International Finance

The evolution of blockchain in bond issuance


In 2018, the iconic power of blockchain in bond issuance came into play when the World Bank first launched bond-i. It was the first global blockchain bond to be ‘created, allocated, transferred and managed through its life cycle using distributed ledger technology’, according to a statement. The two-year bond had raised A$110 million, highlighting the investors’ support toward the World Bank’s development activities in a transaction that is powered by blockchain. 

Arunma Oteh, World Bank Treasurer, said in the statement, “I am delighted that this pioneer bond transaction using the distributed ledger technology, bond-i, was extremely well received by investors. We are particularly impressed with the breath of interest from official institutions, fund managers, and banks. We were no doubt successful in moving from concept to reality because these high-quality investors understood the value of leveraging technology for innovation in capital markets.” 

Bond-i is an integral part of the World Bank’s broader strategic focus to draw the potential of disruptive technologies for financial development. The World Bank issues anywhere from $50 billion to $60 billion annually in sustainable bonds—with an impressive 70-year track record of innovation in capital markets. World Bank’s bond-i blockchain platform was developed by the CBA Blockchain Centre of Excellence. The project prides itself on the profound experience of the CBA’s blockchain team that has taken a lot of effort in assessing and applying blockchain in capital markets. 

By theory, the use of blockchain and distributed ledger technology allows information to be stored securely in a fully traceable, immutable manner. Like the Internet, blockchain is an open infrastructure upon which other applications and technologies can be developed. An advantage of this infrastructure is that it allows individuals to cut through the traditional intermediaries in their transactions, which in turn could lower or eliminate additional costs. And another advantage is that it simplifies transactions and increases transparency which are of utmost importance to the financial world. 

Working mechanism of blockchain in issuances

In Euro markets, for example, the fund-raising time frame might vary from three weeks to six weeks. Typically, the process comprises two stages: pre-issuance and post-trade. The pre-issuance stage more commonly involves the preparation of issuance, selecting modalities of price discovery mechanism and establishing agreements between the issuer and investor in terms of securities. Following that, the post-trade stage involves actual issuance of debt security in central securities depositories and its delivery to investors through custodians, banks and other intermediaries. But what is important to understand here is that there are existing inefficiencies in pre-issuance and post-trade stages as they involve multiple financial intermediaries.

blockchain infrastructure is well-suited to operate in the bond market. 

Aaron Gwak, the head of capital markets, ASEAN, Standard Chartered, told International Finance “There are two key value propositions from a technical perspective: The first is the ability to lower participation denominations in bonds below thresholds that are required given the existing bond infrastructure. The second is making ease of participation as simple as a click in an app versus a manual application and account opening process.”  

Because of the existing inefficiencies what happens is that conventional solutions are under development to foster standardisation and harmonisation in both stages. In fact, various forms of initiatives have been developed to explore solutions that can identify and address those inefficiencies in the present European bond markets. For example, a private sector initiative known as Project Mars, was built to modernise the process of corporate bonds issuance and streamline information exchange flows in primary debt markets. 

Now issuers are relying on blockchain to guard against fraud and ease the process, a mechanism that could otherwise be tedious. Blockchain allows creation of unique shared reference data records that can be viewed by all market participants, which is unlikely to happen in the current system that only provides a separate view of the records. A survey carried out found a common opinion on blockchain and its big role in the allocation and payment process, and even to help in ‘finding reliable patterns and strategies’ depending on the given market conditions. 

The simplest explanation of its impact on pre-issuance is perhaps its ability to eliminate physical documentation, create a single source of information, provide greater access to the capital markets and facilitate a more standardised process. Another example of its greatness is its influential work in the lengthy post-trade that usually involves multiple counterparties. What blockchain can essentially do is carry out real-time settlements and reduce intermediaries. 

Outside the realm of conventional approach

These are just a few opportunities that banks and other financial companies have taken advantage of when they consider applying blockchain in bond issuance outside the realm of conventional approach. It is proven that blockchain and encryption algorithms can enhance investor confidence in the bond market. The report has identified three key domains that are particularly relevant to the bond issue: structuring and distribution; transfer of ownership, payment and settlement; and impact of the investment project. 

