The Current Process
Issuing bonds is a well understood and well-regulated process but can look archaic from a modern perspective.
The current process of bond issuance is tried and tested but leaves room for improvement. A corporate bond is issued by a company as a long-term debt instrument, normally secured against assets that it owns. It is issued as a certificate of indebtedness, which then becomes a tradeable property. The bond may be issued with varying periods to maturity, and coupon (interest) rates that may be fixed or variable.
As we know from Accounting 101, bonds are an alternative to equities in raising finance, and have the advantage of not diluting existing shareholders, nor do they carry voting rights. Corporate bonds are mainly issued in either US Dollars or Euros, and once issued, may be freely traded. The vast majority of bond trading happens in decentralised, over the counter exchanges, facilitated by dealers who match buyers with sellers. This process has been improved in recent years by companies who create digital marketplaces for bonds.
Bonds are typically used for investment purposes by financial institutions and large investors as ways of matching their liabilities with assets. Individuals tend to hold bonds via bond funds, similar to unit trusts. CSDs hold physical or dematerialised bonds and facilitate trading by recording changes of ownership through a book entry. They typically deal with intermediaries who hold bonds on behalf of their clients, or their clients’ clients, and thus the chain of custody is often long and complex.
The process of issuing a secured corporate bond is also well established. The issuer’s financial accounts are reviewed to establish if there is a reasonable ability to repay the proposed debts at maturity, and assets are audited to certify their value, then legally encumbered in favour of the bondholders. At this point secured bonds can be issued using these assets as collateral - and depending on the agreement take priority over other debts in the event of liquidation. Each bond carries an interest coupon, typically paid annually or quarterly. In the traditional process, there are likely to be several intermediaries involved, including trustees, settlement agents, registrars, and others.
Settlement and Clearing
The settlement process is - logically - designed to ensure that the buyer cannot take ownership of the security without the issuer receiving the funds. The mechanism for this is usually a trusted intermediary and an escrow account. Funds are paid into the account, the ownership transferred, and funds released simultaneously. Typically, the transfer of ownership takes place in the CSD while the transfer of funds relies on the banking system. Settlement may occur on the same day as the trade (T+0), or up to three days later (T+3).
Room for Improvement
The current processes of issuing and transacting bonds have a number of interrelated problems. These issues stem from the number of parties involved, particularly intermediaries; the often slow and manual processes across different systems and entities; and the form that the bond itself takes. The processes tend to be slower and more expensive than they could be.
- There are multiple steps across several systems, creating delays, and leading to reconciliations between different versions of the truth;
- The custody chain is complex and makes it hard to achieve transparency and to perform reconciliations;
- The manual nature of the process makes an electronic audit trail impossible;
- The clearing and settlement cycle is long and increases counterparty and settlement risks.
These are issues with the details of the process. The meta-issue, however, is that the bond process as a whole is not entirely fit for purpose. When companies are looking to raise capital, they would ideally like to be able to have flexibility in the process to cater for fluctuating financial requirements. Without this flexibility, the logical thing to do is either to set the bond amount at the expected maximum, or to use some other - potentially more expensive - structure for some or all of the variable portion. Neither solution is ideal, and this problem was a key trigger for this project.
Current Global Status of On-chain Bond Issuance
The discussions around on-chain bond issuance are picking up momentum in both the centralised financial markets (“CeFi”) and the decentralised ones (DeFi). The traditional means of bond issuance can be cumbersome in their due diligence for reasons mentioned above. This creates time-based and financial inefficiencies and frictions, affecting both the issuer and purchaser.
Many of these inefficiencies exist because the current and existing infrastructure was developed in a time when technology did not allow for a better or more efficient system. Current practice was developed to ensure that all parties could take part with minimal risk using the technology of the twentieth century. With the advent of Decentralised Ledger Technology (DLT), there are many areas of potential improvement that allow for a better outcome without compromising on risk and security.
Countries such as Germany and Switzerland are leading the pack in allowing companies to utilise DLT to test the issuance of on-chain bonds in a way that is compliant with regulations. The German regulator BaFin has given the go ahead to Germany’s venerable Bankhaus von der Heydt (BVDH), in partnership with Bitbond, to issue tokenised securities using the Stellar Blockchain. Germany has also released a draft bill with a focus on bearer bonds, called the “Electronic Securities Act”, which eliminates the requirement for a physical document to verify bond issuance; and also introduces a new licence requirement for those maintaining the securities register, under the German Banking Act (KWG). This allows for the offered securities to exist solely in the form of a token on a smart contract that is maintained, in this case, on the Stellar blockchain.
Switzerland has also recently been in the news with the introduction of the “Federal Act on the Adaptation of Federal Law to Developments in the Technology of Distributed Electronic Registers”, which touches on key elements of civil securities law, financial regulation and insolvency law. This act will result in it being possible to process rights and obligations under company law digitally, and it explicitly gives tokenised securities the same legal status as traditional ones. The act is expected to come into effect from February 2021.
Thus, two traditional financial leaders in the international arena have endorsed the use of DLT in the issuance of bonds and other financial instruments, by providing a friendly regulatory environment. This allows for one of Germany's oldest banks to do on-chain bond issuance and opens up the ability for Swiss companies to innovate in this space using DLT.
Other high profile tokenised on-chain bond issuance that has taken place includes the Austrian government who raised $1.4b, the World Bank who raised $108m, Japan's Nomura Research Institute (NRI) who issued two NRI bonds to the value of 30m yen (~$300k), and other companies like Daimler AG and the Russian Sberbank who collectively raised ~$122m through tokenised bond issuance.