Steven M. Dickinson ^*
& Takeo Kosugi ^{* *}

V. The Creation of the Domestic Commercial Paper Market in Japan

A. The Creation of the Domestic Commercial Paper Market for Japanese Residents

During 1986, pressure from government advisory groups, the business community and the securities industry to create a domestic commercial paper market steadily increased.¹¹³ To accomplish this goal, Japan's four largest securities companies¹¹⁴ proposed in mid-1986 that an unregulated domestic commercial paper market be developed. They also argued that domestic commercial paper should be designated as a valuable security, thereby excluding banks from the market. In response to this proposal, the major city banks announced in July 1986 that they would advance their own proposal for developing the domestic commercial paper market. ¹¹⁵

No real progress on domestic commercial paper was made until January 1987, when the BOJ announced its compromise plan concerning fundamental features of the proposed domestic commercial paper market.¹¹⁶Specifically, the BOJ proposed the following:

1. In order to expedite the development of the market, domestic commercial paper should be treated as a promissory note (yakusoku tegata) that would be regulated under the Law on Bills. ¹¹⁷
2. The number of issuers should be strictly limited until an effective system of ratings for issuers is in place.
3. Only dealer paper should be permitted.¹¹⁸ Direct paper should be prohibited.
4. Both banks and securities companies should be permitted to engage in the domestic commercial paper business. ¹¹⁹

After this proposal was announced, the MOF's Banking and Securities Bureaus formed a Commercial Paper Study Group (Study Group) to devise a plan that incorporated the four principles articulated in the BOJ's proposal.¹²⁰ The Study Group developed a detailed plan that remained within the confines of the BOJ's original proposal. The MOF's Securities Exchange Council and Board of Investigation of the Financial System¹²¹ adopted the Study Group's plan unchanged, and issued a paper titled "Concerning the Concrete Proposal for the Domestic Commercial Paper Market" (Concrete Proposal) on May 20, 1987.¹²²

After issuing the Concrete Proposal, the MOF conferred with representatives of the securities and banking industries to definitively establish the contours of the domestic commercial paper market. ¹²³ This group drafted the standard forms for the domestic commercial paper instrument and developed a series of standard contracts that would apply to all aspects of a domestic commercial paper transaction.¹²⁴ On November 2, 1987, the MOF's Banking and Securities Bureaus issued circulars to banks and securities firms outlining the fundamental rules which were to govern the domestic commercial paper market.¹²⁵ Shortly thereafter, on November 20, 1987, the domestic commercial paper market was officially created. ¹²⁶

1. The Legal Characteristics of Domestic Commercial Paper

In setting out rules for domestic commercial paper, the MOF was able for the most part to follow the rules previously issued for foreign commercial paper. The foreign commercial paper rules, however, did not address the issue of the legal status of domestic commercial paper. While this issue could be ignored in the foreign commercial paper rules, a resolution was required for domestic commercial paper. As noted previously, the BOJ had suggested in its compromise proposal that domestic commercial paper be treated as a promissory note regulated under the Law on Bills.¹²⁷ This proposal was eventually adopted by the MOF.¹²⁸

While treating domestic commercial paper as a promissory note was the only viable alternative for creating a domestic commercial paper market within a reasonable time period,¹²⁹ this approach poses some significant problems.

it is fundamentally inconsistent with the traditional view of bills of exchange (bills) and promissory notes (notes) in the Japanese financial system to construe domestic commercial paper as a promissory note. Technically, commercial paper fits within the statutory definition of a promissory note under the Law on Bills.¹³⁰In practice, however, commercial paper is used as an investment vehicle which is inconsistent with the normal usage of bills and notes in Japan as a means of payment and credit creation. ¹³¹

Banks play a key role in these transactions, both in discounting bills and notes from their customers and in employing bills and notes for inter-bank transactions on the inter-bank bill discount market. Within this system, bills and notes "have taken on the character of a semicurrency note, or a second currency."¹³² The introduction of a new and possibly confusing form of promissory note with a function entirely different from that of traditional bills and notes has the potential to disrupt the established financial system.

