What Is Bankers Acceptance?
A bankers acceptance (BA) is a financial instrument that represents a bank's unconditional promise to pay a specified sum of money on a set future date. It originates as a time draft drawn by a borrower, typically a business involved in trade, on a bank. Upon the bank's "acceptance," it becomes a primary and unconditional liability of the bank, substituting the bank's credit risk for that of the underlying borrower. Bankers acceptances are negotiable and can be traded in the secondary market at a discount, making them a significant component of money market instruments. This characteristic allows the holder to sell the acceptance before its maturity date to obtain liquidity.
History and Origin
The concept behind bankers acceptances dates back to the 12th century, emerging as a means to finance uncertain trade through the use of bills of exchange. These instruments gained significant prominence in London's financial markets during the 18th and 19th centuries. In the United States, the formal adoption and promotion of a domestic bankers acceptance market received a significant boost with the passage of the Federal Reserve Act in 1913. One of the objectives of the newly formed Federal Reserve System was to foster a robust market for bankers acceptances in the U.S. to compete with London's established market and facilitate international trade. The Federal Reserve was granted the authority to purchase certain eligible bankers acceptances to support this objective.4
Key Takeaways
- A bankers acceptance is a bank-guaranteed time draft, representing a bank's commitment to pay a specified amount on a future date.
- They are primarily used in international trade to mitigate credit risk between unfamiliar parties.
- Bankers acceptances are negotiable and trade at a discount in the secondary money market.
- They are considered low-risk investment instruments due to the bank's guarantee.
- Maturities typically range from 30 to 180 days.
Formula and Calculation
Bankers acceptances are typically issued at a discount rate to their face value. The return earned by an investor who holds a bankers acceptance until maturity is the difference between the face value and the discounted purchase price. The implied interest rate (or discount yield) can be calculated using the following formula:
Where:
- Face Value = The amount the bank will pay at maturity.
- Purchase Price = The price an investor pays for the bankers acceptance.
- Days to Maturity = The number of days remaining until the bankers acceptance matures.
Interpreting the Bankers Acceptance
A bankers acceptance is interpreted as a highly secure, short-term debt obligation. Its value is largely derived from the creditworthiness of the accepting bank, not the original drawer. For exporters and importers, the bankers acceptance provides a reliable payment mechanism, especially when direct credit lines are not established. For investors, purchasing a bankers acceptance means acquiring a short-term debt instrument with minimal default risk, comparable to other high-quality money market instruments. The liquidity of the bankers acceptance in the secondary market allows investors to exit their positions before maturity if needed, though they would realize a return based on the prevailing market discount rate at the time of sale.
Hypothetical Example
Consider an importer in the United States who needs to purchase goods from an exporter in Germany. The exporter requires payment assurance before shipping. The importer's bank agrees to issue a bankers acceptance.
- The importer draws a time draft on its U.S. bank for $500,000, payable in 90 days, for the purchase of goods.
- The U.S. bank "accepts" this draft, thereby guaranteeing payment to the German exporter or any subsequent holder of the bankers acceptance.
- The German exporter now holds a bankers acceptance, a guaranteed payment instrument. Instead of waiting 90 days for the full $500,000, the exporter can sell the bankers acceptance in the secondary market to a financial institution at a discount—for example, $495,000.
- The financial institution that bought the bankers acceptance now holds it. After 90 days, it presents the bankers acceptance to the U.S. bank and receives the full $500,000 face value, earning a $5,000 return. This arrangement facilitates international trade by providing immediate payment or assured future payment, and a secure, tradable asset.
Practical Applications
Bankers acceptances are predominantly used in international trade financing, particularly for imports and exports. They serve to bridge the trust gap between parties who may not have established relationships by substituting the bank's credit for that of the trading company. Beyond trade, they can also be used to finance the movement and storage of goods. The Federal Reserve Bank of Richmond notes that bankers acceptances are commonly created in amounts over $100,000, attracting institutional investors, including commercial banks and money market mutual funds. T3he Federal Reserve itself has historically engaged in the bankers acceptance market through purchases and repurchase agreements as part of its open market operations, influencing the money supply. Banks that deal in bankers acceptances are subject to specific regulatory guidelines, including those outlined by the U.S. Securities and Exchange Commission (SEC) concerning permissible securities transactions.
2## Limitations and Criticisms
While bankers acceptances are considered low-risk, they are not entirely without drawbacks. Their use can be complex, involving multiple parties and detailed documentation, which can be burdensome for smaller businesses. The market for bankers acceptances, while active, is generally less liquid than that for other short-term instruments like Treasury bills. Furthermore, banks are subject to limitations on the aggregate amount of eligible bankers acceptances they can create. For instance, an individual member bank's eligible bankers acceptances may be limited to a percentage of its capital stock and surplus, as stipulated by regulations like those found in 12 CFR § 250.164 of the U.S. Code of Federal Regulations. Th1is regulatory constraint can impact a bank's capacity to issue new acceptances. Critiques sometimes emerge regarding the market's transparency or its susceptibility to being used to obscure debt levels in less regulated environments, as seen in some historical instances.
Bankers Acceptance vs. Commercial Paper
A key difference between a bankers acceptance and commercial paper lies in the guarantee. A bankers acceptance is a time draft that a bank has accepted, making the bank primarily liable for its payment. This bank guarantee significantly reduces the credit risk for the holder. In contrast, commercial paper is a short-term, unsecured promissory note issued directly by a corporation to raise short-term funds. While highly creditworthy corporations issue commercial paper, it carries the credit risk of the issuing company, not a bank. Both are short-term debt instruments sold at a discount, but the added bank guarantee makes bankers acceptances generally less risky and thus often trade at a lower yield than comparable commercial paper.
FAQs
Q: Who uses a bankers acceptance?
A: Bankers acceptances are primarily used by businesses involved in international trade, such as importers and exporters, to facilitate secure payments. They are also used by investors looking for low-risk, short-term investment opportunities.
Q: Are bankers acceptances safe investments?
A: Yes, bankers acceptances are generally considered very safe investments because their payment is guaranteed by a bank. This makes them similar in safety to other secure investment instruments.
Q: How long is a typical bankers acceptance valid?
A: The typical maturity date for a bankers acceptance ranges from 30 to 180 days, although they are most commonly issued with a 90-day maturity.
Q: Can bankers acceptances be sold before maturity?
A: Yes, bankers acceptances are negotiable instruments and can be sold in the secondary market before their maturity date, allowing the holder to access funds early, albeit at a discounted price.
Q: What is the role of the bank in a bankers acceptance?
A: The bank's role is to accept the time draft, thereby guaranteeing payment to the holder of the bankers acceptance at maturity. This acceptance substitutes the bank's creditworthiness for that of the original drawer, reducing payment risk for the other parties involved.