Smart bonds: Revolutionising debt instruments with blockchain technology

In recent years, there has been growing interest from government authorities, financial institutions and corporations to actively explore the issuance of smart bonds (blockchain bonds). These new financial instruments leverage the power of blockchain and smart contacts and show great potential in transforming the life cycle of debt instruments, and by extension, traditional capital markets.

Institutional investors have long favoured bonds for their ability to preserve capital and provide fixed-income income streams. It’s worth noting that the global bond market is the largest by market capitalisation, valued at approximately USD 133 trillion. This surpasses the value of global equities (USD 108 trillion) and makes the cryptocurrency market (USD 1 trillion) pale in comparison.

Even so, traditional bonds come with various risks, like interest rate risk, credit risks, default risk, inflation risk, and call risk (to name a few). Unlike cryptocurrencies, bonds settle within a couple of days, and in some cases, up to several days after the transaction date. If the settlement fails, this can also lead to a build-up of counterparty credit risk and negatively impact market liquidity.

By converting these bonds into smart bonds, they could be used as an effective solution to mitigate these risks. Here’s why.

What are smart bonds?

Simply put, smart bonds are bonds that utilise blockchain technology and smart contracts. In doing so, they are able to self-execute and automate the various stages of a bond’s life cycle, benefiting both issuers and investors alike.

For instance, smart bonds can provide cryptographic security, near-instant clearing and settlement, reduce costly transfer fees, and improve the overall life cycle management of bonds. Here are a few examples to help illustrate these benefits:

• Issuance and trading: Once the price and details of a bond are established, they can be programmed into a smart contract on a blockchain. This guarantees authenticity, ownership and transparency of the newly issued bonds. These smart bond tokens are then allocated to investors, and payment is automatically deducted from their accounts – settling the transactions instantly for all investors (across all time zones). This decentralised trading environment removes intermediaries like brokers or dealers, while smart contracts update the bondholder registry.
• Clearing and settlement: In this process, smart contracts enable near-instant clearing and settlement, minimising transaction time and reducing the risk of price fluctuations. This is because traditional settlement occurs during regular banking hours and the settlement period can take up to several days. However, while smart bond settlement is not restricted by banking hours, it may still be subject to certain trading platform rules.
• Interest payment and maturity: Smart contracts can automate interest payments to bondholders on specific payment dates, which can reduce counterparty risk. For instance, when the bond reaches maturity, the principal amount is automatically returned to the bondholder, reducing the risk of default and guaranteeing a reliable payment process.

Types of bonds and the role of intermediaries

There are many types of bonds, each with their own unique risks and returns / terms and conditions, regulatory requirements and various participants. Depending on the respective jurisdiction (and their approach to blockchain technology), the utility of smart bonds may vary. Still, by transforming corporate, municipal and government bonds into smart bonds, all stand to gain similar advantages.

Now the role of intermediaries in a “smart bond market” is important to address, given that self-executing smart contracts can replace many manual and technical processes. But this doesn’t render them obsolete; it may actually optimise their operations.

Let’s take transfer agents (TA) as an example. They rely on outdated legacy systems leading to manual processes and overwhelming workloads, not to mention the pressure to reduce costs and keep up with the high data demands from asset managers and investors. This operational complexity affects the entire bond distribution chain.

Blockchain technology can equip TAs with the tools to effectively interact with a large number of participants. It enables recording, timestamping, and updating of fund registers, creating a secure, auditable, and real-time ledger for all participants. For TAs, it eliminates redundant technical and manual tasks.

It is still uncertain whether the role of transfer agents can be fully replaced by a decentralised market infrastructure, as regulations and securities law make this unlikely – at least for now.

There are a few blockchain-based TAs, such as SEC-registered company Securitize, which specialise in bonds and other tokenized securities. Other initiatives include Block Transfer, among others.

The list of smart bond initiatives continues to grow. Here’s a few examples.

Despite their early stages, this hasn’t deterred smart bond initiatives from emerging – rather the contrary. Many major institutions and corporations are actively issuing their own smart bonds, including the launch of several bond trading and settlement platforms. Here’s a list below (this is by no means a full list).

What’s interesting to observe is that despite smart bonds being issued as early as 2017, their size and the number of contributing institutions is increasing. This could indicate a growing level of trust in the reliability of blockchain protocols for issuing bonds.

This is also thanks to increasing institutional activity on the infrastructure and trading front. BNP Paribas has recently teamed up with JP Morgan’s Onyx platform to trade tokenised bonds, SEB and Credit Agricole CIB’s launched its blockchain bond platform, while SIX Group’s SDX Exchange has been involved in several smart bond initiatives. Goldman Sachs also unveiled its GS DAP platform, while Euroclear plan to launch their own digital bond settlement platform later this year.

The case for AT1 bonds: A hypothetical scenario using smart bonds

The case for AT1 bonds is an intriguing one, as they provide an interesting case to examine the benefits of blockchain and smart contracts.

AT1 bonds are a form of “contingent convertible” bond (CoCos) created after the 2007-08 financial crisis to prevent government-funded bail outs and reinforce trust in banks. Today, the current AT1 bond market is worth around USD 250 billion.

In short, these bonds have specific trigger events that can convert the bond into equity or result in “write-offs” during times of financial crisis. But unlike traditional bonds, they do not have a fixed maturity date – adding to their complexity. In light of the recent banking crisis, this complexity and lack of standardization (due to their various conditions, trigger levels and structuring) have created uncertainty for bondholders, leaving them confused and susceptible to losses.

To address these issues, blockchain technology and smart contracts could offer a potential solution. By converting AT1 bonds into smart bonds, the entire bond lifecycle can be optimised – from efficient fundraising to equity conversion. For instance, smart contracts can monitor the financial health of issuing banks in real-time and automatically adjust bond terms or trigger appropriate actions when predefined indicators of financial distress are detected.

This approach not only protects bondholders but also encourages banks to prioritise responsibility from the outset. This means preventing banks from deteriorating to the point of bond losses, as seen in the cases of Credit Suisse and Yes Bank. As such, blockchain technology should inject greater confidence in the integrity of financial institutions and the reliability of these bonds.

Of course, investors should understand the risks tied to AT1 bonds – after all, higher yields often accompany higher levels of risk – but let’s not forget that these bonds should be an option of last resort, rather than a vehicle to sustain risky operations that could jeopardize a bank’s financial stability.

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