A summary of the webinar of April 20 2022 entitled Blockchain in the bond markets could be a Trojan virus that kills incumbents?
What has happened so far?
The US$124 trillion global bond market is now viewed as the most likely candidate to adopt blockchain on a major scale. There are several reasons for this.
The first is that the bond issuance process has changed for the better in decades. It is slow, costly and subject to manual errors. This inefficiency matters more than in bonds than equities because the biggest issuers return to the market regularly.
The second reason is that bonds pay fixed rates of interest rates or adhere to immutable methods of calculating interest payable and payment dates fixed far in advance. This predictability makes the idea of fully servicing bonds via smart contracts embedded in bond tokens feasible.
Thirdly, bonds – and especially corporate bonds – trade much less frequently than comparable equities. This makes it plausible to hope that tokenisation, by increasing the transparency of bond prices and holders, will improve liquidity.
Fourthly, it has proved possible to issue bonds onto blockchains successfully. The World Bank (a benchmark issuer) accomplished this in 2018.
The European investment Bank (EIB, another benchmark issuer) has issued two bonds on to blockchains – including one issue in which it dispensed with a central securities depository (CSD) and used a public, permissionless blockchain rather than a private one (though Société Générale Forge performed a controlling role).
Government bonds have also been issued on to blockchains. The Bank of Thailand introduced a blockchain platform for government bond issuance in September 2020. In December 2021 a Euroclear test of settling French government OATs in CBDC was successful.
Corporate bonds were first issued on to a blockchain as long ago as June 2017 (LBBW led a one year €100 million Schuldschein issue for Daimler).
Both asset-backed bonds (Société Générale Forge manged covered bond issues in April 2019 (€100 million) and April 2020 (€40 million) and “green” bonds (BBVA issued a €35 million “green bond” on behalf of MAPFRE in February 2019) have been issued on to blockchains.
Fifthly, trading platforms for tokenised bonds are active in Singapore (ADD-X), Zurich (SDX) and London (LedgerEdge) and Luxembourg (Luxembourg Stock Exchange (LuxSE)). The new D7 facility being launched in Frankfurt by Deutsche Börse adds Germany to the list.
So there are dozens of successful blockchain bond issues and Proofs of Concept (PoCs), and places to trade tokenised bonds.
However, in the context of annual global long-term bond market issuance of US$27.3 trillion, the volume and value of tokenised bond activity is trivial.
So what is going on?
The primary answer is that the global bond market is huge and complicated, with a variety of intermediaries and processes. Barring a regulatory diktat, it will take a long time for tokenisation to reach the tipping point at which the market takes off.
In fact, even with a strong regulatory push it would probably take several years before significant changes were evident. This reflects structural obstacles.
What are the structural barriers to change?
The global bond market is the largest securities market of all, with every country sporting a crucial domestic market even before the international dimension is taken into account.
Large markets have evolved over many decades – 50 years and more in the case of the Eurobond market, whose origins date back to the early 1960s. As a result, there is a lot of embedded architecture, in terms of both legacy infrastructure, ageing systems and processes and procedures hallowed by time.
On top of that is laid incredibly complex legal and regulatory frameworks. Bond markets and bond market participants are all highly regulated. A bond eligible for purchase by an asset manager for an Undertakings For The Collective Investment In Transferable Securities Directive (UCITS) mutual fund within the European Union (EU), for example, is a subject not just to UCITS regulation. Its trading is governed by the Markets in Financial Instruments Directive (MiFID) and its issuance, settlement and custody by the Central Securities Depositories Regulation (CSDR).
Bond issuance involvies a huge number of actors between issuers and investors, including underwriting banks, CSDs, law firms and paying agents. In order to make a tokenised bond issue a success, all participants have to support change and collaborate to achieve it.
Participants at each step in the issuance and investment process need to adapt their systems and integrate new processes (and regulations).
What obstacles do institutional investors face in buying tokenised bonds?
Institutional investors pondering investment in tokenised bonds face a series of questions.
