Lesson 6

Commercial Paper (CP)

After reading this lesson, you will be conversant with: Features of Commercial Paper Issuing Procedure Evolution and Development of Commercial Paper Market Commercial Papers in International Markets Innovations of Commercial Paper

Treasury Management: Theory and Practice

The money market is relevant to the corporate world in terms of short-term surplus or deficit of funds, which it experiences. If a corporate has a short-term surplus, it invests and if it faces deficit, then it borrows. A corporate needs short-term funds to manage its working capital requirements, pay taxes and meet other short-term commitments. These needs are fulfilled, usually, by obtaining short-term finance from banks, trade credit from creditors, loans from Inter Corporate Deposits (ICDs) market, bill discounting and factoring, etc. Corporates are always in search of new instruments to raise funds that provide them with an optimal combination of low cost, flexible and desired maturity. As a result the Commercial Paper (CP) was introduced in 1990.

Definition
Commercial Paper (CP) is an unsecured usance money market instrument issued in the form of a promissory note issued at a discount, and is transferable by endorsement and delivery and is of fixed maturity. It is a short-term money instrument issued to corporate, who have a high credit rating and have a strong financial background. It is an unsecured obligation issued by a bank or a corporation to finance its short-term credit requirements like accounts receivable and inventory. In other words, the Commercial Paper is an unsecured, short-term loan issued by a corporation typically to finance accounts receivable and inventories and it is usually issued at a discount reflecting the prevailing market interest rates. ISSUERS CPs can be issued by Corporate, Primary Dealers (PDs), and the all-India Financial Institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by the Reserve Bank of India are eligible to issue CP. But, the issuer has to satisfy the eligibility criteria prescribed by RBI as discussed later. The conditions laid by the RBI restrict the entry of issuers into the CP market. INVESTORS CPs may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI). FIIs were allowed to invest their short-term funds in such instruments too. Within a ceiling of the $1.5 billion of the total FIIs were inflows for debt funds set down by the RBI. When NRIs subscribe to CP issue, the conditions regarding non-repatriability and non-endorsability are indicated on the CP. Though the market is open to the above segments, usually, banks, large corporate bodies, public sector units with investible funds function in the market.

FEATURES OF COMMERCIAL PAPER Maturity

Commercial paper has a minimum maturity period of 7 days and a maximum of one year. Unlike CD, the issuer can buy-back his CP. The maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid.

Denomination and Size

CPs are issued at a discount to face value as may be determined by the issuer and no issuer shall have the issue of CP underwritten or co-accepted. CP are issued in denominations of Rs.5 lakh or multiples thereof. A single investor should not invest not less that Rs.5 lakh of face value. ISSUE PRICE The CPs are issued to the investors at a discount to the face value. The discount actually is the effective interest rate. The Issue Price is determined by the corporate issuing it in the following manner: Generally, the merchant banker/ 288

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Issuing and Paying Agent (IPA) on behalf of the corporate client, approaches various investors and takes quotes, and expected amount of investment for the proposed CP for various maturities. After obtaining the quotes, the merchant banker and issuing company compile the data and arrive at an optimal discount rate with a feasible maturity date of the paper. While determining a discount rate, it considers factors such as Prevailing call money rates, Prime lending rate, T-bill rate, maturity of the paper and other relevant expenses (such as brokerages, rating agency fees, stamp duty, etc.). Once the issue price and maturity are decided, the IPA places the CP with the investors. The Issue Price is calculated as below:

P=

F Ix N 1+ 100 x 365

Where, F P I N = Face/Maturity Value = Issue Price of CP = Effective Interest p.a. = Usance Period (No. of days).

For example, a corporate issues a CP at an effective rate of 10.00% for 90 days. This is a discounted instrument and hence is actually issued at Rs.97.5936 per Rs.100. This means that the corporate gets Rs.97.5936 on issuance and has to redeem Rs.100, on the maturity date after 90 days. This is calculated as follows: Rs.100/(1+10.00% x 90/365) = Rs.97.5936 Interest is calculated on an actual/365-day year basis. Typically, CPs are issued for periods of 7/15/30/45/60/90/120/270/360 days.

Factors affecting the Pricing

CP being a short-term instrument, its primary and secondary market determination of the interest rate, i.e., the discount rate, depends upon conditions in short-term money market. The following are the principal factors in pricing the CPs. Interbank Call Rates: Since call rates affect all the other short-term rates and banks are the most important investors in CPs, its pricing is affected very much by call rates. Also, as the lenders in the CP market are predominantly banks, call markets affect the CP market rate; lower call rates mean cash surplus. Banks thus view CPs as an alternative investment route. Competing Money Market Investment Products: Interest rates on CPs are determined by the demand and supply factors in the money markets and the interest rate on the other competing money market instruments such as Certificates of Deposit, Commercial Bills, Short-term Forward Premia and Treasury Bills. The investments in CPs give comparably higher yields than those obtained in bank deposits of similar maturities. Liquidity: Pricing and availability of funds under CPs are determined by the liquidity amongst banks and mutual funds, which are the principal investors. Credit Rating: The initial credit rating requirement was P1. Later, RBI changed the minimum credit rating to P-2 of Credit Rating Information Services of India Ltd. (CRISIL) or such equivalent rating by other agencies such as the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd., or any such other credit rating agencies as may be specified by the Reserve Bank of India for issuance of Commercial Paper. However, two companies with the same rating need not attract the same rate, due to relative credit perception by the public and also, to an extent, the companys long-term credit ratings. 289

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Rating Notches for CPs

The 5-notch scale on which the credit rating agencies rate the CPs is given below: P1: The degree of safety regarding timely payment is strong. P2: The degree of safety is strong, but relatively lower than that of P1. P3: An adequate degree of safety regarding timely payment; but the adverse affects due to the unforeseen circumstances will have more impact on the instrument than on the instrument rated as P1 and P2. P4: The degree of safety regarding timely payment on the instrument is minimal and the effect of unfavorable conditions may be adverse. P5: The instrument is expected to be in default on maturity or is in default. By adding + and symbols after the rating, it is further fine -tuned.

