Digital bonds – a new kid on the block
A brief press release recently from Europe’s largest and possibly oldest industrial manufacturer, announcing a short-dated, small-sized bond, seems hardly significant. In time however it may come to be seen as heralding a transformation of bond markets. Siemens, which is proud of its pioneering spirit since 1847, has issued a blockchain-based ‘digital’ bond. Just as ‘Big Bang’ altered the structure of financial markets, full digitalisation and democratisation of bond markets may prove as disruptive, with winners and losers.
Siemens’ €60m, 1-year bond was issued on a public blockchain or digital ledger platform called Polygon, set-up by a group of engineers in Mumbai in 2017. Software coding creates a series of smart (automated) contract capabilities to handle secure and decentralised transactions. It facilitates direct bond offerings to investors without the need for a traditional financial (‘TradFi’) institution or central clearing. Disintermediation benefits for issuers like Siemens include lower cost, higher transparency, and increased speed of execution and settlement. The absence of a ‘digital €’ however means that investment in Siemens’ new bond, and coupon payments, involves classic bank transfers for now, so not absolutely digital yet. The bond has a mechanism for peer-to-peer trades on Polygon. If the digital ledger is not operational for any reason, Siemens can switch the entire bond to another digital ledger, replace the digital bond with a traditional (‘analogue’) bond, or call the digital bond without bondholder consent.
EIB placed its first blockchain-based bond in 2021, issuing a €100m 2-year eNote under a French law that facilitated registration of digital securities. Last November, EIB placed its second digital € bond, also a two-year €100m eNote and the first one issued, recorded and settled (T+0) using blockchain technology. EIB recently issued its third digital bond, which was also its first Sterling offering in this format, a £50m, 2-year note under Luxembourg law. The latter is soon to be amended to allow digital securities registered in the blockchain to be used as collateral. Some banks have issued blockchain bonds under Spanish law, while several jurisdictions, including the UK, are reviewing securities law to better facilitate digital securities. The EU’s Markets in Crypto Assets (‘MiCA’) legislation is due to come into force this year, with participants having 12-18 months to comply with it.
Blockchain-based or distributed ledger technology (‘DLT’) platforms are developing bridging mechanisms to allow transfers between different platforms. This interoperability is not in place yet in any material way. There is also a lack of digitisation of several functions that TradFi provides in the ‘over-the-counter’ bond market, including liquidity, pricing, corporate actions and operational safeguards over the trade lifecycle. New challenges will emerge, particularly in liquidity provision and the process of best execution, if trading directly with fellow investors. The impact on bond indices is another key area. Will we see new digital-only bond indices, new hybrid digital and analogue bond indices, or seamless amendments to existing indices? The latter is difficult presently, given size and maturity limitations in some digital securities legislation, and due to a lack of harmony across jurisdictions. It seems reasonable to expect an extended interim timeframe where analogue and digital bonds could co-exist. Potentially game changing impacts but yet to be agreed and constructed.
So is this just a gimmick or should professional investors take notice? We would argue the latter, with a wholesale disruption likely, even if the transition pace is hard to predict. While blockchain innovation is rampant, regulators, legislation and processes will need to catch up to manage the novel and numerous risks here, spanning operational, legal and cyber fields. With accurate and secure blockchain coding, supported by comprehensive regulatory safeguards and legislation under development, the prospect of material efficiency savings alongside counterparty risk reductions from instant settlement makes digital bond growth inevitable. We see it as a net positive for asset performance to capture digital benefits in investment stewardship, where increased competitiveness is likely necessary given accessibility expansion. Digital bond ecosystems have some way to go before becoming mainstream in significant transactions but in time could readily replicate Siemens’ other bond market activity last week, the placement of €2.5bn of analogue bonds with maturities that extend to 20 years.
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