Commercial paper is an example of the securitization process. For companies it offers an alternative to bank borrowing or to an existing form of short-term security: the bill of exchange.
In essence, commercial paper is just another form of unsecured short term IOU, issued in bearer form. It is normally issued at a discount rather than paying interest, with a maturity of up to a year. In Britain the average life of commercial paper has been close to 40 days hitherto.
The sterling commercial paper market got under way in London in May 1986 and initially was open only to very large established companies. These conditions have subsequently been relaxed, opening the way for medium-sized companies to tap the market.
The issue process goes as follows. A company wanting to tap the market gets a bank to set up a programme for it: say, £200m. This defines the maximum amount that the company may have outstanding at any one time. At the same time dealers are appointed. When the company wants to raise cash it alerts the dealers, or the dealers may take the initiative by telling the company that there is demand among investors for paper of a particular maturity. The dealers, who are constantly in touch with potential investors, find buyers for the paper. The paper is sold at a discount to its face value which provides the equivalent of a rate of interest. The buyers may be institutions or companies looking for a short-term investment.
When the original issue falls due for repayment, further issues can be made to replace it. Thus, though it is a very short-term market, by rolling over issues in this way companies may use it as a medium-term source of finance. In addition to the sterling commercial paper market there is an active international equivalent the euro commercial paper market where companies can similarly set up programmes, perhaps allowing them to issue in a number of different currencies.
There is also now a longer-term form of money market borrowing in the medium term note or MTN, which has a life of one to five years. Like commercial paper, it has its euro- market equivalent in euro medium term notes or EMTNs.
The multiple option facility or MOF is another form of arrangement for tapping the money markets which was popular in the late 1980s and might possibly see a resurgence. It emerged in various shapes but a typical arrangement might have been as follows.
A company got one particular bank to put together a panel of banks who agreed to make available a certain amount of loans say £150m for a period of five years. The rate of interest, which would be variable, was set at such-and-such an amount above the benchmark rate of interest when the loans were taken up. This £150m was what was known as the committed facility or and by facility.
Another group of banks was put together, comprising the original banks plus others which were recruited. They formed a tender panel. When the company decided it needed cash, the tender panel banks were invited to bid to provide the funds. Those that were flush with cash at the time would have responded, and the bank or banks bidding the lowest rate of interest would have made the loans to the company. If none of the tender panel banks bid at a rate below that on the and by facility, the company would have resorted to raising the money via this standby. Thus it was sure of getting its cash when needed.
The loans made under this arrangement would probably have been short-term: say, for three months. But as one loan fell due for repayment new loans could have been arranged, so for the company it provided the equivalent of medium-term borrowing at a competitive rate of interest. The ‘multi-option’ refers to the fact that the arrangement allowed for the money to be raised in a number of different forms, which might have included straight loans, acceptances, and foreign currency loans and so on.
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