Commercial Paper

Commercial paper is unsecured, short-term debt that large companies, banks and finance companies sell to investors to cover near-term funding needs such as payroll, inventory and receivables. It is usually issued at a discount to its face value and repaid in full at maturity. In the United States most commercial paper matures in a matter of weeks and never later than 270 days, which keeps it outside the full registration requirements of the Securities Act of 1933.

Commercial paper is part of the money markets, alongside Treasury bills, certificates of deposit and repo. It differs from a bank loan in that the borrower raises money directly from investors, and from bonds in its very short life. Its main buyers are money market funds and corporate treasurers, which ties it closely to shadow banking.

Imagine a well-known shop that needs cash for a few weeks to stock up before the holidays. Instead of asking a bank for a loan, it writes IOUs promising to pay a fixed amount in 60 days and sells them to investors for slightly less than that amount. The difference is the investors' reward for waiting.

Because only large, trusted borrowers can do this, the IOUs are seen as almost as safe as cash, and investors simply buy new ones when the old ones are repaid. The weak point is that the borrower usually repays old IOUs by selling new ones. If investors suddenly stop buying, the borrower must find the money elsewhere at short notice, and that is exactly what happened to many issuers in 2008.

Issuers sell paper either directly to investors or through dealers, often under a standing programme that lets them issue repeatedly as needs arise. Because it carries no collateral, only borrowers with strong short-term credit ratings can issue at scale, and most programmes are supported by a back-up bank credit line. Paper is typically quoted on a discount basis using a 360-day year:

• $P$ is the price the investor pays.
• $F$ is the face value repaid at maturity.
• $d$ is the annual discount rate, written as a decimal.
• $t$ is the number of days to maturity.

For paper with a face value of 1,000,000 dollars, 90 days to maturity and a 5% discount rate, the price is $1{,}000{,}000 \times (1 - 0.05 \times 90 \div 360) = 987{,}500$ dollars. The investor earns 12,500 dollars of interest when the paper is repaid at face value. The rate an issuer pays depends on its rating, the term and conditions in the market, and it generally sits above the rate on Treasury bills of the same maturity.

• Non-financial corporate paper. Issued by industrial and consumer companies to fund working capital.
• Financial paper. Issued by banks, their holding companies and finance companies, often the largest share of the market.
• Asset-backed commercial paper (ABCP). Issued by special-purpose conduits that buy receivables, loans or securities and fund them with short-term paper, a form of securitization that relies on a bank sponsor for liquidity support.
• Euro commercial paper. Paper issued outside the issuer's home market, mainly in London, under a separate market convention.

The asset-backed segment grew to about 1.2 trillion dollars outstanding in the United States by mid-2007, much of it funding long-term mortgage securities with paper that had to be rolled every few weeks. That maturity transformation outside banks made the market fragile. When doubts over sub-prime mortgages spread in August 2007, investors stopped rolling ABCP, and conduits fell back on their bank sponsors or sold assets.

The unsecured market seized up a year later. After Lehman Brothers failed on 15 September 2008, the Reserve Primary Fund, which held Lehman paper, fell below a 1-dollar share price, an event known as breaking the buck. Investors pulled money from prime money funds, the largest buyers of commercial paper, and even highly rated companies struggled to borrow for more than a few days. Acting as lender of last resort to the market, the Federal Reserve responded in October 2008 with the Commercial Paper Funding Facility, buying three-month paper directly from eligible issuers, and revived the facility in March 2020 when markets froze again at the start of the pandemic.

In the US, the 270-day exemption lets issuers avoid full Securities and Exchange Commission registration, provided the paper funds current transactions and is sold mainly to sophisticated investors. Indirect rules matter more: money market fund regulation limits how much lower-rated paper funds can hold and requires high levels of daily and weekly liquidity. The main risks for investors are issuer default and rollover risk, the chance that an issuer cannot replace maturing paper, which can turn a temporary funding gap into a default within days.

• Federal Reserve Board: Commercial Paper Rates and Outstanding
• US Securities and Exchange Commission