A large asset manager in the United States, for example, will be running both pooled funds and mutual funds. The pooled funds will belong mainly to pension funds and be subject to the constraints set by the Employee Retirement Income Security Act of 1974 (ERISA). Any mutual funds will be subject to the Investment Company Act of 1940 (`40 Act).
Offered tokenised bonds by an investment bank, the asset manager must assess the quality of the idea as an investment technique; ask how their clients are likely to react to tokenisation as a process or product; consider whether client investment mandates have to be altered; and ponder whether its own ’40 or UCITS funds need to be re-documented.
If they do decide to invest, they have to choose where to hold the tokens. While they are the client of the custodian for mutual funds, in the case of pooled funds the asset owner is the client of the custodian. Due diligence will have to be conducted not just on the custodian but on the token issuance, trading, settlement and custody technology as well. And there is not a single blockchain technology either – each blockchain network on to which tokenised bonds are issued will have to be assessed separately.
None of these obstacles is trivial. They will need time and money to resolve, both on the part of the asset manage and their (often conversative) clients. If tokenised bond issues are too small to be liquid, or are fragmented across multiple blockchain networks, or offer no visible promise of a stream of issues into the future, the temptation to do nothing will be strong.
What obstacles do retail investors face in buying tokenised bonds?
There is some speculation that retail investors are a more promising avenue for bond tokenisation than institutional investors.
Rising interest rates also make bonds more interesting to retail investors in need of income. In addition, there is some evidence that bonds traded on a retail trading platform attract strong demand and generate higher levels of activity.
A further rationale is that retail investors are not currently investing in bonds but have historically been a major source of demand for bonds – and that tokenisation could tempt them back.
The previous high level of participation by retail investors reflected a world of relatively high real rates of interest. Bonds were held to maturity. In the Eurobond market in particular (the home of the “Belgian dentist”) bonds were also a convenient form of tax evasion.
The other drag on retail engagement is issuers wary of placing bonds with smaller investors because of regulatory and legal requirements designed to protect retail investors, creating a fear of litigation and fines for non-compliance. Issuers have been able to raise the same amounts of money cheaply with US$100,000 or €100,000 denominations clearly aimed at institutional investors.
However, the emerging tokenisation structure is more favourable to attracting retail investors. Initial activity is almost entirely on platforms designed for accredited retail investors with relatively small amounts to invest.
Fractionalisation of tokens enables smaller denominations without inhibiting the larger denominations that institutional investors prefer.
The tokenisation platforms also solve the custody problem for retail investors by taking care of safekeeping; indeed, the custody issue becomes invisible to retail investors.
There is some evidence of a higher velocity of trading on retail platforms, which will in principle help tokenised bond market liquidity.
Will tokenisation enhance bond market liquidity?
One possible impact of tokenisation in the bond markets is increased liquidity in a market that has long suffered from a buy-and-hold culture.
Outside sovereign and supranational benchmark issues, liquidity in most areas of the bond market is low. Even government bonds paying non-current coupons – and so trading at premiums or discounts – are not liquid. Above all, liquidity is almost non-existent in some areas of the corporate bond markets.
In the equity markets, a dealer has access to dozens of exchanges, Multilateral Trading Facilities (MTFs) and Organised Trading Facilities (OTFs) simultaneously. Latency is reduced to fractions of a second. Yet in the bond markets, only 30- 40 per cent of trades are completed electronically and the largest trades tend to be executed by voice.
Tokenisation enthusiasts believe tokens can alter these patterns by increased transparency and visibility.
Currently, the ability to buy or sell most bonds depends on a limited circle of broker-dealers who know where the bonds are held. This creates an information asymmetry that favours the broker-dealer, making trading more costly and so reducing overall trading volumes.
Once bonds are issued in tokenised form on a blockchain, holdings can become more visible. Indeed, buyers and sellers have an incentive to broadcast indications of interest in a bond token directly to each other rather than rely on intermediaries.
Once direct transactions start to occur, trading costs are likely to fall and trading volumes to increase. Even broker-dealers might benefit if volumes rose enough to offset tighter margins.
One suggestion to improve liquidity in the secondary market is to get the definition of the underlying cash flows of a bond into machine-readable and machine-executable form. The digitisation of the economics of a bond on a blockchain would allow smart contracts to trade tokens actively without human intervention. Other data-driven securities markets already operate this way.
