Piloting a path to better secondary markets

DLT has the potential to inject long-overdue efficiencies and enhanced liquidity into fixed income market infrastructure

IF YOU’RE a tombstone engraver preparing elegant epitaphs for paying agents, depositories, clearing counterparties and other intermediaries across the life cycle of bonds, it may be as well to set your chisel to one side.

Innovation in blockchain and distributed ledger technology is unlikely to bring about the imminent and wholesale dismantling of long-entrenched processes in the $120tn global fixed income market. ‘Grand visions of disintermediation or total digital transformation at scale are still far from being realised,’ observed the World Economic Forum in a report published in collaboration with the Boston Consulting Group in May 2021.

Charlie Berman agrees. As a fixed income veteran who combines four decades of experience in the bond market with a keen interest in the possibilities arising from its accelerated digitalisation, he is well worth listening to. The former Salomon Brothers, Citigroup and Barclays banker is co-founder and chief executive officer of agora digital capital markets, which in February announced that it had completed a series of successful digitalised multilateral pilot syndicated bond trades. These were intended to demonstrate the ‘workability and readiness of the [agora] product to handle the complex challenges faced in the primary market by the world’s leading global and regional issuers and investment banks.’

Berman emphasised that agora’s focus is on end-to-end digital support throughout a bond’s life cycle. He believed that it is impossible to maximise efficiencies at the primary level without addressing antediluvian post-trade deficiencies: ‘One of the reasons the primary market is so dominant is because secondary market buy and sell liquidity is inadequate,’ he said.

Berman did not subscribe to the view that generating efficiencies in the fixed income market is contingent on dismantling the entire process of its administration from mandate to redemption. ‘Our vision encompassing the full lifecycle is realistic and achievable precisely because it means collaborating with many other service providers in the chain that defines the life of a bond,’ he said. ‘This is a highly regulated and concentrated industry demanding extremely high levels of security, speed, scalability and compliance.’ To believe that the mechanisms greasing the wheels of this market will be swept away overnight by decentralised finance, said Berman, is not credible.

None of this means that the incumbent system is not ripe for an overhaul. Berman said that there has been precious little change in the four decades that he has been working in the debt market.

A starting point, he added, is using the shared ledgers agora is applying to the digitisation of workflows to reduce and simplify what he described as the ‘cacophony of communication mechanisms’ in the market.

From the perspective of the secondary market, most, if not all, of these benefits remain theoretical, chiefly because trading volumes in the smattering of so-called blockchain bonds launched over the last 12-24 months have been low. This is unsurprising, given that issue volumes in these experimental exercises have been tiny. The first end-to-end blockchain bond to emerge from Santander’s petri dish was a $20m deal placed within one of the bank’s units. Santander described this as a ‘first step towards a potential secondary market for mainstream security tokens in the future’.

The digital bond put together by the European Investment Bank on the Ethereum public blockchain in April 2021, meanwhile, was a €100m two-year issue distributed as a private placement. This was a pinprick for an issuer which raised €55bn in 2021, and which has a stated policy of meeting 60% of its borrowing needs through benchmarks of between €3bn-€5bn.

Its modest size did not mean that the architects of the EIB bond never intended it to be a tradable instrument. As many as 20 asset managers engaged in some OTC trading in the EIB issue, according to Jean-Marc Stenger, chief executive officer of Société Générale Forge, the subsidiary set up by the French bank in 2018 dedicated to the development of digital capital markets. ‘But to be honest, few of these investors were expecting to extract profit and loss from trading it,’ he said. ‘They became involved in the secondary market because they wanted to access the legal documentation and learn about how the system worked.’

Did this mean that the secondary market was a secondary consideration for the borrower? Not quite. ‘We would not go so far as to say we never expected to see any secondary trading in the bond,’ said Richard Teichmeister, head of funding – new products & special transactions, at the EIB. ‘But we have to recognise the technical constraints that limited secondary market activity. On the one hand, was it legally possible to structure a bond so that its secondary market was likely to be liquid? On the other, was the bond sold on a platform that could be easily accessed by everyone? The answer to both questions was: not necessarily.’

