Commercial Papers

Commercial paper (CP) is a short-term unsecured promissory note issued by companies, financial institutions, and other entities to raise funds for their short-term financing needs. It serves as an important money market instrument used by creditworthy corporations to meet working capital requirements such as payment of wages, accounts payable, or inventory financing. In India, commercial paper is regulated by the Reserve Bank of India (RBI) under the guidelines of the Reserve Bank of India Act, 1934 and was first introduced in 1990 as part of financial market reforms aimed at developing alternative sources of short-term finance.

Concept and Characteristics of Commercial Paper

Commercial paper is essentially a negotiable instrument representing a promise to repay a fixed amount on a specified future date. It is issued at a discount to face value and redeemed at par, the difference representing the investor’s return.
Key Characteristics:

• Unsecured Nature: CPs are not backed by any collateral; hence, only companies with a strong credit rating can issue them.
• Short-Term Maturity: The maturity period typically ranges from 7 days to 1 year.
• Denomination: CPs are issued in denominations of ₹5 lakh or multiples thereof in India.
• Transferability: CPs are freely transferable through endorsement and delivery, making them a highly liquid investment.
• Issuer Credit Rating: Issuers must obtain a credit rating from a recognised credit rating agency such as CRISIL, ICRA, or CARE before issuing CPs.
• Discounted Instrument: They are issued at a discount and redeemed at face value, thereby providing an implicit interest yield.

Purpose and Importance of Commercial Paper

Commercial paper plays a vital role in the financial system by providing corporations with a flexible and cost-effective source of short-term finance.
Purposes:

• To meet temporary working capital requirements.
• To bridge short-term liquidity gaps.
• To finance seasonal and cyclical business needs.
• To reduce dependence on bank loans and diversify funding sources.

Importance:

• Provides lower-cost financing compared to bank borrowing.
• Enhances liquidity in the money market.
• Offers investors a secure and short-term investment option with moderate returns.
• Helps in the development of the debt market, promoting financial stability.

Eligibility for Issuing Commercial Paper

According to RBI guidelines, the following entities are eligible to issue commercial paper in India:

• Corporates, including manufacturing and service companies.
• Primary Dealers (PDs).
• All India Financial Institutions (AIFIs).
• Non-Banking Financial Companies (NBFCs).
• Scheduled commercial banks.

However, these entities must satisfy certain conditions:

• Possess a tangible net worth of at least ₹4 crore.
• Have a sanctioned working capital limit from a bank.
• Obtain a minimum credit rating of A3 or equivalent from an approved agency.

Participants in the Commercial Paper Market

The commercial paper market comprises various participants involved in the issue, investment, and regulation of CPs:

• Issuers: Corporations, financial institutions, and NBFCs.
• Investors: Banks, mutual funds, insurance companies, and high-net-worth individuals.
• Issuing and Paying Agents (IPA): Generally commercial banks authorised by the RBI to facilitate issue and redemption.
• Regulatory Authority: The Reserve Bank of India (RBI) monitors and regulates the CP market to ensure transparency and stability.

Procedure for Issuing Commercial Paper

The process of issuing commercial paper involves the following steps:

1. Credit Rating: The company obtains a rating from an approved agency.
2. Board Approval: The company’s board of directors authorises the issue of CPs.
3. Appointment of IPA: A commercial bank is appointed as the Issuing and Paying Agent.
4. Documentation: Necessary documents, including a disclosure statement and dealer agreements, are prepared.
5. Issue and Allotment: CPs are issued in physical or dematerialised form to investors.
6. Redemption: On maturity, the issuer redeems the paper at face value through the IPA.

Since most CPs are now issued in dematerialised (demat) form, transactions are facilitated through depositories such as NSDL and CDSL, ensuring efficiency and transparency.

Types of Commercial Paper

Commercial papers can be categorised based on their purpose and structure:

• Promissory Note Type: A simple, unsecured promise to pay the stated amount.
• Draft Type: Includes a negotiable order to pay, commonly used in trade financing.
• Asset-Backed CPs: Though rare in India, these are backed by financial assets to enhance creditworthiness.
• Extendible or Roll-Over CPs: Allow the issuer to extend maturity with investor consent.

Advantages of Commercial Paper

For Issuers:

• Provides short-term funds at lower interest rates than bank loans.
• Enhances the company’s financial flexibility.
• Does not require any security, reducing administrative burden.
• Helps diversify funding sources beyond traditional banking channels.

For Investors:

• Offers higher returns than comparable short-term instruments like Treasury Bills.
• Provides liquidity due to its tradable nature.
• Considered relatively safe, as only financially strong entities can issue CPs.
• Enables portfolio diversification in the money market segment.

Limitations and Risks

While commercial paper is a vital financing tool, it is not free from drawbacks:

• Restricted to Highly Rated Companies: Small and medium enterprises (SMEs) often cannot access this market due to rating requirements.
• Market Risk: Interest rate fluctuations can affect market value.
• Credit Risk: Though minimal, default risk exists if the issuer faces financial distress.
• Lack of Investor Protection: Being unsecured, CP holders have no collateral claim.
• Limited Tenure: It cannot be used for long-term funding needs.

Commercial Paper Market in India

The Indian commercial paper market has grown significantly since its introduction in 1990. Initially confined to large corporations, it now includes NBFCs and financial institutions. The RBI periodically revises regulations to ensure efficiency and transparency.
Key Features of the Indian CP Market:

• CPs are issued in dematerialised form through depositories.
• The minimum tenure is 7 days and the maximum is 1 year.
• CPs can be issued on a standalone basis or under a shelf programme.
• The discount rate or yield is determined by market demand and supply.

The growing participation of mutual funds and insurance companies has enhanced liquidity and depth in the market. Furthermore, with the development of electronic trading and settlement systems, CPs have become an efficient instrument for short-term investment and fund mobilisation.