Commercial Paper

The Federal Reserve Board's published description confirms that many companies use commercial paper to raise cash needed for current transactions and find it a lower-cost alternative to bank loans.

The Statutory Exemption — Section 3(a)(3) of the Securities Act of 1933

The most important regulatory characteristic of commercial paper — the one that makes it economically viable as a short-term financing instrument — is its exemption from the registration requirements of the Securities Act of 1933 under Section 3(a)(3). The Securities Act generally requires that any security offered for sale in the United States be registered with the SEC before it can be sold, a process that takes weeks or months and involves substantial legal, accounting, and filing costs. For a corporation that needs to raise cash to fund payroll in thirty days, the registration process is wholly impractical.

Section 3(a)(3) exempts from registration requirements any note, draft, bill of exchange, or banker's acceptance that arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and that has a maturity at the time of issuance of not exceeding nine months — two hundred and seventy days — exclusive of days of grace. Three conditions must all be satisfied for the exemption to apply.

First, the maturity must not exceed two hundred and seventy days at the time of issuance. This is a hard statutory limit confirmed by the Federal Reserve Board's own website — the Board explicitly states that it only considers maturities of two hundred and seventy days or less in the commercial paper context. Any note with a maturity exceeding two hundred and seventy days falls outside the Section 3(a)(3) exemption and must be registered unless another exemption applies. In practice, most commercial paper has maturities well below the maximum — the Federal Reserve confirms the average is approximately thirty days, with thirty, sixty, ninety, and one hundred and twenty-day maturities the most common increments — because most corporate liquidity needs are truly short-term and because shorter maturities allow issuers to roll the paper at prevailing market rates rather than locking in current rates for longer periods.

Second, the proceeds must be used for current transactions — working capital, the financing of receivables, the payment of current operating expenses — rather than for fixed asset investment. A corporation that issued commercial paper and used the proceeds to purchase land, construct a building, or acquire machinery would not qualify for the Section 3(a)(3) exemption because those are long-term capital transactions, not current transactions. This use-of-proceeds requirement reflects Congress's judgment that the short-term, self-liquidating nature of working capital financing justifies exemption from the registration process, while long-term capital investment requires the full investor protection framework of registration.

Third, the paper must not be of a type ordinarily purchased by the general public. Commercial paper is sold in minimum denominations of one hundred thousand dollars to sophisticated institutional investors, making it inaccessible to retail investors and consistent with the exemption's implicit premise that general public protection through registration is unnecessary when only sophisticated institutions are the buyers.

Alternative exemptions are also used in practice. Section 4(a)(2) of the Securities Act provides an exemption for transactions not involving any public offering, and commercial paper placed directly with a limited number of institutional investors without general solicitation can qualify under this private placement exemption. This so-called 4(2) commercial paper has become common and in practice is largely indistinguishable from 3(a)(3) paper in the institutional investor market.

Discount Pricing and Yield Calculation

Commercial paper is issued at a discount from its face value rather than paying periodic interest. The difference between the price paid by the investor and the face value received at maturity is the investor's return — economically equivalent to interest but structured differently. This zero-coupon, discount-to-par structure is identical to the structure of Treasury bills.

The yield on commercial paper is quoted on a discount basis using a three hundred and sixty-day year — the same convention used for Treasury bills and banker's acceptances. To calculate the dollar discount and the price of a commercial paper note: the discount equals the face value multiplied by the discount rate multiplied by days to maturity divided by three hundred and sixty. The price equals the face value minus the discount. A ninety-day commercial paper note with a face value of one million dollars and a discount rate of five and a half percent would be priced at one million minus one million multiplied by five point five percent multiplied by ninety divided by three hundred and sixty, which equals one million minus thirteen thousand seven hundred and fifty dollars, equalling nine hundred and eighty-six thousand two hundred and fifty dollars.

The bank discount yield quoted for commercial paper slightly understates the true effective yield because it uses face value rather than price in the denominator and uses a three hundred and sixty-day rather than three hundred and sixty-five-day year. Converting from bank discount yield to bond equivalent yield — which uses price in the denominator and a three hundred and sixty-five-day year and is directly comparable to yields on Treasury notes and bonds — requires adjusting for both differences. For most practical purposes at the short maturities typical of commercial paper, the difference is modest, but it becomes the most accurate yield comparison when comparing commercial paper returns to other money market alternatives.

The Federal Reserve confirms that yields on commercial paper are typically ten to twenty basis points above Treasury bills of the same maturity — a spread that reflects three risk differentials: commercial paper is subject to state and local income taxes while Treasury bill interest is exempt, commercial paper carries credit risk that Treasury bills do not, and commercial paper has lower secondary market liquidity than the highly liquid Treasury bill market.

Participants in the Commercial Paper Market

The commercial paper market involves three categories of participants: issuers, investors, and dealers.

