Debt securities are financial instruments that represent transferable debt. Examples of debt securities are bonds, medium-term notes, and commercial papers. These instruments have defined terms such as a notional amount, interest rate, and maturity. The market for debt securities is large. As of June 2017, the Bank for International Settlements calculates the value of debt securities outstanding as USD 107.7 trn. This is 36% larger than the market capitalisation of all listed companies globally in 2017 (USD 79.2 trn).
Compared to conventional bank loans, debt securities are more cost-efficient because the interest rate companies pay to their debt investors is often less than the interest rate they would be required to pay to obtain a bank loan. However, issuing debt securities is still punishingly expensive for most of the borrowers. They offset these costs against the size of the deals they make. The high cost of issuing debt securities is mostly due to the number of intermediaries involved. A closer look at the issuance of a vanilla eurobond — a very common type of debt security — helps make this clear. Issuing a eurobond generally involves filling the following roles:
- A bond issuer to commit to the terms of the bond.
- A nominee to hold the legal title to the bond.
- A registrar to maintain a register of nominees.
- A clearing system for clearing & settling transactions.
- A paying agent to receive and make payments related to servicing the bond.
- Clearing account-holders (custodians) to receive benefits on behalf of beneficiaries.
- Beneficiaries to invest in and claim benefits of the bond — beneficiaries may additionally appoint trustees to fill this role.
This structure relies on trust between multiple parties to carry out actions in accordance with the legal documentation of the eurobond. This documentation is expensive to draw up in the first place because the arrangements that govern the relationship among the parties involved are complex. In the UK, for example, a debt security issuer must comply with at least the EU Directive 2003/71/EC, the European Commission Regulation (EC) No 809/2004, the Financial Services and Markets Act 2000, and the Prospectus Rules published by the Financial Conduct Authority (FCA) in its capacity as the United Kingdom Listing Authority (UKLA). In case of any breach of regulation, or breach of contract between any of the intermediaries in the transaction, the legal documentation is also costly to enforce.
Inefficiencies introduced by intermediaries are due to the fact that people are employed to perform actions in accordance with the documentation and internal policies, which create an additional layer of manual tasks. Trading debt securities listed on exchanges usually requires a clearinghouse as an intermediary to manage clearing and settlement of trades. These arrangements are inefficient and produce a fragmented market for debt securities, with fragmented data about the issuance, investment, and trading of valuable assets.
Blockchain smart contracts are well-suited to model debt security contracts because they encode their conditional logic. These smart contracts execute programmatically. This means that the logic encoded in the smart contract is enforced by the algorithms that sustain the Ethereum public network as a whole. Using blockchain allows intermediaries to be removed since the technology can fulfil the functions outlined above (registry, paying agent, clearinghouse, etc.). This increases transparency, improves data quality, reduces information asymmetries, and enhances price discovery. All of these, in turn, contribute to the efficiency of the market.
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