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

Commercial Paper (CP)

The concept of CPs 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

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

instruments. Non resident Indians can invest in CPs 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

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 investors 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.

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).

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 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 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 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.

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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 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). CDs 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 CDs on a non-repatriable, non transferable basis. They are issued at a discount rate freely determined by the issuer and the market/investors. Rating CDs 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. .

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Risks Involved

Price risk/Interest rate risk Liquidity risk 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 ones 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 14

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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