ISSUING PROCEDURE
A company planning to issue CP requires to fulfill the eligibility criteria prescribed by the RBI, then it needs to select a merchant banker and an Issuing and Paying Agent (IPA) (mandatory) and obtain a resolution from the company board to issue the commercial paper. After the resolution is passed, the company needs to get the CP credit rated by one of the approved credit rating agencies like CRISIL/ICRA/ CARE/DCR, as prescribed by RBI. The company then has to approach its principal banker with a proposal (in the form of schedule-II given in Appendix) along with the credit rating certificate for approval. The banker will, then, scrutinize the same and verify whether all conditions stipulated by the RBI are met, and forward the application to the RBI for intimation (as the approval from RBI is no longer required). On the other hand, the Merchant Banker or Issuing and Paying Agent (at times, company appoints IPA as a dealer) will locate the clients and get their quotes for different maturity periods as discussed below. Then the company and merchant banker/IPA decide the maturity, discount rate and the quantum of the issue. The total amount of CP to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. The amount of CP to be issued should be raised on a single date or in parts on different dates. In case of issuing in parts on different dates, each CP so issued will have the same maturity date. A company can opt for various maturity periods within the stipulated span, i.e., if a company plans to issue a CP for a span of 6 months, it can raise the money in tranches with different maturity periods of either 1 month, 2 months or 3 months, etc., based on the market quotes. If a company decides on a 2 month CP, it can raise the finance within a period of 2 weeks from the date on which the proposal is taken on record by the bank and it can issue the paper on a single day or in parts on different dates (but the whole issue should be redeemed on the same date). The issue proposed should be completed within a span of 2 weeks and the company should intimate the banker to reduce the working capital limit to the extent of the amount raised. The company should pay the applicable stamp duty based on the maturity. After the issue is completed, within 3 days, the company needs to intimate the RBI the actual amount raised through CPs. The CP is not allowed to be underwritten. On maturity, the holder of the CP presents the instrument to the paying agent, who arranges the payment. The agent will receive

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the amount and brokerage for the services provided (the brokerage fee charged by them is given below). No grace period is allowed for the repayment of the paper. If the maturity date falls on a holiday, the issuer is supposed to make the payment on the following working day. Every issue of CP is treated as a fresh issue (including roll over) and the issuer needs to intimate the RBI while doing so.

Role and Responsibilities of Issuing and Paying Agent (IPA)

For issuance of CP only scheduled banks act as an IPA. The role of IPA becomes mandatory while issuing CP. The role and responsibilities of IPA are as follows: i. IPA should make sure that issuer has the minimum credit rating as fixed by RBI and the amount mobilized through issuance of CP is within the limit indicated by Credit Rating Agency (CRA) for the specified rating or as approved by its Board of Directors, whichever is lower. IPA should verify all the documents submitted by the issuer, viz., copy of board resolution, signatures of authorized executants (when CP in physical form) and issue a certificate that documents are in order. It should also certify that it has a valid agreement with the issuer. After verification, all the certified copies of original documents are held in the custody of IPA. All the CP issues should be reported to the Adviser-in-Charge, Monetary Policy Department (MPD), Reserve Bank of India, Central Office, Mumbai. IPA as a member of Negotiated Dealing System (NDS) should report the CP issuance details on NDS platform within two days from the date of completion of the issue. All scheduled banks, acting as an IPA, should continue to report CP issuance details within three days from the date of completion of the issue and should incorporate details till NDS reporting stabilizes to the satisfaction of RBI. Any discontinuation of reporting of CP details to MPD should be communicated separately at a later stage.

ii.

iii. iv. v.

vi.

Issue Expenses
The issue expenses of the CP include payment of stamp duty, brokers fees or issuing and paying agents fees, rating agencies fees and other expenses like charges levied by the banks for providing redemption facilities, etc. All the expenses related to the issue of CPs are borne by the issuers. The brokerage varies depending on the size of the issue and the maximum prescribed brokerage is as follows: Fees charged (% on the issue amount) 0.025 0.050 0.100 Period of CP 3 months 6 months 6 months and above

Every renewal is considered as a fresh issue and it involves expenses. Hence, a company needs to optimize between the interest cost and issue cost while deciding the terms of maturity, i.e., if an issue is raised for a long period, the company may have to pay more interest and if it raises for a short period, it has to incur issue expenses each time. Hence, a company must consider interest paid and issue expenses borne while determining the duration of CP. 291

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Stamp Duty on Commercial Paper

The stamp duty payable by the issuer on CP is based on the period for which the CP is issued. The applicable stamp duty structure for banks and non-banks are given below: Structure of Stamp Duty Period I. II. Up to 3 months Above 3 months up to 6 months Banks 0.012 0.024 0.036 0.05 0.10 (In percent) Non-Banks 0.06 0.12 0.18 0.25 0.5

III. Above 6 months up to 9 months IV. Above 9 months up to 12 months V. Above 12 months

Source: http://www.rbi.org.in/scripts/Notification Government of India in its budget 2005-06 propose to rationalize the stamp duty i.e., regardless of the issuing entity, the stamp duty applies uniformly. This step was intended not only to create a level playing field for banks and non-bank entities to issue commercial paper but also to bring the Indian commercial paper market closer to international standard.

Underwriting
From the beginning, the RBI did not permit underwriting of CPs.

