On April 27, 2021, the European Investment Bank (EIB) issued a digital bond via a series of bond tokens on a blockchain platform, where investors purchased and paid for the digital bond using traditional fiat currency and smart contract functionality. The EIB launched the digital bond in collaboration with a syndicate of Investment banks as subscribers.
This successful EIB issuance in the public sector shows that the digitalization of capital markets is likely to bring benefits to market participants. In this edition of In The KnowBaker McKenzie provides an introduction to developments in the digital bond space, using the BEI bond as a potential indicator of future developments in our markets.
Digital bonds can reduce the need for intermediaries and therefore lead to lower fixed costs provide better market transparency by increasing the ability to see trade flows and the identity of sellers and buyers of assets and provide a much faster speed of settlement. While there are still development steps needed to make these benefits apparent, the private sector has begun discussions on how to enter this space.
Here are some of the foundations of this burgeoning digital arena – along with a few key takeaways:
- Digital link. These are decentralized tokens that are issued on a blockchain platform that aim to be a store of value or a medium of exchange. This type of digital representation would be the next logical step in the evolution of capital and fixed income markets.
- Distributed ledger technology. This can be used to provide a shared record of transactions and/or account balances for a specified set of cash and securities assets and their holders. The distributed nature of the platform avoids the need for an intermediary to control access rights and thus transactions can be carried out without a recognized third-party central governance institution to validate and approve these transactions. Participants may regard the status of the registry as authoritative.
- Block chain. By using the blockchain, issuers are able to have greater transparency on trading. Using blockchain technology to record transactions allows for a single source of information that participants share. This can minimize complex and laborious back-office reconciliations between parties.
- Smart contract. This can be used to define and execute the obligations of a legally binding contract – some or all of the contractual obligations can be defined and/or executed automatically by code. As computer automation of a smart contract requires legal rights and obligations to be translated into code, the code must be verified and validated to ensure that it has been designed to meet the necessary contractual requirements.
Although recent developments indicate that digital bonds are the future, regulations are still essential – particularly with regard to issuance and settlement, trading, custody and post-trade operations and processes. The European Union is beginning to establish these regulatory foundations through the proposed European Commission Regulation on Crypto-Asset Markets (MiCA). Several proposals under consideration seek to create a structured market that aligns with those of more traditional debt financial instruments.
You can read more about this in the new edition of In The Know – Leveraged Finance Newsletter. The full article provides more information on the fundamental requirements and enablers of digital bonds, as well as an in-depth review of key developments and regulatory considerations.
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