Money Market and Structured Products

Commercial paper

Commercial paper is unsecured short-term corporate debt, issued at a discount and redeemed at face value, used by large creditworthy companies to fund receivables and inventory rather than to finance long-term assets.

The defining feature for exam purposes is its maximum maturity of 270 days. That number is not arbitrary: Section 3(a)(3) of the Securities Act of 1933 exempts from registration any note arising out of a current transaction whose maturity at issuance does not exceed nine months. Issuers price paper inside that window precisely to keep the exemption, which is why you will never see 300-day commercial paper.

Commercial paper is issued in large denominations and is overwhelmingly an institutional instrument. It is not FDIC-insured and it is not collateralized; the buyer is relying entirely on the issuer's short-term credit rating, which is why the market seizes so completely when a large issuer's rating is questioned.

CDs, bankers' acceptances and repos

A negotiable certificate of deposit is a large-denomination time deposit at a bank — conventionally $100,000 or more, with jumbo CDs at $1 million — that can be sold in the secondary market before maturity. Negotiability is the whole point: the depositor gets a term rate without being locked in.

A brokered CD is a bank CD distributed through a broker-dealer. Two features matter to a representative. FDIC insurance passes through to the issuing bank, currently $250,000 per depositor per insured bank per ownership category, so a customer holding six brokered CDs is insured bank by bank and must be told to watch for concentration at a single institution. And liquidity works differently from a bank CD: instead of an early-withdrawal penalty, the customer sells in the secondary market at whatever price prevails, which can be below par if rates have risen. A customer who believes a brokered CD is 'principal protected in all circumstances' has been mis-sold, because principal protection applies at maturity, not on an interim sale.

A bankers' acceptance is a time draft drawn on and accepted by a bank, used to finance international trade. The bank's acceptance converts an importer's promise into a bank obligation, which is why BAs trade as high-quality short paper. Maturities run up to about 270 days.

A repurchase agreement is a sale of securities with a simultaneous agreement to buy them back at a higher price on a stated date. Economically it is a secured loan; the difference between the two prices is the interest. A reverse repurchase agreement is the same transaction seen from the other side. Repos are the plumbing of the government securities market and the instrument through which the Federal Reserve conducts open market operations, which is why Module 10's monetary policy lesson comes back to them.

Federal funds are overnight loans of reserve balances between banks. The federal funds rate is the rate on those loans and is the rate the Federal Open Market Committee targets. The discount rate, by contrast, is what the Fed itself charges banks that borrow directly from it. Confusing the two is one of the most common avoidable errors on the economics questions.

Money market funds and the suitability answer

A money market fund is a mutual fund investing in money market instruments and managed to maintain a stable value per share, typically one dollar. It is a security, not a deposit; it is not FDIC-insured, and a fund that fails to maintain its stable value has 'broken the buck,' which has happened.

For the exam, money market instruments and funds are the reliable answer to a customer profile that names capital preservation, liquidity, or a short and specific time horizon. They are the wrong answer when the profile names growth, inflation protection over decades, or income sufficient to live on — their yields are structurally low, and a retiree who moves an entire portfolio into them has traded market risk for purchasing power risk, which the exam expects you to name as inflation risk.

Structured products

An exchange-traded note is a senior unsecured debt obligation of a bank that promises to pay a return linked to an index, with no periodic interest and no ownership of the underlying assets. It trades on an exchange like a fund, which is where the confusion begins.

The critical distinction: an exchange-traded fund holds a portfolio, so a customer owns a proportionate share of real assets. An ETN holds nothing. It is a promise by the issuing bank, so the holder carries the issuer's credit risk in full. If the bank fails, the ETN's index performance is irrelevant. That is the exam's point every single time an ETN appears, and it is a genuine risk rather than a theoretical one — ETN holders have lost their investment through issuer failure while the referenced index was fine.

ETNs also carry the risk that the issuer calls them, and the risk that the market price diverges from the indicative value, particularly if the issuer stops creating new units.

Equity-linked securities and structured notes generalize the idea: a note whose return depends on the performance of an equity, an index or a basket, often with a participation rate, a cap, and some degree of principal protection at maturity. Every one of them carries the issuer's credit risk, is typically illiquid before maturity, and carries embedded costs that are not separately itemized. Principal protection, where offered, is a promise by the issuer and not an insurance guarantee, and it applies only at maturity.

The representative's obligation with structured products is disclosure of exactly these features — issuer credit risk, liquidity, the cap, and the conditions on any protection — in terms the customer can act on. Selling a structured note by its headline participation rate alone is the classic complaint.