On May 22, 2024, the Financial Stability Board (FSB) issued a report on vulnerabilities in the markets for commercial paper (CP) and negotiable certificates of deposit (CDs). The report analyzes the structure of the markets, identifies vulnerabilities, and suggests reforms that policy makers might consider. It acknowledges that limitations exist, and, therefore, the adoption of the reforms will vary by industry as well as by regional and national authorities. In this Legal Update, we discuss potential market reforms and considerations.
BACKGROUND
CP is a short-term unsecured debt instrument issued by a corporation to finance its working capital needs. A CD is a time deposit obligation that is issued by a bank. CP generally is, and CDs can be, negotiable, which allows them to be readily transferred and traded in the secondary market. This gives issuers access to short- to medium-term funding that is usually low-cost.
VULNERABILITIES
While CD and CP markets usually function well, the FSB report notes that issuers and investors may face challenges during stress events. First, CDs and CP tend to be illiquid, in part because most investors intend to hold them to maturity and only limited secondary market activity exists but also because dealers have CP trades, which reduces their incentive to carry inventory. Further, the CD and CP markets are mostly opaque regarding disclosures and reporting and use documentation that lacks standardized terms. These features, coupled with the small pool of involved broker-dealers, exacerbate illiquidity. In particular, most broker-dealers will only repurchase CP or CDs that they were responsible for placing in the primary market and will not carry inventory even in those issues.
The interconnectedness of the CD and CP markets can create the vulnerability that any stress propagates quickly across borders and has an immediate impact on issuers' ability to roll funding. This was observed in March 2020, when the turmoil prompted by the COVID-19 pandemic led to investors requesting to sell their CP and CDs in the secondary market and dealers increasing their involvement as intermediaries. Ultimately, public authorities had to intervene to restore order to the market.
REFORMS AND CONSIDERATIONS
The FSB report identifies potential market reforms for policy makers to consider, including: (i) increased reporting of CD and CP transactions, (ii) greater public disclosure of issues and investors, (iii) standardized documentation and more developed trading platforms, and (iv) enhanced repo mechanisms that allow investors to obtain secured funding in times of stress. The FSB believes that these proposed solutions are changes to the market structure that would not only help to enhance efficiency but also limit the negative impacts of interconnectedness while maximizing uniformity through standardization.
STANDARDIZATION
Developing standardized processes would improve access because it would benefit less sophisticated market participants. Digitization of documents is one form of standardization discussed extensively. Currently, document digitization is not widespread and is limited to certain platforms. If properly implemented, the issuance process would be made faster and more efficient, and T+0 settlements could become more widespread in global markets.
TRANSPARENCY
More disclosure and regulatory reporting could encourage broader market participation, particularly among non-dealers. Increasing transparency in areas such as amount outstanding per issuer and post-trade information would improve the monitoring of the CP and CD market size and trends, thus improving long-term market analysis. Although this brings more functionality to the market, the FSB warns that the transparency still may not overcome the vulnerabilities of the stressed market.
REPO MECHANISMS
Material challenges exist with expanding CP and CD financing. In some jurisdictions, investors may use repo markets to raise liquidity instead of selling their holdings at a discount during times of stress. However, repo borrowing may increase vulnerabilities and shift liquidity risks to other parts of the market. Regulatory frameworks designed to mitigate risks for institutional investors may restrict the use of these assets as collateral for repo borrowing. Those who may develop a private repo market for CD and CP collateral should take into account these challenges and feasibility considerations.
TAKEAWAYS
While the FSB's analysis and recommendations are not binding authority, they indicate regulator interest in improving the resilience of CP and CD investments; composed of national regulators, the FSB would not have issued this report unless its members were concerned about the CP and CD markets. However, addressing the variation in market practices and national market structures in multiple jurisdictions will be critical to a comprehensive policy response. As noted in the report, the CP and CD markets are highly interconnected with the global economy, and even small regulatory changes may have an oversized effect. Thus, stakeholders should expect to see regulators continue to investigate and propose reforms in the CP and CD markets and should be ready to comment on and shape the reforms' development.
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