The technology for digital bonds will likely be provided by?


Public or Private?

Market participants believe the expansion of the investor base at the secondary level will be one of the longer-term benefits associated with the more widespread use of blockchain and DLT. ‘From a secondary market point of view, it should be more straightforward to locate bonds and easier and cheaper to manage the admin involved, such as processing corporate actions on the bond, settling interest and so on,’ said David Brickell, director of institutional sales at BEQUANT. ‘That should make the market more accessible, while tokenisation and the fractionalisation of bonds should allow for a more diversified investor base, with smaller investors able to participate more easily.’

Asia appears to be ahead of Europe in its use of technology to broaden investor participation in the bond market. Singapore-based fintech BondEvalue has accelerated the process of democratisation of fixed income markets by launching the world’s first blockchain-based bond exchange. This allows investors to trade BondbloX, which are $1,000 fractions of traditional wholesale bonds. BondbloX deploys hyperledger sawtooth, a permissioned network which the network describes as a ‘great fit for creating a broad but closed framework of approved participants’.

Pilot regime: game changer for secondary markets?

Perhaps the most important landmark for the secondary market in digital bonds is the European Commission’s DLT pilot regime, the proposal for which was originally published in September 2020. This appears to clear the way for the removal of at least some of the regulatory constraints to the development of a more vibrant secondary market.

Under this initiative, service providers such as central securities depositories and other regulated market operators will be able to establish DLT multilateral trading facilities and DLT trading and settlement systems. A briefing published in January by law firm Ashurst explained that firms operating this DLT infrastructure will be exempt from certain markets in financial instruments directive and central securities depositories regulation requirements which could otherwise inhibit the issuance, trading and settlement of tokenised securities using DLT. The DLT operators would instead comply with alternative conditions, which will be set out in the pilot regime regulation.

This has far-reaching implications for secondary market liquidity. ‘The pilot regime will be a game changer,’ said John Whelan, managing director of crypto and digital assets at Santander, which arranged the EIB deal alongside Goldman Sachs and Société Générale Forge. ‘We’ve already done DLT-based primary issuance, we’ve done multi-dealer issuance and we’ve done settlement with digital cash and with synthetic central bank digital currency.’

‘This is the next step because it will give practitioners the authority they need to list these instruments and provide them with secondary market liquidity,’ Whelan added. ‘Discussions are ongoing for a similar arrangement to be put in place in the UK in 2023 and the US won’t be far behind. So the secondary market for programmable digital securities worldwide will hit a tipping point over the next year or so.’

But there are some significant restrictions on the size of assets eligible for the pilot regime. The most notable of these is that bonds and other forms of securitised debt must have a maximum issuance size of €1bn to be admitted to trading, while sovereign bonds are ineligible. This implies that benchmark bonds from regular borrowers such as supranationals are effectively ruled out.

Bankers said they are relaxed about these apparent shackles for several reasons. Stenger said that the guidelines on eligibility cover about 70% to 80% of the potential market for DLT bonds. He added that in any case discussions are already underway with a view to securing local regulators’ approval for lifting these limits.

Whelan echoed Stenger in emphasising that the pilot scheme is a transitory initiative, due to last for three years. ‘It’s called a pilot regime for a reason,’ he said.

Whelan said that the most important feature of the pilot regime is that it shifts the focus away from the experimental and theoretical and towards practical use cases. ‘It’s easy enough to show proofs of concept for digital bonds on PowerPoint presentations,’ he said. ‘But the pilot regime involves real institutional money and real systems. It doesn’t really matter if it’s 10m or 100m or 500m. It’s about proving that the system works.’

This is key, because as Stenger argued, once the efficiency of the infrastructure has been put to the test, issuance sizes, overall volumes and secondary activity will increase in lockstep. He said that Société Générale Forge is now discussing its digital solution with several prospective borrowers, some of which are contemplating new blockchain issues in the €100m-€500m range.

‘With the pilot regime in place, in less than two years we will start to see the first billion euro deals applying this type of solution,’ said Stenger. This implies that there may be a lengthening of the maturity of digital bonds, with issuers looking towards more strategic maturities than the short-dated experimental trades launched to date.

