Money market instruments

The term "Money Market" refers to the market for short-term requirement and

deployment of funds. Money market instruments are those instruments, which have a

maturity period of less than one year. The most active part of the money market is the

market for overnight and term money between banks and institutions (called call money)

and the market for repo transactions. The former is in the form of loans and the latter are

sale and buy back agreements – both are obviously not traded. The main traded

instruments are commercial papers (CPs), certificates of deposit (CDs) and treasury bills

(T-Bills). All of these are discounted instruments i.e. they are issued at a discount to their

maturity value and the difference between the issuing price and the maturity/face value is

the implicit interest. One of the important features of money market instruments is their

high liquidity and tradability. A key reason for this is that these instruments are

transferred by endorsement and delivery. Another important feature is that there is no tax

deducted at source from the interest component.

Money Market Instruments :

Commercial Papers

Commercial Bills

Certificates of Deposit

Treasury Bills

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Commercial Paper (CP)

The concept of CP’s was originated in USA in early 19 th century when

commercial banks monopolized and charged high rate of interest on loans and advances.

In India, the CP was launched in January 1990.

It is an unsecured money market instrument issued in the form of a promissory

note. CP was introduced in India in 1990 with a view to enabling highly rated corporate

borrowers to diversify their sources of short-term borrowings and to provide an additional

instrument to investors.

These are issued by corporate entities in denominations of Rs2.5mn and usually

have a maturity of 90 days. CPs can also be issued for maturity periods of 180 and one

year but the most active market is for 90 day CPs.

Two key regulations govern the issuance of CPs-firstly, CPs have to be

compulsorily rated by a recognized credit rating agency and only those companies can

issue CPs which have a short term rating of at least P1. Secondly, funds raised through

CPs do not represent fresh borrowings for the corporate issuer but merely substitute a part

of the banking limits available to it. Hence, a company issues CPs almost always to save

on interest costs i.e. it will issue CPs only when the environment is such that CP issuance

will be at rates lower than the rate at which it borrows money from its banking

consortium.

Who can issue Commercial Paper (CP)

Highly rated corporate borrowers, primary dealers (PDs) and satellite dealers

(SDs) and all-India financial institutions (FIs) which have been permitted to raise

resources through money market instruments under the umbrella limit fixed by Reserve

Bank of India are eligible to issue CP.

A company shall be eligible to issue CP provided - (a) the tangible net worth of

the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the

working capital (fund-based) limit of the company from the banking system is not less

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than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard

Asset by the financing bank/s.

Commercial Papers when issued in Physical Form are negotiable by endorsement and

delivery and hence highly flexible instruments

Rating Requirement

All eligible participants should obtain the credit rating for issuance of

Commercial Paper, from either the Credit Rating Information Services of India Ltd.

(CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA)

or the Credit Analysis and Research Ltd. (CARE) or the Duff & Phelps Credit Rating

India Pvt. Ltd. (DCR India) or such other credit rating agency as may be specified by the

Reserve Bank of India from time to time, for the purpose. The minimum credit rating

shall be P-2 of CRISIL or such equivalent rating by other agencies. Further, the

participants shall ensure at the time of issuance of CP that the rating so obtained is

current and has not fallen due for review.

Maturity

CP can be issued for maturities between a minimum of 15 days and a maximum

upto one year from the date of issue. If the maturity date is a holiday, the company would

be liable to make payment on the immediate preceding working day.

Denominations

CP can be issued in denominations of Rs.5 lakh or multiples thereof.

Investment in CP

CP may be issued to and held by individuals, banking companies, insurance

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 30 per cent limit set for their investments in debt

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instruments. Non resident Indians can invest in CP’s on a non repatriable,

non transferable basis.

Trading

Trading is Over-the-counter or on the NSE. Market participants quote dealing

levels on yield basis specified up to two decimal places. For quotes on the NSE

equivalent prices up to 4 decimal prices need to be specified. Two way quotes are rarely

offered for Commercial Paper. Secondary market transactions do not attract any stamp

duty. There are no brokers in the Commercial Paper market. Trading is

done over the counter with the counterparties involved.

