Digital bonds are attracting growing interest from issuers and investors, as the increasing volumes of issuance show, albeit from very low levels. Since the beginning of 2021, issuers have raised €160 million through the issuance of three digital bonds, compared with the same number of transactions for the whole of 2020. A few companies have been created to facilitate the issuance of digital bonds or sukuk (an Islamic finance product similar to bonds), some of which are affiliated with existing banks or financial intermediaries. For a broader overview of the digitalization of markets, please see Digitalization Of Markets: Framing the Emerging Ecosystem, published Sept. 16, 2021, on RatingsDirect.

In most economies, corporate funding is typically routed directly (through direct lending) or indirectly (via bond arranging or underwriting) via banks, and therefore benefits from their existing relationships with customers as well as their selling power. However, we believe that once technology enables a seamless way to source funding via platforms, these established relationships could be replaced. Furthermore, a more digital option to source funding might also promote financial inclusion in the smaller universe of corporates and small and midsize enterprises (SMEs).

For issuers, digital bonds may provide a quicker and cheaper way to tap the financial markets due to the limited number of intermediaries involved. The benefits may also include enhanced security, traceability, and integrity of the transaction. However, this assumes the availability of flawless technology and the readiness of the legal environment to handle these instruments. Without these, digital bonds may prove more costly for investors or could pose a higher risk of them losing their investments.

For rated bank issuers, this would mean disruption of certain business lines, the speed of which would depend on how fast regulators and other stakeholders remove existing hurdles.

Chart 1

A Solid Foundation Will Spur More Issuance

Over the past three years, there have been very few digital bond issuances on the blockchain (see figure below). The most recent transaction was the European Investment Bank's €100 million senior bond issuance using Ethereum. Overall, issuers raised €160 million since the beginning of 2021 in three transactions compared with the same number of transactions in the whole of 2020. We expect to see more transactions as intermediaries streamline their offerings.

Societe Generale-Forge and Wethaq Capital Markets Ltd. are new intermediaries that are exploring the possibility of tapping the digital bond or sukuk markets using blockchain technology. The emergence of market platforms could also help accelerate the adoption of digital bonds by offering the necessary infrastructure to standardize the process of both listing and exchanging them. The confluence of more supportive regulators, flawless technology, and increased investor and issuer appetite could spur more widespread adoption of digital bonds.

Chart 2

Greater Efficiency Is A Plus Point For Issuers

For issuers, using digital bonds reportedly reduces costs as transactions involve fewer intermediaries, thus simplifying the issuance process. Additional benefits include enhanced security, better traceability, and stronger integrity of the transaction. In short, the distributed ledger technology offers a single source of truth on bond terms, trade or settlement, ownership, and payment instructions. As all the dealings are documented and processed on the blockchain, each transaction or payment is properly documented, allowing for a real-time view of bondholders and the capacity to interact with them as required. These features enable greater efficiency for issuers.

Meanwhile, corporates would need to accept leaving their established relationships with banks that provide them with greater capacity to distribute bonds, as well as access to their balance sheets for lending. At the same time, they would likely gain access to a new segment of investors if digital bonds were offered in smaller ticket sizes. It remains to be seen whether that would be more beneficial for them, however.

Digital bonds may enable a new class of issuer to access a new class of investor. For example, they could appeal to an increased number of tech-savvy individuals or reach a wider pool of potential investors via a lower minimum ticket size through the fractionalization of debt instruments. This could support activity volume for the companies managing or interplaying with these new platforms. However, it is hard to gauge the potential size of this untapped market and the related potential for additional economic growth. Meanwhile, investor protection is another potential hurdle.

The use of digital bonds could also promote financial inclusion and offer better financing options to corporates or SMEs that are not able to access capital markets. Using platforms could open new avenues of cheaper financing (disintermediated and listed on the blockchain) versus bank financing (intermediated and over the counter). If digital bonds ultimately mean very rapid access for small tickets, they could represent a more flexible tool for corporate treasurers to manage liquidity and reduce their reliance on bank lines for cash flow funding in some cases.

What's In It For Investors?

Investors could again access a new asset class that would otherwise be inaccessible thanks to fractionalization and the reduction of ticket sizes. They would also benefit from a more efficient way to manage their investments, especially as transactions would not be restricted by business hours. Finally, a growing number of investors have incorporated Environmental, Social, and Governance (ESG) factors in their investment mandates. Digital bonds can offer better traceability of the underlying assets that underpin specific transactions, thereby helping them with their ESG goals.

