Commercial paper is a short-term, unsecured financial instrument companies use to raise funds for their operating expenses or other short-term needs. Issued at a discount, it is redeemed at face value on maturity, normally within 270 days. Despite its utility, however, there are several limitations of commercial paper that prevent its wide usage. The constraints include its eligibility requirements, market risks, and the requirement for robust financial stability among issuing firms.
What is Commercial Paper?
Commercial paper is the money market instrument issued by corporations to meet their short-term financial obligations. Commercial paper is an alternative mode of financing that corporations raise with lower interest rates in comparison to traditional bank loans. Companies with good credit ratings mainly use commercial paper, which provides a relatively safe and liquid investment choice for investors.
Characteristics of Commercial Paper
- Unsecured Nature: It is not backed by collateral.
- Short-Term Tenor: The maturity period ranges from 7 days to 270 days.
- Discount Pricing: Sold at a discount to its face value.
- Eligibility Criteria: Only large, creditworthy corporations can issue it.
Commercial paper helps corporations manage liquidity and short-term debt but is unsuitable for long-term financial needs.
Advantages of Commercial Paper
Commercial paper offers several benefits to issuers and investors. Its advantages have popularized it among large corporations seeking quick financing options.
Flexibility in Financing
Commercial paper provides issuers with the ability to quickly secure funds without undergoing the lengthy processes involved in traditional bank loans. Its issuance process is streamlined and adaptable, which is crucial for companies facing immediate financial requirements.
Cost Efficiency
The commercial paper cost of borrowing is often below the rate charged on the bank loan. It thus makes it a highly attractive option for corporations that wish to keep their financing costs down. For investors, it comes with slightly higher returns relative to traditional savings or fixed deposits.
Liquidity for Investors
Commercial paper is a liquid asset that can be traded in secondary markets. This ensures that investors can access their funds before maturity if needed.
No Collateral Requirement
Since commercial paper is unsecured, corporations do not need to pledge assets to raise funds. This is advantageous for companies seeking to preserve their asset base for other purposes.
Limitations of Commercial Paper
Limitations in commercial paper arise from market conditions, the creditworthiness of issuers, and restrictions placed by regulators. Despite its efficiency as a tool for some corporations, limitations render it unfeasible for many companies.
Restrictive Eligibility Criteria
Commercial paper can be issued only by large corporations that are financially stable with good credit ratings. Companies that have poor credit ratings or are small and medium-sized enterprises are usually disqualified. This means that, as a source of funding, commercial paper is less accessible to small businesses.
Lack of Collateral Security
The unsecured nature of commercial paper exposes it to default risk. If the issuer fails to repay, investors may lose their principal, making it less attractive to risk-averse investors.
Short-Term Nature
Commercial paper is appropriate only for short-term liquidity requirements. Businesses that need funds for long-term investments or projects cannot rely on this instrument. This often makes companies seek alternative funding sources, such as bank loans or equity.
Sensitivity to Market Conditions
Commercial paper is highly sensitive to market conditions. In a financial instability or economic downturn, companies may not be able to issue commercial papers at favorable terms. Investors will also avoid the market when there is uncertainty, further limiting its viability.
Limited Investor Base
The investor base for commercial paper is restricted to institutional investors and high-net-worth individuals (HNIs). Retail investors generally do not participate in this market due to the high denomination of commercial paper and lack of awareness.
Regulatory Compliance
Issuing commercial paper involves adhering to stringent regulatory norms set by governing authorities. Companies must ensure compliance with these regulations, which might complicate the issuance process.
| Aspect | Description | Limitation |
|---|---|---|
| Eligibility | Only large corporations with high credit ratings qualify. | Excludes smaller businesses and startups. |
| Nature | Unsecured instrument. | Exposes investors to default risks. |
| Tenor | Short-term financing only. | Unsuitable for long-term projects or investments. |
| Market Dependency | Affected by economic conditions. | Reduced investor participation during financial instability. |
| Investor Scope | Primarily institutional investors. | Limits retail participation due to high denominations and lack of awareness. |
| Regulatory Requirements | Compliance with strict norms. | Increases administrative burden on issuing companies. |
Disadvantages of Commercial Paper FAQs
Who can issue commercial paper?
Only large corporations with high credit ratings and financial stability are eligible to issue commercial paper. SMEs and startups typically cannot participate in this market due to their higher credit risk.
What are the limitations of commercial paper?
The limitations of commercial paper include restrictive eligibility criteria, its short-term nature, lack of collateral, high market dependency, a limited investor base, and regulatory challenges.
Why is commercial paper unsecured?
Commercial paper is unsecured because it relies on the creditworthiness of the issuing company rather than collateral. Only financially stable companies can issue it without security.
Can small businesses use commercial paper?
Small businesses generally cannot use commercial paper due to their lower credit ratings and inability to meet regulatory requirements.
What happens during an economic downturn?
During economic downturns, the market for commercial paper often shrinks as investors become risk-averse, and issuers struggle to secure favorable terms.
