Certificate of Deposit: Meaning, Example, Features & More

A time deposit or certificate of deposit is an interest-bearing time deposit offered by banks. A person reserves one-time money in the CD for a particular time period, on the commitment that the depositor will not withdraw the amount in the meantime, and thus the depositor receives interest income. When the deposited sum and the earned interest mature, they are returned to the depositor. CDs are in huge demand due to their stability and predictable returns. Of course, however, if one withdraws the money before it actually matures, there are early withdrawal penalties which may be applied and considerably curtail the overall returns.

The topic of Certificate of Deposit falls under the paper of General Studies Paper III of the UPSC syllabus, which is mainly under the bracket of Economics. It is a part of the problems of the Indian Economy and resources such as planning, mobilization, growth, and development. In-depth knowledge regarding Certificates of Deposit is necessary to understand the overall financial system and its tools in an economy.

Certificate of Deposit Meaning

A CD, or an abbreviation of the term Certificate of Deposit, that essentially refers to a type of time deposit offered by banks and other financial institutions, is a fixed-term savings account that the depositor agrees to leave a sum of money in for a predetermined period in exchange for earning a fixed rate of interest on it. The interest rate usually generated from this type of account is better compared to that provided by an ordinary savings account. At the end of the term, the principal amount deposited with the interest accrued is repaid back to the depositor. Withdrawals prior to the term's end incur some penalty and lower the overall return in most cases.

Certificate of Deposit Example

Now consider a depositor depositing an amount of ₹1,00,000 for one year in a CD carrying an annual interest of 6%. Now at the time of maturity, the interest amount will be ₹6,000 and total amount will be ₹1,06,000. But if the depositor withdraws the amount before the expiry of one year, then the interest accrued may get debited or even the principal amount may get reduced.

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Key Features of the Certificate of Deposit

Following are the key features of a Certificate of Deposit:

• Fixed Deposit Period: CDs are issued for a specific fixed tenure which may range from a few weeks to several years.
• Interest Rate: As a general rule, the rates are higher compared to standard savings accounts and they remain fixed for the entire duration of the CD.
• Penalty for Early Withdrawal: They are mostly subject to early withdrawal penalties, which will reduce the interest earned or even a portion of the principal in some cases of premature withdrawal.
• Safety and predictability: CDs are low-risk investment opportunities because the interest rates are fixed along with the fixed maturity date that is sure to deliver returns.
• Non-transferable: CDs may not be transferred to another party before they achieve maturity; hence, they are relatively less liquid than other financial instruments.
• Minimum Balance and Denomination: Generally, CDs have a minimum balance that needs to be invested and this could be more as compared to saving or current accounts.

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Issuance of Certificate of Deposit in India

The CDs in India can be issued by:

• Scheduled Commercial Banks: All scheduled commercial banks except regional rural banks and local area banks are eligible for issuing CDs.
• Financial Institutions (FIs): There are other financial institutions which have been empowered by the Reserve Bank of India (RBI) to issue CDs.

These are issued at a discount to their face value and generally available in the denominations of ₹1 lakh or multiples thereof. RBI regulates the issue and these are issued with complete transparency so that all the guidelines are strictly followed. The maturity period for CDs issued by banks is seven days to one year while CDs issued by financial institutions have a tenure from one year to three years.

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Advantages of the Certificate of Deposit

There are also some benefits of Certificates of Deposit. Benefits include being highly attractive to conservative investors. These benefits are as follows:

• Higher Interest Rates: CDs offer more interest than ordinary savings accounts and, therefore, a better return on locked-up capital.
• Certainty of Returns: Given the fixed nature of the interest rate, investors are well aware of what they will receive at the maturity date of the CD.
• Low Risk: CDs are relatively low-risk investments as it is provided for by banks and major financial institutions, and most are insured to the maximum limit offered by the Deposit Insurance and Credit Guarantee Corporation (DICGC).
• Flexibility in Tenure: CDs are offered with different tenures, and investors can select a tenure that best meets their financial needs.
• Accumulating Savings: The fixed term of CDs ensures that savings habits become disciplined. Funds are not debited out for a specified time period.