Investors will continue to bear traditional risks, including:

• Credit risk, in the form of a default of the bond's issuer or sponsor. This may also increase as digital bonds open the door to the financing of SMEs, some of which could be riskier than well-established corporates.
• Market risk, such as exposure to interest rate or foreign exchange risk. The fluctuation of the value of the bond could also be relevant as the market opens to less sophisticated investors.
• Liquidity risk could also be relevant as the sector develops and platforms expand their client bases. The adoption rate of traditional investors and interoperability with existing distribution channels would be key to gauge the liquidity of these instruments.
• Operational risks related to technology, both in terms of its stability and immunity to cyber risks.

Several Hurdles To Conquer

Before digital bonds become a more widespread source of financing, certain hurdles need to be removed.

Regulation.   The main challenge relates to the status of digital bonds, the mechanism of recourse in case of need, and the legal force of smart contract protocols. We understand that these issues have been partly, or in some cases fully, resolved in some countries. In Germany, for example, the cabinet approved a legislation on electronic securities in late 2020. This law removed the need to have a paper certificate for transactions and permitted the registration of digital bonds on an electronic ledger. The law also affirmed that digital bonds qualify as securities and are generally subject to the existing regulation. In France, the above issues were reportedly resolved by an ordinance published in December 2017 that established the regime governing the registration of securities on distributed ledgers.

The harmonization of the regulatory environment is yet to take place in Europe, however. We note that the European Commission published a proposal for a pilot regulatory regime for market infrastructures based on distributed ledger technology. This is designed to help regulated financial institutions develop infrastructure for trading, custody, and settlement of securities. We expect other regulators to follow these examples to remove any additional regulatory hurdles when and where necessary. Besides regulation, the legal documents underpinning digital bonds must be verifiable and executable. In most cases, these documents are standardized as part of the offering of the issuance platforms.

Compliance.   Digital bonds aim to eliminate the need for financial intermediaries, but many of the tasks these intermediaries perform will still be required, such as anti-money-laundering checks and compliance with antiterrorism financing regulations. While technology may allow new ways to carry out these tasks (such as digital signatures) over time, it is also not without risks. For example, smart contract risk is potentially significant for digital bond issuers and investors, because the written code could contain bugs or be attacked by third parties.

Effectiveness of existing technology.   Another issue relates to the readiness of existing technology. As it is yet to be tested for broader adoption, potential risks could emerge. The vulnerability to cyberattacks is a risk that we have seen before where distributed ledgers have been used. The slowness of the network and the amount of work needed to validate transactions are other sources of risk, potentially resulting in higher costs for investors or lower liquidity for the digital bond.

The environmental footprint of networks where validation is based on proof of stake can also be a hurdle. For bonds that use the Ethereum blockchain, for example, the upgrade of the network's validation method from "proof of work" to "proof of stake" could result in some unforeseen risks. The upgrade, scheduled for 2022-2023, is designed to reduce the network's carbon footprint. To manage these risks, some issuers have amended the legal documents of their issuances to transfer the management of the transaction from blockchain to other, more traditional ways.

Resolving These Hurdles Will Determine The Speed Of Disruption

Digital bonds are likely to disrupt the business of several intermediaries in bond issuance. This includes banks if they are not able to establish digital bond sales platforms themselves. The confluence of more supportive regulators, flawless technology, and increased investor and issuer appetite to use digital bonds could spur more widespread adoption of digital bonds. If this is the case, bank fees are likely to take a hit if nimbler companies offer more efficient solutions to tap the capital markets. Similarly, other financial infrastructure intermediaries could also see a reduction in their revenues. We therefore expect that banks, exchanges, and other intermediaries will establish their own test environments to prepare for such an eventuality. By doing so, banks might also use digitalization of bonds to materially reduce their operating costs, for example the number of staff involved and the onboarding of new clients onto automatic platforms.

A lack of successful preparation for what could be a material shift in the capital markets might not only materially reduce debt market revenues, but also cut lines with important clientele. In our view, not being ready is not an option for banks and intermediaries that want to maintain their business in the debt capital markets.

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