Are Digital Bonds the future?
In recent years, there’s been a significant focus on the potential benefits of using blockchain or distributed ledger technology (DLT) in bond markets. Several jurisdictions have adapted frameworks, and the EU and UK are setting up for experimentation.
Personally, I’m thrilled that several innovative digital bond issuances, such as the Economic Association Blockchain (EAB) and data deals are coming (where the technology is being integrated with data analytics and AI to facilitate new types of data-sharing and management agreements). These transactions attract much attention and interest. Before we delve into the current status and expected legal and market developments, let’s start by understanding how a digital bond differs from traditional or conventional bond.
Digital bonds are bonds that use Distributed Ledger Technology (DLT) for all or part of their life cycle. They can be native digital bonds issued directly on a distributed ledger or security tokens where a traditional bond is issued off-chain and immobilised before ownership or beneficial interests are transferred on-chain. This is known as tokenised bonds. DLT can be used for issuance, transfer, custody, and cancellation of bonds. Communications between issuers and holders including the passage of resolutions and declaration of events, as well as the settlement process. DLT can also be used post-issuance for real-time tracking of proceeds, key performance indicators, and allocation reporting for ESG and sustainability link bonds. The biggest difference between conventional bonds and those cleared and settled through DLT is the replacement of some or all of those processes, depending on the structure and processes being replaced.
In capital markets, DLT adoption is centred around asset classes that benefit most from efficiency gains or innovation and where there’s the biggest market readiness for said innovation. For example, shallow liquidity in OTC trading or workflow inefficiencies (such as manual processes) are the key drivers. The fixed income market is expected to benefit significantly from digitalisation. Operating cost efficiencies, such as reduced back office costs and clearing and settlement costs, are specific advantages of digital bonds. Workflow automation based on smart contracts, like automated coupon payments for digital bonds based on a transparent Ledger of ownership, is another advantage. Fractionalisation reduces minimum ticket sizes, broadening the investor base and opening the bond market to smaller issuers and issuance sizes. Secondary trading advantages include 24×7 trading, improved markets, improved collateral, mobility, and faster settlement cycles. The immutable and transparent nature of the blockchain Ledger increases pellucidity and reduces the risk of fraud, key efficiencies and advantages of DLT.
Stablecoin solutions and other digital assets are being considered, with a focus on building an interoperable ecosystem with multiple solution providers. While regulatory frameworks vary, there’s a general eagerness from regulators to collaborate and establish harmonised systems. Issuing digital bonds, like the FAA digital green bonds, which involves navigating legal complexities, educating stakeholders, and integrating with existing systems, but progress is being made towards streamlining the process.
The development of the digital bond market is driven through education and advocacy, focusing on harmonising global regulatory frameworks, building interoperability, and advancing DLT. The transition from traditional to digital bonds will be gradual, but the market is expected to evolve significantly, complementing the existing DLT ecosystem. Investor demand for digital bonds is growing, though it’s still in the early stages, with a focus on educating investors and building networks to facilitate adoption.
The above highlights the varying treatment of digital bonds across various jurisdictions and the increasing focus on digital assets. The intersection of digital bonds and ESG/sustainability is noteworthy, with green bonds utilising blockchain for transparency and avoidance of greenwashing. For further information please contact me
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