Standby Facility
RBI allowed banks to sanction standby arrangement to the company issuing a CP. As the amount raised by CP is utilized to reduce the working capital finance, a company may experience a liquidity crunch when the CP matures. In such instances, banks provide standby facility to redeem the sum at maturity. When such a facility is provided by the banks the instrument is secured indirectly. The real risk associated with corporates was not assessed properly, as the banks indirectly assured repayment of the CPs to the investors. Hence, the RBI attempted to rectify this anomaly by abolishing standby facility in October, 1994, to make the CP market more realistic. In October 2000, this issue was resumed after the review of cross-country experiences. Wherein, these experiences showed that rating agencies insisted on issuers of CPs to have in place back-up liquidity lines with banks at any particular point of time up to a stipulated percentage on the amount of CPs outstanding. This is not only to assure investors that the issuers have access to sufficient liquidity and they would be repaid when the refinancing of outstanding CPs is not possible but also to ensure that there is no systemic disruption in CP market in the event of default of any large CP issuer. Beside considering all these issues and to further preserve the integrity of the CP market as well as to generate further investment interest in this instrument, RBI encouraged issuers to use back-up credit lines from banks/FIs to a stipulated percentage of their outstanding CP issuance at any particular point of time. Thus, CP being a stand alone product, it was not obligatory for banks/FIs to provide stand-by facility but they were given the flexibility to provide credit enhancement facility within the prudential norms and subject to specific approval of their Boards.

Secondary Market and Trading

The transactions in secondary market take place in lots of 5 lakh each. Banks trade in secondary market as CPs are generally placed with them. The secondary market transactions do not attract stamp duty. The CP being a discount paper does not 292

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attract income tax, but the trading income, which is the difference between the cost of acquisition and resale value, attracts income tax. There are very few market makers who offer two-way quotes in Commercial Paper. For the intermediary market deals, the brokerage charged is in the range of 0.05%-0.20%.

Settlement
The transfer is done through endorsement and delivery. On maturity, the instrument is presented to the paying agent for receiving payments. The company cannot have any grace period and it is liable to make payment whenever the paper matures. As there is no roll over, every issue of commercial paper including renewal is treated as a new/fresh issue.

Taxation
For the Corporate: The discount is treated as an interest expense, deductible for tax purpose. For the Investor: Profit/loss on sale of investment Income is taxed under the head Profits and Losses from Business and Profession. Losses are allowed as business losses for banks and investment companies. For, corporates that invest in other company CPs, this would amount to other Income/Interest Income. Box 1: Tax Deducted at Source The Central Board of Direct Taxes vide Circular No.647 dated 22nd March, 1993 clarified that the difference between the issue price and the face value of the Commercial Papers and the Certificates of Deposits is to be treated as discount allowed and not as interest paid. Hence, the provisions of the Income Tax Act relating to deduction of tax at source are not applicable in the case of transactions in these two instruments. Source: www.incometaxindia.gov.in / TDS ADVANTAGES OF COMMERCIAL PAPER Commercial paper favors both borrowers and investors. It is considered as an optimal combination of liquidity and returns in the short-term market. To borrowers, it implies low cost of funds, and to investors it implies liquidity, marketability and returns. The paper work involved in raising the funds through the Commercial Paper is very less because more funds can be procured without any underlying transaction. The flexibility provided by the instrument enables the company to raise additional funds especially when the market is favorable. The cost of funds for the company is reduced because it can raise 75% of its working capital through the Commercial Paper issue, at an interest rate lower than the interest rate on borrowings from the banks. In the cash credit system of lending, the borrower can reduce the outstanding amount as and when he gets surplus funds. This results in a reduced effective interest cost. The companies, which borrow funds through the issue of CP, can take advantage of a situation by following the money market rates. This is because of the administrative lag in aligning the banks lending rates with the overall interest rates. The companys image will be improved, casting a positive effect on the long-term borrowing program of the company. The level of access to the national by banks gives CP market is considered as a key factor to accept the issues in the international market. From the investors point of view, CPs have higher liquidity, varied maturity and higher yield (when compared to bank deposits). The liquidity is high because it can be transferred by endorsement and delivery. Though these securities are unsecured, the standby facility its holders confidence to get the return on the due dates. The holders can get quick payments from the company s banker on its behalf as soon as the permissible working capital limit is achieved. 293

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EVOLUTION AND DEVELOPMENT OF COMMERCIAL PAPER MARKET

The concept of raising funds through commercial paper is new to Indian corporates. The introduction of CPs is a result of the suggestions of the Working Group on Money Market in 1987. The working group was of the opinion that the CP market had the advantage of giving high-rated corporate borrowers cheaper funds than they could obtain from banks, while providing the investors higher yields than they could obtain from the banking system. In 1989, the RBI announced its decision to introduce CPs. It was launched with a view to enable highly rated corporate borrowers to diversify their sources of short-term borrowings and a lso provide an additional instrument to investors, by which certain categories of borrowers could issue CPs in the Indian Money Market. It was also allowed because the RBI desired to discourage the practice of lending in the Inter Corporate Deposit (ICD) market. As ICDs were unsecured and the transactions were not transparent, the RBI felt that CPs may serve as a good substitute for such funds. Initially, the RBI issued guidelines on issue of CPs in January, 1990, and these guidelines later were revised many times to facilitate the growth of the market. It was indicated in April, 2000 policy statement that the current guidelines to issue the CPs would be modified in the light of recommendations made by an Internal Group. Accordingly, a draft of the revised guidelines as also the Report of the Internal Group was circulated in July, 2000. Taking into account the suggestions received from the participants, the guidelines have now been finalized. The new guidelines are expected to provide considerable flexibility to participants and add depth and vibrancy to the CP market while at the same time ensuring prudential safeguards and transparency. In particular, the guidelines will enable companies in the services sector to more easily meet their short-term working capital needs. At the same time, banks and FIs will have the flexibility to fix working capital limits duly taking into account the resource pattern of companies finances including CPs. The changes in the guidelines originally issued are summarized hereunder. Earlier, a company was eligible to issue CP only if it had a tangible net worth of Rs.10 crore as per the latest balance sheet. In April 90 , it was reduced to Rs.5 crore and in October 93, it was further reduced to Rs.4 crore as per the latest audited balance sheet. Similarly, the working capital requirement limit, which was Rs.25 crore, was reduced to Rs.15 crore and later to Rs.4 crore in October 93. besides this, company has been sanctioned working capital limit by bank/s or all-India financial institution(s) and the borrowed account of the company is classified as a standard asset by the financing bank(s)/institutions. The minimum credit rating required was A1 and P1 and the same was reduced to A2 and P2 in October93. Later, RBI changed the minimum credit rating to P-2 of Credit Rating Information Services of India Ltd. (CRISIL) or such equivalent rating by other agencies. The amount a company was allowed to raise through CP was limited to 20 percent of its Maximum Permissible Bank Finance (MPBF) and the same was raised to 75 percent in October, 93. Since the concept of MPBF was abolished recently, now a corporate can raise up to 100 percent of its fund-based working capital (without increasing its overall short-term credit). As far as Financial institution are concerned, they can issue CP within the overall umbrella limit fixed by the RBI, i.e., issue of CP together with other instruments, viz., term money borrowings, term deposits, certificates of deposit and inter-corporate deposits should not exceed 100 percent of its net owned funds, as per the latest audited balance sheet. The RBI initially stipulated that the company should be listed on one or more of the stock exchanges. Later, it permitted even unlisted companies to issue CPs. 294

