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Almost every business, whether small or large, will at some point have difficulty in providing for its short-term cashflow needs. It is very common for a business in this situation to use a form of short-term financing known as commercial paper. A commercial paper loan usually matures in three to six months. Sometimes, commercial paper is backed by some type of collateral, in which case it is known as asset-backed commercial paper.
In a typical situation, asset-backed commercial paper is purchased by a business which intends to pay back the loan when receivables come due – in other words, when their customers pay them money that they have already committed to pay. If a business needs money in the short term for inventory or payroll, for instance, it may purchase an asset-backed commercial paper loan to meet these immediate needs. Then, when client accounts come due, the loan is paid back with that money.
Even though it is also common for businesses to maintain lines of credit with banks, it is often better for the business to use asset-backed commercial paper instead, since it carries a lower interest rate. Lines of credit serve as a kind of safety net, to be used when other, cheaper options are exhausted or unavailable. While commercial paper can be a much-needed lifeline for a business with immediate financial obligations, this is not the only purpose that it serves.
In a larger sense, asset-backed commercial paper helps provide liquidity to an economy, meaning the easy availability of cash. Liquidity is very important to the functioning of economies everywhere. It is a matter of much concern when this liquidity is lost, as happened in 2008 when commercial paper suddenly but briefly became unavailable as part of a larger economic crisis in the U.S.
Those institutions which make short-term loans to businesses may in turn issue this debt to investors. When investors purchase the right to collect on debt, this investment is what technically constitutes commercial paper, although this term is used colloquially to refer to the loan itself as well. The bank which originally issued the loan, if it sells the debt to a third party, is freed of the obligation to collect on it. This can lead to the one large downside of asset-backed commercial paper, that of a potential lack of discipline on the part of the lending institutions. If a loan is issued to a company that is not creditworthy or is not able to pay it back, the risk of default is increased, making investors less likely to buy commercial paper and thus leading to a lack of liquidity.