Digital Bonds: A New Era of Finance
This article is a deep dive into digital bonds
Digital bonds, also known as blockchain bonds or tokenised bonds, are a new way of issuing bonds that use blockchain technology to create a digital asset that represents a bond.
They have 3 defining characteristics:
Integrity of Content
Secure Access
Verifiability / Enforceability
The Market
The market for digital bonds is expected to grow rapidly in the coming years. According to a report by S&P Global Ratings, the market for digital bonds could reach $200 billion by 2025, up from $10 billion in 2020. This growth is driven by the many benefits that digital bonds offer, including faster settlement times, lower costs, and greater accessibility.
History of Digital Bonds
While it is still early days, digital bonds' potential in terms of cost, security, and access to new sources of funding is evident. It is thus not surprising that issuers are testing the market.
How do Digital Bonds work?
Typically, in a digital bond transaction, the bond is transferred from the issuer to investors' digital wallets. When the bond reaches maturity or an interest payment is due, an instruction to pay and the necessary fiat currency amount are sent to a paying agent, which is often the same bank sponsoring the platform on which the bond was issued. Once the payment is received, a native token is created on the platform and sent to the investors' wallets. These tokens can be exchanged for fiat currency when the investors choose to cancel or "burn" them. This process is illustrated in the "Illustration Of Digital Bond Issuance And Repayment" diagram (below).
In recent digital bond issuances, the platform owner has also created an off-chain record of who holds which bonds and what payments have been made. This can be used as a backup in case the blockchain is unavailable due to platform issues. Unlike bonds that use CBDCs or stable coins, the absence of cash on the blockchain adds a layer of security to the transaction. Furthermore, if the digital bond is listed on an exchange, the paying agent, typically a bank, would ensure the safety of the money flows.
What are the Advantages of using digital bonds?
Faster Settlement Times
One of the main benefits of digital bonds is that they offer faster settlement times. With traditional bonds, settlement times can take weeks or even months to complete. This is because traditional bond issuance requires a lot of paperwork and intermediaries to be involved in the process. In contrast, digital bonds can be issued and settled within minutes, making them a much faster and more efficient way of investing in bonds.
Lower Costs
Another benefit of digital bonds is that they can reduce costs for issuers. Traditional bond issuance involves many intermediaries, which can be expensive. With digital bonds, the use of blockchain technology eliminates the need for intermediaries, resulting in lower costs. This can be particularly beneficial for smaller issuers who may not have the resources to issue traditional bonds.
Accessibility
Digital bonds are also more accessible than traditional bonds. In the past, only large institutional investors and corporations had access to the bond market. With digital bonds, anyone with an internet connection can participate in the market. This means that smaller investors can now invest in bonds, democratising access to the bond market.
Transparency and Security
Digital bonds are also more transparent and secure than traditional bonds. The use of blockchain technology means that digital bonds are stored on secure digital platforms, making them less vulnerable to fraud and counterfeiting. Additionally, the transparency offered by digital bonds can help to reduce the risk of insider trading and other unethical practices.
Recent Digital Bond Issuance Example: Siemens
Siemens, the German multinational conglomerate corporation and the largest industrial manufacturing company in Europe, has recently taken a bold step forward with the issuance of a blockchain-based 'digital' bond. This could be the start of a major shift in the way bond markets operate!
Siemens' €60 million, 1-year bond was issued on the public blockchain platform Polygon, which allows for secure and decentralised transactions through a series of automated contracts. By using this digital ledger, Siemens can offer bonds directly to investors, without the need for a traditional financial institution to facilitate the transaction. This means lower costs, increased transparency, and faster execution and settlement times for Siemens.
But it's not just Siemens that's embracing this new technology. The European Investment Bank (EIB) has also jumped on the bandwagon with the issuance of its own blockchain-based bond. In fact, EIB has already placed three digital bonds, including a £50 million, 2-year note under Luxembourg law, which is soon to be amended to allow digital securities to be used as collateral.
What are the disadvantages?
While the benefits of digitising the bond market are clear, there are still some challenges to be addressed. For example, there's a lack of interoperability between different blockchain platforms, and several functions provided by traditional financial institutions, such as liquidity and pricing, have yet to be digitised. Additionally, regulators, legislation, and processes will need to catch up to manage the novel risks associated with this new technology.
While the pace of transition to digital bonds is hard to predict, the potential efficiency savings and counterparty risk reductions from instant settlement make digital bond growth inevitable.
This is a net positive for asset performance, with the increased competitiveness necessary given the expansion of accessibility. While digital bond ecosystems have a way to go before becoming mainstream in significant transactions, it's only a matter of time before they become as commonplace as Siemens' other bond market activity last week, the placement of €2.5 billion of analogue bonds with maturities that extend to 20 years.
Where are we heading now?
Digital bonds are an exciting advancement in securities issuance and trading. However, in order for digital bonds to grow in the future, there needs to be a common regulatory framework and public understanding of the underlying concepts. Although there is currently regulatory uncertainty as standards are being developed, we expect to see blockchain technology being used more frequently in the market, particularly for private offerings using private blockchain ecosystems. This allows issuers and investment banks to test the benefits of blockchain technology before it is adopted more widely in syndicated markets.
It is important for market participants and their advisors to stay updated in this area and develop their understanding of how digitisation can make our markets operate more efficiently.
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