For green bonds, the works of blockchain can bring two identifiable benefits: efficiency and credibility. That has in fact increased the credibility of securities because it helps to save cost, time and prevent third-party interferences. Blockchain serves as the best example to date in making the transfer of value and token-based issue fraud proof because of its built-in encryption features. 

Perhaps the more common long-term benefit is its transformative characteristics, where digitised debt instruments can substitute traditional physical bond certificates and they can be easily issued on the debt ledger technology. By using it, individuals can purchase financial products or exchange money securely, eliminating the need for a bank account, or even national borders. So in the case of bond issuance, blockchain can drive the process towards innovation in both the public and private sector, through smart contract-led automation, reduction of intermediaries, automated asset-servicing using distributed ledger technology and a full-time audit trail. 

A known fact about blockchain application in bond issuance is that it could enable real-time book building. But that’s not all. It even has the potential to direct dealings and communications among issuers, investment banks and syndicate banks, which is so much more worth than a conventional execution. Institutional investors could consider securities issuance directly on blockchain platforms and the issuers will have the ability to view the transaction in real-time. 

Even securities and cash can be tokenised to accelerate the clearing and settlement process. Currently, the securities market uses a range of identifiers, but blockchain would bypass such complexities by integrating unique security identifiers into the trade lifecycle process. This is possible because distributed ledger technology can facilitate  the implementation of unique reference systems, which are similar to unique security identifiers. Also,  because  blockchain makes it possible to streamline the process and workflows, it is on the threshold of a revolution in digitising bond issuance processes and integrating capital markets. Beyond these benefits, smart contracts would be on top of distributed ledgers and they would ensure auto-execution of the terms and conditions, in addition to establishing confidentiality agreements without human intervention. 

Inspired by the World Bank’s bond-i? 

That is the reason why the World Bank is in awe of blockchain-powered bonds. Almost a year after it issued the bond, it issued a second round, which raised to a total $108 million. Last August, the World Bank again joined forces with CBA’s Blockchain Centre of Excellence to raise around $80 million by issuing a two-year bond which used a ‘private version of Ethereum’s blockchain software’. With that, the platform allows investors to trade bonds on the security market, and the transactions are automatically recorded on blockchain. The World Bank was quoted that this “the first bond whose issuance and trading are recorded using distributed ledger technologies.”

The passive side to all these developments is that many blockchain experiments within large organisations have not seen the light of day. But that is not to say that these developments are futile. If anything, a second round of blockchain bonds initiated by the World Bank means that there is something powerful. It is reported that according to Sophie Gilder, the CBA head of blockchain and AI, the CBA has tangible evidence on the benefits of blockchain. The few facts that must be memorised about this technology is its capabilities to deliver high levels of efficiency, transparency and risk management, as opposed to the current market infrastructure. 

A simple demonstration of the issuance process 

As with the issuance process—blockchain developed solution is easily understandable—and is constituted by a series of steps. Stage one: The bond is issued in a tokenised form. Stage two: Investments banks approached by an issuer will initiate a digital term sheet on which the latter will sign-off. Stage three: Lead managers and syndicate banks will be provided with individual single views on the master book which essentially comprises bids and orders from potential investors. Stage four: The issue will need to provide KYC details of investors to add them into the bond blockchain. Stage five: Transactions will take place as the deal reaches the closing stage. As part of the settlement process, custodians or banks will act as token keepers and transfer funds to the beneficiary accounts in line with the instruction. Stage six: Cash will be tokenised in the cash ledger to complete the transaction. 

That said, there are fundamental high level factors that need to be defined while applying blockchain in issuance. First: The characteristics of digital bond tokens such as the type, value, size and action of the debt instrument must be specified. Second: Regulators should be provided access to the transactions blocks, allowing them to monitor and audit. Third: Due diligence mechanisms should be provided to prevent financial fraud, especially considering the fact that procedures may vary according to the nature and security type of the issuer. 

High street banks take new interest 

BBVA has thrown its considerable weight behind the issuance of blockchain green bonds. A report titled  Blockchain: Gateway for Sustainability Linked Bonds was published by HSBC has dedicated a section to a green bond which was issued by BBVA and Spanish insurance company Mapfre. BBVA acted as issuer and Mapre as investor when the issue was carried out in February 2018. During the issuance, Mapre had invested €35 million through a private placement. In accordance with the Second Party Opinion, the project was qualified as green—and the negotiation and bond issuance process were developed through the bank’s internal platform. 

