As banks continue experimenting with issuing digital-native bonds, the industry is starting to think about whether a future of blockchain-based securities poses the risk of fragmenting liquidity.
This is the question that the International Capital Markets Association is addressing. The association, headquartered in Switzerland and representing banks active in debt securities markets, has recently created a new role to research such questions related to innovation.
It has hired Georgina Jarratt in London as managing director and head of fintech and digitization. Jarratt is an experienced financier, having served as HSBC’s global head of transformation, where she led complex digital restructurings of its private bank and its HR department.
On a recent visit to Hong Kong, she told DigFin that the biggest question is the impact of distributed-ledger technology on bond-market operations and trading.
“Worldwide, banks have issued about 100 digital bonds, each using a different infrastructure,” she said. “It’s not always clear what aspect of these is truly digital, or whether digital bonds will become their own asset class. So far this has been done through private networks, with no interoperability. This doesn’t boost liquidity in capital markets.”
She believes that without a means of interoperability, digital bonds might fail, because they will remain in too many silos.
Traditionally, the largest banks operate as global warehouses and sources of liquidity for trading bonds. Until the 2008 global financial crisis, liquidity in fixed income was concentrated among about 20 global banks. Since then, a combination of regulation, tighter rules on capital, and changes within markets have reduced banks’ ability to play this role, particularly in secondary markets. But they still remain critical to bond markets.
Some technology vendors have stepped in and begun to automate trading in bonds, particularly with Treasuries and other liquid government or corporate bonds.
But Jarratt says these vendor offerings are not a substitute for banks as liquidity providers. “These platforms help connect buyers and sellers, but their impact can be overstated,” she said. “A big asset manager can get any quote they want. There’s a difference between getting a realistic quote, and getting access,” that is, the ability to execute the trade.
DLT-based infrastructure, on the other hand, represents a sea change in how bond markets might trade and operate. The prospect of atomic settlement of blockchain-native securities means cash and securities change hands in real time, versus the typical two-day settlement in Europe.
The European Central Bank is launching a pilot scheme this summer within its regulatory sandbox to test this, following on proofs of concept launched by many commercial banks. The eventual goal would be to create a platform that all banks would use.
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But integration and systems work to enable this among participating banks is costly, so Jarratt doesn’t know if the ECB will garner the critical mass of participants.
This risks the same outcome as other tokenization issuances: no secondary market, and questions about exactly how digital these bonds really are.
What are we talking about?
ICMA is trying to move things forward by publishing dictionaries of agreed-upon terminology and standards, such as defining a true digital asset, from creation to settlement to trading. It is formally involved in making suggestions in the ECB’s sandbox. Jarratt has only informal relationships with Asian regulators, where the focus is more on retail participation in tokenized assets.
Last year’s crypto meltdown, as well as Australia Stock Exchange’s decision to write down its failed blockchain-based replacement for its post-trade systems, have led to more questions about DLT. But for all the drama, the industry is ploughing ahead.
“It’s not about the technology, but the whys, is there a benefit to using it,” Jarratt said. “It can simplify processes, create full automation, and provide atomic settlement. But we don’t know what impact it will have on liquidity, and each step involves the political and legal sides.”
She adds, “The power is in interoperability, which would allow the lifecycle to be fully automated. But this raises questions about the visibility or privacy of shared ledgers, and we’re not there yet.”
The industry must also grapple with the ESG impact of DLT. Bitcoin’s network is notoriously wasteful of energy. Ethereum, having moved to Proof of Stake, has removed this problem, although it now faces questions over governance.
Bond tokenization experiments using an array of layer-1 blockchains haven’t addressed the environmental implications. Some experiments have been conducted over Ethereum or other public, permissionless chains, but this raises questions over privacy and regulation.
ICMA is not in a position to answer such gargantuan questions. Instead Jarratt is leading a drive to improve standards.
“Even the experts don’t agree on what a digital bond means,” she said. “We’re trying to get people to agree on terms.”
This comes in two formats. One is ICMA’s own project, called the Common Data Dictionary. It’s an ongoing project to agree on data elements of a bond’s term sheet, to lay the groundwork for digitizing primary markets. The software is built and is now available, and Jarratt will be campaigning for banks to begin to use it.
Secondly, ICMA has picked up on a longstanding project launched by the International Swaps and Derivatives Association that has backed a similar ‘dictionary’. Its Common Domain Model has been built over the past six years to standardize terms that go into data fields defining swaps contracts.
ICMA is now contributing to CDM by defining actions around repurchase agreements. Goldman Sachs and Barclays have taken the lead on defining data terms and functions, so that banks and tech vendors can gradually integrate these.
A third leg of CDM around securities lending is being addressed by the International Securities Lending Association.
The new database was just launched in December, jointly owned by ICMA, ISDA and ISLA, as an open-source project so that developers from any bank or vendor can contribute. It is now operating under FINOS, or the Fintech Open Source Foundation, a non-profit, member-supported organization promoting open innovation in financial services.
By designing something through open source, there is a better chance that banks’ various DLT systems can communicate, so that complex transactions involving multiple participants flows seamlessly. Without interoperability, it will be difficult to get the industry behind new use cases.
Between ICMA’s Common Data Dictionary, and the FINOS-supported Common Domain Model, the hope is that banks will agree on transaction flows, which will enable market-wide automation of bonds and other debt instruments.
If that is accomplished, then it will be straightforward to write smart contracts that program DLT-based securities and their processes. Then the true power of blockfin can be realized.