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According to the initial guidelines, the maturity period of CP was a minimum of 3 months and a maximum of 6 months from the date of issue. The maximum limit was extended to 1 year in October, 1993 and the minimum was reduced to 30 days in 1997. However, in later guidelines, the minimum was reduced to 15 days and In October 2004, RBI in its guidelines further reduced the minimum maturity period to 7 days. Earlier, the denomination was Rs.10 lakh and the minimum size of an issue to a single investor was Rs.50 lakh (face value). In October, 1993 the minimum amount for a single investor was reduced to Rs.25 lakh in multiples of Rs.5 lakh. At present, it is Rs.5 lakh in multiples of Rs.5 lakh. Earlier, the company which was listed on a stock exchange was eligible to issue a CP; later this condition was relaxed. Similarly, the company willing to raise CP had to take prior approval from the RBI which is not essential now. The standby facility which was allowed to facilitate redemption has now been abolished to activate the market. Though the above conditions were relaxed/modified for the growth of CPs, the growth was not as appreciable as expected. The RBI had taken further steps to activate the market for CPs as there were hardly any market makers offering two-way quotes in CPs. The Discount and Finance House of India (DFHI) was expected to be a market maker by giving two-way quotes. On April 15th 1997, RBI permitted the Primary Dealers (PDs) to raise the funds for their operations by issuing CPs hoping that this would, in turn, enable the PDs to access greater volumes of funds thereby enhancing the level of activity in the secondary market. Later on October 10 th 2000, RBI permitted all-India Financial Institutions (FIs) to raise short-term resources through the issue of CP under the umbrella limit fixed by RBI. Satellite dealers, which were allowed to issue CPs earlier, were discounted from issuing with effect from June 1, 2002. Currently, every issuer must appoint an Issuing and Paying Agent (IPA) for issuance of CP and only scheduled bank can act as an IPA for issuance of CP. On maturity of CP, the holder of CP shall present the instrument for payment to the issuer through the IPA. However, when CP is held in demat form, the holder of CP will have to get it redeemed through the depository and receive payment from the IPA. IPA monitor defaults in redemption of CP. Scheduled banks which act as IPA have to report to RBI in case of such occurrence giving full particulars of default of repayment of CPs.

Market Potential and Interest Rates of Commercial Paper

The following table presents an overview of the outstanding amounts and the effective interest rates for CPs in the years from April 2004 to April 2007. It can be observed that the size of the market is very small. Also, there were many inter year and intra year fluctuations on the amount of CPs. Table 1: Issue of Commercial Paper* by Companies
(Amount in Rs. crore) Fortnight ended 1 2004-05 April May June July 15 9,590.25 30 9,706.45 15 10,322.45 31 10,328.45 15 10,353.95 30 10,909.95 15 10,688.20 31 10,848.20 4.66-6.20 4.50-6.50 4.47-5.95 4.56-7.00 4.50-6.05 4.60-6.20 4.63-7.00 4.61-5.60 July June May Total Amount Outstanding 2 Rate of Interest (percent) @ 3 April Fortnight Total Amount ended Outstanding 1 2005-06 15 30 15 31 15 30 15 31 15,213.90 15,597.90 16,077.90 17,181.90 17,521.90 17,796.90 18,156.51 18,349.11 5.55-6.33 5.50-6.65 5.38-6.65 5.40-6.65 5.42-6.65 5.45-6.51 5.57-7.50 5.25-7.50 2 Rate of Interest (percent) @ 3 April Fortnight Total Amount ended Outstanding 1 2006-07 15 30 12,968.25 16,525.15 6.77-8.95 6.35-9.25 2 Rate of Interest (percent) @ 3

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(Amount in Rs. crore) Fortnight ended 1 August Total Amount Outstanding 2 15 11,097.20 31 10,956.30 September 15 11,094.80 30 11,319.30 October 15 10,712.10 31 10,266.30 November 15 9,193.20 30 10,149.70 December 15 11,723.70 31 12,106.70 January 15 12,215.30 31 12,371.90 February 15 13,322.90 28 13,068.90 March 15 13,209.90 31 13,418.90 * @ : : Rate of Interest (percent) @ 3 4.65-6.50 4.60-7.69 4.68-7.00 4.55-6.50 4.95-7.25 5.10-6.30 5.10-6.23 5.40-7.00 5.35-6.75 5.10-7.10 5.40-6.35 5.10-7.10 5.21-10.33 5.37-7.33 5.50-6.76 5.20-7.25 March January October Fortnight Total Amount ended Outstanding 1 August 15 31 2 19,226.71 19,206.71 Rate of Interest (percent) @ 3 5.50-7.50 5.45-7.50 5.50-6.56 5.45-6.65 5.69-7.50 5.63-7.50 5.75-6.60 5.90-6.79 6.21-7.75 6.20-7.75 6.50-7.75 6.65-8.50 7.03-8.50 7.22-8.75 7.75-8.95 6.69-9.25 Fortnight Total Amount ended Outstanding 1 2 Rate of Interest (percent) @ 3

September 15 19,798.71 30 19,694.71 15 18,561.71 31 18,545.51 November 15 17,902.51 30 17,768.35 December 15 16,871.35 31 17,180.35 15 17,225.15 31 16,320.80 February 15 16,173.35 28 15,876.35 15 12,862.35 31 12,767.35

Issued at face value by companies. Typical effective discount rate range per annum on issues during the fortnight.

