On 27 April 2021, the European Investment Bank (EIB) issued a digital bond through a series of bond tokens on a blockchain platform, where investors purchased and paid for the digital bond using traditional fiat currency and smart contract functionality. The EIB launched the digital bond in collaboration with a syndicate of investment banks as the underwriters.
This successful public sector EIB issuance shows that the digitalization of capital markets is likely to bring benefits to market participants. In this edition of In The Know, Baker McKenzie provides a primer following the developments of in the digital bond space, using the EIB bond as a potential bellwether event for future developments in our markets.
Digital bonds can reduce the need for intermediaries and therefore lead to lower fixed costs provide better market transparency by increasing capacity to see trade flows and the identity of asset sellers and buyers and provide a much faster settlement speed. While there are still development milestones necessary to make these benefits apparent, the private sector has begun discussions on how to enter this space.
Here are some of the foundations of this up and coming digital arena – with some key takeaways:
- Digital bond. These are decentralized tokens that are issued on a blockchain platform that aim to be a store of value or a medium of exchange. This kind of digital representation would be the logical next step in the evolution of capital markets and fixed income securities.
- Distributed ledger technology. This can be used to provide a shared record of transactions and/or account balances for a specified set of cash assets and securities and their holders. The distributed nature of the platform avoids the need for an intermediary to control access rights and so transactions can be carried out without a recognized third-party central governance institution to validate and approve these transactions. Participants can consider the status of the ledger as authoritative.
- Blockchain. By using blockchain, issuers are able to have greater transparency over trading. The use of blockchain technology to record transactions allows for a single source of information that the participants share. It can minimize intricate and laborious back office reconciliation between parties.
- Smart contract. This can be used to define and perform the obligations of a legally binding contract — some or all of the contractual obligations can be defined in and/or performed automatically by code. As the automation by computer of a smart contract requires the legal rights and obligations to be translated into code, the code must be verified and validated to ensure it has been designed to meet the necessary contractual requirements.
Although recent developments indicate that digital bonds are the future, regulations are still critical – specifically around issuance and settlement, trading, custody, and post-trade operations and processes. The European Union is beginning to establish this regulatory groundwork through the European Commission’s proposed Markets in Crypto-Assets (MiCA) Regulation. Several proposals in consideration intend to create a structured market that lines up to those of more traditional financial instrument of debt.
You can read more about this in the new edition of In The Know – Leveraged Finance Newsletter. The full article provides more information on the foundational requirements and enablers of digital bonds, and an in-depth look on key regulatory developments and considerations.