While the banking industry feared such disadvantages in the bills and notes system, their concerns were partially met by the introduction of a standard form of domestic commercial paper promissory note which dealers are required to use. The standard form, in which the mark "CP" (for commercial paper) is prominently displayed, is designed to prevent confusion between the traditional forms of promissory notes used as a means of payment and the new promissory notes which are used as a means of investment. ¹³³

A second major problem with treating domestic commercial paper as a promissory note is that it subjects domestic commercial paper to a stamp tax.¹³⁴ If a promissory note is denominated in yen, a stamp tax is imposed in graduated amounts based on the face amount of the note.¹³⁵ This tax is imposed each time the promissory note is executed. Therefore, a new stamp tax must be paid each time a domestic commercial paper instrument is renewed ("rolled over"). The potential cost is considerable. For example, a one-month note issued in the amount of ¥100 million would be rolled over 12 times per year, resulting in a total stamp tax of ¥240,000. This results in a stamp tax interest rate of 0.24% per annum. In short-term markets where the prime rate is only 3.375%, 0.24% is a significant amount and could make the issuance of domestic commercial paper economically unfeasible. The stamp tax encourages issuers to issue domestic commercial paper with longer terms and higher face values in order to reduce the effective rate of the tax, even if such terms are not attractive from a marketing standpoint.

To remedy this situation, the MOF indicated that it would seek to have domestic commercial paper exempted from the stamp tax during the 1989 session of the Diet.¹³⁶ Other countries that have created successful commercial paper markets do not impose such taxes on commercial paper transactions. Elimination of the stamp tax is vital to the success of the Japanese domestic commercial paper market. ¹³⁷

2. The Regulatory Scheme for Domestic Commercial Paper

The promissory note was chosen as the legal form for domestic commercial paper in order to allow both banks and securities companies to deal in domestic commercial paper on an equal basis.¹³⁸To accomplish this goal, the regulatory scheme for domestic commercial paper followed the scheme developed for foreign commercial paper. ¹³⁹ Banks are now permitted to deal in domestic commercial paper as monetary claimable assets under article 10 of the Banking Law, which regulates the incidental business of banks. ¹⁴⁰ Securities companies are now permitted to deal in domestic commercial paper under article 43 of the SEL as a subsidiary business. ¹⁴¹ Because a promissory note is not a valuable security under article 2 of the SEL, no provision of the SEL, the Law Concerning Foreign Securities Dealers,¹⁴² or the Law Concerning the Regulation, etc., of Investment Advisory Business Regarding Valuable Securities¹⁴³ is applied to transactions involving domestic commercial paper.

As with foreign commercial paper, in the absence of a statutory basis for regulation the MOF has used administrative guidance to fill in the gap. The Concrete Proposal and the circulars issued to banks and securities firms set out the fundamental rules for the domestic commercial paper market. In addition, the MOF worked closely with both of these industries to prepare standardized contracts governing every aspect of the domestic commercial paper business. Since all participants are expected to use these standard contracts, the MOF has ensured uniformity of practice with respect to domestic commercial paper.

As mentioned above,¹⁴⁴ these "rules" are administrative guidance, with no explicit statutory basis, and are effective only as part of the MOF's overall administrative control over the banking and securities industries. The ministry does not exert such control over persons and businesses outside of these industries, however. For this reason, the direct issuance of domestic commercial paper by sellers to investors (direct paper) is prohibited.¹⁴⁵ Domestic commercial paper must be issued through banks or securities companies (dealer paper). In this way, the MOF can ensure compliance with its rules for domestic commercial paper. ¹⁴⁶

This regulatory approach, which reflects the MOF's balancing of the competing interests of the banks and the securities companies, is not without criticism. The MOF has introduced domestic commercial paper in a manner that is inconsistent with the normal use of bills and notes, that maintains the artificial distinction between "securities" and "valuable securities" and that fails to provide adequate protection for investors. Indeed, this criticism extends to the basic terms of offering for domestic commercial paper which, as will be discussed below, seem to have been adopted to balance competing interests rather than to create a commercially and financially viable investment instrument.

3. The Terms of Offering for Domestic Commercial Paper

a. Basic Terms of Offering

The repayment period for domestic commercial paper must be at least one month and no more than six months.¹⁴⁷ The six-month upper limit was chosen to distinguish domestic commercial paper from corporate debentures which currently have a minimum term of one year.¹⁴⁸The lower limit was chosen to parallel the time limit for CDs and large-lot time deposits.¹⁴⁹ The MOF's intention in setting these limits was to prevent domestic commercial paper from diverting funds from the inter-bank call-money market, which is composed entirely of funds invested for less than one month.

