Blockchain x Bonds: Smart Bonds Solve Longstanding Problems in Capital Markets | CoinDesk JAPAN

In the 1988 film Die Hard, a NYPD detective travels to Los Angeles to meet his estranged wife and attends her company party. In the meantime, terrorists occupy the building and take the partygoers hostage.

The purpose of the terrorists is a bearer bond worth 640 million dollars (approximately 89.6 billion yen, converted to 140 yen to the dollar). Unlike registered bonds, bearer bonds do not have serial numbers or registrations and are not traceable as there is no record of ownership. If the theft is successful, legally the person holding the bond is considered the rightful holder.

But with the advent of blockchain, robberies like “Die Hard” no longer make sense. Digital bonds stored on a distributed ledger, so-called smart bonds, are a new application of blockchain that verifies ownership and gives each security a unique digital signature that eliminates the need for physical securities. Blockchain will record and store all transactions forever, making it difficult to steal or change the value of a bond without detection.

Smart bonds have the potential to transform bond lifecycles and disrupt fixed income capital markets. Digitization of fixed income may increase processing efficiency and liquidity, reduce costs, simplify and democratize capital raising for issuers, and broaden investment horizons.

traditional bonds

Smart bonds have the potential to transform bond lifecycles and disrupt fixed income capital markets. The digitization of fixed income could increase processing efficiency and liquidity, reduce costs, simplify and democratize capital raising for issuers, and broaden investment horizons.

Bonds have been issued as paper certificates for over 300 years. However, as trading volumes increased, companies became obsessed with paperwork. In 1973, the Depository Trust Company (DTC), a securities depository, was established in the United States to deal with the enormous amount of paperwork and security issues. Paper securities were at risk of loss, tax evasion, money laundering and theft.

In 1990, a London bond robbery stole £291.9 million (£848.8 million today, equivalent to about $1.4 billion), highlighting the risks associated with bearer bonds. As a result, the use of physical bearer bonds has declined in favor of electronic records.

In 1995, the US Securities and Exchange Commission (SEC) announced paperless rules. The era of paper securities is over, and DTCC (Depository Trust & Clearing Corp.: U.S. Securities Depository) was established to handle all securities custody. This will speed up middle and back office processing and make the stock market safer.

Paper certificates had a five-day settlement period, but the new system required a minimum of two days to settle bond trades. Digitization has increased efficiency and reduced human error, but the long settlement cycle exacerbated the liquidity crisis banks faced during the 2008 financial crisis. Payments to customers were delayed after Lehman Brothers filed for bankruptcy.

The SEC recently proposed shortening the settlement cycle to one day, but this is only a temporary stopgap measure. Capital market participants want accurate and complete information and fast settlements. Blockchain technology can do that, and the emergence of smart bonds is just the first step.

Digitization: Disrupting the bond capital market

The point of smart bonds is to digitize the terms of the bonds and turn them into smart contracts. Smart bonds are self-executing bond contracts that use blockchain technology to automate the various stages of a bond’s lifecycle and perform certain actions based on pre-determined conditions without human intervention. is.

Such straight-through processing (STP) is in the DNA of smart bonds. Bond issuance, trading, clearing, settlement and interest payments are optimized, reducing the time and resources required to execute trades.

Smart bonds can also greatly reduce the need for intermediaries such as banks, brokers and clearinghouses. Eliminating the middleman eliminates the fees charged by the middleman’s services. This means that the overall cost of managing bonds can be lowered.

• Issuance and trading: When the bond issue price is set, the agreed contents (issuer, maturity date, coupon rate, issue price, face value, etc.) are written as code in the smart contract and stored in the blockchain. Authenticity, provenance and transparency are thus ensured.
  A lead manager or underwriter distributes smart bond tokens to investors. Payments are automatically debited from investor accounts, resulting in immediate and simultaneous settlement of all investor trades regardless of time zone. Blockchain connects issuers and investors and enables tokenized platforms, a decentralized and secure trading environment where transactions can be conducted without intermediaries such as brokers and dealers.
  A smart contract automates the transfer of ownership and updates the registry of bondholders. This ensures accuracy and reduces the risk of mistakes.
• clearing and settlement: Bonds are traditionally settled during bank business hours. Furthermore, the settlement period can take up to 5 days on the primary market and 2 days on the secondary market. This latency exposes market participants to the risk of price fluctuations.
  Smart contracts, by contrast, automatically initiate the clearing and settlement process once both parties agree on the terms of the contract and the necessary conditions are met. Immediate settlement reduces the time required to do the work and reduces the risk of price volatility between trade and settlement.
  Smart bond settlements are not restricted to bank hours, but may be subject to trading platform and exchange rules.
• Interest payments and maturity: Smart contracts can automate interest payments by sending money to bondholders on specific payment dates. Eliminating the need for a central authority eliminates the risks associated with it. This means that on the maturity date of the bond, the principal is also automatically returned to the bondholder, ensuring timely payment and reducing the risk of default.

Future challenges and prospects

With attacks on cryptocurrency exchanges making headlines, there are concerns that smart bonds are vulnerable to security breaches such as hacking.

But unlike cryptoassets, smart bonds are not bearer assets. Owners of smart bonds are automatically recorded on the blockchain. In other words, unauthorized movements of smart bonds can be revoked.

Depending on regulatory requirements, the agency may also be recorded as the owner of the smart bond. In the unlikely event that a mistake or malicious attack occurs, the agency protects customer assets by making it easy to freeze, cancel, and exchange tokens. But this also reduces the degree of decentralization.

The digitization of financial products will bring about major innovations in the operation of capital markets. However, current regulations rely on electronic entries into private ledgers by accredited entities, preventing the full benefits of smart bonds.

In the short term, legal challenges may hinder the adoption of smart bonds, but further innovation and growth can be expected as infrastructure evolves and more institutions and municipalities adopt the established technology. .

*This article is for general information purposes only. Arca Labs LLC does not provide investment advice and this article is not a solicitation or offer to sell securities or provide investment advisory services.

Mr. Anthony Bufinsky: Head of growth at Arca Labs, which develops financial infrastructure and networks using digital assets and blockchain.

｜Translation and editing: Akiko Yamaguchi, Takayuki Masuda
｜Image: Unsplash
｜Original: Blockchain Meets Bonds: How Crypto Can Solve Long-Standing Issues in Capital Markets