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Why do issuers like extremely short maturities for commercial paper?

This research models the debt maturity choice of firms in the presence of fixed issuance costs in the primary market and searches frictions in the secondary market for debt.

Author(s): Dr Max Bruche - Cass Business School; Anatoli Segura - Bank of Italy

Commercial paper has been used to create substantial maturity mismatch. For example, Schroth, Suarez, and Taylor (2014) estimate that before the recent financial crisis, asset-backed commercial paper with an average maturity of around 37 days was used to finance assets with an average duration of around 5.8 years. Although the maturity of commercial paper has increased after the crisis, it is still very short. The Federal Reserve, for instance, reported an average maturity of about 55 days for all outstanding commercial paper, on February 23, 2015 (see http://www.federalreserve.gov/releases/cp/maturity.htm). A central question is why issuers choose to finance long term assets with such extremely short-term debt securities.

Issuers find longer maturities more expensive, as investors demand higher yields for these. But why do investors prefer shorter maturities? Consider a typical investor in commercial paper such as a money market fund, which may have to liquidate investments in order to meet outflows. The fund will find it easier to do so with shorter-maturity commercial paper. If the maturity is short enough, the fund may just be able to wait for repayment at maturity to convert the paper back into cash. Alternatively, the fund may try to sell the paper in the secondary market. Since the secondary market for commercial paper is notoriously illiquid, it can be hard to find a buyer who will offer a reasonable price for the paper. In the negotiation over price, a short maturity also helps, as the seller will be able to plausibly threaten to wait until maturity, if the price offered by the buyer is not good enough.

At the same time, the fact that short maturities enhance the bargaining position of the seller in the secondary market also implies that they worsen the bargaining position of the buyer in that market. Because commercial paper maturities tend to be extremely short, it is not very profitable to be a buyer in the secondary market, which explains why there are few of them and why the secondary market is so illiquid. So maturities are short because the market is illiquid, and the market is illiquid because maturities are short.

In a recent paper, Debt Maturity and the Liquidity of Secondary Debt Markets (Bruche and Segura 2016), we examine a model that describes this feedback loop between secondary market liquidity and maturity choice. The model suggests that any given small issuer probably does not internalize the effect that its individual maturity choice has on the number of buyers scouring the secondary market. Hence it is likely that collectively, issuers choose maturities that are too short, and that as a consequence, secondary markets are too illiquid.

This feedback loop matters for regulation. For instance, the push to get banks to reduce their reliance on short-maturity funding (e.g. via the Net Stable Funding Ratios of Basel III) may lengthen average maturities in the secondary market for commercial paper, which would tilt the bargaining power from sellers towards buyers, meaning more buyers and hence improved liquidity. Also, the introduction of a financial transaction tax is likely to decrease liquidity in the secondary market and hence would force issuers to choose shorter maturities. Overall, regulation should take into account that secondary market liquidity and maturity choice are linked.

Schroth, E., Suarez, G., Taylor, L. A., 2014. Dynamic debt runs and financial fragility: Evidence from the 2007 ABCP crisis. Journal of Financial Economics 112, 164-189.

Bruche, M., Segura, A., 2016. Debt Maturity and the Liquidity of Secondary Debt Markets. Accepted at the Journal of Financial Economics.

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