Moving primary bond markets into the digital era

Whether referring to removing manual verification processes from bond issuance, automating lifecycle management or tokenising the bonds themselves to create digital assets, digitalisation is one of those elusive terms. Either way, there is almost universal agreement that the bond markets must significantly modernise.

“My personal experience is that the bond market is still working on an updated version of how things worked in the Victorian times,” says Conor Hennebry, Santander’s global head of debt capital markets (DCM). “It is only recently that documents didn’t have to be physically wet-signed. Bookbuilding and trading have been updated in various ways, but fundamentally it’s the way things worked in the 19th century, made a bit better.”

This is a view echoed by Charlie Berman, CEO and co-founder of digital capital markets platform, agora, who contrasts the hugely important role these markets play with the fact they “raise trillions of dollars every year” using outmoded technology.

“My frustration comes when I look at the world of consumer finance and the enormous revolution that has taken place there,” he says. “In the bond markets, we send each other emails, we attach Word documents, we have to call each other up and nothing is centrally gathered or correlated. So, it needs tons of manual reconciliation and checking. There is massive potential for change there.”

Greater efficiency

Capital markets digitalisation generally covers two main pillars: changes to issuance and lifecycle management workflows (and the systems around that); and tokenisation.

John Whelan, managing director of crypto and digital assets at Santander, describes the first part as “meat and potatoes” digitalisation.

“You can look at the entire securities lifecycle of a bond — origination, structuring, negotiation, bookbuilding, trade, the post-trade lifecycle — and you can pick any part of that lifecycle and say there is an opportunity to improve the efficiency of the market through digital means,” he observes. “That is not a mystery.”

Here, platforms such as agora, DirectBooks and the London Stock Exchange’s DCM Flow are seeking to make a difference.

DirectBooks is a primary markets communication and documentation platform focused on improving the issuance process. Its CEO, Rich Kerschner, says: “DirectBooks simplifies the processes and streamlines the communications workflow in partnership with underwriters and institutional investors. The platform enables standardised and structured data communications to ensure consistent transaction data.”

For Mr Berman, he has the full lifecycle of the bond in his sights, “from inception to redemption”. He describes agora as a “connective layer” between participants in bond issuances and their lifecycle management. The platform, the company says, “provides a single golden source of the critical bond information, digitally signed and available to all participants in a deal.”

The benefits of such platforms are clear: greater efficiency can mean lower costs, increased business capacity and freeing up staff for other activities, such as delivering a richer service to clients.

Complexity to manage

But despite the clear benefits, the rollout is complex. DirectBooks, for instance, went live with a small initial group of users in November 2020, with functionality and users growing thereafter. It currently has 22 global underwriters using it, as well as 250 institutional investors. Initial capabilities began with investment-grade issuances in major currencies, but it has since expanded to include emerging markets, with additional categories and functionality due to be added.

Mr Kerschner reflects that “we face the normal challenges to evolution: consistent behaviour changes to existing habits across multiple institutions with a wide range of technical capabilities,” adding that a “difficult part to manage is the timing and rollout of improvements to a wide range of users with different expectations and capabilities — this requires careful alignment driven by planning, patience and disciplined execution”.

Mr Berman says that the agora platform is currently being “onboarded” for bonds issuance use by several banks. Its structured products workflow has been live and in use by Italian investment bank MedioBanca for six months.

However, he also highlights the complexity of the development process. “In the world of highly regulated financial markets you need to have technology that is incredibly reliable, secure, scalable and fast. So, by the time you have real people using it, it has to be industrial quality, which means building it is a very long and complicated process,” he explains.

Part of the complexity relates to need to develop a platform like agora in a comprehensive manner, so that it can integrate new issuance methods and support continued innovation. “The real benefits will come if you do everything from issuance all the way to settlement via a digital platform,” says one senior innovation practitioner at a leading European bank, who did not wish to be named. “The analogy I make is having the full benefits of moving to an electric car; you do not get the full benefits by putting a new engine into an old car. It needs to all be built together.”

DLT potential

A key supporting technology is distributed ledger technology (DLT), which was first popularised in the world of cryptocurrency. agora, for instance, utilises DLT as the foundation for issuance and lifecycle management workflows. SIX Digital Exchange (SDX), part of SIX — the financial markets infrastructure group which operates the Swiss stock exchange — has also utilised this technology in its issuance processes.

“The benefits are about using DLT to achieve faster execution, instant liquidity knowledge and traceability,” says Chris Agathangelou, head of digital capital markets at NatWest Markets. A concept associated with DLT and securities issuance is the idea of atomic settlement: i.e. instant ownership transfer and payment.

In relation to the idea of quicker execution, Mr Hennebry says: “T+0 settlement is a big benefit for me. There’s nothing an issuer hates more than settlement being outstanding for several days. It will also make liability management so much easier as you know who owns the bonds; you know where they are and can get a message straight to them.”

Programmable securities

The traceability element relates to the tokenised bonds being “programmable” or acting as “smart contracts”. Santander’s Mr Whelan explains it as a security that “has a certain value and other core characteristics; it also has various lifecycle events that are triggers (e.g. coupon payments). With tokenisation, in theory, we could create securities where these things are entirely defined within just a few lines of code. And then their entire lifecycle becomes automated.”

This would also enable, according to agora’s Mr Berman, the asset to be “interrogated” at any time to find out information about it, to ask it to conduct calculations and to easily make any necessary changes.