This in turn should generate more symbiosis between supply and demand. ‘This is a chicken and egg process,’ Stenger added. ‘Secondary demand will grow because investors will be attracted by the increasingly high quality of issues. And we are talking here about real money investors, not about hedge funds trading cryptocurrencies.’

Whelan agreed the pilot regime will attract a diversified range of issuers. ‘I strongly suspect that the leaders on the issuer side will be the supranationals and large corporates with innovation teams within their treasury units that are looking to move the needle on this,’ he said. ‘But I think it may also be interesting for smaller issuers and possibly smaller banks that want to expand their product offering to SMEs.’

Do you think that blockchain will be the technology underpinning digital bonds?

Yes, private or permissioned blockchains
Yes, public
No, some other non-distributed database

Reduced costs

At the EIB, Teichmeister remains confident about the long-term potential of DLT to increase efficiency for borrowers across primary and secondary markets. ‘If you think about a floating rate note, for example, the daily fixings are currently done by the issuer, the paying agent, the lead managers and by investors,’ he said. ‘Everybody is doing the same thing, but they often reach different results. We may only be talking about cents, but time-consuming reconciliations arising from these differences could be eliminated if everybody refers to the same golden source.’

Whelan agreed. ‘If we do this properly, we should be able to bring down the costs of issuance substantially through maximum digitalisation,’ he said. This means optimising the use of digital cash and programmable securities to eliminate many of the labour intensive functions that have kept costs elevated.

‘If you have programmable digital cash, you can do all kinds of things in reducing intermediaries,’ he said. ‘We know, for example, that if you have programmable digital securities on one side and programmable cash on the other you can enforce atomic settlement via a cryptographic cross-ledger.’

Effecting the cost savings that could be generated by streamlining time-honoured administrative functions may be easier said than done, because there are still plenty of vested interests that have no incentive to expedite change. ‘There is likely to be a lot of regulatory and political resistance,’ said Soren Mortensen, a former Morgan Stanley, BNP Paribas and HBOS banker who is now global director of financial markets at IBM. ‘This is because today, too many people are making a lot of money out of inefficient markets.’

In an address on the implications of atomic trading in securities markets last year, Securities and Exchange Commission Commissioner Hester Peirce insisted that these blockers should not be allowed to frustrate technological innovation. ‘Resisting regulatory changes that would permit new ways of doing business (or insisting on regulatory changes to forestall technological innovation) may be a matter of life or death for some of these legacy firms,’ she insisted. ‘We regulators should refuse to allow ourselves to be used to block new firms from coming into the industry with fresh, new ways of doing things.  We must do what is best for investors and markets.’

Mortenson believed that resistance to change will be eroded as pressures grow for more efficient networks. Some of those pressures, he said, may come from industries that in some cases are adopting blockchain technology and tokenisation more quickly than many banks.  As an example, he pointed to the TradeLens project that IBM originally developed for AP Moller-Maersk in 2018. This uses blockchain technology to help the Danish shipping company to track the movement of its containers across the world. Today, said Mortensen, many of the largest carriers have joined the network and track over 65% of global trade. By early this year, the TradeLens platform had tracked more than 55m container shipments, 4.7bn events and over 25m published documents.

Fundamental to the success of this project, Mortenson explained, has been the development by IBM and HSBC of a tokenised bill of lading which is increasingly being used by banks to support their trade finance risk management processes. ‘Because every update on TradeLens triggers a payment or an foreign exchange transaction, this is the sort of platform that financial institutions are going to use in order to provide more customised services for their corporate clients,’ said Mortensen. ‘Because if they don’t, I can promise you that plenty of fintechs will be lining up to offer those types of services based on the same data.’

Potential of smart orders

The potential for DLT to inject long-overdue efficiencies and enhanced liquidity into secondary market infrastructure in the fixed income space has attracted scores of enterprising fintechs. One of the most compelling of these is LedgerEdge. This was co-founded in 2020 by David Rutter, founder and chief executive officer of R3, and David Nicol, who was previously head of digital assets at R3 and is now LedgerEdge’s CEO.

