Negotiable certificate of deposit
Negotiable certificate of deposit is a receipt issued by a commercial bank for the deposit of funds. Banks issue negotiable Certificate of Deposit (CD) in order to attract additional funds to make available to borrowers or to counteract the restrictive effect of the withdrawal of deposits from the bank[1].
The receipt stipulates that the bearer will receive annual interest payments of a specified magnitude and, at maturity, will receive a lump sum equal to the original principal. The certificate may not ordinarily be redeemed for cash by the bank prior to maturity. Hence, the name "negotiable" CD's[2].
Negotiable CD's are one of the more popular money market instruments for institutional investors. The maturities on negotiable CD's generally range from 3 to 18 months, although most have original maturities of 6 months or less. CD's issued with maturities greater than one year are called term CD's. CDs are interest-bearing notes, usually sold at their face value, with the principal and interest paid at maturity if the CD is less than one year and semiannually if it is a term CD[3].
Example of negotiable CD
The impetus for the initial establishment of negotiable CD's in the early 1960s resulted from an increase in money market interest rates, which caused many corporations to withdraw funds held in banks in order to purchase high-yielding commercial paper, treasury bills, and other money market instruments. Banks issued the new instrument - negotiable certificate of deposits[4]:
- Negotiable certificate of deposits are held by units with a need for a temporary investment outlet for large amounts of funds, often in excess of $1 million. The primary buyers of CD's include business corporations, government institutions charitable organizations, and foreign buyers.
- When credit demands escalate, the volume of negotiable CD's outstanding typically expands.
Origins of certificate of deposit
Certificates of Deposit were first issued in 1961 in commercial banks in the USA. Before this, U.S. banks had issued registered, non-negotiable certificates of deposit, which had limited appeal. The incentive for introducing a negotiable instrument was Federal Reserve Regulation Q which limited the interest rates that banks could offer on time and savings deposits. As interest rates in the money markets rose above Regulation Q levels, bank lost deposits to non-banks such as money market funds, which were not subject to this regulation. Deposits of 100,000 dollars or more and with a minimum tenor or maturity of 14 days were exempt from Regulation Q, but investors managing overnight and short term funds needed liquidity by being able to sell holdings of CDs in a secondary market. The first issues of CDs in London were made in 1966 in U.S. dollars[5].
Advantages of Negotiable certificate of deposit
Negotiable certificate of deposit offers a range of advantages to investors, including:
- High Yield: Negotiable certificates of deposit offer a higher yield than regular savings accounts. This makes them an attractive option for investors looking to maximize their returns.
- Liquidity: Negotiable certificates of deposit can be traded in the secondary market, making them more liquid than traditional certificates of deposit. This allows investors to access their funds more quickly in the event of an emergency.
- Security: Negotiable certificates of deposit are insured by the FDIC up to $250,000 per account, providing investors with peace of mind that their funds are safe.
- Flexibility: Negotiable certificates of deposit can be customized to meet the needs of the investor, including the option to choose the term length and the interest rate.
- Tax Advantages: Negotiable certificates of deposit are tax-free until maturity, allowing investors to defer their tax payments until the certificate matures.
Limitations of Negotiable certificate of deposit
Negotiable Certificate of Deposit (CD) presents certain limitations. These include:
- Early withdrawal penalties: Negotiable CD generally include a penalty for early withdrawal, meaning the depositor cannot access the funds until the maturity date.
- Tax implications: Negotiable CD may be subject to taxes, depending on the size of the deposit and the interest earned.
- Lack of liquidity: Negotiable CD is not as liquid as other forms of investment. Funds may not be available for use until maturity.
- Low returns: When compared to other forms of investment, negotiable CD generally have lower returns.
- Lack of flexibility: Negotiable CD have a fixed maturity date and cannot be cashed out until the maturity date.
Negotiable Certificate of Deposit (CD) can also be used in other ways to manage liquidity. These include:
- Investing in CD: CD's are a safe and reliable instrument to invest in, as they provide a guaranteed return over a fixed period of time.
- Leveraging CD's: Banks can use CD's to manage the liquidity of their portfolios by buying and selling CD's to generate higher returns.
- Hedging with CD's: CD's can be used to hedge against market risks by investing in CD's of different maturities.
- Liquidity management: Banks can use CD's as a tool to manage their liquidity by buying and selling CD's in the open market.
In summary, Negotiable Certificate of Deposit (CD) is a flexible and reliable financial instrument that can be used to manage liquidity and generate returns. It can be used to invest, leverage, hedge, and manage liquidity.
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References
- Perminder K., (2005), Advanced Study in Money and Banking: Theory and Policy Relevance in the Indian Economy Publishing house Atlantic Publishers & Dist, Delhi, p.89
- Stafford R. J., (2013), Debt Markets and Analysis Publishing house John Wiley & Sons, New Jersey, p.370
- Stafford R. J., (2000), The Capital Markets & Financial Management in Banking Publishing house Global Professional Publishi, Chicago, p.151
Footnotes
Author: Piotr Tarsa