Mode of Issuance

CP can be issued either in the form of a promissory note or in a dematerialised

form through any of the depositories approved by and registered with SEBI. As regards

the existing stock of CP, the same can continue to be held either in physical form or can

be demateralised, if both the issuer, and the investor agree for the same.

How payment is received and made for CP

The initial investor in CP shall pay the discounted value of the CP by means of a

crossed account payee cheque to the account of the issuer through IPA(Issuing and

Paying Agent). On maturity of CP, when the CP is held in physical form, the holder of

the CP shall present the instrument for payment to the issuer through the IPA. However;

when the CP is held in demat form, the holder of the CP will have to get it redeemed

through depository and receive payment from the IPA.

What is the procedure of issuing CP

Every issuer must appoint an IPA for issuance of CP. The issuer should disclose

to the potential investors its financial position as per the standard market practice. After

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the exchange of deal confirmation between the investor and the issuer, issuing company

shall issue physical certificates to the investor or arrange for crediting the CP to the

investor’s account with a depository. Investors shall be given a copy of IPA certificate to

the effect that the issuer has a valid agreement with the IPA and documents are in order

Coupon Terms

CP will be issued at a discount to face value as may be determined by the issuer

and redeemable at par on maturity.

Risks Involved

Liquidity risk : This risk is managed be laying down deal size limits for the

dealers, heads of desk and heads of groups.

Credit risk : This risk is managed by laying down counterparty limits based upon

the financial strength of the counterparty.

Operational risk : The risk involved in the operations of the issuer.

Taxation

The CBDT vide circular no 647 dated 22nd March 1993 has 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.

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Credit-enhanced commercial paper

Since its introduction in the Indian market in 1990, commercial paper (CP) has

gained popularity as a convenient short-term debt instrument. Companies use it today to

reduce their borrowing costs while investors use the tradable instrument to park their

short-term funds. Yet, since commercial paper is a confidence-sensitive instrument, its

benefits have been limited to highly rated companies so far. This is evident from the fact

that 'P1+' paper accounted for 94 per cent of the Indian CP market. Even globally,

instruments rated 'P1' and 'P1+' account for 89 per cent of the total CP market.

CRISIL, however, believes that, if issuers look beyond plain vanilla CPs, the benefits of

this short-term instrument can be extended to companies that have not yet been able to

take advantage of them.

Types of Credit-Enhanced Commercial Papers

Although there are several ways of enhancing the credit quality of a CP

programmed, guaranteed CPs and asset-backed CPs are by far the most popular.

1. Guaranteed CPs

Concept

In this case, a higher-rated entity issues a guarantee to enhance the credit quality

of a CP that is issued by a lower-rated entity. The guarantee must be irrevocable and

unconditional.

Internationally, 5 to 10 per cent of the CPs issued are guaranteed. Closely held

companies and those with weaker credit quality typically use this instrument. In India

companies like International Cars & Motors Limited have used this by taking guarantee

from its stronger parent (International Tractors Limited).

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Benefits to Issuers

The instrument enables lower-rated entities to access cheap funds, even net of

expenses such as the guarantee charges levied by a bank for issuing such a guarantee. The

effective cost of funds is cheaper than working capital borrowings. Currently most of the

Indian Banks charge a PLR of around 10.5% p.a.

Also, since the Reserve Bank of India (RBI) has allowed corporates to guarantee

CPs, group companies can guarantee the CPs of weaker entities, enabling the

latter to lower their cost of funds.

Bigger corporates can also guarantee the CPs of their key vendors (small and

medium enterprises); enhancing the latter's liquidity position.

Current scenario

Till 2000, the RBI's regulations did not permit guaranteed CPs. In 2000, the

central bank allowed banks/financial institutions to guarantee CPs. Since then, several

corporates have used this facility to enter the CP market. Typically, banks extend

guarantees for a fee, which, in turn, depends on the issuer's standalone credit quality. The

scope of guaranteed CPs has also widened with the RBI permitting companies to issue

guarantees in its 2003-04 credit policy.

