Digitizing Bonds on the Blockchain
The article below is from our BRIEFINGS newsletter of 10 June 2021
Earlier this year, the European Investment Bank (EIB) issued and settled its first-ever digital bond using Ethereum blockchain technology. We sat down with Mathew McDermott, global head of digital assets, and Maud Le Moine, head of sovereign, supranational and agency origination in the Investment Banking Division, to discuss the transaction and its implications for capital markets and digital finance.
Goldman Sachs was one of three banks leading the transaction for EIB’s first-ever digital bond on the blockchain. Can you provide some of the background on how the deal came together?
Maud Le Moine: There’s a history of public sector clients, such as the EIB, the World Bank and other public sector issuers, being at the forefront of innovation in the capital markets. For the EIB, which has a long history of spearheading innovation (the bank issued the market’s first green bond, for example) and is one of the largest issuers in the European markets, debt issuance on the blockchain was a natural space for them to explore. We’ve worked with the EIB on a variety of initiatives, and they came to us, along with Societe Generale and Santander, about a year and a half ago with the goal of being the first to issue a fully digital bond. So we worked closely with the other banks on the design, technological setup and the legal framework to bring the transaction to life.
Mathew McDermott: Because the regulatory framework for this market is evolving, we needed to issue the digital bond in a jurisdiction that enabled us to achieve the client’s objective. Issuing under French law was a natural fit because the country passed a law that allows for the registration of digital securities to be recognized as financial securities; this permits the registration and transfer of unlisted securities using blockchain technology, removing the need for a central securities depositary (CSD) and a custodian. That’s not the case for many jurisdictions in many countries around the world, although Germany and Spain recently passed similar laws, and Luxembourg, Sweden and Singapore are working on similar legislation.
How does issuing a digital bond on the blockchain change the characteristics of the bond?
Maud Le Moine: The bond was a standard two-year 100 million euro-denominated bond but, because it was issued on the blockchain, it is in fully registered form and removed the need for a CSD and sharply reduced the settlement time. Normally, it takes five days after the transaction to settle debt issuance for the EIB, but because of the smart contract functionality and speed of transacting on the blockchain, we were able to settle it in one day. Theoretically, the transaction could have settled on the same day of issuance, but we wanted to give ourselves extra time since this was the first digital bond issuance in this format. Not only can using blockchain technology increase the speed and certainty of execution, as well as the efficiencies of transactions, it can also lower the transaction costs.
Mathew McDermott: Ultimately, issuers should be able to automate the entire lifecycle of their bond transactions on the blockchain—certainly an area of focus of our net digital debt issuance. Reducing the settlement time to T+0, for example, reduces the settlement, operational and liquidity risks vis-à-vis existing issuances. Issuers also gain greater transparency to trading behavior on blockchain, albeit in a private way. And over the longer term, issuing debt on the blockchain would allow firms to appeal to a much broader investor base by leveraging the programmability of the technology to fractionalize the digital debt or any financial instrument. In other words, it’s democratization in action.
So traditional finance relies on intermediaries to manage the process, but the EIB transaction in this case eliminated the need for a custodian. In the future will this replace the existing infrastructure players?
Mathew McDermott: In this transaction, EIB obviously did, but there are different jurisdictions where the rules and regulations are slightly different, so they could continue to interplay. The initial issuance is executed under a smart contract, so the debt and cash were separately represented using customized ERC20 tokens on the Ethereum blockchain. And post issuance, in theory, the investors could just transact with each other on a peer-to-peer basis and notify the registrar to make the change in ownership, following confirmation fiat has moved from the settlement agent.
And when could we start to see other digital issuances?
Mathew McDermott: Over time you could see the marketplace migrate to issuing and secondary trading on a blockchain, however I would caveat we are still in the early stages of educating investors and issuers regarding adoption. What’s exciting from my perspective is that we’re seeing a lot of interest on the investor side, but we’re also seeing a lot of appetite from issuers, as well. This is definitely a collaborative effort across the market.
Maud Le Moine: If you think about the evolution of capital markets and fixed income, we’ve already moved from bearer bonds to the registration of all securities, so this is just the next step that will be the standard, given the efficiencies it brings. The interesting thing about this trade is because it was a multidealer public issuance, it’s the first proper validation of the use of this technology that issuers can look to replicate.