Bonds, otherwise known as fixed-income securities, enable diverse organizations, including companies, international agencies, and governments to obtain funding from the global institutional investor base. Bonds are a preferred asset class for both the borrower and lender. From a borrower’s perspective, the bond provides a predictable financial impact over the life of the borrowing agreement, irrespective of who the owner of the bond is or what market conditions in the future may look like. From an investor’s perspective, the bond provides flexibility to easily sell the investment to someone else if a need arose or if the investor’s faith in the borrower changes.
Bond instruments support many different configurations for coupon payment and repayment arrangements to meet arguably all potential financing requirements of a borrower in all jurisdictions. The credit rating of a borrower, or issuer, is a reflection of the level of risk for the investor or in other words the likelihood of repayment by the borrower. Credit ratings divide the bond market into two main classifications: high-yield bonds (those rated double-B or below), and investment-grade, those rated between triple-A and triple-B.
The traditional bond marketplace
The bond market is mainly accessible to large corporations, banks, and governments all over the world. The issuing of bonds brings about an onerous administrative burden for the issuer (borrower), including the maintenance of an investor register. Such administrative and legal requirements are a daunting task for issuers when thousands of investors can potentially own a specific bond. In the established capital markets, this task is typically performed by centralized custody providers throughout various jurisdictions. The challenge and cost associated with maintaining a registry often influence decisions on who is able to buy specific bonds.
As alluded to above, the investor is exposed to the potential that the borrower may not be able to repay the debt instruments or any of the obligations of the bond agreement. The risk associated with a particular bond instrument influences the price at which investors are willing to buy a bond. This does not impact the issuer’s obligations during the lifetime of the bond however, investors need to manage these risks prudently.
Investors need to manage their exposures to borrowers to ensure that their overall business and solvency will not be jeopardized in one of two ways:
A market event that impacts all bond instruments negatively in a similar way, which causes the price that investors are willing to pay for bonds to drop sharply in a short period of time. (Market Risk)
An issuer is not able to meet the obligations of the bond agreement and/or is bankrupt. (Credit Risk)
Well-established institutional investors, such as pension funds, typically manage these risks using complicated mathematical models and require specialized teams to monitor these exposures and developments continuously. Because of the market constructs and requirements listed above, the Bond market is often restricted to large institutional investors.
How public DLTs can overcome the challenges faced by bond marketplace participants
To effectively manage the trillions of dollars in bond market investment flows, the tokenization of bonds on a public distributed ledger is primed to revolutionize the bond market in the following ways:
Incentivized ecosystem: The technology can create an ecosystem with distributed ownership and responsibility that rewards participants for the business they conduct within the ecosystem while minimizing cost and complexity for both the Issuer and Investor.
Fractional ownership: The ability to maintain an accurate ledger of fractional ownership will make the bond market accessible to potentially millions of retail investors.
Emerging markets: The ecosystem can create a formal trading environment for bonds across emerging markets that will provide much better access for global investors into those markets. The transparency and trust created by the DLT could alleviate many of the restrictions for investors to invest in the world’s developing economy.
Settlement efficiency: Current market operations require 3 business days, even more, to transfer the bond to a new owner and facilitate payment to the seller. Settlement in the ecosystem will be finalized within a few seconds.
Elimination of settlement risk: Coded logic in the ecosystem guarantees ownership at the time of the trade agreement. This enables near real-time settlement, eliminating settlement risk with the trade counterparty.
Global accessibility: For borrowers, a decentralized bond marketplace will provide direct access to a global investor base, simplifying the search for investors during the deal’s evolution leading also to a reduced overall cost of finance.
Enhanced liquidity: A decentralized ecosystem will enable instant secondary market trading across various platforms, allowing investors to sell assets around the clock. This in turn will also provide more bond investors with reduced costs of finance.
Increased market participation: Dependence on expensive technologies and centralized registry providers will be reduced, making it possible for many more entities to participate in the market.
Expanding business opportunity: The ecosystem can create new business opportunities for small and large businesses.
Programmable rules: Governance and regulatory oversight can be embedded in the ecosystem to protect the interest of all parties involved.
Importance of creating a decentralized economy
It is envisioned that participants in the ecosystem must be rewarded for doing business in a manner that promotes trust and protects the interest of all market participants. Trust and transparency are the pillars of the decentralized economy. Applying the technology solutions of public ledgers across the capital markets will open the gateway to new forms of doing business, enhancing liquidity and access among bond market participants in the process. Tokenization can not only ensure traceability at the transactional level but can also open up market access to retail investors across the world, without jurisdictional limits.
In order to ensure great market access and efficiency, market activity should be tracked and made transparently available to all other participants in the ecosystem. Doing so will enhance and support the investment decision-making process. Importantly the integrity of a Sole Sovereign Identity must be honored at all times while making information available to all investors to aid sound investment decisions.
Different entities will perform different functions on the ecosystem to create and facilitate business in the ecosystem effectively. The ecosystem must reward the entities that make positive contributions to the ecosystem. As an example, a bank can help one of its corporate customers to launch a bond in the ecosystem. As the advisor, the bank may be entitled to a portion of the trading value of that bond throughout the life of the bond.
Capability must also exist to reward specialist entities for specific work requirements that can not be performed by non-specialized entities. As an example, a specialized participant can facilitate the process for an issuer that defaults on its obligations. The specialist participants need to be rewarded for the function they perform for the issuer in the ecosystem.
Considerations when choosing a public distributed ledger
To bring to market bond tokenization within a decentralized marketplace, it’s imperative that the underlying distributed ledger meets the needs of every marketplace participant at scale. In evaluating various distributed ledger technologies across the categories of performance, security, accessibility, cost, and technological differentiation, Standard Bank has determined that Hedera Hashgraph aligns well with our use case requirements:
Public network: The transparency and trust offered by a public network ensure expanded access, audit-ability by regulatory bodies, and an incentivized ecosystem for marketplace participants.
Low, predictable fees: A low-cost per transaction fee structure and elimination of congestion charges ensure a consistent and end-user experience.
Decentralized governance: A fully decentralized governance across global jurisdictions, industries, and time mitigates the risk of any single ecosystem participant amassing undue control.
Performance: For the ecosystem to achieve global, synchronous participation and mass adoption it must meet the needs of millions of concurrent users through transaction scalability, throughput, and instant settlement
Transaction ordering: Marketplaces rely on a source of time for ordering participant transactions. The underlying distributed ledger must offer a native ability to achieve consensus on transactions with timestamps in a fair and trusted way
Native tokenization: An easy and cost-effective way to mint, transfer, fractionalize, and burn tokenized assets ensures a consistent and reliable experience across retail and institutional participants.