Blockchain Meets Bonds: How Smart Bonds Can Revolutionize Debt Capital Markets
Smart bonds are digital bonds that use blockchain technology to automate the life cycle of debt instruments. They have the potential to transform debt capital markets by enhancing process efficiencies and liquidity, simplifying and democratizing capital raising for issuers, and creating a broader investable landscape. In this article, we explore how smart bonds can revolutionize debt capital markets and the potential benefits they offer.
Traditional Bonds and Their Limitations
For over three centuries, bonds were issued as paper certificates. However, as the volume of trading grew, companies became inundated with paperwork. Physical certificates were vulnerable to loss, tax evasion, money laundering, and theft. As a result, the use of physical bearer bonds declined in favor of electronic records. The Depository Trust & Clearing Corporation (DTCC) was established to provide a central depository for the custody of all securities. This change ushered in faster middle and back-office processes and greater protections in trading.
While electronic processes increased efficiencies and reduced human error, extended settlement timelines exacerbated the liquidity disaster faced by banks during the 2008 financial crisis. Recently, the Securities and Exchange Commission (SEC) proposed a reduction of settlement time to one day, but this is a temporary bandage. Capital market participants want accurate and complete information and expedited settlement; blockchain technology can make it possible, and the emergence of smart bonds is a step in this direction.
How Smart Bonds Work
Smart bonds are self-executing bond contracts that use blockchain technology to automate the various stages of a bond’s life cycle and execute specific actions based on predetermined conditions without manual intervention. This straight-through processing (STP) is built into the DNA of smart bonds, which optimizes debt securities issuance, trading, clearing, settlement, and interest payments, reducing the time and resources required to execute transactions. Smart bonds can also significantly reduce the need for intermediaries, such as banks, brokers, and clearinghouses, reducing the overall cost of managing bonds.
Issuance and Trading
After a bond’s issue price is established, the agreed-upon details, such as issuer, maturity date, coupon rate, issue price, and face value, can be coded into a smart contract and stored on a blockchain. This ensures authenticity, provenance, and transparency. The lead manager or underwriter allocates smart bond tokens to investors, and payment is automatically deducted from investors’ accounts, immediately and simultaneously settling the transaction for all investors across all time zones. Smart contracts automate the transfer of ownership and update the bondholder registry, ensuring accuracy and reducing the risk of errors.
Blockchain enables a tokenization platform, a decentralized and secure trading environment that connects issuers with investors and allows transactions without intermediaries like brokers or dealers.
Clearing and Settlement
Traditionally, bonds are settled during banking hours, and the settlement period can take up to five days in primary markets and two days in secondary. This latency period exposes market participants to potential price swings. Conversely, smart contracts can automatically trigger clearing and settlement processes as long as both parties have agreed to the contract terms and the necessary conditions have been met. This instant settlement reduces the time required to complete these tasks and the likelihood of a price change between the time of trade and settlement. While smart bond settlement is not limited by banking hours, it may still be subject to certain trading platform or exchange rules.
Interest Payments and Maturity
Smart contracts can automate interest payments by releasing funds to bondholders on a predetermined schedule, removing the need for intermediaries such as banks or other financial institutions. This can reduce transaction costs and increase efficiency in the bond market. Additionally, smart contracts can be designed to include various conditions that must be met for payments to be released. For example, a bond issuer could include clauses in the contract that ensure that funds are only released if certain financial metrics are met, such as revenue targets or profitability thresholds. Smart contracts can also be used in trade finance to automate the process of creating, verifying, and executing contracts for the exchange of goods or services. This can help to reduce the amount of time and paperwork required in the trade finance process, as well as improve transparency and security. In supply chain management, smart contracts can help to streamline the process of tracking goods and verifying their authenticity. By recording information about the origin, ownership, and movement of products on a blockchain, smart contracts can enable more efficient supply chain management and reduce the risk of fraud or counterfeiting. In the field of real estate, smart contracts can automate the process of buying and selling property by recording ownership information on a blockchain and automatically transferring ownership rights when predetermined conditions are met. This can help to reduce the amount of paperwork and time required in the real estate transaction process, as well as improve transparency and reduce the risk of fraud. Overall, smart contracts have the potential to revolutionize many industries by providing a secure, transparent, and efficient way to automate complex processes and transactions. However, there are still challenges that need to be addressed, such as ensuring the security and reliability of smart contract code and addressing legal and regulatory issues related to their use.
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