Overview of Short-Term Financing

In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of one to 364 days. Commercial paper is a money-market security issued (sold) by large corporations to get money to meet short-term debt obligations (for example, payroll). It is only backed by an issuing bank or a corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency can sell their commercial paper at a reasonable price.

Commercial paper is usually sold at a discount from face value and carries higher interest repayment rates than bonds. The longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions but are typically lower than banks' rates.

There are two methods of issuing paper. The issuer can market the securities directly to a buy-and-hold investor, such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells it in the market.

The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies. Most of these firms are also dealers in U.S. Treasury securities. Direct issuers of commercial paper are usually financial companies that have frequent and sizable borrowing needs and find it more economical to sell paper without an intermediary.

In the United States, direct issuers save a dealer fee of approximately five basis points, or 0.05% annualized, which translates to 50,000 on every 100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the United States.

U.S. Commercial Paper Weekly 2001-2008 U.S. Commercial Paper outstanding at the end of each week from January 3, 2001, to October 29, 2008. The vertical scale shows debt in billions (thousands of millions) of dollars, and the horizontal scale shows years. Each blue marker indicates commercial paper outstanding at that date, which matures after one week.

U.S. Commercial Paper 2001-2007 United States Commercial Paper is outstanding at the end of each year from 2001 to 2007. The vertical scale shows debt in millions of dollars, and the horizontal scale shows years. All markers indicate that the commercial paper is outstanding and maturing after December 31. Circles on the blue line indicate Total commercial paper; triangles and diamonds on the pink line indicate SEC rule 2a-7 tier-1 commercial paper; triangles on the blue line indicate Asset-backed commercial paper; squares on the yellow line indicate SEC rule 2a-7 tier-2 commercial paper.

Weekly Commercial Paper Outstandings Commercial paper is a lower-cost alternative to a bank line of credit. Once a business becomes established and builds a high credit rating, it is often cheaper to draw on commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a backup. Banks often charge fees for the amount of the line of credit that does not have a balance.

Advantages and Disadvantages

Commercial paper's advantages include lower borrowing costs, term flexibility, and, due to its trade ability, more liquidity options for creditors.

Commercial paper's disadvantages include limited eligibility, reduced credit limits with banks, and reduced reliability due to its strict oversight.

Asset-Backed Commercial Paper (ABCP)

Asset-Backed Commercial Paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. ABCP is typically a short-term instrument that matures between one and 180 days from issuance and is typically issued by a bank or other financial institution.

The firm wishing to finance its assets through the issuance of ABCP sells the assets to a Special Purpose Vehicle (SPV) or Structured Investment Vehicle (SIV) created by a financial services company. The SPV/SIV issues the ABCP to raise funds to purchase the assets. This creates a legal separation between the entity issuing and the institution financing its assets.