Even Standard Chartered Bank has made a substantive case for blockchain in bond issuance by collaborating with the Union Bank of the Philippines. It is reported that both banks have successfully completed a proof of concept for a retail bond issuance on a blockchain platform. This development is for bond tokenisation. In light of this development, Gwak said “Specific to our recent partnership with Union Bank of the Philippines on blockchain-enabled bond issuance in the Philippines, the tokenisation engine that was used to issue and mirror allocate tokens was built by SC Ventures.” 

The proof of concept was co-created with the Union Bank of the Philippines and it seeks to provide retail investors with a transparent platform to achieve direct access to bonds. “By cutting through the current cumbersome bond infrastructure through bonds on blockchain, we expect larger participation of retail investors in this market both in primary and secondary markets,” Gwak explained. 

Pandemic makes a case for blockchain in bonds 

Surprisingly, an unexpected factor that is also making a strong case for digitising bond issuance using blockchain is the coronavirus pandemic. The pandemic has witnessed companies’ unrelenting efforts to raise money to stay afloat during the crisis, yet the issuance process has slowed on the back of using legacy systems. This indicates that a huge technological shift is necessary to normalise blockchain bond issuance. Last year, it was observed that the global corporate bond issuance was on track to reach a historical high. The observation was made on the basis that the total capital raised in last June was close to $6.4 trillion—which was already 71 percent of the total in the previous year. Despite that, the process remains slow and largely manual.

The reason for a slow process is legitimate. It is reported that it requires an average of 30 stages with frequent human intervention. The intervention is needed at every point and includes multi-step processes such as paperwork and communication between multiple parties and intermediaries. This type of process is archaic and ineffective in a highly competitive financial environment. So there is no question of whether blockchain can modernise the system—as it clearly points to an affirmative answer. 

World’s first blockchain-based government savings bonds 

Amid the pandemic, the Bank of Thailand launched the world’s first blockchain-based platform for government savings bonds. blockchain platform allows investors to benefit from quick bond issuance and the time length of the process from15 days to two days. According to the Thai Bond Market Association, the outstanding bond market in Thailand stood at $$421 billion as of December 2019. 

Previously, the sale of government bonds were considered to be a ‘complex, multiparty, time-consuming process’, that was reliant on a non-real time system. According to a statement, as blockchain now streamlines the process, it will make the government savings bond platform become an ‘immutable, real-time single source of truth for network participants’. 

Thailand is an ‘active adopter’ of blockchain, and the central bank seeks to extend blockchain to all government bonds for retail and wholesale investors. Institutions including Bank of Thailand, Public Debt Management Office, Thailand Securities Depository, Thai Bond Market Association—in addition to Bangkok Bank, Krungthai Bank, Kasikorn Bank and Siam Commercial Bank, along with IBM Blockchain as the technology and cloud platform partner, were actively involved in developing a secure government bond infrastructure. In fact,  the Thai Customs Department  was the second government agency in Southeast Asia to use TradeLens.

Tenets of blockchain—an overview

Blockchain in bond issuance is meaningful, but is also error-prone. There are a set of technology challenges that question how to integrate blockchain into the regulatory system and what is the role played by law in making sure there are no unintended consequences. It seems that most of the permissioned blockchain platforms necessitate a core technical skills and robust infrastructure setup for it to perform efficiently. This means, it requires a profound knowledge of Information Technology and good investment practices at the nascent stage. 

The world is full of interconnected technologies and technical innovation in blockchain stems from the preceded fact that it could lead to execution risk. A classic example of that would be building conflict of interest between fintechs and traditional technology companies today. There are numerous market participants at play—so transparency could mean different things to each of them—representing either benefits or costs depending on their circumstances. The legal, tax and regulatory requirements typically vary under different jurisdictions. 

Again, countries under different legislations will have different capital market regulations, and there can be complexities associated with legal enforceability of smart contracts, depending on the jurisdiction. This integrated view of blockchain is only a fragment of what is truly said and done. The real benefit of it will accrue only when all participants in the issuance process share the same platform—which then will result in a swifty settlement cycle and a unified view of the master book. In the view of the Capgemini report, organisations can gain competitive advantage by engaging in an innovation lab to create proof of concepts, identify key business capabilities and fully realise the benefits of blockchain in bond issuances.

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