Digital Pfandbrief issuances by Germany-based Berlin Hyp AG and Natixis Pfandbriefbank AG in August 2024 have sparked discussions about integrating blockchain technology in covered bond issuances. The first digital covered bonds were issued by Societe Generale in 2019 and 2020. The recent issuances are part of a cautious trend in 2024 toward digital bond issuances across different sectors (see chart 1), driven primarily by pilot schemes run by the Swiss National Bank (SNB) and the European Central Bank (ECB). These schemes aim to test the use of distributed ledger technology for the settlement of wholesale transactions in central bank money. So far, the focus is on the digitalization of the primary issuance process rather than secondary markets.
Chart 1
Key Benefits
Digital bonds promise improved collateral mobility. By enabling same-day or even instant settlements, digital bonds can enable financial institutions to optimize their intraday liquidity by borrowing or lending, for a few hours only, against liquid assets posted as collateral. Digitalization is therefore particularly relevant for asset classes that are eligible for collateral operations. So far, most digital bond issuers have been sovereigns or SSAs--sovereigns, supranationals, and agencies. Covered bonds are a logical expansion.
Using blockchains to issue covered bonds can increase accuracy and transparency. Smart contracts--computer codes that are deployed on a blockchain and contain business logic and read/write functions that users can interact with--can automate or optimize operational processes and reduce errors. The issuance of traditional syndicated covered bonds typically requires multiple revisions and dependencies on several counterparties, while the issuance of registered covered bonds (n-bonds) is typically paper-based and involves numerous manual steps, which are time-consuming and error-prone. The blockchain technology allows for a digitalization of the issuance process, which subsequently requires less control, enables same-day settlements, and optimizes security standards. All transaction parties could have access to the distributed ledger, which could create real-time deal performance transparency.
Challenges
An established secondary market for digital bonds does not yet exist. The volume of digital bonds issued to date has generally been low and maturities have been short. The absence of a liquid secondary market is one of the reasons why there has not yet been an on-chain benchmark size covered bond issuance. Benchmark covered bonds are treated favorably under liquidity coverage regulations that apply to banks (and are therefore more liquid and used in collateral operations), whereas non-benchmark covered bonds are not. Realizing the collateral mobility benefits of digitalization requires benchmark issuances, which in turn require an active secondary market.
Interoperability challenges will continue to limit the growth of an on-chain secondary market over the short term. So far, most digital bonds have been issued on private blockchains via platforms from traditional intermediaries, including HSBC Orion and Kinexys by J.P Morgan. This setup is closest to existing operations and therefore the easiest way to meet regulatory obligations. In some instances, digital bonds were listed and stored on digital exchanges, such as Six Digital Exchange or D7 by Deutsche Börse. They are effectively issued in a so-called walled garden--a secondary market that is limited to investors who are members of the platform or go through intermediaries that are members.
Investors need to access the blockchains on which the bonds are issued, and institutions need to connect their legacy systems to these blockchains. Different options are emerging to address these challenges, including the use of:
- Private permissioned blockchains that are shared among partner institutions. We understand this was used for the SWIAT covered bond setup for the two German covered bond issuances (see chart 2);
- Public blockchains, which optimize interoperability and, in some cases, strengthen operational resiliency. Although anyone can interact with these blockchains at their base level, applications and assets created on these blockchains can be permissioned, enabling regulated institutions to meet their obligations. Nonetheless, uncertainty remains in many jurisdictions on the regulatory treatment of bonds issued on these chains, in particular due to concerns raised by the Basel Committee on Banking Supervision; and
- Cross-chain communication technologies that enable different private and public blockchains to interact, while mitigating security risks.
Without on-chain cash payments, investors do not get the benefits of digital bonds. Until recently, digital bonds have used blockchain to record bond ownership and transfer but relied on traditional payment systems (see chart 2). This is beginning to change with the pilots run by the SNB and ECB. If successful, these pilots will boost the adoption of on-chain payments. Emerging regulatory frameworks in key jurisdictions will also support the use of compliant stablecoins for bond payments--as an alternative or complement to wholesale central bank digital currencies--and may increase investors' appetite for digital bonds.
Chart 2
The Effect Of Blockchain-Based Issuances On Our Ratings Process
We assess any additional operational risks and dependencies associated with digital bonds. In our rating analysis, we will continue to apply our covered bonds criteria since the digitalization of the issuance does not change the underlying credit risk drivers. It may, however, introduce novel operational risks associated with technological failures and dependencies on new intermediaries.
For existing issuances, we understand that these risks are mitigated by the fact that digital bond issuers can--at any point and at their discretion--return to traditional issuance procedures if the distributed ledger platform they use is disrupted. Further, to ensure business continuity, previous blockchain-based bond issuances were backed up by a fully independent, off-chain database that stored all details of the initial subscription and any subsequent transfers.
Related Research
- Your Three Minutes In Digital Assets: Digital Bond Innovations Could Accelerate Adoption, June 6, 2024
This report does not constitute a rating action.
| Primary Credit Analysts: | Casper R Andersen, Frankfurt + 49 69 33 999 208; casper.andersen@spglobal.com |
| Andrew O'Neill, CFA, London + 44 20 7176 3578; andrew.oneill@spglobal.com |
No content (including ratings, credit-related analyses and data, valuations, model, software, or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced, or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees, or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness, or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment, and experience of the user, its management, employees, advisors, and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.spglobal.com/ratings (free of charge), and www.ratingsdirect.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.spglobal.com/usratingsfees.