How Tokenization Can Disrupt the Bond Market
By : Adrian Lai
Blockchain isn’t just for coins, as World Bank proved in 2018 with the issuance of its tokenized bond. Now, as regulators examine the risks and rewards of tokenization, it’s time to look at what tokenized bonds could mean for financial markets.
The World Bank has issued two tranches of bond-i, the world’s first bond to be created, allocated, transferred and managed through its life cycle using blockchain technology. Working with the Commonwealth Bank of Australia (CBA), the World Bank has now raised A$160 million (US$107 million) with this tokenized bond.
Significantly, Secondary Bond Trading was enabled on the bond-i platform in May 2019, making it the first bond that is not only issued but traded using distributed ledger technology.
WHAT ARE BONDS?
A bond is a debt instrument issued by a company or government (the “Issuer”) to raise funds, from which investors earn a fixed income from interest over the term of the bond. The amount that an investor pays for a bond (the “principal”) is effectively a loan to the issuer. After a fixed period of time at a date specified on the bond (the “maturity date”), the investor will be repaid an amount equal to the principal they paid for the bond (“par value”).
In the time between the sale of the bond and the maturity date, the bondholder will receive interest at a fixed percentage of the par value (“coupon rate”) at intervals specified in the terms of the bond. Issuers benefit from the upfront availability of capital, and investors benefit from periodic payments of interest.
Investors can also trade bonds before they reach maturity. Bond prices change as market interest rates fluctuate. As a simplified example, if you bought a $1,000 bond with a 10% coupon rate payable annually that had a maturity date set 20 years later, you would receive $100 each year for the next 20 years, at the end of which you would also get back the $1,000 you originally paid for the bond.
If, halfway through the 20 years, interest rates dropped to 5%, chances are that another investor would be willing to buy the bond from you at a price higher than the par value (a “premium rate”) because of the favorable interest rate on your bond compared to the other options available in the market.
WHY TOKENIZE BONDS?
Bond issuance is a long process that involves multiple intermediaries, incurring high costs and the risk of human error. These are common pain points in the financial securities market that technological innovations are hoping to solve. As a fixed-income security, bonds generally carry lower risk and less variable factors than equities, making the bond market a good place to start implementing and refining new technology solutions.
Bond tokenization is an application of blockchain technology that aims to lower the various costs associated with bond issuance. The idea is that applications of blockchain technology can develop to benefit the bond market as a whole by enhancing data visibility, reducing counterparty risk, and improving operational efficiency. The concept of bond tokenization has risen in popularity over the last few years, and multiple reputable organizations have launched their own tokenized bond initiatives, summarized in the table below.
|Issuer||Daimler AG||Russian Sberbank||Austrian Government||BBVA (partner with MUFG & BNP Paribus)||Societe Generale SFH||World Bank||Santander|
|Date||28 Jun 2017||18 May 2018||2 Oct 2018||7 Nov 2018||18 Apr 2019||24 Aug 2018, 16 Aug 2019||12 Sep 2019|
|Blockchain||Private Ethereum||Hyperledger Fabric||Permissioned Ethereum||Hyperledger & Rinkeby testnet (Ethereum)||Ethereum public||Private Ethereum||Ethereum public|
|Issuance||1-yr bond bond||Commercial bond transaction||Notarization of auction of government bond||Syndicated loan||5-yr covered bond||2 tranches of AUD-denominated bond “Bond-i”, raising US$108m total||bond|
Tokenized bonds aim to reduce the administrative process and cost by using blockchain technology for the digital issuance, trading and management of bonds. To issue tokenized bonds, the issuer’s company information is first placed on the blockchain as a digital record. Smart contracts are coded on the blockchain with the terms of the bond issuance. Tokens are issued to investors as digital forms of the bond. Settlement, trading, and post-issuance bond action management–such as regular payments of interest to investors – can be completed by smart contracts.
BENEFITS OF TOKENIZATION
More secure data, fewer intermediaries
Blockchain is a type of distributed ledger technology (“DLT”), which describes digital databases in which transactions are recorded and shared among multiple devices in the network.
This is in contrast to a centralized database, which essentially has a single point of failure: with a centralized database run by an administrative account, anyone who hacks that account gains access to view and corrupt the original data stored in the database. In contrast, DLT is built for identical copies of a database to be held in all devices that participate in the network (“nodes”).
Once recorded on the blockchain, financial data cannot be altered retroactively without the consensus of the network. As a result, the record of bondholders on the blockchain can be trusted. When trading bonds, buyers can ensure that the sellers own the legal title of the bond by reviewing the blockchain. Blockchain is an ideal alternative to having countless intermediaries and bond managers, since it is a distributable, trustless and immutable ledger. Investor record management will be much more efficient for issuers, and the transparency of bond transaction data will make it easier for investors to make informed investment decisions.
Automated issuance and post-issuance bond action management
Issuances of tokenized bonds are made possible by smart contracts coded on the blockchain. Smart contracts are computer protocols which contain the terms of a legal agreement directly written into the code. When the terms of the contract are fulfilled, smart contracts are executed automatically without the need for implementation by a third party.
