One of the most effective use cases of blockchain technology is in the bond markets. Before we get into details about how blockchain can be used, let’s first review the current state of the bond market and how it operates.
Conventional Bond Markets
Bonds are currently traded over-the-counter or OTC, and have traded in this manner for the past few decades. OTC means that the bond buyer and seller negotiate directly with one another using conventional mediums of phone/chat/email in order to trade. In addition, in most cases, you will find that trade confirmations would happen in a one system, while trade settlements will would entirely separately in another system. This is vastly different from stocks, which are today traded electronically and via stock exchanges where straight through processing takes place.
OTC bond trading have the following disadvantages:
1. Delayed Settlement Cycles – Trades settle 2 business days from the trade date, which leads to increased counterparty risk.
2. No Transparency – Since the bond buyer and seller trade directly with one another, other market participants are unaware of the price at which the trade closed. Thus, the only source of price information are the traders or dealers, with each dealer quoting a different price for the same bond at the same point in time. While there has been a rise in regulatory scrutiny in jurisdictions like the U.S. where trades are required to be reported to a central reporting authority, this practice is not prevalent in other parts of the world like Asia.
3. No Trading on Exchanges – While many bonds are listed on exchanges such as the Singapore Exchange (SGX) or the London Stock Exchange (LSE), they are not traded in large volumes on these exchanges. The lack of exchange trading leads to increased counterparty risk and lack of a universal pricing source.
4. Inefficiency – The current bond trading workflow involves several middlemen between the end investor and the bond seller. These middlemen include private bankers or relationship managers, investment advisors and traders. This leads to high levels of inefficiency, when compared to the equity markets where investors can trade electronically with just a few clicks without any middlemen.
5. High Costs – The high costs of maintaining various middlemen between the end investor and the ultimate bond seller lead to high costs for the end investors in the form of commissions/fees.
Use of Blockchain in Bond Trading
Blockchain or distributed ledger technology (DLT) was made famous by the cryptocurrency Bitcoin, but the underlying technology has various use cases. One of the most effective use cases is in the bond markets, which are today highly inefficient and opaque.
Blockchain is a digital record of transactions that is distributed across many computers. The distributed ledger is maintained in sync through a protocol referred to as consensus. It provides certain guarantees on immutability of the ledger, even when some participants are faulty or malicious. This makes it more secure and difficult to hack or infiltrate. The blockchain network can be public (like Bitcoin) or private, each with its pros and cons. Commonly used blockchain are Ethereum, Corda and Hyperledger.
The key advantages of using blockchain in bond trading are as follows:
1. Instant Trade Settlement – Blockchain enables trades to be settled instantaneously, which is a huge improvement from the current settlement cycle of 2 business days from the trade date. This is possible because trade confirmation and trade settlement take place on the same platform.
2. All-to-all Trading – A departure from bilateral trading relationships, end investors can instead trade with each other. They are no longer forced to trade with only their bank or broker as the counterparty. This heightens investors’ access to the market and improves make bond prices more competitive and less prone to contain hidden spreads/mark-ups.
3. Ease of Use – While electronic trading is gaining traction with institutional players in the bond market, individual investors still have to trade bonds OTC for lack of a trading platform. The use of blockchain in order matching and trade settlement coupled with an electronic interface for all investors (individual & institutions) will enable bonds to be traded conveniently with just a few clicks.
4. Low Costs – With all-to-all electronic bond trading, end investors can trade directly with one another without the need for middlemen. This saving in costs for the banks and brokers can be passed on to clients in the form of lower fees.
5. Regulatory Oversight – The regulator can be part of the blockchain network so that it can review and overlook the flow of transactions on it. This will lend confidence to end investors, which will drive trading volumes on the platform.
6. Ability to Fractionalize – The use of blockchain allows for the option to fractionalize bonds into smaller sizes. Large minimum denomination is a problem specific to Asia wherein bonds are traded in sizes of US$ 200,000 or S$ 250,000. Fractionalization will allow existing bond investors to diversify their bond holdings more effectively. With the right regulations in place, it can also be used to offer retail investors an opportunity to gain exposure to fixed income via small sized bonds.
We at BondEvalue are developing a blockchain-based bond exchange – BondbloX. You can read more about the exchange on the BondbloX website: https://bondevalue.com/bond-exchange/