Issuers are the large, highly rated corporations that sell commercial paper. The primary issuers are finance companies — the captive finance subsidiaries of large industrial corporations like General Motors Financial, Ford Motor Credit, and GE Capital — bank holding companies, large industrial corporations with the highest short-term credit ratings, and sovereign or supranational institutions. Only corporations with the strongest credit profiles can access the commercial paper market. Issuers with lower than top-tier credit ratings face substantially higher spreads above Treasury bills and may find the market effectively closed to them during periods of market stress when institutional investors restrict their holdings to only the highest-quality paper.

Investors in commercial paper are virtually exclusively institutional. Money market mutual funds are the dominant buyer class — they are required by SEC Rule 2a-7 under the Investment Company Act of 1940 to invest only in high-quality short-term instruments, and commercial paper from top-rated issuers qualifies. Other significant buyers include insurance companies, pension funds, corporate treasury departments managing excess cash, bank trust departments, and government entities managing short-term cash pools.

Dealers serve as intermediaries between issuers and investors in the dealer-placed commercial paper market, purchasing paper from issuers and reselling it to institutional investors, earning a spread or commission. Large investment banks including Goldman Sachs, JPMorgan, and Citigroup are the major commercial paper dealers. Some of the largest issuers place commercial paper directly with investors without using dealers — direct-placement programs are common among the largest and most frequent issuers who have established ongoing relationships with their investor base.

Credit Ratings — A Prerequisite for Market Access

Because commercial paper is entirely unsecured — backed solely by the issuer's promise to pay and its general creditworthiness — credit ratings from Nationally Recognised Statistical Rating Organisations are not merely informative in the commercial paper context. They are a prerequisite for market access. Money market funds subject to Rule 2a-7 may only purchase commercial paper that carries one of the two highest short-term ratings from at least two NRSROs. The Federal Reserve's classification of commercial paper for its statistical releases defines tier-one paper as carrying the highest short-term rating from at least two NRSROs and tier-two paper as carrying one of the two highest ratings from at least two NRSROs. Paper that does not qualify as tier-one or tier-two cannot be purchased by Rule 2a-7 money market funds at all, effectively excluding non-investment-grade issuers from the commercial paper market entirely.

The major rating agency scales for short-term obligations use different notation than the long-term scales. At Moody's, the highest short-term rating is P-1 — Prime-1 — followed by P-2 and P-3. At Standard and Poor's, the highest is A-1, followed by A-2 and A-3. At Fitch, the highest is F1, followed by F2 and F3. An issuer with P-1 or A-1 short-term ratings is a tier-one issuer with full access to the money market fund investor base at the tightest spreads. An issuer with P-2 or A-2 ratings is a tier-two issuer who can access the market but at wider spreads and with a smaller investor universe. A downgrade from tier-one to tier-two can be a significant adverse event for a corporate issuer's short-term funding costs and market access.

Backup Liquidity Facilities — The Structural Requirement

Rating agencies require commercial paper issuers to maintain backup liquidity facilities — typically committed bank credit lines — to ensure that maturing commercial paper can always be repaid even if the issuer cannot sell new paper in the market to refinance it. The Richmond Federal Reserve confirms that rating agencies require evidence of short-term liquidity and will not issue a commercial paper rating without it. The highest-rated issuers can maintain backup lines covering as little as fifty percent of their outstanding commercial paper, but issuers with lower than top-tier ratings may need to maintain backup coverage of one hundred percent.

The backup facility serves as the ultimate safety net against rollover risk — the risk that an issuer cannot sell new commercial paper to repay maturing paper, either because the market has tightened, credit concerns have emerged about the issuer, or general money market conditions have deteriorated. Without a committed backup line, an issuer who cannot roll its paper would face an immediate liquidity crisis. With the backup facility in place, the issuer can draw on the bank credit line to repay maturing paper and buy time to resolve whatever caused the market disruption.

Asset-Backed Commercial Paper

Asset-backed commercial paper differs structurally from traditional unsecured corporate commercial paper. Rather than being the direct obligation of the corporate issuer, asset-backed commercial paper is issued by a separate special purpose vehicle — a conduit — that holds a pool of financial assets such as trade receivables, auto loans, credit card receivables, or mortgage loans. The conduit issues commercial paper backed by these assets, with the paper repaid from the cash flows generated by the asset pool rather than from the general creditworthiness of the original asset originator.

Asset-backed commercial paper conduits were extensively used by large bank holding companies in the years leading up to the 2008 financial crisis to finance pools of mortgages and other assets off balance sheet, funded through continuously rolled short-term paper. By early 2007, asset-backed commercial paper represented the largest single category of commercial paper outstanding. When concerns about the quality of the underlying mortgage assets emerged in the summer of 2007, the asset-backed commercial paper market began experiencing severe stress — investors became reluctant to hold paper backed by assets whose creditworthiness they could no longer evaluate, and spreads surged from approximately ten basis points above Treasury bills to one hundred and fifty basis points or more. The Federal Reserve noted that between the beginning of July 2007 and the end of August 2007, interest rates on asset-backed commercial paper increased from ten basis points to one hundred and fifty basis points — a development that preceded and contributed to the broader financial crisis that unfolded over the following year.