Source: RBI, Bulletin, may, 2006

Reasons for Underdevelopment

The experts attribute the following reasons for underdevelopment: Restricted entry of corporates into this market. The stringent conditions laid down by the RBI have made entry of good but small companies difficult. A company is prompted to issue a CP if the cost of funds is lower than the PLR of the banks, which is usually the rate the top class companies will be obtaining. Since the cost of CP includes rating charges, stamp duty, IPAs fee in addition, to the discount, the effective cost should be lower than the PLR. Otherwise, it will not be prudent for a corporate to issue CP. All these costs have to be incurred each time a company issues a CP thus increasing the effective cost. Hence, a company may not be able to come out with a CP issue if the difference in the effective cost and PLR is marginal. The minimum size of investment for an individual investor is too high, there are no tax benefits. Hence, the individuals and other small investors are away from this market.

Scheduled Commercial Banks Investments in Commercial Papers

The outstanding amounts of scheduled commercial banks and their investments in the commercial paper, bonds, debentures, shares, etc., are given in the following table. The outstanding amount as on March 27, 2002 was Rs.8,497 crore and on march 31st 2006 it was Rs.4,821crore. When compared with the investments in other instruments like bonds debentures by private and public sector the investment in the commercial paper is very less. The following table shows the scheduled commercial banks investments in commercial paper, bonds, debentures, shares, etc. 296

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Table 2: Scheduled Commercial Banks Investments in Commercial Papers

(Rs. crore) Outstanding as on 1 March March March March October September October October October October November November November November December December December December January January January January February February February February March March March March April March 22, 21, 19, 18, 1, 30, 15, 14, 29, 28, 12, 11, 26, 25, 10, 9, 24, 23, 7, 6, 21, 20, 4, 3, 18, 17, 4, 3, 18, 17, 1, 31, 2002 2003 2004 2005 2004 2005 2004 2005 2004 2005 2004 2005 2004 2005 2004 2005 2004 2005 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 Commercial Paper 2 8,497 4,007 3,770 3,891 3,312 4,090 3,579 4,286 3,828 4,354 3,663 4,077 3,614 4,227 3,901 3,664 3,726 3,900 3,492 3,861 3,354 3,562 3,367 3,321 3,464 3,312 3,633 3,869 3,891 3,989 3,798 4,821 Shares issued by Public Sector Undertakings (PSUs) 3 1,587 1,430 1,272 1,613 1,461 1,653 1,525 1,695 1,716 1,710 1,764 1,726 1,714 1,653 1,606 1,620 1,719 1,647 1,697 1,653 1,702 1,772 1,694 1,761 1,692 1,928 1,658 1,967 1,613 2,051 1,843 1,884 Bonds/Debentures issued by Private Corporate Public Sector Private Corporate Sector Undertakings (PSUs) Sector 4 4,327 7,589 7,395 10,288 7,810 9,958 10,317 10,039 10,333 10,169 10,344 10,100 10,017 10,130 10,338 10,022 10,347 10,571 10,170 10,608 10,275 11,412 10,180 11,725 10,260 11,330 10,372 12,229 10,288 11,217 10,131 10,918 5 39,520 46,854 48,646 45,937 45,839 38,272 45,350 37,877 45,123 36,529 44,658 35,309 43,884 34,442 43,734 33,896 43,734 33,892 42,115 33,800 41,606 33,417 40,772 33,416 40,098 32,904 41,054 32,912 45,937 33,105 46,593 32,574 6 27,069 32,973 27,903 31,934 27,036 28,295 31,063 28,735 31,859 28,910 32,197 28,798 32,407 28,832 31,915 27,999 31,915 28,416 32,235 28,914 32,305 29,340 31,883 30,658 33,057 30,482 33,989 30,520 31,934 31,183 30,719 30,875

Note: From the financial year 2001-02, data on investments are based on Statutory Section 42(2) Returns. Such data for the earlier period were based on Special Fortnightly Return (SFR VII), which has since been discontinued.

Future Outlook
The RBI is constantly watching the growth of the CP market, and it is modifying/relaxing the guidelines for the enhancement of the same. While doing so, the RBI can consider the following measures to facilitate the growth of the market: Relax stringent conditions to reduce the overall cost of a CP. For example, the rating fees charged by rating agencies is relatively high, in spite of which the RBI insists upon a fresh rating (less than 2 months old) every time a CP is issued; this in turn pushes up the cost of issue to the issuer.

