Introduction to Commercial Paper (CP)

Commercial Paper (CP) is a short-term financial instrument, consisting of unsecured promissory notes issued in bearer form which can be therefore be readily traded. At maturity, the CP issuer pays the amount due to the person presenting the paper.

Commercial paper is an example of ‘securitization’ i.e raising loan funds by issuing negotiable debt securities rather than by bank borrowing. A bank acts as agent for a CP issue, packaging and selling the paper to investors, but does not advance its own funds. (Securitsation, such as CP is also a form of disintermediation, i.e raising funds directly from investors without the banks acting as intermediaries through their loans and deposit business.)

CP is issued as a series of notes, and each note promises to pay the bearer a stated sum of money at the maturity date. Each note shows:

• The name of the issuer
• The amount (value) of the note
• The issue date
• The maturity date
• A certificate of authentication, signed by an authorized signatory of the issuer’s issue agent

Each note will also indicate that the note is negotiable, its bearer is entitled to payment, and the payment will be made (on presentation of the note at maturity through a recognised bank) by the issue agent on behalf of the company. An issuing or paying agent handles the administrative processes.

An investment bank will help arrange the issuance of CP by its large corporate clients, and provide them an immediate market by undertaking to bid for the paper and on-trade it to the investor market .A CP trader at a bank hopes to make a small margin of profit on huge volume turnover. This margin might be small as 2 basis points, i.e USD 50 on a USD 1m CP issued for 90 days. The investor in CP is buying the unsecured debt of the corporate issuer, but in buying through a bank dealer the investor is also getting a moral obligation from the bank dealer to buy it back again, at the prevailing market price, if the investor wishes to return to cash. This obligation is not enforceable.

Origins of the CP market

Like CDs, commercial paper (CP) originated in the US market and its creation and volume growth is very much a product of the banking environment there. The Us banking industry is still very fragmented, (despite some mergers and takeovers). About 10 or 15 years ago it was even more so, with a large number of local banks. In such an environment, it was often the case that major trading and manufacturing companies were a better credit risk than the banks. These institutions needed a channel through which money could be directed from cash-rich companies that needed short term financing. The invention of commercial paper provided such a channel avoiding the need of banks to intermediate through the loans and deposits market.