Only a few companies are, however, using the stand-by facility for CPs in India

today, primarily because of high guarantee charges and the higher coupon rate attached to

a credit-enhanced instrument.. Also, banks are reluctant to provide standby facilities to

weak entities. Yet, in spite of these high charges, guaranteed CPs still entail lower

borrowing costs than conventional working capital borrowings. Hence, CRISIL believes

that lower-rated corporates could do well to explore the standby facility option. Over the

last two years some of the companies who have availed this facility include Jindal

Polyester Ltd, JK Industries Ltd., Goetze (India) Ltd., United Shippers Ltd., BPL Ltd.,

The Arvind Mills Ltd., Gujarat Ambuja Exports Ltd.

2. Asset-Backed Commercial Paper

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Concept

Asset-backed CPs entail the creation of a pool of assets that are assigned to a

bankruptcy-remote entity (a special purpose vehicle called conduit) to back up the

repayment on the CP. This special purpose vehicle (SPV) buys assets from the issuer and

funds them by issuing a CP. The instrument is typically used to fund trade receivables.

The issuer collects the receivables and redeems the instrument by passing funds to the

investors through the conduit. The conduit is a nominally capitalised SPV and is

structured to be bankruptcy-remote. This is accomplished by limiting the scope of the

conduit's business activities and liabilities. Such SPVs are generally sponsored by banks,

which also provide liquidity support to ensure timely repayments.

The underlying pool of assets can also be revolving wherein the pool is regularly

replenished with similar assets as and when an asset matures.

International scenario

Since their introduction in the early 1980s, asset-backed CPs have become

immensely popular in the US. These issuances have registered a compounded annual

growth rate (CAGR) of 30 per cent in the last decade. Currently, they represent 50 per

cent of the total CP market in USA. The credit enhancement used includes a wide variety

of assets like credit cards, trade receivables and securities. Multi-seller programmes are

also popular.

Benefit to Issuers

Since an asset-backed CP is issued by an SPV, its credit quality is independent of

the issuer's credit profile. This enables weak entities with a good pool of assets to

tap the market with a higher rating (and hence, lower interest rates).

Even if a company's credit quality deteriorates, unlike in the case of regular CPs,

the SPV need not exit the market. The rating remains unaffected as long as the

credit quality of the underlying assets remain strong.

This instrument's benefits can also be extended to smaller issuers if a number of

them come together and pool their assets in the same SPV.

Benefit to Investors

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A plain vanilla CP is an unsecured promissory note without any underlying assets

supporting its repayments. In the event of a default, these unsecured papers are

last on the priority list of repayments. Investors in asset-backed CPs, however,

have better protection since the credit is backed by specific assets that offer higher

levels of safety.

It is also easier to monitor these instruments as the assets in the pool are tracked

closely and a monthly performance report is generated on them.

Besides, credit enhancement is available through pool-specific and programme

support mechanisms, which facilitates timely repayments. Over-collateralisation

and liquidity support from banks are examples of such credit enhancement.

Constraints in the Indian market

So far, only guarantees have found acceptance as a credit enhancement tool in the

Indian CP market. This is because SPVs cannot issue CPs under the current regulations

though they can float asset-backed short-term debt programmes.

Conclusion

It is thus clear that credit-enhanced CPs, especially guaranteed and asset-backed

CPs, offer several benefits to investors and issuers. These instruments can also help to

deepen the Indian CP market. CRISIL believes that although the Indian credit-enhanced

CP market is at a nascent stage today, as in the west, these instruments will gain immense

popularity once the securitization market reaches critical mass

 

 

Commercial bills

Bills of exchange are negotiable instruments drawn by the seller (drawer) of the

goods on the buyer (drawee) of the goods for the value of the goods delivered. These bills

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are called trade bills. These trade bills are called commercial bills when they are accepted

by commercial banks. If the bill is payable at a future date and the seller needs money

during the currency of the bill then he may approach his bank for discounting the bill.