Both the upper and lower limits have been criticized as overly restrictive. ¹⁵⁰ The one-month lower limit, in particular, is a serious disadvantage for domestic commercial paper. Many companies' short-term fund raising needs would be better served by a device with a shorter term. In addition, the lower limit equals the current minimum term for CDs and large-lot time deposits. As a result, domestic commercial paper competes directly with these instruments in the short-term market. In the United States, commercial paper is typically issued for periods ofless than one month, precisely to avoid such direct competition. ¹⁵¹

The minimum face amount for domestic commercial paper is ¥100 million ($800,000).¹⁵² This contrasts with the typical minimum amount of $100,000 for U.S. commercial paper. ¹⁵³ The MOF set such a high minimum amount in order to ensure that the sale of domestic commercial paper would be restricted to institutional investors.¹⁵⁴ To prevent evasion of the mandatory limitation, purchases of a single instrument by a group of investors acting as a pool is prohibited. ¹⁵⁵ The minimum amount for domestic commercial paper is the same as the current minimum amount for CDs and large-lot time deposits, ¹⁵⁶ which again forces domestic commercial paper into direct competition with those instruments. Interest is provided by discounting from the face value of the note.¹⁵⁷ This is the only permissible method for granting interest on promissory notes under the Law on Bills. ¹⁵⁸

In the United States, investors rely almost exclusively on rating services to determine whether commercial paper issuers are creditworthy.¹⁵⁹ In Japan, rating services have not been widely used, and are only now beginning to expand their activities.¹⁶⁰ Without an effective system of rating services, investors in Japan cannot adequately assess the creditworthiness of domestic commercial paper issuers. It is likely that the issuance of domestic commercial paper and the increasing issuance of unsecured corporate debentures will encourage the development of an effective rating service system in Japan.

Until rating services are well established, however, the MOF has decided to permit only the most creditworthy companies to issue domestic commercial paper. Therefore, issuers are limited to companies that either meet the standards regarding the issuance of unsecured straight bonds¹⁶¹ or companies that are permitted under special statutes to issue general mortgage bonds.¹⁶²Currently, the number of eligible issuers is limited to approximately 190 companies,¹⁶³ a small number compared to the over 1,400 estimated issuers presently active in the U.S. commercial paper market.¹⁶⁴

b. Backup Lines of Credit

In general, issuers are expected to provide for a bank guarantee or a backup line of credit to ensure payment of the domestic commercial paper obligation.¹⁶⁵ In the United States, virtually all commercial paper is covered by backup lines of credit.¹⁶⁶ Considering the general policy of requiring collateral for corporate bonds, it would be natural for the Japanese system to require a backup credit line, especially in the absence of an effective rating system. ¹⁶⁷

It is therefore somewhat surprising that an exemption from the backup credit line requirement is granted to companies that meet any of the following standards:

1. Companies which have an AAA rating for unsecured corporate debentures.
2. Companies which have an AA rating for unsecured corporate debentures and net assets over ¥3 billion.
3. Companies whose net assets and current assets both exceed ¥3 billion yen (provided that the ratio of liquid assets to liquid liabilities exceeds 10% and that the ratio of current assets to liquid liabilities exceeds 80%).
4. Companies permitted to issue general mortgage corporate debentures by special statutes. ¹⁶⁸

B. The Domestic Commercial Paper Market in Japan: Results

The domestic commercial paper market opened on November 20, 1987 with an initial issue of ¥800 billion from twenty-four companies.¹⁶⁹ By mid-February 1988, the total number of issuers had risen to forty,¹⁷⁰ with an aggregate outstanding balance of ¥2.5 trillion.¹⁷¹ The five major trading companies have been the major issuers, with outstanding issues of over ¥ 1 trillion.¹⁷² Mitsubishi Trading Co. has been by far the largest issuer, with an outstanding balance in mid-February of ¥500 billion.¹⁷³

The underwriting of the initial domestic commercial paper issues has been evenly divided between banks and securities companies, with Mitsubishi Bank leading the banks and Nikko Securities leading the securities companies.¹⁷⁴ Commercial paper issued during the first month of activity carried a three-month term,¹⁷⁵ a longer term than had been expected, probably due to concerns over stamp tax costs.¹⁷⁶