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Banks were earlier permitted to sanction standby facility to the companies issuing CPs so that upon redemption the working capital limits would be automatically restored. While RBI disallowed sanction of standby facility, it has not delinked the amount to be raised from fund-based working capital limits. As the concept of MPBF has also been abolished, the limit to raise funds under CP may be delinked from the fund-based working capital limits. The validity of the credit rating may also be extended beyond two months. If the CP is allowed to be underwritten, it can facilitate more corporates to issue CPs thereby widening the market. The scope to develop the CP market is high in view of the flexibility a corporate enjoys and the liquidity available in the system. Box 2: Commercialization of Commercial Paper There are no hard and fast rules regarding the means and methods of finance for a corporate; all are meant to keep the wheels of the industry moving. However, there are established usages of a means of finance and any remarkable deviation from the erstwhile norms merits discussion. As we all know, a corporate gets working capital limits sanctioned by his banker or consortium of bankers and draws credit as and when required. The cost of this cash credit or overdraft is the banks PLR at the minimum or anything over and above the PLR, depending on the credit rating, fundamentals and negotiating powers of the corporate. Though as a matter of policy CPs are not part of working capital limits, very few corporates get the facility of standalone CPs. According to guidelines, a CP can be issued as a standalone product and banks have the flexibility to fix working capital limits taking into account the resource pattern of the companys financing including CPs. However, from the issuers perspective as well, it is better to have a fallback, as market conditions may turn averse at the time of maturity of the CP. As a matter of trade usage, the investor, particularly the subsequent investor, needs the comfort of fallback on the working capital limits. Optionally, banks may provide standby credit facility, for which they are entitled to charge fees; but corporates would not like to increase the cost of funds. Many issuers issue CPs perpetually, i.e., with a revolving facility at maturity. This way, through a short-term instrument, the corporate gets access to longterm funds. If the existing investor is not interested in re-investing, the corporate can get another investor to continue with it. There is a typical set of investors: banks, mutual funds and financial institutions, who invest in CPs. Even if there is a problem in negotiating with the existing or prospective investor, it is a matter of a few days only. The corporate can resort to CC/OD during the interlude. The higher cost of CC/OD would be incurred only for a few days during the negligible period. In this fashion, short-term funds can be used for long-term purposes. Conventionally, for project financing, a corporate would approach a term-lending institution or bank, which would entail a lot of paraphernalia and higher cost. It is a win-win situation. For the company, it means lower cost of funds. Even if the savings is not 4 percentage points as discussed above, it is substantial. In this age of competition, it renders the bank able to keep the corporate within the consortium. Though it leads to a deliberate asset-liability mismatch, by funding long-term projects through short-term means, the objectives of a corporate are different from those of a bank; the basic objective of a business enterprise is to produce goods and services in the most efficient manner with resources at the lowest cost. In the bargain, the market for CPs is getting expanded; which is beneficial both to the issuer as well as to the investor. 298

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The rise in volume of CP issuances can be traced to the profile of investors, apart from the advantages discussed above. Nowadays, the major chunk of inflows in mutual funds is in liquid/money market schemes, income schemes and gilt schemes. A major avenue of investment for mutual funds is commercial papers, apart from call and call-linked instruments, and corporates would be happy to oblige by supplying papers, thereby saving cost vis--vis regular working capital. Banks and financial institutions are happy to invest in CPs even at a lower rate, as there is a dearth of good quality borrowers and it is important to keep them within the consortium. Of late, insurance companies, i.e., LIC and GIC, who are sitting on surplus cash, are investing extensively in CPs. Source: www.debtonnetindia.com

COMMERCIAL PAPERS IN INTERNATIONAL MARKETS

The concept of raising money through Commercial Papers has been known to the US markets since the 18th century. Other nations came to know of it only in the earlier part of the 19th century. The US firms started selling open market paper as a substitute to the customary bank loan that was required for working capital. Commercial Papers (CPs) are defined as short-term, unsecured usance promissory notes issued at a discount to face value with fixed maturity by well-known companies that are financially strong and carry high credit ratings. They are referred by different names such as Industrial Paper, Finance Paper and Corporate Paper depending on the nature of the issuing firm.

Issuers and Buyers

Commercial paper is the second largest money market instrument in the US, after Repos, surpassing T-bills, with a total value exceeding $1.4 trillion, by the end of 1999. American commercial paper is rated by one or more credit rating agencies and as such the credit risk on it is perceived to be low, but existent. The liquidity of the instrument is also very low. The CPs are generally issued by the public utilities, bank holding companies (corporations organized to acquire and hold the stock of one or more banks), insurance companies, transportation companies, and finance companies. Banks, liquid business concerns, insurance companies, state and local governments and non-banking financial institutions mostly buy CPs. Commercial Paper: A Comparative Position Countries Legal Basis USA Securities Act United Kingdom France English Common 1. French 1. Financial and Law Monetary Code 2. Decree and CRBF 2. Regulation India Non-banking (Acceptance of deposit through CP) Direction 1989 Section 45K of RBI Act, 1934 Between one day 15 days and up to and upto one year 1 year

Maturity Period

Denomination

No minimum and Less than 365 Maximum period days but in effect ranges from 1 day to 270 days. No required Minimum EUR 40, 000 Denomination but market practice of $1,00,000

A unit value Denominations of equivalent at least Rs.5 lakh or multiple thereof. EUR 1,50,000 Amount invested by a single investor should not be less than Rs.5 lakh (face value).

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Issuers

Both Financial and No restriction non-financial corporation

Rating

Tough not compulsory, in practice A-1/P1 Money market mutual funds, banks, financial corporations, securities dealers and private and govt. pension funds

Rating not compulsory, purely driven by market convention Institutional

Investment firms, companies making public offer, EIG, public companies, community institutions and international organization of which France is member. Rating is not compulsory

Corporates, primary dealers (PDs) and FIs.

Investors

Institutional

Asset Backed Euro Commercial Medium Term Commercial Paper Paper, NIF, Notes Revolving Underwriting Facilities Placing and Trading Buy back possible No buy back trading open to authorized credit institution or investment firm. Buy back is possible through central depository Issued in book No central Same day Settlement entry form & same Securities settlement day settlement depository. Market practice is to clear ECP transactions through Euroclear or clearstream. No demat, Dematerialization Dematerialization DTC immobilised is compulsory global certificate since 1993 with a central depository Taxation and Only Income Tax No withholding Withholding Tax Stamp Duty on the interest and tax and no stamp capital gain tax as duty for CP upto sales, no other 365 days. For faxes. non-residents for CP above 365 days with holding tax applicable Source: www.rbi.org.in Innovation 300

P2 of CRISIL or its equivalent from other rating agencies Individuals, banks companies, other corporate bodies registered or incorporated in India and unincorporated bodies, NonResident Indians (NRIs) and Foreign Institutional Investors (FIIs).

