Blockchain Solution for the Bond Markets — Part 2
Blockchain Solution for Issuance and Trading of Bonds — Part 2
After understanding the nature of the processes and industry requirements in Part 1 of this series of articles, Part 2 aspires to come up with a comprehensive model of a regulated decentralized information and value ledger for the issuance and trading of bonds. This ledger captures the complete life of a bond from genesis (pre-issue) to redemption. The decentralised permissioned ledger is private until issuance, public after issue opens (if not a private placement) and archived at maturity.
Lifecycle of a Bond Blockchain
Issuer creates separate multi-stakeholder blockchains for each instrument. Regulator, the supervisor node by default, specifies the basic characteristics of the blockchain whose instance the issuer spins. The bond blockchain story goes as follows
1. Genesis: Issuer decides on a bond issue and creates a permissioned private consortium blockchain for a new bond issue. Issuer requests the addition of the regulator node to the blockchain. Regulator joins the blockchain after the fit-for-issuance check.
2. Pre-Issue: Issuer adds intermediaries (merchant bankers, rating agencies, trustees, legal counsel etc.) to the consortium blockchain for the pre-issue process. The issuer adds intermediaries after checking their certification / license, which is in turn provided by the regulator. The consortium completes the due diligence and pre-issue documentation.
3. Issue Launch: Once the issuer is ready with all the requisite documentations and disclosures for the issuance, regulator’s approval is sought. Regulator checks the documentation and digital bond contract and approves the issue if satisfied. The private blockchain becomes permissioned and open for subscription. Investors / traders with read-only permissions are added to the blockchain (after KYC status check) by the permissioned members. Digital instrument tokens to be issued and maintained in investor’s wallet
4. Trading and Asset Servicing: Transactions executed on the exchange are referred to the bond blockchain for settlement. Intermediaries participating in the consensus process validate the transactions and settle the same by storing the transaction information on the bond’s blockchain. Beneficiary positions can be derived from the bond blockchain. Also the bond blockchain can have capabilities to execute fund transfers for coupon payment, exercising call options, investor voting and redemptions.
5. Archiving: Blockchain is archived on maturity, conversion or issuer liquidation. This archive has all the information about the bond and its transactions. Separate copies are maintained by issuer, regulator and intermediaries for compliance.
Since each bond’s information is maintained in a separate bond blockchain, the market participants (nodes) — regulators, market intermediaries, issuers and investors are members of multiple blockchains. Other than the bond blockchains the market also has market infrastructure blockchains (or shared databases if that’s more appropriate) including Payment Network, Exchange Network and KYC Network. Applications are built over these blockchains / networks for the participants to access / write information from / to these blockchains.
Going by Hyperledger’s philosophy that the future will involve a world with many interconnected distributed databases, each of which will be specialized to suit the purposes of its use and requiring inter-ledger communications; this article is proposing a market ecosystem of interacting permissioned blockchains or shared databases. These networks talk to each other through gatekeepers who are member node in all these permissioned blockchains or networks — bond blockchains, Payment Network, Exchange Network and KYC Network. The gatekeeper maintains the connectivity between the market infrastructure and the bond blockchains.
Exchange Network: The Exchange has two components — an order matching engine (OME) and a permissioned blockchain (Exchange Blockchain) where gatekeepers are permissioned members. The gatekeepers sit between the bond blockchain and the Exchange Network for seamless trade execution. Exchanges add value in maintaining anonymity, order matching, dissemination of price information and second-stage trade commitment.
KYC Network: KYC is a permissioned shared ledger / blockchain where gatekeepers share KYC data amongst themselves. Issuers seek KYC details of the investors from gatekeepers, for adding investors to their bond blockchain.
Payments Network: Like that of a bitcoin blockchain, the Payment Network is for payments / value transfer between gatekeepers.
The KYC and payment networks need not necessarily be blockchains, they could well be shared databases. In a utopian world even trustees should interact with each other over a shared database or a blockchain for information exchange. This can check illegal hypothecation of assets already hypothecated to some other lender and other such malpractices. There could also be a possibility that one blockchain has multiple capabilities and some of these networks can be combined into one ledger without losing functionality and efficiency.
Bond Blockchain Participants
Supervisor: The regulator(s), oversee the consensus formation and are part of all the blockchains. The regulator can retrieve information from any network or participant in the ecosystem. Participants can submit grievances to the regulator in case of permissioned members misbehaving or cartelizing. The regulator may punish the intermediaries by revoking licenses, monetary penalties and / or intermediary rating downgrades. The regulator maybe authorized to reverse transactions by putting in a transaction that is counter to an illegal transaction. If the regulator opposes a block formation, even if the blockchain has a majority consensus, it would be considered there is no consensus.
Permissioned Members: Market intermediaries certified by the regulator and permissioned by the issuer to join the bond blockchain. Other than the issuer, this set includes the gatekeepers, rating agencies, merchant bankers, trustees, etc. They take part in the consensus mechanism of the bond blockchain, for which they are compensated with the intermediary fees (from the issuer) and the transaction fees (from the investors/traders). Intermediaries — rating agencies, merchant bankers and trustees monitor risk and collateral of the bond to update info on the bond blockchain. The registration details and KYC details of the intermediaries are maintained by the regulator.
Gatekeepers: Permissioned Members who securely store and manage identity in order to reconcile on and off-chain ownership. They are member of market infrastructure (Exchange, KYC and Payment) networks. All market participants maintain multi-asset multi-currency wallets with gatekeepers. Market participants can exchange currency tokens used on the bond blockchain for fiat currency and vice versa, through gatekeepers.
