Commercial Paper is an important instrument of the money market. It is a short-term unsecured financial instrument issued by companies to meet their immediate working capital requirements. In India, Commercial Paper was introduced to provide highly rated corporate borrowers with an alternative source of short-term funds and to reduce their dependence on bank credit.
Commercial Paper is important because it reflects the market-based borrowing system and plays a key role in improving liquidity and efficiency of the money market.
Meaning and Concept of Commercial Paper
Commercial Paper is a promissory note issued by a company in the form of a discounted instrument. It represents a promise by the issuer to repay the face value of the instrument to the investor on a specified maturity date.
Since Commercial Paper is unsecured, it does not carry any collateral or security. Therefore, only companies with strong financial position and high credit rating are allowed to issue Commercial Paper. Because of this, CP is considered a relatively safe instrument within the money market.
Commercial Paper is issued at a discount to its face value, and the difference between the issue price and the face value represents the return to the investor.
Objectives of Commercial Paper
The main objective of introducing Commercial Paper was to enable corporates to raise short-term funds directly from the market at competitive rates. It also helps in:
- Diversifying sources of short-term finance for companies
- Reducing pressure on banks for working capital finance
- Providing investors with a short-term investment option with better returns than traditional deposits
Issuers of Commercial Paper
In India, Commercial Paper can be issued by financially sound entities. These generally include:
- Companies
- Primary Dealers (PDs)
- All-India Financial Institutions
However, issuance is subject to eligibility conditions prescribed by the Reserve Bank of India (RBI). Only those entities which meet the minimum net worth, credit rating, and banking relationship requirements are allowed to issue CP.
Investors in Commercial Paper
Commercial Paper is mainly subscribed by institutional investors because of its large denomination and short maturity. Typical investors include:
- Banks
- Mutual Funds
- Insurance Companies
- Primary Dealers
- Corporates with surplus funds
Retail participation is limited, but indirectly retail investors can invest through debt mutual funds.
Maturity Period of Commercial Paper
Commercial Paper is a short-term instrument. In India, the maturity of CP ranges from 7 days to 1 year from the date of issue.
The maturity is decided by the issuer depending on their fund requirement, but it must always remain within the RBI-prescribed limits. Since CP is used to meet working capital needs, it is not suitable for long-term financing.
Credit Rating Requirement
Since Commercial Paper is unsecured, credit rating plays a crucial role. A high credit rating indicates the issuer’s ability to repay the instrument on maturity.
In India, CP must be rated by a RBI-recognized credit rating agency such as CRISIL, ICRA, CARE, or India Ratings. Only issuers with minimum prescribed rating are eligible to issue CP.
A higher rating helps the issuer raise funds at lower discount rates, while a lower rating increases the cost of borrowing.
Issuance and Mode of CP
Commercial Paper can be issued in dematerialised form and is normally held in demat accounts. This improves safety, transparency, and ease of transfer.
CP is issued at a discount and redeemed at face value on maturity. The discount rate depends on market conditions, credit rating of the issuer, and maturity period.
Role of Banks in Commercial Paper
Banks play a limited but important role in the CP market. They do not issue CP (except PDs and financial institutions), but they:
- Act as investors
- Provide credit facilities and back-up lines to issuers
- Act as Issuing and Paying Agents (IPA)
Banks benefit from CP by investing surplus funds and earning short-term returns, but CP also creates competition for banks as corporates may prefer CP over bank loans due to lower cost.
Advantages of Commercial Paper
Commercial Paper offers several benefits to both issuers and investors.
For issuers:
- Lower cost of borrowing compared to bank loans
- Quick access to short-term funds
- Flexibility in maturity and amount
For investors:
- Better return than treasury bills or fixed deposits
- High liquidity
- Low risk due to high credit quality of issuers
Limitations and Risks of Commercial Paper
Despite its advantages, Commercial Paper has certain limitations. Since it is unsecured, there is always a credit risk, though it is limited due to strict eligibility norms.
CP is also sensitive to market conditions. During periods of tight liquidity or financial stress, investors may avoid CP, making it difficult for issuers to roll over their borrowings.
Only large and well-rated companies can access the CP market, which limits its availability to smaller firms.
Role of Commercial Paper in Money Market
Commercial Paper contributes to the development and deepening of the money market. It promotes financial discipline among corporates as only creditworthy firms can raise funds through CP.
By providing an alternative to bank finance, CP enhances market efficiency and supports the transition from a bank-dominated financial system to a more market-oriented system.
Summary
Commercial Paper is a short-term, unsecured, discounted money market instrument issued by highly rated companies and institutions to meet working capital needs. It plays an important role in improving liquidity, reducing dependence on banks, and strengthening the money market.