No buy back

Generally T+ 2 basis

Dematerialization since June 2001

Stamp duty applicable as per maturity.

Financial Markets and Instruments

PURPOSE The funds raised by means of CPs by corporates are used for current transactions such as purchase of inventories, payment of taxes, meeting payrolls and to meet other short-term rather than long-term obligations.

Types of Commercial Paper

There are two major types of commercial paper direct paper and dealer paper. The direct paper is issued by large finance companies and bank holding companies deal directly with the investor rather than use a dealer as an intermediary. Though the issuers of direct paper do not have to pay any dealers commission, these companies must operate a marketing division to maintain constant interaction with active investors. And also these companies need to pay fees to banks for supporting lines of credit, to the rating agencies and to agents (i.e., bank trust departments). Hence, this paper must be sold in large volumes to cover the substantial costs of distribution and marketing. The dealer paper is issued by dealers on behalf of their corporate customers. It is mainly issued by non-financial companies and finance companies. The issuing company sells the paper directly to the dealer at a discount and commission. The dealer will resell it at the highest possible price in the market. Companies using dealers to place their paper are generally smaller, less frequent borrowers than issuers of direct paper. An open rate method is followed by which the company receives some money in advance but the balance depends on the performance of the issue in the open market. Rate of Return The rate of return on a commercial paper is computed by using the following formula in a secondary market transaction: D=

Par Value Purchase Price 360 x Par Value Days to Maturity

This could be well understood by the following example. Illustration 1 Mr. A purchased a commercial paper of Maxwell Inc., issued for 3 months in the market for $976,000. The company issued CP with a face value of $1,000,000. Determine the rate of return which A earns. DR =

Par Value Purchase Price 360 x Par Value Days to Maturity

1,000,000 976,000 360 = 0.048 or 4.8% x 1,000,000 180

Commercial Papers in UK
Various aspects relating to the issue, regulatory, accounting and tax matters are provided in the London Market Guidelines on commercial paper issued by the BBA (British Bankers Association) in April, 2000. Some aspects of these regulations were modified when the FSMA (Financial Services and Markets Act, 2000) came into force in December, 2001. In UK, the Commercial Paper (CP) is regarded as a flexible short-term instrument through which a cost-effective funding of requirements can be done. The markets for Euro Commercial Paper (ECP) emerged in the early 1980s as a derivative of underwritten Note Issuance Facilities (NIFs), which resulted in the development of uncommitted US Dollar based ECP programs. One important feature of ECP was that it did not meet the terms of Securities Exchange Commission in the US and hence could not be sold to US investors. Since then the ECP market is being transformed into the only truly multi-currency short-term market, encompassing a number of currencies, including Sterling, Swiss Francs, Japanese Yen and the Euro. 301

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The London Market Guidelines for the Commercial Paper market issued by the BBA in April, 1999 altered the earlier CP issuance guidelines made in 1997. These guidelines stood as the standard practice in Europes most active CP market.

INNOVATIONS IN COMMERCIAL PAPER

Master note is a new financial paper issued by finance companies to bank trust departments and other permanent money market investors. In an arranged agreement, the investing firm notifies the issuing company as to how much paper it will purchase on that particular day, and the issuing company in turn issues a paper on the maximum agreed amount. The interest on daily papers is pooled and taken by the investors during the current month. Medium-term notes are unsecured obligations, papers with a maturity period of 9-10 months. These are issued by investment grade corporations at a fixed interest rate. These papers suit companies with substantial quantities of medium-term assets as they have longer maturities when compared to conventional CPs and IOUs. Asset-backed commercial paper gives credit at a lower interest rate to the corporates. This paper is nothing but, a pool of loans or credit receivables made into packages. These packages are issued in the form of a paper, and these loans or receivables are removed from the issuing companies balance sheet and are placed in a Special-Purpose Entity (SPE). SPE issues the commercial paper to cover discount price and uses the proceeds for purchase of the receivables. The issuing customer usually services the underlying receivables, collects interest and principal payments and passes the funds to SPE. In the process a bank is chosen to service the receivables supporting the paper issue. CPs are likely to have good future so long as they can be tailored to meet the needs of both the buyers and issuers in terms of maturity, liquidity and returns.

Latest Developments in India

The RBI in its mid-term Review of the Annual Policy Statement for the year 2004-05, base on the discussion with market participants and Recommendations of the Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets had issued notification of reporting of issuance of CP on the Negotiated Dealing System (NDS) platform by the end of the day and holding of CPs in denaturalized form. The RBI is has set-up a group under the Chairmanship of C.E.S Azariah, the Chief General Manager, State Bank of India within FIMMDA for viewing the settlement on T+1 basis. Preference for Dematerialized Holding Banks, FIs, PDs and SDs were advised to invest and hold CP only in dematerialized form, as soon as arrangements for such dematerialization are put in place. As the existing arrangements for dematerialized holding for CP are now considered adequate and satisfactory, banks, FIs, PDs are permitted to make fresh investments and hold CP only in dematerialized form. Similarly, they are also permitted to make fresh investments and hold bonds, debentures, privately placed or otherwise only in demat form. As regards the equity instruments they are permitted to be held by the above-mentioned institutions only in dematerialized form, from the date notified by SEBI.

SUMMARY
Commercial Papers (CPs) are short-term unsecured usance promissory notes issued at a discount to face value by reputed corporates with high credit rating and strong financial background. CPs are open to individuals, corporates, NRIs and banks, but the NRIs can invest on non-repatriable/non-refundable basis. FIIs have also been allowed to invest their short-term funds in CPs.

