What Are Negotiable Certificates of Deposit?
A negotiable certificate of deposit (NCD) is a type of time deposit issued by banks that can be bought and sold in the secondary market before its maturity date. Unlike traditional CDs, which are typically held by individual investors until maturity, negotiable certificates of deposit are large-denomination instruments, usually $100,000 or more, and are primarily traded among institutional investors. They are classified under money market instruments, representing a significant source of funding for banks and a liquid investment option for large entities.
History and Origin
The concept of certificates of deposit has existed for centuries, with banks in the U.S. issuing them as early as the 1800s. However, the modern negotiable certificate of deposit revolutionized the financial landscape when it was introduced in 1961 by the First National City Bank of New York, now known as Citibank.15 At the time, banks faced a significant challenge: a steady outflow of demand deposits from corporations that sought higher-yielding alternatives like Treasury bills.14
Walter Wriston and John Exter at First National City Bank recognized that European banks were issuing similar, albeit non-marketable, time deposits. They adapted this idea to create a marketable, interest-bearing time deposit.13 The bank also facilitated the creation of a viable secondary market for these instruments, allowing investors to sell them before maturity, similar to how they would trade a Treasury bill.12 This innovation enabled large banks to attract corporate deposits and efficiently raise funds for lending, addressing a critical deposit shortage that had impacted banks throughout the 1950s.11 The popularity of negotiable certificates of deposit soared, with outstanding issues reaching $15 billion by 1965.10
Key Takeaways
- Negotiable certificates of deposit (NCDs) are large-denomination, marketable time deposits issued by banks.
- They can be bought and sold in a secondary market before their maturity date.
- NCDs are primarily used by institutional investors seeking a low-risk, liquid investment.
- The Federal Deposit Insurance Corporation (FDIC) insures negotiable certificates of deposit up to certain limits, similar to other bank deposits.
- Their interest rates are typically negotiated and influenced by money market conditions.
Formula and Calculation
The calculation for the value of a negotiable certificate of deposit at maturity is straightforward, similar to that of a traditional CD, and typically uses a simple interest calculation based on a 360-day year.
The future value (FV) of a negotiable certificate of deposit can be calculated using the formula:
Where:
- (FV) = Future Value (amount at maturity)
- (P) = Principal (initial deposit amount)
- (r) = Annual interest rate (as a decimal)
- (t) = Number of days to maturity
For example, a $1,000,000 NCD with a 3% annual interest rate maturing in 90 days would yield:
This method of calculating interest is often referred to as "CD basis" or "actual/360 basis."9
Interpreting the Negotiable Certificate of Deposit
Negotiable certificates of deposit are interpreted primarily as short-term debt instruments that offer both safety and marketability. Their yield reflects prevailing money market interest rates and the creditworthiness of the issuing bank. Because they are traded in a robust secondary market, their market price can fluctuate based on changes in interest rates, even though the interest rate set at issuance is fixed.
Investors evaluate NCDs based on their stated interest rate, maturity, and the issuing bank's reputation. A higher yield might compensate for a longer maturity or a less-established issuer. Their appeal lies in providing a predictable income stream while offering the flexibility of liquidity through secondary market sales, unlike non-negotiable certificates of deposit that must be held until maturity.8
Hypothetical Example
Consider an institutional investor, such as a corporate treasury department, that has $5 million in excess cash. Instead of leaving the funds in a low-interest checking account, the treasury decides to invest in a negotiable certificate of deposit.
They purchase a $5 million NCD from a large commercial bank with a three-month maturity and an annual interest rate of 4.5%. At the end of the three months (approximately 90 days), the bank will pay back the principal plus the accrued interest.
Using the calculation:
Principal = $5,000,000
Annual Rate = 0.045
Days = 90
Interest = ( $5,000,000 \times (0.045 \times \frac{90}{360}) = $5,000,000 \times (0.045 \times 0.25) = $5,000,000 \times 0.01125 = $56,250 )
At maturity, the investor would receive $5,000,000 (principal) + $56,250 (interest) = $5,056,250.
If the corporation needed the funds before the three-month period was over, it could sell the negotiable certificate of deposit to another institutional investor in the secondary market, rather than incurring penalties for early withdrawal, which would be the case with a traditional certificate of deposit. The sale price would depend on prevailing market interest rates at the time of sale.
Practical Applications
Negotiable certificates of deposit are significant components of the money market and serve several practical applications:
- Corporate Cash Management: Large corporations use NCDs to manage their short-term cash surpluses, earning a return on idle funds while retaining the ability to access capital through the secondary market.
- Bank Funding: For issuing banks, negotiable certificates of deposit are a crucial source of wholesale funding, allowing them to raise substantial amounts of capital quickly to support their lending activities.
- Institutional Investing: Institutional investors like pension funds, insurance companies, and mutual funds include NCDs in their portfolios for capital preservation and short-term income generation. They are considered a low-risk fixed income instrument.
- Monetary Policy Indicator: The interest rates on negotiable certificates of deposit are closely watched indicators of short-term market conditions and liquidity within the banking system. The Federal Reserve, for instance, used to track average rates on these instruments.7
- Market Liquidity: The existence of a robust secondary market for negotiable certificates of deposit contributes to the overall liquidity and efficiency of the money markets, providing a mechanism for investors to adjust their short-term holdings.6
Limitations and Criticisms
While negotiable certificates of deposit offer advantages, they also have limitations and points of criticism:
- Interest Rate Risk: Although the stated interest rate is fixed, the market value of a negotiable certificate of deposit in the secondary market can decline if prevailing interest rates rise after the NCD is issued. This means an investor selling before maturity might receive less than the original principal plus accrued interest if rates have increased significantly.5
- Denomination Size: NCDs are typically issued in large denominations ($100,000 or more, often $1 million or greater), which makes them inaccessible to most individual investors. This limits their utility primarily to institutional and wealthy individual investors.
- Credit Risk: While generally considered low-risk, NCDs are unsecured obligations of the issuing bank. If a bank were to fail, the investor's principal and interest would be subject to the limits of FDIC insurance23