In the 1988 film ” Die Hard“, a New York City Police officer travels to Los Angeles in order to reunite his estranged spouse at her company holiday party. The terrorists take over the building as the party begins. They hold everyone hostage. The intruders were on a mission to steal $640 million in bearer bond, which unlike registered bonds had no serial numbers or registration records, and were untraceable without any record of ownership. If they were successful, the law presumed that the bearer of the bond was the owner.

Smart bonds have the ability to transform the debt instrument lifecycle and disrupt the debt capital markets. This digitalization may improve process efficiencies, increase liquidity, lower costs, simplify capital raising, and democratize the market for issuers. It can also create a wider range of investable securities. Over the past three centuries bonds have been issued on paper certificates. As the trading volume increased, businesses became overwhelmed with paperwork. In 1973, the <a href="https://www.dtcc.com/about/businesses-and-subsidiaries/dtc#:~:text=DTCC's%20subsidiary%2C%20The%20Depository%20Trust,to%20ownership%20of%20the%20securities. The Depository Trust Company was formed to deal with the growing paperwork and security concerns. Paper certificates are vulnerable to theft, loss, and tax evasion. The London City Bonds Robbery in 1990 saw thieves steal 291.9 million British Pounds (equivalent of 848.8 Million Pounds today). This highlights the risks that come with physical bearer bond records. In turn, electronic records have replaced physical bearer bond records. In 1995, the Securities and Exchange Commission released Paperless Rules. This ended the era for paper securities and introduced the Depository Trust & Clearing Corporation. This change brought about faster middle and rear office processes, and better protections for the securities market.


Digitalization of financial instruments has led to major innovations in capital market operations.

Although electronic processes increased efficiency and reduced human error, extended settlement timelines exacerbated the a href=”https://www.britannica.com/event/financial-crisis-of20072008#::text=financial%20crisis%20of%202007%E2%80%9308%2C%20also%20called%20subprime%20mortgage%20crisis%20of%20the%20U Although electronic processes increased efficiencies and reduced human error, extended settlement timelines exacerbated the liquidity crisis faced by banks in 2008 during the financial crisis. Payments to counterparties who had traded with Lehman Brothers were delayed after the bankruptcy filing. The SEC recently proposed a reduction in settlement time. However, this is only a temporary solution. Blockchain technology is the answer to capital market participants’ desire for accurate, complete and expedited information. Smart bonds are a first step towards this goal.


Digitalization: Disrupting debt capital markets

Smart bonds are characterized by the digitalization and incorporation of covenants in debt instruments into smart contracts. Smart bonds are automated bond contracts which use blockchain technology. They automate various stages in a bond’s lifecycle and perform specific actions according to predetermined conditions, without any manual intervention. Smart bonds are designed to use straight-through processing. It optimizes the debt securities issuance and trading, clearing and settlement, and interest payments. Smart bonds reduce the need for middlemen, including banks, brokers and clearinghouses. The fees for intermediaries’ services can be eliminated by eliminating them. The overall cost to manage bonds is reduced.

  • Issue and trading: Once the bond’s price has been established, all of the details agreed upon (such as the issuer, maturity, coupon rate and issue price) can be encoded into a Smart Contract and stored on blockchain. This guarantees authenticity, provenance and transparence. Smart bond tokens are allocated to investors by the lead manager or underwriter. Payments are automatically deducted and settled instantly for all investors in all time zones. Blockchain allows for a tokenization platform, a secure and decentralized trading environment which connects investors with issuers and allows transactions to be made without the need of intermediaries such as brokers or dealers. Smart contracts automate ownership transfers and update the bondholders registry to ensure accuracy and reduce the risk of error.
  • Clearing & Settlement: Bonds are traditionally settled during bank hours. The settlement period in the primary market can be up to 5 days, and 2 days for secondary markets. This latency period exposes participants to possible price swings. Smart contracts can also trigger the clearing and settlement process automatically, as long as the parties to the contract have agreed on the terms of the contract and all the conditions are met. Instant settlements reduce the time needed to complete these tasks, and also the possibility of price changes between the trade and settlement. Smart bond settlement may not be limited by bank hours but it is still subject to trading platform and exchange rules.
  • Interest Payments and Maturity: Smart Contracts can automate the payment of interest by releasing funds on specific dates. By eliminating the need for central counterparties, counterparty risks are reduced. At maturity, principal can be returned automatically to the bondholder. This ensures timely payments and reduces the risk of default.

A perceived vulnerability of smart bonds to hacking and other security breaches is due to the high-profile attacks that have been made on cryptocurrency exchanges. Smart bonds, unlike cryptocurrencies are not bearer securities. Ownership of smart bonds, however, is automatically recorded on the blockchain. Fraudulent transfers of smart bond can therefore be invalidated. According to regulatory requirements, smart bonds’ ownership may also be recorded by transfer agents. Transfer agents protect customer assets by making it easier to freeze, cancel or replace tokens in case of an error or malicious attack. This reduces the decentralization component.

Finance

Digitalization is bringing about significant innovation in capital market operations. The benefits of smart bonds are not fully realized because the regulations rely on electronic entries by authorized parties in private ledgers. Legal challenges may hinder the adoption of smart bonds in the short-term, but as infrastructure develops and more municipalities and organizations adopt the technology, we expect greater innovation and growth.


This commentary is intended to be a general guide. Arca Labs LLC is not a financial advisor and this commentary does not constitute an offer or solicitation to buy securities or advisory services.

Christie Harkin is the editor.