Digital bonds are slowly gaining momentum in a complex landscape

October 21, 2024

Key Takeaways

  • Recent issuances and trading on blockchain could signal new era
  • Digital bonds offer fast settlement, transparency, broader investor base
  • Regulatory, technological and security hamper wider adoption

In the past few years, major financial institutions have begun experimenting with digital bonds – – instruments issued and traded on blockchain technology, or distributed ledger platforms (DLT).

In February, HSBC, on behalf of the Hong Kong Monetary Authority, settled what it called a game-changing transaction — the largest-ever digital bond deal of HKD 6bn (USD 780m) and also the first multi-currency digital bond. Previous to that, the European Investment Bank had issued four bonds on the blockchain, and UBS, in November 2022, executed a CHF 375m bond transaction that it said was the first by a bank to be listed, traded and regulated on a regulated digital exchange.

These and other recent issuances offer a glimpse into the future of capital markets. Yet, the adoption of digital bonds has been slow, limited by regulatory, technological, and market challenges.

Over the 18 months leading to mid-2024, S&P Global ratings said it had rated 14 digital bonds worth a combined USD 1.6bn. This represents only a fraction of the broader bond market (global long-term fixed income issuance was USD 25.2trn last year), and most digital bonds still rely on off-chain payments and traditional processes for settlement and repayment, S&P said.

Fixed income has not been the fastest mover in the capital markets when it comes to modernizing workflows. According to Coalition Greenwich data, during the first quarter, 44% of investment grade and 29% of high yield traded electronically.

When it comes to DLT, bond market participants are not packing away their tried and tested technology and processes just yet. Digital bonds are only in the foothills of what will be a steep ascent to wider acceptance and part of a wider push towards digitalization and automation.

Benefits for issuers and investors

Among the many benefits digital bonds offer are efficiency and lower costs. German tokenization firm Cashlink said that blockchain can save 35 to 65% in insurance costs. It simplifies the issuance process, reducing administrative burdens.

DLT allows near-instant settlement compared to traditional systems. This was the case with UBS’s DLT-based bond, which saw instant and automatic settlement via SDX CSD without the need for a central clearing counterparty.

Lower entry barriers help attract a broader range of investors. The HKMA’s issuance via HSBC’s digital platform (Orion), for example, drew a diverse pool of investors, showcasing how digital bonds are democratizing bond markets.

Because of their smaller denominations, digital bonds let retail investors access markets that were previously only available to institutions. Since this digital avenue eliminates intermediaries, investors can benefit from reduced fees and faster trades, while also reaping the advantages of complete transaction histories and more effective decision-making. Enhancing trust and accountability in ownership and transfer processes through a transparent ledger is what helps set the technology apart. However, while there might be momentum in issuing digital bonds, there are barriers to their wider adoption.

What’s holding digital bonds back?

Legal and regulatory uncertainty stands out as a primary challenge. The rules surrounding digital assets differ across jurisdictions, complicating cross-border issuance and limiting global acceptance. Due to the innovative nature of DLT, ownership structures are frequently untested, making the need for clear legal title crucial. While regions like Europe are making progress with new regulations to support digital securities, the legal infrastructure is still evolving, creating a hesitant environment for wider adoption.

Technological challenges also play a significant role. Digital bonds rely on DLT platforms, which are relatively new and require significant upfront investment in infrastructure and expertise. The lack of interoperability between DLT systems and other financial technology platforms adds complexity, limiting the efficiency gains that DLT promises. In addition, many digital bonds are settled using off-chain methods, preventing the full realization of DLT’s potential for faster settlements.

Until DLT fully replaces legacy infrastructure, firms will need to integrate the two – that’s no mean task! Moreover, DLT will only generate the aforementioned benefits when other market participants adopt the new infrastructure, thereby creating scale.

Security concerns also weigh heavily on issuers and investors. The digital nature of these bonds makes them vulnerable to cyberattacks, presenting a significant risk that traditional bonds face to a lesser extent.

Liquidity risks present another hurdle. Digital bonds have the potential to improve liquidity, but secondary markets are underdeveloped, meaning investors may struggle to find sufficient trading volume. The overall market is cautious, with issuers and investors hesitating to embrace new technologies due to the limited number of successful precedents.

Growth amid challenges

Digital bond issuance has become increasingly sophisticated and is slowly gaining traction among governments, corporations, and multilateral institutions. Faster transactions, reduced costs, and greater transparency are major attractions and a recipe for growth.

Likewise, if the digital ecosystem deepens with more central bank digital currencies (CBDCs), the potential to reshape bond markets and boost liquidity will only grow. According to the Atlantic Council think tank, 134 countries and currency unions, representing 98% of global GDP, are exploring CBDCs. In May 2020, the number stood at 35.

However, as we have seen, the widespread adoption of digital bonds remains far off due to legal, technological, security, and liquidity challenges. Until DLT processes can be integrated into legacy technology workflows, extensive testing by market participants will be needed and progress is likely to be piecemeal.

And lest we forget, DLT is not the only innovation. As ION wrote recently, fixed-income trading has historically lagged behind other financial markets in technological advancement, but is likely to take a giant leap forward in the future due to the adoption of Artificial Intelligence (AI) and Machine Learning (ML). More immediately, though, fixed-income market participants are increasingly aware of the efficiencies offered by cutting-edge execution management system (EMS) technology as they strive to attain full trading workflow digitalization.

ION Markets

Don't miss out

Subscribe to our blog to stay up to date on industry trends and technology innovations.