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Limitations of the Certificate of Deposit

Like every other financial instrument, CDs also comes with some limitations:

• Liquidity Problems: Given the fact that funds cannot be withdrawn before the maturity date without penalty, CDs lack liquidity compared to other investment forms.
• Inflation Risk: With fixed returns, actual value of interest earned could diminish in case inflation rate is more than the interest rate of CD.
• Opportunity cost: Compared to some other potential earnings, the money lying with the fixed time deposit could be earning much more.
• Penalty for early withdrawal: In most cases, a penalty applies to the early withdrawal of deposits. Overall return may, therefore, be reduced.

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Major Amendments to the Certificate of Deposits

Over the years, several regulatory changes and amendments to issues and managing CDs in India have been brought in the books to make them stronger and to increase investor safety over the years:

• Eligibility Criteria: RBI evolves its eligibility criteria for entities that can issue CDs time and again. This has been amended from time to time to mirror the constantly changing financial scenario and the evolving risk assessment strategies over a period of time.
• Minimum Denomination and Tenure Adjustments: The minimum denomination has changed and conditions of tenures to suit different classes of investors and prevailing economic conditions.
• Interest Rate Deregulation: CDs are deregulated in some cases concerning interest rates to market forces with the objective of making it an honest competition.

These regulatory measures ensure that CDs are a safe financial instrument and, at the same time, allow responding to the current market situation and the needs of investors.

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Difference Between Commercial Paper and Certificate of Deposit

Though both Commercial Papers (CPs) and Certificates of Deposit (CDs) are short-term financial instruments, there are numerous differences in them in various aspects as they fulfill the investment needs of different kinds of investors. Here is all the information about comparison:

Difference Between Commercial Paper and Certificate of Deposit
Feature	Certificate of Deposit	Commercial Paper
Issuers	Banks and Financial Institutions	Corporates, Primary Dealers, All-India FIs
Tenure	7 days to 1 year (Banks); 1 to 3 years (FIs)	7 days to 1 year
Interest Rate	Fixed	Typically issued at a discount
Minimum Denomination	₹1 lakh	₹5 lakh
Security	Usually unsecured	Unsecured
Primary Investors	Individual Investors, Corporates, Trusts	Institutional Investors
Transferability	Non-transferable	Transferable through endorsement and delivery

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Conclusion

Certificates of Deposit are valuable financial instruments that offer a stable and predictable return, making them an attractive investment for conservative investors looking for low-risk options. With higher interest rates compared to regular savings accounts, they provide a better return on investment for those willing to lock their funds for a fixed period. However, restrictions like low liquidity and risk of inflation call for utmost cautious calculation of the financial goals and the general scenario of the market before investing in CDs. Keeping oneself updated on the regulatory amendments and knowing the primary difference between a similar type of instrument like commercial paper helps in making the right kind of investment decision.

Key Takeaways for UPSC Aspirants Definition: A Certificate of Deposit, or CD, is a financial instrument issued by banks and other financial institutions to raise funds from the secondary money market. Purpose: A means by which a bank can meet its short-term funding requirements; fixed return/investment option for the investors, fairly safe. Interest Rates: Higher than what is offered on savings account; time-bound, and the principal amount is more at the time of opening. Maturity Period: The maturity period of CDs in India usually ranges from seven days to one year, depending on the issuing institution. Transferability: CDs are negotiable instruments; hence, they can be sold or transferred to another party prior to maturity, offering liquidity to the holder. Issuer and Holder: Issued by scheduled commercial banks and some other financial institutions, CDs are held by individuals, corporations, and institutions in search of a low-risk investment. Regulation: RBI is responsible for the regulation of issuance and trading of CDs ensuring transparency and stability in the money market. Benefits and Risks: In addition to safe returns and liquidity, CDs are subject to interest rate risk, as well as the creditworthiness of the financial institution and potential impacts from a change in that financial institution.

We hope your doubts regarding the topic have been addressed after going through the above article. Testbook offers good quality preparation material for different competitive examinations. Succeed in your UPSC IAS exam preparations by downloading the Testbook App here!