Nicol said that the idea for LedgerEdge had been in formation for many years. But he explained that its genesis dates to 2019, when he was working for R3 on the development of the ground-breaking SIX Digital Exchange in Zurich, by which time the technology for LedgerEdge’s execution had ripened. ‘That was a compelling test case of the potential of DLT to improve processes when data is scarce and therefore valuable, making data leakage very painful,’ he said. ‘This makes market participants’ control of data and trading intentions important, especially where assets are relatively illiquid.’

The identification of the value that could be added in the secondary market for less liquid assets through the creation of a DLT-powered search engine encouraged Rutter and Nicol to concentrate on opportunities in the $40tn-plus corporate bond market. ‘We’re starting with corporate bonds because over 60% of trades in even the most liquid part of the market are still voice-negotiated,’ Nicol explained. ‘Believe it or not, someone even told me the other day that they had just completed a trade over a fax machine.’

LedgerEdge’s response to these inefficiencies is a permissioned smart order ecosystem in which users display data not just on orders and holdings but also on their trading intentions. This data is searchable on a node-to-node, person-to-person basis, allowing users to engage, negotiate and trade on a regulated venue. LedgerEdge is authorised as a multilateral trading facility in the UK and expects to be granted alternative trading system status in the US and multilateral trading facility status in the European Union soon.

For the time being, LedgerEdge’s DLT is focusing on bolstering transparency and liquidity in legacy securities by digitalising orders rather than assets. ‘We could have started by saying we’d only trade pure digital assets,’ said Nicol. ‘But as there aren’t many of those yet, we saw a much larger opportunity in the legacy asset space.’

Nicol said that allowing users to engage bilaterally on a node-to-node basis means they can agree how and when to exchange information, trade and settle. That won’t expedite atomic settlement in the legacy corporate bond space just yet. But Nicol is confident that it will help eliminate some of the inefficiencies in today’s clunky settlement cycle. ‘I don’t think anyone is expecting corporate bonds to move towards delivery versus payment or T-plus-zero settlement soon,’ he said. ‘But everybody is clearly looking for a more efficient settlement solution. Eventually I think this will take the form of an asset that is easier to settle. This will probably be some form of obligation token which will be netted off and cleared in cycles, and then settled on a reasonable basis allowing standard corporate bond trading desks to make more efficient use of their capital throughout the day.’

Nicol said that interest in the LedgerEdge smart order system is gathering momentum among broker-dealers and investors alike. ‘We started with 18 sell-side and 21 buy-side firms and we are now onboarding around 40 customers in the UK and the US. So we believe volumes will be ramped up significantly over the next three to four months,’ he said.

Nicol said that there is already clear evidence that investors are eager to leverage the efficiency gains promised by technology such as DLT. ‘I think it’s a myth that the buy-side is technology averse,’ he said. ‘We’ve had some wonderful conversations from the very beginning with asset managers who have to figure out a way to generate alpha to allow them to compete with low or no-fee brokerages.’ Those managers, he added, have been highly receptive to the opportunity presented by DLT allowing them to retain control of their data and engage the market with intelligent orders.

LedgerEdge’s focus will remain on the corporate bond market for the foreseeable future. But Nicol said that from a technical perspective there is no reason why the smart order mechanism can’t be applied to other fixed income instruments, or even to other asset classes, such as equities.

Stenger agreed about the applicability of digital solutions to a variety of asset classes, saying that programmable securities lend themselves especially well to structured products. ‘Structures with a more complex payoff than a vanilla bond are a dream for banks using this technology,’ he said. The Liechtenstein-based Bank Frick has already acted as a pioneer in this area, using the Ethereum blockchain to automate waterfall cash flows in the market for corporate loan securitisations.

Elsewhere in Europe, a number of fintechs are already exploring how digitalisation and DLT can be applied to traditionally illiquid markets. One example is the Frankfurt-based VC Trade, which is driving digitalisation in the German Schuldschein market. Its co-founder and managing partner, Stefan Fromme, said this is already creating extensive efficiencies at a primary level by integrating workflow, documentation, ownership transfer and payments into a single venue. This process, he said, has reduced time to market for Schuldschein issuers from between four and eight weeks to a matter of days.

