Certificate of Deposit

Certificates of deposit (CDs) are interestbearing receipts for funds deposited with banks or other depository institutions. Depositors purchase CDs in fixed denominations ($1,000, $10,000, etc.) and for a fixed time to maturity, which typically ranges between six months and five years for CDs of less than $100,000. At maturity, the owner of a CD receives the original purchase price of the CD plus interest. A purchaser of a one-year, $1,000 CD bearing 5 percent interest would receive at the end of a year $1,000, plus $50 interest. Certificates of deposit in denominations less than $100,000 are not negotiable and cannot be sold in a secondary market. Also, the issuing institution imposes a substantial penalty for early withdrawal. Since the deregulation of interest rates, CDs pay interest rates slightly higher than the treasury bill interest rates.

Negotiable certificates of deposit come in denominations of $100,000 and up. The most common denomination is $1 million, and time to maturity is usually six months or less. These CDs are sold mainly to corporations, state and local governments, foreign central banks and governments, wealthy individuals, and financial institutions. They can be can be sold in a secondary market before maturity if the owner needs cash, but most negotiable CDs are held to maturity. In 1961, First National City Bank of New York, now Citibank, first offered the large denomination CDs to its largest customers. Large CDs grew rapidly in popularity, and by 1973 the Federal Reserve Bank had lifted all interest rate ceilings on these large-denomination, negotiable CDs.

Negotiable CDs quickly became a financial instrument for the Eurodollar market. Eurodollar CDs are CDs denominated in dollars but issued by foreign banks, or foreign branches of U.S.-owned banks. Eurodollar CDs first appeared in 1966 and owed their success to the high interest rates paid by institutions beyond the reach of U.S. banking regulations and interest ceilings. In 1968, U.S. and British banks began issuing sterling pound CDs.

The small denomination CDs (less than $100,000) came into being in the late 1970s and were intended to give small savers the advantages of market interest rates. The Federal Reserve Bank includes CDs of less that $100,000 in the calculation of M2, a monetary aggregate often regarded as the best measure of the money supply. The larger CDs are included in the calculation of M3, the most broadly defined monetary aggregate.

Negotiable CDs enable banks to attract deposits that they can count on having for a fixed period without losing to withdrawal, and the owners of negotiable CDs may always sell them for cash, albeit at a sacrifice of part of the interest yield. In contrast to demand deposits, which allow depositors to withdraw funds on demand, CDs assure the bank that deposits will be left with the bank for a while, taking some pressure off the bank. For thrift institutions, CDs are a powerful tool for raising funds, but at the price of higher interest rates for small savers.