“Bond” or “Debt” is one of the oldest financial instruments to be used by mankind. According to Wikipedia, the first known bond in history dates back to 2400 BC in Nippur, Mesopotamia. Eons before its more glamourous cousin “Equity” or “Stock” made its debut in 1602 with the first-ever joint-stock corporation, the now infamous Dutch East India Company. However, owing to its lack of the aforementioned “glamour” quotient (measured by the thrill-ability of making you rich overnight), Bond hasn’t quite gone mainstream as direct equity has, especially in the everyday-man’s investment portfolio. It has remained the fiefdom of big conglomerates, corporations, pension funds and mutual funds. While the majority of new-age tech and finance-savvy young investors are more than happy to dabble in and hold direct stocks in their portfolios, the only way they invest in bonds is through their mutual fund units.
The disparity between the two asset classes is starker, the more you move away from developed economies like the US and the UK to developing economies like India. There are various reasons why bonds haven’t seen the same level of retail participation as stocks have, apart from the one mentioned above.
- The bond issuance and lifecycle management are still paper-based in a lot of economies around the world. This makes it slow and prone to errors.
- The cost of bond issuance and management is high for corporates due to the presence of myriad self-serving, rent-seeking intermediaries like investment/merchant banks, syndicate members, asset managers, agent banks, payee banks, custodians, clearing houses, etc. The list is an un-ending one, with every entity working in separate silos.
- The process is not only time and resources-consuming for the corporate looking to burrow, but also requires a lot of know-how to file the correct documentation. Cue the intermediary banks, who charge a bomb for their specialized services.
- The aptly-named syndicate members comprise of investment banks, wealth managers, broking houses, etc., who sell the bonds to their client-base consisting of institutional treasuries, mutual fund and pension fund houses, family offices, HNIs and finally retail investors, etc. The syndicate doesn’t do it out of the goodness of their heart, but for hefty commissions, many-a-times both upstream as well as downstream.
- Bonds typically have a much higher Minimum investment amount compared to stocks. This results in the average investor giving them a wide berth, unlike many stocks which can be bought for pennies on the dollar.
All of the above reasons and more, compel the bond issuer to take the route of “Private placement”, which by nature precludes the retail investors from participating. The bond issuer doesn’t get the economies of scale that mass retail participation could provide, while the retail investors lose out on a stable and inflation-adjusted mode of saving or investment. Close to 90% of all bond issuance in India happens through private placement instead of through public offer. This also makes the bonds much more illiquid compared to stocks in the secondary markets.
A healthy, liquid and mass-adopted bond market is a pre-requisite for development as shown by all the leading economies of the world. If India has to realize its ambition of becoming a $5 Trillion economy by 2024, developing the bond market is imperative. Banks cannot serve the expansion and working capital needs of all the corporates as well as SMSEs efficiently, nor do they have the risk appetite for it. Only an efficient, agile and liquid Bond market can. This can happen with the application of Blockchain technology in the bond issuance and lifecycle management. Let’s take a brief look at the recent innovations, which can ultimately lead up to Blockchain “saving the day” for the bond market.
The earlier bond issuance and lifecycle management process was a paper-based one. It made the payment and settlement process for the bonds very long and complicated due to the movement of physical paper through many convoluted channels, while also making the process very expensive, inefficient and error-prone. These problems were solved to an extent by the digitization of all records and making the bonds issuance and management process completely paper-less. The issue of centralization of economic power and lack of regulatory oversight was solved to an extent, by giving greater power to regulators like SEBI and introducing multiple parties like agent banks, merchant banks, custodians, counterparties, exchanges like NSE, BSE and making all payments mandatorily through central clearing houses. However, these multiple systems/authorities involved in the process existed in silos, creating the need for continuous reconciliation of records among them, thereby keeping the settlement cycles long. This could be solved by implementing a distributed ledger infrastructure (DLT) among all the major participants in the bonds’ lifecycle, where every participant would have and agree on the same information on the bonds real-time. However, the implementation of DLT was held back due its inherent security issue known as Byzantine Generals Problem (BGP). If 50% or more of the participants fell off the grid or turned rogue, the information on the DLT couldn’t be trusted to be immutable any longer. “Bit Gold” proposed by Nick Szabo first attempted to overcome this problem by proposing a decentralized currency based on “computing a string of bits from a string of challenge bits”, introducing innovative concepts like “proof of work (PoW) function” and “client puzzle function”. This, along with the consensus mechanism of having at least 50% of participants or nodes to agree on the longest chain with the highest cumulative PoW as the only legitimate version of truth, helped overcome the BGP problem in a decentralized network. While Bit Gold never went live, it became the precursor to arguably the most seismic tech invention in recent times “Bitcoin”, proposed by Satoshi Nakamoto. Bitcoin improved on Bit Gold and was also able to solve the problem of double-spending. Double-spending is the act of easily copying and reusing the same currency twice, without the presence of a central authority to decide whether a coin has been spent more than one time by the same person or participant. This was achieved by implementing distributed peer-to-peer timestamp servers, which generate computational proof for the chronological order of transactions stored in a chain of blocks called the Blockchain which forms the ledger or the database of the network.
While, Bitcoin presented a distributed ledger technology which could be reliably used for “transfer and store of value” in a decentralized, immutable, transparent and reliable manner, it could neither automate the payment & settlement process and hence, disintermediating the bond issuance process, thereby it near instantaneous. This final hurdle can now be solved with the introduction and evolution of the ‘Smart Contracts” technology pioneered by Ethereum.
Using this technology, Blockchain can finally help in removing or at least deleveraging the multiple intermediaries in the bond ecosystem by automating the bond contracts between the producers and the end consumers in the value chain. Smart contracts can also help with tokenization of bonds. These Bond Tokens possess the unique characteristic of embodying both the ownership as well as value of the bond in a single construct, without the need for a central authority to record and prove the ownership. Tokenization can also help in fractional ownership of bonds, allowing them to be traded directly in much smaller denominations, without the need for an investor to take the mutual fund route. This will enable mass-adoption of bonds as well as solve the problem of illiquidity in the secondary bond market.
The stage is set. The technology, infrastructure, know-how, everything is set. For the ultimate revolution in the bond market to begin, only thing it needs is regulatory openness and willingness to take the plunge.