Whatever the merits of these ideas for boosting bond market liquidity – and they may well ameliorate the problem – they do face two fundamental limitations.
The first is that a corporate which issues only one line of equity might still have dozens of forms of debt, including bonds. This mean that every investor can trade a single equity ticker while liquidity in bonds issued by the same company is fragmented across multiple issues. The same is true even of government bonds: there is one issuer but hundreds of issues.
Secondly, in fixed income investors tend to hold to maturity and then reinvest the proceeds. This is the primary limitation on turnover in fixed income markets and explains why bonds are less liquid than equities.
How can workflows be digitalised?
Workflows in many areas of the capital markets – and especially in the primary market – are still in the pre-digital age.
The issuance process is characterised by spreadsheets, emails and telephone exchanges. Compared even to online banking, the capital markets are at the stage where customers have to go to a branch to make a deposit or withdrawal. Nobody provides the equivalent of a mobile banking app or online banking services.
This is why many of the most prominent innovators in the bond markets are focusing their efforts on improving primary market processes.
Agora, for example, is using blockchain to share issue information; synchronise the various parties to the issue; eliminate reconciliations between issuers, investment banks, issuing and paying agents, custodians and CSDs; and automate workflows, generate documents and manage the lifecycle.
Capexmove, to take another example, is using blockchain to make the drafting and management of bond issue documentation more efficient, and deploying smart contracts to improve asset servicing.
Origin Markets is also looking to digitise primary market issuance, documentation and post-trade data gathering.
These FinTechs are a measure of the room for the digitalisation of workflows in the bond markets. They are also a necessary precursor to the tokenisation of assets, because digital assets cannot fitted efficiently into a non-digital workflow.
For bond tokenisation to work, all parts of the eco-system need to be on an inter-connected or inter-operable digital infrastructure capable of supporting a high volume of transactions in standardised data flows akin to what now occurs in the equity markets.
In the equity markets, orders move seamlessly from clients to dealers to central trading facilities via FIX; trade, customer and service provider data flows to exchanges, central counterparty clearing houses (CCPs), CSDs and custodian banks with minimal manual intervention.
For the bond markets to reach a similar state of automation, much time will need to pass.
First, the current processes have such a large manual component that any change must begin from first principles – workflows must be re-designed, not automated as they are.
Secondly, the primary market is much more important in the bond markets than it is in the equity markets. Issues occur more frequently. It is also at the primary market stage that asset servicing is locked in both in terms of what needs to serviced (notably coupon payments) and in terms of the service providers (such as paying agents). Smart contracts will be assuming responsibility for crucial functions.
Thirdly, digitalisation cannot halt at the primary market stage. A tokenised bond needs to be digitalised from issuance, through trading by the algorithmic and systematic means that support exchange-traded funds (ETFs), parametric and portfolio trading, to settlement (with the ultimate goal being “atomic” settlement).
Over time, tokens and a tokenised infrastructure will mutually reinforce each other. A better connected, more functionally capable infrastructure will encourage more tokens to be issued, while an increase in token issuance will generate more revenue (and more knowledge, creating entirely new capabilities).
For example, a tokenised bond issued to comply with Environmental, Social and Governance (ESG) can incorporate smart contracts that tailor coupon payments to environmental impacts. To deliver the data flows that make such a sophisticated instrument possible at low cost, the token market infrastructure needs to outstanding.
Who will be disintermediated in tokenised bond markets?
One major promise of blockchain is a reduction in the number of intermediaries. Indeed, this is the major source of cost savings.
In theory, the re-design and automation of workflows eliminates redundant processes and costs. Ultimately, issuers will place bonds directly with investors; secondary holders trade tokens directly between their digital with atomic settlement achieving finality; and settled trades captured by the blockchain provide an automatically updated register.
Yet there has so far there has been virtually no disintermediation. Even the EIB issue which dispensed with a CSD retained a register controlled by a bank.
Why has disintermediation proved so hard to achieve?