The maturity proceeds or face value of discounted bill, from the drawee, will be received

by the bank. If the bank needs fund during the currency of the bill then it can rediscount

the bill already discounted by it in the commercial bill rediscount market at the market

related discount rate.

The RBI introduced the Bills Market scheme (BMS) in 1952 and the scheme was

later modified into New Bills Market scheme (NBMS) in 1970. Under the scheme,

commercial banks can rediscount the bills, which were originally discounted by them,

with approved institutions (viz., Commercial Banks, Development Financial Institutions,

Mutual Funds, Primary Dealer, etc.).

With the intention of reducing paper movements and facilitate multiple

rediscounting, the RBI introduced an instrument called Derivative Usance Promissory

Notes (DUPN). So the need for physical transfer of bills has been waived and the bank

that originally discounts the bills only draws DUPN. These DUPNs are sold to investors

in convenient lots of maturities (from 15 days upto 90 days) on the basis of genuine trade

bills, discounted by the discounting bank.

Certificates of Deposit (CD)

These are issued by banks in denominations of Rs0.5mn. Banks are allowed to

issue CDs with a maturity of less than one year while financial institutions are allowed to

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issue CDs with a maturity of at least one year. These are issued in denominations of Rs.5

Lacs and Rs. 1 Lac thereafter. Bank CDs have maturity up to one year. Minimum period

for a bank CD is fifteen days. Financial Institutions are allowed to issue CDs for a period

between 1 year and up to 3 years. Usually, this means 366 day CDs. The market is most

active for the one year maturity bracket, while longer dated securities are not much in

demand. One of the main reasons for an active market in CDs is that their issuance does

not attract reserve requirements since they are obligations issued by a bank. They are like

bank term deposits accounts. Unlike traditional time deposits these are freely negotiable

instruments and are often referred to as Negotiable Certificate of Deposits. And are also

freely transferable by endorsement and delivery. At present CDs are issued in physical

form (in the form of Usance promissory note). CD’s are not required to be rated.

CD is subject to payment of Stamp Duty under Indian Stamp Act, 1899 (Central Act).

All scheduled banks (except RRBs and Co-operative banks) and financial

institutions are eligible to issue CDs. They can be issued to individuals, corporations,

trusts, insurance companies, funds and associations. Non-resident Indians can

invest in CD’s on a non-repatriable, non transferable basis. They are issued

at a discount rate freely determined by the issuer and the market/investors.

RatingCD’s are not required to be rated.

Coupon terms

They are issued at a discount to face value and are redeemable at par on maturity.

Trading medium

CDs are traded over the counter directly with the counterparty. .

Risks Involved

Price risk/Interest rate risk

Liquidity risk

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Credit risk – Counter party risk is minimal since CD is a secure

instrument

Settlement Risk

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Treasury Bills (T-Bills)

These are issued by the Reserve Bank of India on behalf of the Government of

India and are thus actually a class of Government Securities. At present, T-Bills are

issued in maturity of 14 days, 91 days and 364 days. The RBI has announced its intention

to start issuing 182 day T-Bills shortly. The minimum denomination can be as low as

Rs100, but in practice most of the bids are large bids from institutional investors who are

allotted T-Bills in dematerialized form. RBI holds auctions for 14 and 364 day T-Bills on

a fortnightly basis and for 91 day T-Bills on a weekly basis. For example a Treasury bill

of Rs. 100.00 face value issued for Rs. 91.50 gets redeemed at the end of it's tenure at Rs.

100.00. 91 days T-Bills are auctioned under uniform price auction method where as 364

days T-Bills are auctioned on the basis of multiple price auction method. There is a

notified value of bills available for the auction of 91 day T-Bills which is announced 2

days prior to the auction. There is no specified amount for the auction of 14 and 364 day

T-Bills. The result is that at any given point of time, it is possible to buy T-Bills to tailor

one’s investment requirements.