Investors: Members, who would like to trade in a bond, can join the particular bond blockchain as read only members. They can read relevant details about the issuer and the bond term-sheet from the bond blockchain. Gatekeepers will authorize participation of investors / traders (market participants) after making sure they have the KYC details. Investors though are read only members and don’t take part in consensus formation, there are specific Investor Actions that they take part in like voting, which are directly recorded on the blockchain on a consolidated fashion by the logic built into the network.
The proposed application layer would consist of tools for reading / writing into these blockchains and networks. Few of the prominent ones may be
Wallet: Used by investor to hold assets and payment tokens. Held with the gatekeeper, the wallet will have functionality for exercising options, voting and other investor rights and privileges. All assets are tokenized and maintained as non-fungible
KYC Check: Used by issuer / gatekeeper for client verification. Admission to the bond blockchain is restricted by KYC processed by any one of the gatekeeper. Other gatekeepers can pay and get this info with investor’s consent from investor’s gatekeeper (this information is shared on the KYC Network). Issuer uses information here for asset servicing.
Asset Servicing: Used by issuer for servicing investors. Acts as a registry service for the issuer — gives a holding statement view for the issuer from the bond blockchain. Coupon payment, redemption and other corporate actions may be authorized by the issuer or automated as the case maybe
Regulatory Oversight: Used by the regulator for supervision and dispute resolution. The regulator can check the trade details of a particular investor and can see the movement of a security across trades to check on market rigging or market manipulation by round tripping or other methods
Issuance on Blockchain
As described in the Lifecycle section, issuer decides on bond issuance and creates an instance of bond blockchain as prescribed by the regulator. Issuer then adds intermediaries (gatekeepers, rating agencies, trustees, merchant bankers, and legal counsel) after checking their valid regulatory licenses.
All the issuance related documents are versioned and maintained on the working group private blockchain. Creation, review, approval, signing is cryptographically authorized and recorded on the blockchain. Nodes in the network reach consensus after they independently verify that all of the required documentation / authorizations are in place. Once regulator approves issuance, issue opens and investors join the blockchain as read only members to access issue details. Membership is restricted to investors with KYC checks done.
Issuer creates digital bond tokens with a unique asset ID (the minting process). Asset ID is a globally unique identifier for the bonds (like ISIN) — provided by the regulator while approving the bond. The digital bonds are dematerialized securities, the ownership and transfer of which are recorded on the bond blockchain. The bonds are denominated in a currency that can be maintained in the investor’s wallets and has support for settlement in the Payment Network. They have the rights, preferences and privileges of a traditional bond of the same class and the instrument details are recorded on the bond blockchain. These bonds can be traded only on the closed-system bond blockchain.
Investors post purchase request for bond subscription after funding their wallet with currency through their gatekeepers. On allotment of bonds to investor’s wallet, issuer’s wallet is funded with subscription amount.
After allotment and commence of trading some intermediaries, like the merchant banker or the legal counsel, may leave the bond blockchain after taking off their intermediary fee, if their services are no more required. The intermediary fees payable to rating agencies, trustees, is paid throughout the life of the bond in mini-payments as they provide their services through the tenure of the bonds and are permissioned members of the bond blockchain till redemption.
Transacting on Blockchain
Trading on the bond blockchain can be broken down into the following sequence
1. Investors / traders use Watchlist, an application provided by the Exchange Blockchain for querying price information of securities
2. Investor order gatekeeper to add the former to the bond blockchain, if it is a fresh purchase in this counter. KYC data encrypted with the public key of the issuer is provided to the issuer by the gatekeeper, if not already provided
3. Gatekeepers simultaneously report investor’s order details to Exchange Blockchain after freezing the investor’s bonds or money in the bond blockchain as appropriate. Trade requests are queued by the gatekeepers in the Order Matching System of the Exchange. The exchange is not aware of the trader’s details and the exchange network only gets the anonhy
4. Matched orders (executed trades) are maintained in a transaction-queue to be added to the bond blockchain for settlement.
5. Once committed to bond blockchain by the Permissioned Members and the wallets of the transaction parties are updated, the trade is settled. If the gatekeepers of the buyer and the seller are different, the transfer of the on-chain money between the gatekeepers are settled in the Payment Network.
6. Hash of executed transactions from multiple bond blockchains are periodically blockchained together in the Exchange Blockchain (blockchain anchoring) for further improving immutability. This is second-stage trade commitment.
The two phase commit mechanism is a system where trade execution is instantaneous but committing it to the bond blockchain and later to the exchange blockchain has a latency. In this manner digital bonds settle almost instantaneously, without manual intervention.
Presently, in many markets, brokers maintain a black book, capturing the information as to which investor is holding a particular security and target getting the bonds from that trader/investor through OTC trades. We can try automating this since all holders definitely are members of the bond blockchain and interested investors can subscribe to a feed which will send in targeted trading messages for buying from holders. The wallet can maintain a flag — Available for Sale, through which the investor can subscribe to this feed and can get popup messages — bids. This is specifically possible as we have modelled the blockchain around the bond and we are trying to avoid fragmentation of market. This is also similar to the good old days when specific assets were sold in a particular location in the exchange pits.
In the next part of this series of articles, we will look at gatekeepers in more detail, benefits of this solution & how pain points are addressed, design considerations, intermediary ratings, present landscape and possible corporate strategy to experiment and adopt the technology.
Design is an iterative process and we will have to get back to the drawing board to make fundamental changes, multiple times, to improve the model. Thus, there is a definite possibility that you might have a better, more appropriate model to solve the market’s pain points. Please feel free to point out errors, constraints in implementation and do express your suggestions.