Blockchain Solution for the Bond Markets — Part 1
The global bond markets have about $100 trillion worth of securities outstanding and about $250 trillion worth of bonds are traded in a year. Although the process of issuance of bonds in different jurisdictions may be different to a certain extent, there are majorly two mechanisms of issuance — private placement and public issuance. This article, after analysing the current market setup, proposes a design for the issuance and trading of bonds on decentralized permissioned ledgers to address the market pain points and bring in efficiencies. Blockchain services help in streamlining the issuance where all participants work in real time on common datasets and trading of bonds by eliminating duplicative steps and shrinking the settlement cycle, which in turn, reduce costs and risks, thereby lowering the market’s capital needs.
Issuance of Bonds
Bond issuance process involves multiple mutually-untrusting stakeholders playing specialized roles. These entities, which include the issuer (company), merchant bankers, legal counsel, rating agencies, trustees, collection bankers, registrars form a consortium or a ‘working group’. The group works on several documents including engagement letters, consent letters, disclosure documents, due diligence certificates, issuer undertakings, escrow agreements, regulatory submissions etc. The working group members discuss, exchange emails, negotiate, create these documents, review them, approve them by wet-ink signing & sealing and finally submit them to the regulators for permission to issue. The working group does all this in tight deadlines and also putting up their reputation and licenses at stake. Once regulator approves the issue, it is open for subscription and then the investors subscribe. In a public issue, subscription money is locked up, sometimes up to 12 days and then allotment and refund is initiated. During allotment, there are several intermediaries who are involved in record keeping and reconciliation. The below figure is a highly simplified version of the issuance process after skipping many details. Some of the intermediaries like rating agencies, trustees etc. are engaged with the bond issuer till the security is redeemed / extinguished.
Similarly, trading bonds in the secondary market involve intermediaries who add value that they are specialized in. In the bond markets, trading volume is fragmented across the exchanges, brokers and order matching systems. The non-homogenous character of the bond markets (hundreds of bond issuances from one issuer v.s. one or two equity issuance) adds further dearth of liquidity.
Trading transpires in three stages — execution, clearing, and settlement. Trade execution is a mature, secure and efficient process perfected by exchanges over the years using the best in technology. Globally the clearing and settlement of bonds are completed by up to 3 days from the day the trade was executed. During this time frame securities and capital are tied up to honour the trade and to provide for risks. Although the clearing corporations reduce counterparty risk, nothing is full proof, as there have been instances of clearing members defaulting in the past. Moreover, there are intermediaries who are involved in the netting of transactions, reconciliation and record keeping. Multiple copies of the same transaction are interpreted and stored in different ways and reconciled by intermediaries (back office, custodian, clearing bank, depository, central counterparty) leading to delays, errors and costs in clearing and settlement. Intermediaries who are involved in clearing, settlement, collateral management and custodial services made around $40 billion in revenue in 2013 (according to Oliver Wyman). This and other costs including back office costs, cost of capital tied up add further pain to the already low-yielding global bond markets. A simplified schematic of the bond trading process is as below
Due to the nature of these processes and the nature of the product, the global bond market has following pain points
1) Costs: Regulatory costs (large financial institutions spent $12 billion/year for KYC/AML in 2013), systemic costs, transaction costs ($26 billion for US bonds, 2015), specifically back office costs related to settlement and clearing eat away bond returns. Added to this is the cost of capital of margins posted. And this in an environment where about $13 trillion worth of bonds are yielding near-zero or negative returns. Bonds are so non-homogenous and have multiple characteristics that manual intervention is required while settling the security as different counterparties use different terminologies and IT infrastructures — which brings in errors in reconciliation and sometimes even disputes. Also, issuance costs and asset servicing costs that an issuer spends increases the cost of capital.
a. Credit Risk: Monitoring credit risk continuously through the tenure of the instrument is a challenge and generally there is a conflict of interest in the credit rating business as it is the issuer who pays for these services. Sometimes rating agencies also provide other services to borrowers and give favourable ratings to such borrowers who help in the rating agency’s revenue growth.
b. Liquidity Risk: Also due to capital constraints and global regulatory reforms we can now see sell-side players getting less involved in market making, thereby increasing the liquidity risk. Fragmented OTC markets and multiple order matching systems (OMS) lead to higher liquidity risk
c. Operational Risk: Clearing and settlement through intermediaries and back offices also bring associated risks of counterparty risk and operational risk. Settlement failures, disputes, reconciliation errors etc. due to multiple intermediaries add to uncertainties.
Is there a possible solution to address the pain points of the bond markets?
If one analyses the characteristics of issuance & trading processes
1) Bond issuance involves creating, sharing, reviewing and approving information between multiple mutually-untrusting stakeholders
2) Bond trading involves multiple copies of the same transaction information separately maintained and reconciled by intermediaries
and ask the 5 questions for the appropriateness of a blockchain solution:
1) Does the process involve a shared repository of information?
2) Should this shared information have multiple authorized writers putting in transactions?
3) Are these writers mutually untrusting?
4) Will avoiding a central intermediary add value to the system in terms of cost-savings, quicker process and / or increase in efficiency?
5) Do transactions created by different writers often depend on one another? In the sense are there interactions between the transactions?
We get a yes for all the above questions, both for issuance and trading.
Having said that, capital markets is a highly regulated industry. Heavy regulation makes the innovation process hard to come by, as the rules of the game are etched in stone. Once a process has been perfected, regulation is built around this process (or vice versa) and the process remains so for a long time, limiting creativity and innovation. Thus while designing a solution, other than addressing the present pain points, one should keep in mind the motivations of all the essential industry participants and what they expect from a solution:
- Compliant — The solution should have capabilities for regulatory reporting and should be in compliance with existing capital market regulations including KYC and AML
- Scalable — The issuance and trading platform should be able to scale and perform when there is a lot of volumes
- Confidential — Identity and patterns of behaviour of any party / traders on a network must be difficult for unauthorized parties to ascertain
- Secure — Data should be secure and protected from attacks and leakages
These are non-negotiable asks, that the solution should deliver on. In Part 2 of this post, we will look at a possible solution that can address the pain points, keeping in mind the domain we are working on and the current realities.