Banks, Primary Dealers, State Governments, Provident Funds, Financial

Institutions, Insurance Companies, NBFCs, FIIs (as per prescribed norms), NRIs &

OCBs can invest in T-Bills.

Coupon terms

T-Bill is a discounted instrument and is issued in the form of a

zero coupon instrument at discount to face value redeemable at par on

maturity.

Repayment

The amount on repayment is directly credited to the current

account of the investor held with RBI.

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Risks on investment in T-Bills

Price risk. There is price risk due to interest rate sensitivity

Liquidity risk ( in some maturity segments). It should be ensured

that investment in illiquid T-Bills may not be made for that maturity

profile.

Counterparty risk. This is minimal due to DVP mode of settlement.

Operational risk. This is minimal and it is ensured that trades are

confirmed on the trade date itself and the settlement is done before

the time prescribed by RBI.

Reputation risk. The instances of SGL bouncing has reduced due to

introduction of Liquidity Adjustment Facility (LAF) by RBI. RBI

has also mentioned the introduction of Real Time Gross Settlement

(RTGS) to avoid such instances

Taxation

The discount earned on T-Bills, as well as the profit/loss on

investment is charged under the head “Income from Business and

Profession”. By virtue of proviso (iv) to Section 193 of income tax act no

tax is required to be deducted at source on interest payable on any

security of Central or State Government.(only for coupon payments) No

TDS is attracted on discount i .e. differential between issue price and face

value in case of treasury bills.

Potential investors have to put in competitive bids at the specified times. These

bids are on a price/interest rate basis. The auction is conducted on a French auction basis

i.e. all bidders above the cut off at the interest rate/price which they bid while the bidders

at the clearing/cut off price/rate get pro rata allotment at the cut off price/rate. The cut off

is determined by the RBI depending on the amount being auctioned, the bidding pattern

etc. By and large, the cut off is market determined although sometimes the RBI utilizes

its discretion and decides on a cut off level which results in a partially successful auction

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with the balance amount devolving on it. This is done by the RBI to check undue

volatility in the interest rates.

Non-competitive bids are also allowed in auctions (only from specified entities

like State Governments and their undertakings and statutory bodies) wherein the bidder is

allotted T-Bills at the cut off price.

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CAN A RETAIL INVESTOR BUY GOVERNMENT OF INDIA SECURITIES,

STATE GOVERNMENT BONDS OR TREASURY BILLS?

Theoretically, a retail investor can buy Government of India Securities, State

Government securities and Treasury Bills. The minimum amount for participation in

securities auctions is Rs10000 but these securities can be made available in

denominations of Rs100. However, there are enormous practical difficulties in buying

these. The main problems are as follows:

These securities are usually traded in large lots – at least Rs5mn with the average

transaction size being at least 10 times higher.

These securities are usually traded in the dematerialized form through the SGL

accounts maintained by the Reserve Bank of India. An individual cannot open an

individual SGL account but has to get a constituent or subsidiary account opened

with a bank. This process is tedious and costly and most banks may not entertain

individuals.

Sometimes, these securities are also available in the form of physical certificates

in the secondary market. Even here, the transaction size would be higher – in the

range of Rs0.5mn and the prices quoted for these are extremely unattractive.

Securities bought in physical certificate form are extremely illiquid and an

investor may have to hold it till redemption. Alternatively, he may be offered a

very bad price for it

All the above suggest that buying and selling of such securities on the

secondary market is almost impossible. They are listed on the BSE/NSE but do not

actually trade there in any significant manner. The debt market is actually a telephone

market where transactions get verbally concluded on the phone but are then "routed"

or "consummated" on the NSE just to fulfill the internal requirements of many

institutions. Hence, BSE/NSE brokers may not be able to help an investor in buying

these securities.

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The best way to buy these is directly from the RBI in the periodic auctions held

by it. There is a special counter at the RBI where an investor can submit a bid in an

auction or in an Open Market Operation. Here, individual investors have to present RBI

with Demand Drafts.

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