HKMA experiments show progress but connective tissue still missing

Benefits of digitalisation projects won’t emerge until they begin to operate together

Institutions like the Hong Kong Monetary Authority are making progress on the journey to modernise capital markets infrastructure. But while individual projects are valuable in their own way, it is not until these pieces of infrastructure join up that the real benefits of tokenisation will emerge.

In the HKMA’s latest experiment with digital green bond issuance, the HKMA created digital bonds, rather than issuing and then tokenising conventional bonds. However, unlike some previous digital bond efforts, investors can access the HKMA’s new digital green bonds via their Euroclear and Clearstream accounts – thanks to external linkages from the Central Moneymarkets Unit (Hong Kong’s clearing and settlement system). This means that the notes are tradeable in the secondary market on conventional infrastructure, which ensures that the digital format does not compromise the instruments’ liquidity.

This is an important step. Digital bond infrastructure that fragments the market is unlikely to be adopted. The ability to sell a security without affecting the price – its liquidity – is a key factor in determining its value.

No matter how great the efficiency savings offered by new market plumbing, it is all but certain that it will have to operate in parallel with the incumbent system – at least at first. Custodians and asset managers will take time to adopt new systems, so for instruments to be as liquid as possible, they must be seamlessly transferable between old and new systems.

Bringing primary and secondary markets together

While enabling digital instruments to be traded on conventional rails is a critical step, for tokenisation to have a truly transformative effect on market infrastructure, the new plumbing must function for both primary and secondary markets. Modernising the primary markets issuance processes is important, but most trading takes place in the secondary market.

Although, the secondary market trading of HKMA’s digital bonds occurs on traditional rails, elsewhere, tokenisation has already been applied to secondary market operations.

Several funds, mostly based in the US, have already begun tokenising exchange-traded funds and money market funds to improve the efficiency of their operations. The customer’s experience does not change at all, but the funds are able to reduce their overheads and the risks inherent in their operations.

Extending this infrastructure to become a market-wide utility will require extensive experimentation and collaboration between public and private sector institutions. Yet the fact that the technology has been implemented in live use cases suggests that there should not be insurmountable technical obstacles. The challenge will be to coalesce around shared standards to ensure interoperability.

Bring cash settlement on ledger

As well as being able to handle both primary and secondary trading, unlocking the true potential of digital capital markets requires a means of settling the cash leg of the transaction on-chain. On-chain cash settlement allows for settlement of the asset and the cash legs of a transaction to be delivered atomically – eliminating counter-party risk. It also means the lifecycle payment of the security can be made automatically.

Whether instant settlement is desirable remains to be seen and will likely vary based on the asset class in question. But having both asset and cash on-chain is likely to make the settlement window a great deal more flexible than having just one.

The technology to deliver this exists. Private sector stablecoins are traded in enormous volumes every year and HKMA’s own Project Ensemble will allow the settlement of tokenised money and is intended to enhance the HKMA’s other tokenisation projects – its digital green bonds, carbon credits and more.

The components of the next generation of financial infrastructure are emerging. Many of the key technical challenges have been overcome in isolation. What remains is developing the connective tissue that will allow them to operate cohesively.

Lewis McLellan is Editor of the Digital Monetary Institute at OMFIF.

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