One forceful explanation is that tokenised bonds will remain highly regulated securities traded between highly regulated entities. Even otherwise unregulated crypto-currencies are already subject to Know Your Client (KYC), Anti-Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks.
Some intermediaries were created or at least universalised directly by regulation (CSDs and CCPs are examples).
But most have evolved in response to specific needs. Bond issuers, for example, need investment banks to gauge the correct price for issues and to know who to sell to.
Most institutional investors do not want the burden of managing a global custody network and prefer to appoint a third-party specialist custodian bank (whose services are cheap, especially as they have a strong insurance character).
Besides, investors do not have the ability to assess trading or settlement counterparties, and prefer to leave that task to the banks, which also provide capital to make markets and generate liquidity.
But the main constraint on disintermediation is legacy attitudes and methodologies which investors in particular are reluctant to relinquish.
Over time, intermediary roles may change, disappear, or disappear and then re-emerge. Incumbents are still in the best position to adjust as they have the relationships, the cash flow and the expertise. Custodian banks, for example, are not going to offer custody of traditional assets only; they are already developing custody services for private keys to tokens.
If or when atomic settlement becomes a reality, CCPs will not be needed. If tokens are “smart,” paying agents will not be needed either because smart contracts will doing all the work.
But new needs are bound to arise, such as validation buyers have funds before placing orders or the provision of intra-day credit to those counterparties that do not have funds.
There is already a need for interoperability between multiple blockchain protocols, and between blockchain protocols and traditional networks. It is creating a ned for secure “bridges” that a new class of intermediary can fulfil.
Current intermediaries need to plan for a different future. The only foolish strategy will be to do nothing, because there is plenty of opportunity as well as threat.
When will tokenisation happen in the bond market?
There is consensus on the scope for improvement and enhancement of the primary and secondary bond markets, and on the contribution that tokenisation can make. The question is to bring change about. Does it require regulation, or collaboration, or competition, or some combination of all three of them?
Bond tokenisation demonstrably works. It offers many attractive features: lower cost, faster speed to market, automation of asset servicing by smart contracts, transparency and visibility, and possibly improved liquidity.
A recent survey by the Official Monetary and Financial Institutions Forum (OMFIF) found benchmark bond issuers consider tokenisation inevitable– half of a surveyed group within five years. Major exchanges – SIX, Deutsche Börse and SGX – have placed major bets on that outcome, because they are running tokenised bond trading venues already.
There is no insuperable impediment to tokenisation of bonds either. Most market participants support the idea. Regulators view the prospect benignly. So it looks inevitable. Yet there several reasons to be cautious.
First, there are frictions throughout the current system which in total require sizeable and costly changes to make tokenisation work.
Secondly, current volumes of token issuance are nugatory. Few market participants have made or are making the intellectual and systems investments required to make it work.
Thirdly, the financial services industry is notorious for permitting rank bad processes to continue, for decades let alone years. Corporate actions is a good example of a costly problem with known solutions that are not adopted because they require cooperation. Likewise, the primary bond market process could have been radically improved many years ago, but it was never enough of a priority for the decision-makers to act.
Fourthly, major changes in securities markets tend to be driven by regulators. MiFID is one example, in creating MTFs. The Group of Thirty (G30) report on settlement infrastructure is another. The General Data Protection Regulation (GDPR) has also sparked a series of changes. Regulatory compliance also drains technology budgets.
Fifthly, some of the new requirements necessitated by tokenisation are non-trivial. Creating a network of blockchain networks, inter-operable between blockchain protocols and between blockchain protocols and traditional markets, is essential to the success of tokenisation but is so far unresolved.
Sixthly, inertia. There is a risk is that tokenisation never generates enough momentum to take off. Projects will fail for want of sustained interest, and market participants will gradually drop the idea.
Is there a one interest that can force tokenisation into self-sustaining growth?
Regulators are the easy answer, but it seems unlikely that they will act. Which leaves the fate of the tokenisation of the bond markets in the hands of the group of sovereign and supranational bond issuers that OMFIF interviewed. They alone can kick-start the tokenised bond market into life by issuing trillions of dollars of new bonds in tokenised form.
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