The major issue that arose during this early period has centered on interest rates. Prior to the first issue, investors were expecting to receive a rate of 4.2% to 4.3%, which paralleled the rate of return on bank CDs. However, due to intense competition between dealers for market share, issuers were able to obtain from dealers "harakiri" (i.e., very low) rates, which hovered around 4.0%. ¹⁷⁷ Due to such low rates, domestic commercial paper was not attractive to investors, and underwriters were forced either to hold the domestic commercial paper without reselling it to investors, or to resell it at a higher interest rate and absorb the loss. ¹⁷⁸ In early 1988, it was reported that the domestic commercial paper rate had been rising toward 4.2%.¹⁷⁹ However, this rate was still not attractive to issuers, who have indicated that they would not issue at such a rate "in the absence of strong funding needs."¹⁸⁰

C. The Extension of the Domestic Commercial Paper Market to Non-Residents in Japan

1. Non-Resident Issuance of Euroyen Commercial Paper

As a first step in allowing foreign issuers access to the yen-denominated commercial paper market, the MOF announced on November 18, 1987 that restrictions on the issuance of Euroyen commercial paper would be lifted on November 20, 1987, the same date on which the domestic commercial paper market was launched. ¹⁸¹Japanese residents were prohibited from purchasing Euroyen commercial paper in an effort to ensure that they would participate in the domestic commercial paper market.¹⁸² Without this restriction, there is little doubt that Japanese residents would have utilized the Euroyen commercial paper market, thereby avoiding the stamp tax and the other restrictions on domestic commercial paper. ¹⁸³

The MOF intended to allow non-residents to issue Euroyen commercial paper with minimal restrictions, an approach which would be consistent with the relatively unregulated Euroyen market.¹⁸⁴The rules applicable to Euroyen commercial paper are therefore not onerous.

The government's main concern was to prevent Euroyen commercial paper from adversely affecting domestic commercial paper.¹⁸⁵Thus, a non-resident who is not affiliated with a Japanese company can issue Euroyen commercial paper in a virtually unrestricted manner, unless the foreign resident intends to bring the Euroyen commercial paper into Japan for resale.¹⁸⁶ In that case, the terms of the Euroyen commercial paper must comply with the timing and minimum sales amount restrictions of domestic commercial paper, and the foreign resident must observe a two week waiting period before making such a resale in Japan.¹⁸⁷ Proceeds from the issuance of Euroyen commercial paper may be remitted freely into Japan, provided that the recipient is not a bank, securities company or other financial institution. ¹⁸⁸

Overseas subsidiaries of Japanese companies are also permitted to issue Euroyen commercial paper with minimal restrictions. ¹⁸⁹However, unlike unaffiliated foreign companies, Japanese subsidiaries are prohibited from reselling the Euroyen commercial paper in Japan and also from remitting the proceeds into Japan.¹⁹⁰These measures are intended to prevent Japanese companies from evading the restrictions on the domestic commercial paper market by using their overseas subsidiaries to raise funds on the Euroyen commercial paper market. Similarly, since financial institutions are prohibited from issuing domestic commercial paper, overseas subsidiaries of Japanese financial institutions are not permitted to issue Euroyen commercial paper. ¹⁹¹

The first issue of Euroyen commercial paper occurred on November 30, 1987 when Svensk Exportkredit issued ¥3 billion worth of three-week paper.¹⁹² Subsequent activity, however, has been minimal. ¹⁹³

2. The Issuance of Domestic Commercial Paper by Non-Residents: Samurai Commercial Paper

On January 20, 1988, the MOF announced that non-residents would also be permitted to issue domestic commercial paper (samurai commercial paper) in Japan beginning on January 29, 1988.¹⁹⁴ Eligible issuers have been limited to foreign companies listed on the Tokyo Stock Exchange which meet certain financial requirements.¹⁹⁵ The other rules that apply to the samurai commercial paper are the same as those for domestic commercial paper.¹⁹⁶ About fifty foreign companies are currently eligible to issue samurai commercial paper, but to date they have shown little interest in doing so.¹⁹⁷This lack of interest is partly due to the fact that the only foreign companies with a current need for yen funds are financial institutions which are prohibited from issuing domestic commercial paper.¹⁹⁸Another factor is that foreign companies can raise funds more easily outside of Japan than inside, and typically at lower rates. ¹⁹⁹

Next Section:VI. Assessment: Concerns About the Commercial Paper Market in Japan

Previous Page