Did you know that the earliest forms of negotiable instruments date back as far as the ninth century in China?
Back then, it was known as “flying money” and used to transfer large amounts of money over long distances.
But what are negotiable instruments today?
By definition, negotiable instruments are legally binding contracts that promise a sum of money to a specified person at a specific future date. The person receiving payment is the bearer, and they must appear in this legal document.
Negotiable instruments are transferable in nature. Therefore, the benefits of these contracts pass from the original owner to a new party. Once a negotiable instrument is transferred, the holder of this instrument acquires the full legal right to use it however they like.
Here are 6 types of negotiable instruments used today
Checks are some of the most common and safest negotiable instruments to use.
This method of payment involves three parties which take part in the transaction: one party orders the second to pay a certain amount to the third party.
The second party is known as the drawee. In most cases, the drawee is the bank where the drawer has an account. The bank clears the payment and collects the amount on the check on behalf of its customer. It’ll then credit the exact amount to the customer’s account. This defining feature differentiates checks from other financial negotiable instruments.
For this payment method to work, funds have to be set aside for the payee before issuing the check. This way, all parties involved are protected from fraudulent activities.
Negotiable checks have specified expiry dates and paid on demand when presented to the bank.
Promissory notes are negotiable instruments involving two parties: the maker and the bearer. A promissory note is written by the maker to show the amount owed to the bearer. This amount includes the interest rate accumulated over the specified period on the note.
For instance, a customer can make a promissory note to their creditor promising to unconditionally pay a certain amount of money over a pre-decided duration. In this case, the reputation of the buyer is a deciding factor on whether the note payable should be issued.
Just like checks, promissory notes are a secure mode of business transaction. The bearer can claim their promised funds in a court of law in case of non-delivery of the promised amount after the expiry date. Check out this article to read more on judgments passed on negotiable instruments.
Bill of Exchange
A Bill of Exchange is a legally binding document which instructs one party to pay a pre-determined amount of money to a second party at a fixed future date. It’s given to the party entitled to the payment (the payee) by the party who owes the money (the payer).
If bills of exchange are issued by an individual, they’re known as trade drafts. On the other hand, those issued by a financial institution are bank drafts.
Like promissory notes, bills of exchange are used both for domestic and international trade. You can use them to acquire both goods and services.
In an international transaction, the exporter addresses a bill of exchange to an importer. A third party (the bank) is usually involved in the transactions to act as a guarantee for any payments made and to reduce any transaction risks involved.
Currencies such as bank notes are a common type of negotiable instruments used for day-to-day transactions. The government promises and guarantees to pay the amount on the currency note to the individual holding the note.
The legal owner of the banknote is referred to as the bearer. They can obtain goods and services in consideration of the amount on the note they possess.
This medium of exchange is safe and considered to be the most liquid type of asset since it has no expiry date. You can store it for future use, for emergency purposes, or for forex exchange.
Treasury bills are short-term negotiable instruments used by the government to raise short term loans. They’re largely purchased by financial institutions like banks.
The maturity period of these bills is typically three months, and they don’t accumulate interest before the maturity period. For this reason, banks prefer to use them for short term funding.
They’re also used for raising funds through open market operations and for regulating money supply in the economy.
Treasury bills are almost a risk-free investment as they’re backed by the government’s credit. As a result, they’re attractive to institutional investors despite their relatively low yield.
Letter of Credit
A letter of credit is a document from a bank or any other financial institution that guarantees a seller’s payment is received on the agreed time and for the exact amount.
This letter assures the seller of payment even if the buyer fails to do so. It transfers the risk of failed payments from the seller to the banks. According to the agreement, the bank may pay the full or remaining sum of purchase.
This process involves both the issuing bank (of the letter of credit) and the advisory bank to the seller. The issuing bank sanctions the advisory bank to make payments to the seller.
However, a letter of credit is only considered negotiable if it includes an unconditional promise of the payment at the specific predetermined time.
The Future of Negotiable Instruments
Over the years, negotiable instruments have proven to be effective trading channels in the financial market. Their secured commercial transactions have allowed smooth trading activities.
However, with the modern world technology, the use of these instruments is constantly reducing. Other effective electronic payment methods – such as Internet banking, virtual cards, debit and credit cards – have eased money transaction processes.
For more insightful financial reads, check out our business category.