What is a Negotiable Instrument in Banking?- Meaning, Types, and Uses

The Negotiable Instrument in banking is a topic covered under the Banking Awareness section of the General Awareness section in banking exams. Questions from this topic are frequently asked in the examination. This topic is part of the most important banking terms essential for banking exam preparation. Having a basic knowledge of these terms, such as the Negotiable Instruments, will be useful in your bank exams. Continue reading below to get all the important information related to Negotiable Instruments, their meaning, types, and uses.

A Negotiable Instrument in Banking – Meaning

The banks usually issue two main types of instruments: negotiable and non-negotiable. A negotiable instrument can be transferred to another person, but a non-negotiable instrument cannot be transferred to another person. A negotiable instrument is a written document that guarantees the payment of a specific amount of money from one party to another. It can be either on demand or at a future date. The holder of the instrument can transfer it to another party by delivery or endorsement. It allows the new holder to claim the payment. These instruments are easily transferable. The common examples of Negotiable Instruments include checks, promissory notes, and bills of exchange.

Important facts about negotiable instruments:

• In India, the Negotiable Instruments Act, 1881, is responsible for governing negotiable instruments.
• According to Section 13 of the Negotiable Instruments Act of 1881, a negotiable instrument means “a promissory note, bill of exchange or cheque, payable either to order or to the bearer”.
• There are 147 different sections under the Act. The key sections are Section 4 (Promissory Notes), Section 5 (Bill of Exchange), Section 6 (Cheque), and Section 15 (Endorsements).

Features of Negotiable Instrument in Banking

The negotiable instruments are an essential part of banking. Some of the key features of negotiable instruments include transferability, payment method, standardized format, and recognition by law.

1. Transferability: It can be easily transferred from one person to another. There is not much paperwork involved in the formation of negotiable instruments. The ownership of an instrument can transfer simply by delivery or by a valid endorsement. This enables easy transfer of notable instruments.

2. Written and Signed: Must be in writing. Must be duly signed by the maker/drawer.

3. Standardized formats: They are generally issued in a recognized format. This makes them recognizable. And, they are easily processed by the banks.

4. Legal Recognition: They are recognized by law as a valid form of payment. It gives them legal banking status.

5. Unconditional Promise or Order: Must contain an unconditional promise (in a promissory note) or order (in a bill or cheque) to pay money.

6. Payment in Money Only: The amount must be payable only in legal currency (not in goods or services).

7. Certainty of Amount and Parties: The amount to be paid must be certain. The parties involved (drawer, drawee, payee) must be identifiable.

8. Time of Payment: Must be payable on demand or at a specified future date.

9. Holder in Due Course: The person who receives it in good faith and for value gets better rights than the previous holder.

10. Title to the Instrument: The title can be passed even without a formal assignment.

Types of Negotiable Instrument in Banking

There are three main types of negotiable instruments in banking. These are, namely, cheque, Promissory Notes, and Bill of Exchange. These types are mentioned with their meanings below.

1. Cheque

The cheque is a type of negotiable instrument. It is a special type of bill of exchange drawn on a bank and payable on demand.

It includes:

• Bearer Cheque: A bearer cheque is a type of cheque that is payable to the person holding or presenting it at the bank, regardless of their name. The words “or bearer” is mentioned in the cheque.
  • For example: Pay ₹10,000 to Ram or bearer
• Order Cheque: An order cheque is a cheque that is payable to a specific person whose name appears on the cheque, or to anyone authorized by them. The words “or order” are written on the cheque.
  • For example: If a cheque is written as:
    “Pay ₹5,000 to Ramesh or order”,
    Then only Ramesh or someone he endorses the cheque to can receive the money.
• Crossed Cheque: A crossed cheque is a cheque that cannot be encashed over the counter at the bank. It must be deposited into a bank account and is payable only through a bank.

Parties Involved: Drawer (account holder), Drawee (bank), and Payee.

2. Promissory Notes

A Promissory Note is a written promise by one party (the maker) to pay a certain amount of money to another (the payee) either on demand or at a fixed future date.

Parties Involved: Maker and Payee.

3. Bill of Exchange

A bill of Exchange is a written order by one party (drawer) to another (drawee) to pay a certain sum to a third party (payee) on demand or at a fixed date.

Parties Involved: Drawer, Drawee, and Payee.

4. Bank Draft

A Bank Draft (also known as a Demand Draft) is a prepaid instrument issued by a bank, used to transfer money from one place to another. It is payable on demand and guaranteed by the bank, making it a secure method of payment. It is a kind of cheque issued by a bank that guarantees payment.

5. Pay Order

A Pay Order (also known as a Banker’s Cheque) is a prepaid instrument issued by a bank, instructing payment of a specific amount to a named person or organization within the same city. It is non-negotiable and guaranteed by the bank. It is similar to a demand draft but used for local transactions.

6. Traveller’s Cheque

A Traveller’s Cheque is a prepaid, fixed-amount cheque issued by a bank or financial institution. It is used as a safe and convenient substitute for carrying cash while travelling, especially internationally. Prepaid cheques are used while traveling to make payments in foreign countries.

7. Dividend Warrant

A Dividend Warrant is a payment instrument issued by a company to its shareholders. It authorises them to receive dividend payments from the company’s bank. It works as a cheque and can be encashed at the bank. It is used as a profit distribution tool by the companies.

Uses of Negotiable Instruments in Banking

The Negotiable instruments play an important role in the banking and financial system. Some of the major uses include facilitating easy transfer of funds, acting as a substitute for money, ensuring safety and convenience, promoting credit transactions, legal evidence of debt or payment, standardized payments, banking operations, and facilitating trade and commerce. Below mentioned points highlights the major uses:

1. Facilitate Easy Transfer of Funds

• Enable smooth transfer of money from one person to another without physical cash.
• Useful for both short-term and long-term payments.

2. Acts as a Substitute for Money

• Cheques, drafts, and promissory notes serve as legal alternatives to cash transactions.

3. Ensure Safety and Convenience

• It is safer than carrying large amounts of physical cash.
• The payments can be tracked and verified.

4. Promote Credit Transactions

• The Promissory notes and bills of exchange are used to extend credit in trade and commerce.

5. Legal Evidence of Debt or Payment

• They serve as a written, legally enforceable proof of transactions.
• They can be used in courts if disputes arise.

6. Standardized Payment Instruments

• They are recognized under the Negotiable Instruments Act, 1881, making them reliable and legally accepted.

7. Banking Operations

• It is used in the banking operations such as:
  • Depositing money (cheques)
  • Borrowing/lending (promissory notes)
  • Settling dues (bills of exchange)

8. Facilitate Trade and Commerce

• It is mostly used in domestic and international trade to ensure trust and guaranteed payments.

Summary

Negotiable instruments are a written document used in banking transactions. They are transferable. They are of different types, such as cheques, promissory notes, and bills of exchange. The holder of this instrument is guaranteed payment by the bank on the date mentioned in the document. Read the above blog to know the uses, features, and types of negotiable instruments in Banking.

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