   • Issued by financial institutions like IDBI, SIDBI, and EXIM Bank for 1–3 years.
   • Used for long-term resource mobilisation.
3. Negotiable Certificates of Deposit (NCDs):
   • Can be traded in the secondary market before maturity.
4. Non-Negotiable Certificates of Deposit:
   • Cannot be transferred or traded and must be held until maturity.

Example of Certificate of Deposit

Suppose an investor purchases a ₹10 lakh Certificate of Deposit from a bank for 6 months at an interest rate of 6% per annum.

• Investment Amount = ₹10,00,000
• Tenure = 6 months (0.5 year)
• Interest = Principal × Rate × Time
• Interest = ₹10,00,000 × 6/100 × 0.5 = ₹30,000

At maturity, the investor receives ₹10,30,000 (principal + interest).
If the CD is issued at a discount (say ₹9,70,000), the investor redeems it at ₹10,00,000 — earning ₹30,000 as the return.

CDs vs Other Money Market Instruments

Regulation and Guidelines in India

• Issued under: RBI’s Master Direction on Money Market Instruments.
• Eligibility to Issue: Scheduled commercial banks (excluding RRBs and cooperative banks) and specified financial institutions.
• Form of Issue: Dematerialised or Usance Promissory Note.
• Minimum Size: ₹5 lakh.
• Tenure:
  • Banks: 7 days to 1 year.
  • Financial Institutions: 1 year to 3 years.
• Transferability: Freely transferable by endorsement and delivery.
• No Lock-in for Trading: Can be traded in secondary markets before maturity.

Importance of Certificates of Deposit in the Financial System

1. Enhances Liquidity: Provides short-term funding to banks and institutions.
2. Deepens the Money Market: Expands the range of instruments for investors.
3. Supports Monetary Policy Transmission: RBI uses CD rates as an indicator of liquidity conditions.
4. Facilitates Resource Mobilisation: Enables banks to manage mismatches between deposits and credit.
5. Attracts Institutional Investors: Serves as a safe avenue for corporates and mutual funds to park surplus funds.