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The features of CPs are: They do not originate from specific trade transactions like commercial bills. They are unsecured, involve much less paper work and have very high liquidity. CPs have a minimum maturity of 7days and a maximum maturity of 1 year. They are available in denomination of Rs.5 lakh and multiples of Rs.5 lakh and the minimum investment is Rs.5 lakh per investor. CPs can be direct paper if issued directly to the investors by the corporate or dealer paper if issued through an intermediary/merchant banker. CPs are usually placed with the investors by issuing and paying agents. Secondary market trading takes place in lots of Rs.5 lakh each usually by the banks. The transfer is done by endorsement and delivery. The main reasons for poor development of the CPs market are: restricted entry of corporates, tendency to issue CPs only if the total cost is lower than the PLR of banks, high minimum investment of individual investors and no tax benefits. In the US markets, CPs are defined as short-term, unsecured usance promissory notes issued at a discount to face value with fixed maturity by financially strong companies with high credit ratings. The main purpose of issuing CPs in the US is to finance current assets. The main features are: high liquidity and safety, high quality instruments negotiable by endorsement and delivery, issued in multiples of $1,000 as bearer documents at a discount to the face value. They are unsecured by nature and tailored to the user requirement as far as maturity period is concerned. Two types of CPs exist in the US: direct paper (issued directly by the corporates and large banks) and dealer paper (issued by the dealers on behalf of their corporate clients). The innovations in the American CP market are: master note (financial paper issued by finance companies to bank trust departments with interest pooled by the investors), medium-term notes (unsecured obligation papers with maturity of 9-10 months issued by investment grade corporations at fixed rate) and asset-backed commercial papers (packages of pooled loans or credit receivables with lower rates of interest and placed with a special purpose entity).

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(Specimen) Appendix* Schedule I

Stamp to be Affixed as in force in the State in which it is to be issued

--------------------------------------------------------(NAME OF THE ISSUING COMPANY/INSTITUTION)

SERIAL NO.

Issued at:--------------------------------------------- Date of issued: -----------------------(PLACE) Date of Maturity:------------------------------------------without days of grace. (If such date happens to fall on a holiday, payment shall be made on the immediate preceding working day) For value received --------------------------------------------------------------------hereby (NAME OF THE ISSUING COMPANY/INSTITUTION) Promises to pay ------------------------------------------------------------- or order on the (NAME OF THE INVESTOR) maturity date as specified above the sum of Rs.------------------------------------------(in words) upon presentation and surrender of this Commercial Paper to---------------------------------------------------------------------------------------------------------------(NAME OF THE ISSUING AND PAYING AGENT) For and on behalf of -------------------------------------------------------------------------(NAME OF THE ISSUING COMPANY/INSTITUTION)

AUTHORISED SIGNATORY

AUTHORISED SIGNATORY

* Source: RBI/master circular/commercial paper/July 1, 2005

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ALL ENDORSEMENTS UPON THIS COMMERCIAL PAPER MUST BE CLEAN AND DISTINCT EACH ENDORSEMENT SHOULD BE WRITTEN WITHIN THE SPACE ALLOTED Pay to ------------------------------------------------------------------------ or order (NAME OF TRANSFEREE) the amount within named.

For and on behalf of ---------------------------------------------------------------------------------(NAME OF THE TRANSFEROR) ----------------------------------------------------------------------------------

1. 2. 3. 4. 5. 6. 7. 8.

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Schedule II
Proforma of information to be submitted by the Issuer for issue of Commercial Paper (To be submitted to the Reserve Bank through the Issuing and Paying Agent (IPA) within 3 days of the completion of issue of CP to MPD, RBI, Mumbai) To: The Adviser-in-Charge Monetary Policy Department Reserve Bank of India Central Office Mumbai 400 001.

Through: (Name of IPA)

Dear Sir

Issue of Commercial Paper In terms of the guidelines for issuance of commercial paper issued by the Reserve Bank dated August 19, 2003, we have issued Commercial Paper as per details furnished hereunder:

i. ii. iii. iv.

Name of the Issuer

Registered Office and Address : Business activity Name/s of Stock Exchange/s with whom shares of the issuer are listed (if applicable) : :

v.

Tangible networth as per latest audited balance sheet : :

vi.

Total Working Capital Limit

vii. Outstanding Bank Borrowings : vii. a) Details of Commercial Paper issued (Face Value) Rate : Date of Issue i. ii. b) Amount of CP outstanding (Face Value) including the present value 306 : Date of Maturity Amount

Financial Markets and Instruments

ix.

Rating(s) obtained from the Credit Rating Information Services of India Ltd. (CRISIL) or any other agency as specified by Reserve Bank

i.

ii.

iii.

x.

Whether standby facility has been provided in respect of CP issue?

xi.

If yes i. the amount of the standby facility ii. provided by (Name of bank/FI) : Rs. crore

xii. Whether unconditional and irrevocable guarantee has been provided in respect of CP issue? xiii. If yes i. the amount of the guarantee : Rs. crore

ii. provided by (Name of guarantor) iii. Credit rating of the guarantor

For and on behalf of

-------------------------(Name of the issuer)

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(Specimen) CERTIFICATE** 1. We have a valid IPA agreement with the---------------------------------------------(Name of Issuing Company/Institution) 2. We have verified the documents viz., board resolution and certificate issued by Credit Rating Agency submitted by -------------------------------------------------(Name of the Issuing Company/Institution) and certify that the documents are in order. Certified copies of original documents are held in our custody. 3.* We also hereby certify that the signatures of the executants of the attached Commercial Paper bearing Sr. No.____________date_________________for Rs.___________________(Rupees_________________________________) (in words) tally with the specimen signatures filed by____________________________ (Name of the issuing Company/Instittuion)

(Authorized Signatory/Signatories) (Name and address of Issuing and Paying Agent) Place Date : :

* (Applicable to CP in physical form)

** Source: RBI/master circular/ commercial paper/ July 1, 2005

308