After company information and bond issuance details are digitized, the terms and conditions of the bond, including the principal amount, coupon rate, and maturity date, can be coded into smart contracts to run on the blockchain.
Smart contracts can also be coded to take care of bond action management in the post-issuance process, including the periodic distribution of interest payments to bondholders and the repayment of par value upon the bond’s maturity date. Investors receive tokens in return for payment, which entitle them to receive fixed income from interest and the par value of the bond upon maturity. The payment process can be automated using blockchain: issuers can dispatch stablecoins directly to the bondholder’s wallet address. In these ways, the use of smart contracts streamlines the issuance process and eliminates repetitive steps.
Reduced settlement risk
Am innovative feature of blockchain technology is the HTLC, a time-bound conditional payment which allows a transaction to be executed only if specific conditions are met within a particular time-frame. Essentially, HTLCs allow secure payment via two-factor authentication before a deadline. On the issuer’s side, the bond is made available on the blockchain in the form of a token, but locked by encryption. On the investor’s side, the principal is made available on the blockchain as a cryptocurrency, but is locked by encryption. Because the data is encrypted, no one can unscramble it to obtain meaningful information unless they possess a specific key corresponding to each piece of information.
A deadline is coded into the HTLC for each participant to either settle or cancel the transaction. If both parties confirm the validity of the transaction before the deadline, the tokenized bond is delivered to the investor and the cryptocurrency investment is delivered to the issuer at the exact same time. If the investor pays the investment amount, fulfilling their end of the bargain, but the issuer fails to deliver the tokenized bond, the investor’s funds are simply returned to his digital wallet at the deadline.
There is no danger of one party being defrauded if the other party defaults–the swap either happens in totality, or not at all. Parties to a transaction no longer need to trust that their counterpart will fulfil their end of the bargain, or pay a third party (who could conceivably also defraud both the investor and the issuer) to enforce the contract. This would potentially eliminate the need for escrow agents in the settlement process.
LIMITATIONS OF TOKENIZATION
Transparency vs privacy
A limitation of current blockchain technology is the imbalance between freedom of participation and secure governance. Levels of access and governance are key distinguishing factors between public and private (or “permissioned”) blockchains.
Public blockchains achieve the closest thing to the concept of decentralization: in theory, anyone can participate in a public blockchain by verifying or adding data to it, and transactions can be tracked while participants remain anonymous unless direct transaction requires the disclosure of information between parties. No single governing body can hold an imbalanced degree of power over transactions on the blockchain.
One issue is that public blockchain platforms such as Ethereum currently do not allow the selective sharing and withholding of sensitive transaction data, which is an important requirement in financial transactions. Such deliberate information sharing is, however, possible with private blockchains such as Corda and T2S.
Private blockchains are only open to known and approved participants, and are not truly decentralized as they are still governed and operated by specific bodies. For example, five banks can operate a private blockchain with permissions granted to their clients, or a company can run a private blockchain to provide services. This halfway point between public blockchains and centralized database systems might be preferred by entities that wish to retain the security of governing control and the ability to screen participants at the entrance.
Private blockchains allow a greater degree of control in information sharing, but, on the other hand, participants are unable to track transaction records on a private blockchain as they would on a public one. The use of private blockchains alone would do little to alleviate the problem of information asymmetry that decentralization set out to solve. It is encouraging that two of the seven blockchain bond issuances have been conducted on the public blockchain. The recent issuance on the Ethereum public blockchain by Santander, a European bank, illustrated “the possibility for unrestricted networks, like Ethereum, to be used for regular operations by large traditional financial institutions” (Binance).
Regulatory frameworks around securities issuances and trading have not evolved at a pace to match the rapid advance of technology. For example, German securities law requires a physical representation of every issued security to be held by a designated custodian, meaning that tokenized bonds would still require physical documentation, instead of being entirely created and stored digitally. However, promising news came in July 2019 that the German Financial Market Supervisory Authority (BaFin) approved the country’s first blockchain-based real estate bond.
The remaining quandary is that real-life applications of the technology are needed as references for sophisticated regulatory development, yet the deployment of real-life application is impeded without a robust regulatory structure. Fortunately, multiple jurisdictions have begun to implement regulatory sandboxes involving different members of the security token ecosystem to formulate comprehensive security tokenization frameworks.
The success of the World Bank and CBA in enabling secondary bond trading is an exciting development in the nascent space of tokenized bonds, bringing us one step closer to a new norm where the entire life cycle of bonds can be digitally managed with blockchain technology. Although there are limitations to tokenized bonds, the benefits of instantaneous settlement and process automation will eventually drive financial institutions to adopt tokenization technology.
About the Author
Adrian Lai is the co-founder and CEO of Liquefy, a venture-backed security token issuance platform. He is also a trainer at the Hong Kong Securities and Investment Institute, and a columnist at the South China Morning Post. Adrian has been a commentator on digital assets for major international media such as the Wall Street Journal and CNN. Before joining the blockchain space, Adrian worked at BlackRock Asset Management.