Such applications are in their infancy, but Mr Whelan would like to see the market keep an open mind about their possibilities. “One of the big challenges that we’ve had to date is everyone’s looking at the existing bond market and saying the future will just be like that, but more efficient. Yes, the first transactions will look a lot like a traditional bond of today, but I strongly suspect that we’re going to move beyond traditional securities design.”

For example, he suggests coupon payment schedules could be transformed. “In the [future], there will be no reason why a security can’t be issued with continuous real-time cash flows. We’re only scratching the surface of what’s possible,” Mr Whelan says.

Proof of concept

Despite there being exciting possibilities, moving to a place where bonds are frequently being issued as digital tokens — with enough liquidity for a viable market — remains a work in progress. Recent years have seen proof of concept issuances, demonstrating the viability of different aspects of the issuance process for digital bonds.

Notable transactions include the European Investment Bank’s (EIB’s) first digital bond issuance in April 2021. The €100m two-year bond utilised DLT for the registration and settlement of the digital bonds. And, significantly, in partnership with Banque de France, the payment of the issue monies from the underwriters to the EIB was represented in the form of central bank digital currency (CBDC).

As the innovation specialist at a leading European bank notes: “People have started to test the technology in sub-components of the workflow to say, for instance, can we just issue a bond and do the allocation on a digital ledger platform? Yes, we can. Can we trade it on a venue based on DLT for more security and privacy? Yes, we can. Can we settle it with a central bank digital currency? Yes, we can. So, it is being proven from a technological point of view that all those components can work. We are still in the early stages of having all those components linked.”

Such transactions are important not only to develop the necessary system architecture and demonstrate its functioning, but also as a means to build market awareness.

In November 2021, SIX issued a SFr150m ($157.78m) digital bond that was in two parts: SFr100m in digital format, listed and traded via SDX, and SFr50m listed on the regular Swiss stock exchange. The two tranches are interlinked, with investors in the traditional tranche able to convert their holding into digital form and vice versa, giving investors additional comfort while demonstrating how digital assets can be legally identical.

Stefan Bosshard, head of fixed income at SDX, suggests that the dual-tranche structure was important to “bring everyone along on the journey,” no matter their current level of comfort or experience with digital issuance. He believes having this structure transformed “some interest” in the bond to “real demand”, with multiple investors partaking. It was, he says, an important “transitional” structure, but (within a Swiss context) he believes it will be possible to issue in purely digital form for future transactions. “People have seen it is not black magic,” he says. While he also acknowledges there is further technical development needed, he expects to see “more and more digitally native bonds” and traditional issuance gradually diminishing in parallel.

Regulatory approval

The SIX digital bond was also notable as it was issued within a fully regulated environment. SDX gained regulatory approval from the Swiss Financial Markets Supervisory Authority to operate a central securities depository for digital assets in Switzerland in September 2021. This was a significant step as regulation in markets such as the EU and the UK has required public debt issuances to be registered with central securities depositories.

Regulators are currently examining new approaches for managing this, such as new categories of intermediary. In the EU, this is part of the DLT pilot regime, which entered into force in June 2022. Market participants are generally complimentary of growing regulatory engagement, as well as that of central banks who are increasingly working on their own CBDCs.

“I think it initially took regulators a few years before they realised this was real. But that has completely changed,” says Mr Whelan. “From what I’ve seen from engaging with regulators on the topic, it’s quite an engaged audience: whether it’s the regulators, dealers, issuers, the buy side or legal firms. Everyone is rolling up their sleeves and working together in a way that I haven’t witnessed before.”

Industry group the International Capital Market Association has also set up an industry-wide working group on “blockchain bonds” — which includes participation from banks, central banks, issuers and investors (among others) — to focus on interoperability, as well as legal and regulatory considerations.

Mr Agathangelou observes that it is not in individual banks’ interests to work independently in developing these markets. “If we all went our own way, trying to implement this technology there would be significant fragmentation, and that will slow down the adoption.” He suggests an overarching framework, providing a clear and agreed set of principles, similar to the impact the UN’s Sustainable Development Goals had for sustainable finance, would be a helpful step forward.

Building a market

This market remains very much in its infancy. The pool of issuers and investors with significant knowledge is small, and the number ready and able to execute in a digital format even smaller.

“Everyone wants to talk about this area and learn more about it — and, actually, lots of people want get involved,” says Mr Hennebry. “But we aren’t quite there yet; the bond market is not currently ready for digital bonds en masse."

“I really enjoy the meetings that we have with issuers and investors on this topic,” he adds. “But at this stage, those are generally educational and there are a lot people to bring up to speed … In order to have a functioning market, we need a lot of investor adoption, and more issuer adoption. That will happen over time.”

Mr Agathangelou agrees with this sentiment: “We will continue to see proofs of concept. But what will be important for the market is a more public type of transaction with a long lead-up time, in terms of market education and working through with the investor base on their connectivity with necessary systems,” he says. “And I think that if there is high engagement from the banks and the platforms running that transaction, you may see a much rounder execution and a further adoption.”

He believes that the issuer should be one “that has a very broad investor base … the most obvious route will be behind either a national champion institution, financial institution, or an SSA [sovereign, supranational and agency], to really start that conversation or work through it in detail.”

As to when the market will really take off, that is the million-dollar question. “I think it will be a landslide kind of process,” says Mr Hennebry, “where it will start with a few participants and issuances, and then a lot more will join. There will come a tipping point where it will go from incrementally one investor at a time becoming active in this area to everyone going at the same time. It is hard to say when that will be though.”