Inter corporate deposits


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Inter corporate deposits

  1. 1. INTERCORPORATE DEPOSITSWhen borrowing from banks, there are many formalities in terms of documentations to be adhered to.All these formalities can be done away with when borrowing and lending short term funds with the aidof inter corporate deposits. Inter-corporate deposits are deposits made by one company with anothercompany, and usually carry a term of six months. These deposits are made by corporate having surplusfunds to cash starved companies.Features of Inter corporate deposits•Since it is an unsecured loan, the risk involved is higher. Also, since the cost of funds(interest rates) aremuch higher for a corporate than a bank, the rates in this market are higher than those in theother markets.•The short term credit rating of the corporate would determine the rate at which the corporate wouldbe able to borrow funds. Further the credit spreads demanded even for the top rated corporate wouldbe higher than similar rated banks and the rates on ICDs would be higher than those in the Certificate ofDeposit (CD) market. The tenor of ICD may range from 1 day to 1 year, but the most common tenor ofborrowing is for 90 days.•The ICD market is not well organized with very little information available publicly about transactiondetails.•Primary dealers cannot lend in the ICD market, they are only entitled to borrow. The borrowingunder ICD is restricted to 50% of the Net Owned Funds and the minimum tenor of borrowing is for 7days.•Cash rich companies, NBFC’s and financial institutions are eligible to act as market participants. Evenstock broking firms qualify as market participants for ICDs.•Defaulted companies are not allowed to extend loans.•The amount cannot exceed 60 % of paid up capital and 100% of free reserves.Types of inter corporate depositsThe three types of inter-corporate deposits are: three month deposits, six month deposits, and calldeposits.•Three month depositsThese are the most popular type of inter-corporate deposits. These deposits are generally considered bythe borrowers to solve problems of short-term capital inadequacy. This type of short-term cash problemmay develop due to various issues, including tax payment, excessive raw material import, breakdown inproduction, payment of dividends, delay in collection, and excessive expenditure of capital. The annualrate of interest given for three month deposits is 12%.
  2. 2. •Six month depositsThese are usually made with first class borrowers, and the term for such deposits is six months. Theannual interest rate assigned for this type of deposit is 15%.•Call DepositThe concept of call deposit is different from the previous two deposits. On giving a one day notice, thisdeposit can be withdrawn by the lender. The annual interest rate on call deposits is around 10%.Other types of ICDs•Fixed rate ICD’s with a call/put option Fixed rate ICDs are normal Inter Corporate Deposits (ICDs)having periodic put/call options exercisable any time after a pre-specified lock-in period.Put Option is the option on the ICD, which is the right but not the obligation with the Investor, to ask theIssuer of the ICD to redeem the ICD along with the accrued interest on the entire face value of the ICD,from the date of placement of the ICD till the date of settlement of the put option of the ICD.Call Option is the option on the ICD, which is the right but not the obligation with the Issuer of the ICD,to ask the Investor of the ICD to accept redemption of the ICD along with the accrued interest on theentire face value of the ICD, from the date of placement of the ICD till the date of settlement of the calloption of the ICD.•Floating rate ICDs with a call/put option, wherein the rates are linked to a benchmark called MIBOR.Why ICDs with Put/Call make sense?For the Investor:If the short term interest rates go up, it makes sense for the Investor to exercise the put option, i.e. askthe Issuer of the ICD to repay the principal along with the accrued interest till the number of days theICD is held. The Investor can then invest the amount received in higher yielding short term issues.For the Corporate:If the short term interest rates go down, it makes sense for the Issuer to exercise the call option, i.e.cancel the ICD and repay the principal before the original maturity, along with the accrued interest tillthe number of days the ICD is held. The corporate can then borrow the amount again at lower shortterm interest ratesRisks involved•Liquidity risk
  3. 3. ICDs with periodic put/call have a very short maturity and they also have periodic put/call options. Onaccount of a temporary liquidity shortage, the corporate may face a temporary back stop liquidityfacility. This could translate into a liquidity risk for the corporate.•Interest Rate RiskIf the interest rates rise, and the ICDs are put by the investor, then the re-funding of the liability wouldhave to be done at a higher interest rate for the remaining tenor. However, the converse is also true forthe investor, i.e. if the interest rates fall and the corporate calls the ICD, then the investor would thenhave to deploy the funds at a lower interest rate for the balance tenor. However, seen practically, theinvestors are generally deploying surplus short term funds rather than actually trading on interest rates,and hence, on rise of interest rates, only if there is another borrower at higher rates, will the investorput the ICD and redeploy the funds elsewhere. On the contrary, if the interest rates fall down, thecorporate will always get funding from alternative sources at lower rates, and hence is in abetter interest rate position than the investor.•Operational RiskThe investor and the corporate needs to keep a track of all the call and put options, and from which timeonwards, if there is a minimum lock in period. This could become a operational issue and the settlementon the exercise of either options, if exercised. For this, a detailed procedure with specific responsibilitiesfor exercise of call and put options has to be laid down by both the issuer and the investor of the ICD, atthe time of the transaction.Why companies borrow and lend in this market?•The biggest advantage of inter-corporate deposits is that the transaction is free from bureaucratic andlegal hassles. The business world otherwise is regulated by a number of rules and regulations. Theexistence of the inter-corporate deposits market shows that the corporate world can be regulatedwithout rules.•The market of inter-corporate deposits maintains secrecy. The brokers in this market never reveal theirlists of lenders and borrowers, because they believe that if proper secrecy is not maintained the rate ofinterest can fall abruptly.•The market of inter-corporate deposits depends crucially on personal contacts. The decisionsof lending in this market are largely governed by personal contacts•Advantages to the investors are as follows:a. It helps the investors take advantage of the increase in interest rates, by exercising the put option.b. It increases the yield on the investment, as the ICDs are unsecured and unrated, hence the investorcan demand a higher interest rate. However, as the nature of the instrument is as short as the investor
  4. 4. and the corporate would like, based on the corporate credit quality, the safety of the instrument is wellcovered, to the extent that the investor has done a basic due diligence on the borrower.c.As compared to competing short term investment avenues like call money, CPs, short term secureddebentures, etc. these instruments offer a relatively better yield for the same corporate for similartenors, while imparting more liquidity to the investor.•Advantages to the corporate borrowing:a. The corporates could use this instrument to meet their requirement for short maturity funds atcompetitive rates.b. The corporates would retain the flexibility of retiring these liabilities as per their requirementsbecause of the periodic put/call options.c. The corporate can take advantage of any decline in the interest rates, by exercising the call option.d. The corporates can raise money at a very short notice through this instrument, as the instrument isunrated and unsecured and the corporate does not have to undertake any necessary formalities beforeborrowing the money. All the documentation that is exchanged is a confirmation letter and post datedcheques, if required.Difference between ICD’s and Term loans•The number of formalities required in the ICD market is way lesser as compared to term loan market.This is one of the main reason why the borrowing is so high in the Inter corporate deposit market.Acorporate requiring immediate funds to meet its short term requirements can easily go in for intercorporate deposits as the level of bureaucracy involved is lower. ( Easy availability of funds)•Term loans are secured loans i.e. they are collateralized. ICS’s are unsecured financial instruments.•As the ICD’s are unsecured, the risks involved is higher. Thus the interest rates are way higher in ICD’sas compared to term loans which are available at a cheaper interest rate.•Both the sources are available depending on the creditworthiness of the company. i.e. its credit ratingin the market.