The 2008 Crisis — Breaking the Buck and the CPFF

The most consequential episode in the history of the commercial paper market occurred in September 2008 in the days following the bankruptcy of Lehman Brothers on September 15, 2008. The Reserve Primary Fund — a sixty-two billion dollar prime money market mutual fund that held seven hundred and eighty-five million dollars in Lehman Brothers commercial paper — announced on September 16, 2008 that the default of Lehman Brothers had caused its net asset value to fall to ninety-seven cents per share, breaking the fundamental one dollar per share convention that money market funds had maintained since their creation. This event — breaking the buck — triggered immediate and massive redemption requests from institutional investors across the entire prime money market fund industry, as investors feared further losses from exposure to other financial institution commercial paper.

As prime money market funds liquidated holdings to meet redemptions, they became unwilling to purchase new commercial paper from any but the most unimpeachable issuers. Within approximately one week of the Lehman bankruptcy, outstanding commercial paper had been reduced by roughly three hundred billion dollars according to Federal Reserve research. The commercial paper market effectively shut down for even the highest quality issuers — corporations that depended on the commercial paper market for routine working capital financing faced an acute liquidity crisis through no fault of their own credit quality.

The Federal Reserve responded on October 7, 2008 by establishing the Commercial Paper Funding Facility, which purchased highly rated unsecured and asset-backed commercial paper with maturities of three months directly from eligible United States issuers through a special purpose vehicle, backstopping the market and providing the liquidity that institutional investors had withdrawn. The CPFF was a direct application of the Federal Reserve's emergency lending authority and demonstrated with unmistakable clarity the systemic importance of the commercial paper market to the functioning of the broader economy.

Commercial Paper Versus Treasury Bills

Commercial paper and Treasury bills are both short-term, discount-to-par money market instruments, and the comparison between them is frequently examined in the securities licensing curriculum. Both are issued at a discount, mature at face value, and carry maturities under one year. The differences are significant in credit risk, liquidity, and tax treatment.

Treasury bills carry the full faith and credit of the United States government — there is no default risk. Commercial paper carries the credit risk of the issuing corporation — even tier-one paper from the most creditworthy companies carries some non-zero default probability. Treasury bill interest is exempt from state and local income taxes. Commercial paper interest is fully taxable at the federal, state, and local levels. The Treasury bill market is the most liquid fixed income market in the world — bills can be sold in enormous quantities with minimal market impact. The secondary market for commercial paper is much thinner — most commercial paper is held to maturity rather than traded, and investors seeking to sell before maturity may face significant bid-ask spreads. Reflecting these differences, commercial paper yields are consistently above Treasury bill yields of the same maturity — the spread compensating investors for the additional credit risk, state and local tax exposure, and reduced liquidity.

Examination Relevance and Key Takeaways

Commercial paper is tested on the SIE, Series 7, and Series 65 examinations in the context of money market instruments, the Securities Act exemption framework, discount pricing, and the distinction between capital market and money market securities. Candidates must understand commercial paper as a short-term unsecured promissory note exempt from SEC registration under Section 3(a)(3) of the Securities Act of 1933, its two hundred and seventy-day maximum maturity, its discount-to-par pricing, its institutional investor base, and its role in the 2008 financial crisis.

The core points to retain are these: commercial paper is a short-term unsecured promissory note issued by large creditworthy corporations, finance companies, and banks with a maximum maturity of two hundred and seventy days, and is exempt from SEC registration under Section 3(a)(3) of the Securities Act of 1933 provided it meets three conditions — maturity does not exceed two hundred and seventy days, proceeds are used for current transactions rather than long-term capital investment, and it is not of a type ordinarily purchased by the general public; it is issued at a discount from face value and matures at par, with yields quoted on a bank discount basis using a three hundred and sixty-day year, typically ten to twenty basis points above comparable Treasury bill yields reflecting additional credit risk, state and local tax exposure, and reduced liquidity; commercial paper is sold exclusively to institutional investors in minimum denominations of one hundred thousand dollars and purchased predominantly by money market mutual funds operating under SEC Rule 2a-7; only corporations with the two highest short-term ratings from Nationally Recognised Statistical Rating Organisations — P-1 and P-2 at Moody's, A-1 and A-2 at Standard and Poor's — qualify as tier-one and tier-two issuers eligible for purchase by Rule 2a-7 funds; backup liquidity facilities in the form of committed bank credit lines are required by rating agencies to ensure that maturing paper can always be repaid even if the issuer cannot roll the paper in the market; asset-backed commercial paper is issued by special purpose vehicle conduits rather than directly by corporations, backed by pools of financial assets; and the 2008 crisis demonstrated the systemic fragility of the commercial paper market when the Lehman Brothers bankruptcy caused the Reserve Primary Fund to break the buck on September 16, 2008, triggering a three hundred billion dollar reduction in outstanding commercial paper within one week and forcing the Federal Reserve to establish the Commercial Paper Funding Facility on October 7, 2008 to backstop the market.