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
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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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