Digital Bond Issuance on Blockchain: What’s Holding Back Market Growth?

In recent years, Initial Coin Offerings (“ICOs”) have emerged as a new form of venture capital for startups, raising over $12.9 billion as of 2020. However, the debt market, through the issuance of digital native bonds or notes (“D-bonds”), has not experienced similar growth. Over the past 18 months, Standard & Poor has rated 14 digital bonds that totaled about $1.6 billion and were issued by sovereigns, multilateral lending institutions, local and regional governments, corporations, and financial institutions. This article explores the advantages of digital bond issuance, the obstacles currently hindering its growth, and potential steps forward.

What is a D-bond, anyway?

While there is no widely accepted definition, D-bonds are understood to be instruments whose register of ownership is stored using Distributed Ledger Technology (“DLT”). Two main models can be distinguished:

1. Native DLT Bonds. These D-bonds are issued directly onto a distributed ledger or blockchain and are held and traded through the DLT, independent of traditional market infrastructure. For instance, the European Investment Bank (EIB), following this model, issued a €100 million digital bond in 2021 on the Ethereum blockchain. The EIB used blockchain technology to manage the issuance, settlement, and trading processes, enabling faster and more transparent transactions.

2. Tokenized Traditional Bonds.  In this model, traditional bonds are immobilized from an operational perspective, and a tokenized version is deployed onto the DLT. The conventional bond is deposited in a traditional custodian. Since 2018, the World Bank has been issuing BOND-I, a series of Blockchain-based bonds, using this model. Although these bonds are issued through traditional mechanisms with custodians and regulatory compliance in place, they are also tokenized and recorded on the Ethereum blockchain.

What is Ethereum?

Ethereum is a public blockchain with smart contract capabilities. Any third party may review and access the transactions and information recorded in the ledger. Ethereum is a decentralized network that validates transactions under a proof-of-stake protocol. It allows any person to deploy on the blockchain smart contracts that self-execute when certain criteria embedded in the code are satisfied.

In both models, bonds can be referred to as tokenized assets. Critical bond information, including, but not limited to, DLT bond identifiers, issuance amount and maturity, coupon features, identification of approved operators, transfer conditions, and other reference data, can be embedded into its code-based representation.

Each D-bond issuance may have specific particularities, such as off-chain payment settlements (i.e., interest or principal payments delivered to bondholders using regular channels such as banks or financial intermediaries), the existence of traditional custodians (i.e., bank, central security deposits, broker, etc.) collateral arrangements (i.e., guarantee agreement, escrow deposits, mortgages, floating liens, etc.), but a general structure will be as follows:

What are the potential advantages?

Some of the main advantages that D-bond offers include the following:

1. Streamlined issuance Process. By simplifying the issuance process, D-bonds could reduce transaction costs and expenses payable to the intermediaries by 35% to 65%. This means Issuers will retain a higher amount of the net proceeds of their issuances.

2. Efficient bookkeeping. DTL automates the recording and updating asset ownership, transaction history, and regulatory compliance, reducing manual work for back-office and middle-office staff.

3. Faster settlement cycles. Delivery against payment automatization via smart contracts could make the payment of coupons and principal, calculation of interest payments, and reconciliation cycles almost instant.

4. Round-the-clock transactions. Markets will not be restricted to standard business hours. Transactions may occur at any given time of day and year, increasing market efficiency.

5. Fractionalization. Although generating momentum, the ability to split a bond into smaller portions (similar to a stock split) can enable smaller investors to acquire a bond. D-bonds can be adapted to smaller markets, opening the door to small and medium-sized companies.

6. Improving collateral liquidity. D-bonds may be used as collateral to increase liquidity in emerging markets when fully developed.

Why has the market not taken off?

Despite the potential advantages, several difficulties and issues need to be addressed before substantial growth in the debt market can occur:

1. Lack of a Secondary Market: D-bonds suffer from limited liquidity, primarily when issued on private or “walled garden” blockchains that restrict access to a specific group of investors. This limits the secondary market potential, reducing liquidity or the ability to be used as collateral compared to traditional bonds. Developing an on-chain secondary market and broader adoption of digital assets would be necessary to support consistent liquidity, but these structures are not fully established yet.

2. Technological and operational integration: Investors need to access the blockchains on which the bonds are issued, and institutions need to connect their legacy systems to these blockchains. Additionally, there is no consensus on whether the issuances should be in private, permissioned blockchains shared among partner institutions, public blockchains (such as Ethereum), or cross-chain communication between them.

3. Novel risks: Risks include operations and security, technology, governance, legal, compliance—including money laundering/financing of terrorism—and settlement finality. Certain risks stem from blockchains’ reliance on unknown third parties, which makes it difficult for financial entities and governments to conduct due diligence and oversight.

4. Regulatory clarity: DTL and securities law are subject to a rapidly evolving regulatory landscape (including tax treatment), which might affect the security, privacy, and ability to buy or sell D-bonds. If laws and regulations regarding DLT-based debt instruments exist worldwide, they are in an early stage, highly varied, and lack harmonization.

Conclusion and next steps

The potential for digital bond issuance on blockchain technology is significant, offering numerous advantages that could transform the debt market. However, key challenges must be addressed for D-bonds to realize their full potential. There must be greater regulatory clarity to balance innovation with investor protection. Further, attention needs to be focused on facilitating the integration of legacy systems with DLT, ensuring seamless access for investors and issuers, and eventually promoting the development of a secondary market. By taking these steps, stakeholders can create a more favorable environment for the growth of the D-bond market, ultimately unlocking its potential for broader adoption and use.

Manuel Valdez Magaña is an LL.M. (Corporation Law) candidate at NYU School of Law and serves as a Graduate Editor of the NYU Journal of Law & Business and as a student member of the Banking Law Committee of the New York City Bar Association. Before attending NYU, Manuel worked as an Associate in the Corporate and Finance team at a leading international law firm in Mexico City. His practice was focused on cross-border M&A, financing transactions, and corporate. He also worked on structuring credit facilities, securitizations, and fintech-crypto-related projects, including banking regulation. His main practice areas were financial services, technology, and banking.