The VC Trade blueprint suggests that the willingness to embrace new blockchain-related technology extends to investor bases that may traditionally have been regarded as conservative.  Fromme said that as much as 95% of the existing Schuldschein investor base is already onboarded to the VC Trade system, which equates to about 850 accounts. About 60% of these investors, he said, are from outside German-speaking Europe, which suggests that digitalisation is supporting the internationalisation of markets once regarded as parochial.

Fromme said the potential of DLT to enliven secondary trading in Schuldscheine is probably limited, chiefly because of its appeal to buy-and-hold accounts. Where Fromme saw more potential is in the market for institutional term B Loans. Trading in these has historically been constrained in part by the requirement for third party consent for transfer of ownership, which has been a time-consuming manual process. Fromme explained that by applying smart contract technology to the secondary market for loans, DLT can be used to allow borrowers to pre-authorise the transfer of risk at the click of a mouse.

Who should bear the costs of new digital infrastructure?

Investors (via reduced yield in exchange for improved liquidity)
Others (Banks, issuers and investors)

Chasing squirrels up a tree?

‘We tend to over-estimate what technology can do over a three-year horizon, but under-estimate its potential from a ten-year perspective,’ said VC Trade’s Fromme, citing the evolution of iPhone technology as a recent precedent.

Ten years may be a more realistic timeframe than three in which the full benefits of DLT are likely to be applied across the life cycle of bonds. These benefits would fulfil the vision of what Ken Monahan, a senior analyst at Greenwich, described in a 2019 report as the ‘DLT maximalists’. They have argued that this technology should supplant rather than enhance the existing clearing and settlement system. DLT’s most vocal evangelists contend, wrote Monahan, that ‘cryptographically enforced contracts can make secure settlement instantaneous and default impossible, thus obviating the need for posting collateral.’

It’s easy to see why the achievement of atomic or instantaneous settlement is regarded by so many of DLT’s most vocal advocates as a virtual nirvana for bond markets. They believe that the existence of an absolutely binding and universally recognised digital handshake would make operational and counterparty risk a thing of the past. This is because the recourse by all market participants to a single, trusted golden source of truth would allow trade confirmations, affirmation, allocation and settlement to be combined into a single step.

As a report published by Deloitte in 2020 said, this would make reconciliations virtually superfluous. It would make central clearing functions increasingly obsolete and reduce or even eliminate collateral requirements. And from the perspective of investors, atomic settlement in digital currencies would allow for the frictionless flow of data and stores of value among market participants. This would in turn help to free up liquidity, injecting more dynamism and visibility into secondary markets.

Industry-wide, the cost savings ought to be dramatic. They would also be timely. An Oliver Wyman/Morgan Stanley report published in 2020 noted that over the last decade European banks in particular have seen their capital and revenue fall faster than their costs, eroding their return on equity. Small wonder that even before the Covid-19 pandemic, cutting trading costs was already ‘squarely in the crosshairs of banks and broker-dealers trying to wring inefficiencies from every part of their operations’. So said a Depository Trust and Clearing Corporation white paper on the cost savings of post-trade automation released in November 2020.

Deploying technology as the deus ex machina that could sweep many of these costs away is appealing, but it will not be straightforward. Nor may it be as alluring to the buy-side or to regulators as it is to banks or fintechs with powerful incentives to accelerate digitalisation across securities markets. As Kevin McPartland, head of market structure and technology research at Greenwich said, factors such as regulatory uncertainty and market volatility may explain why some investors remain reluctant to explore the potential of decentralised finance and crypto.

Regulators, meanwhile, recognise the benefits of the speed and efficiency which DLT and smart contract technology can bring to securities markets. They too are alive to their risks, as SEC Commissioner Peirce observed in a speech last year. Although her focus was mainly on accelerated settlement in equity markets, the potential vulnerabilities she identified may be common to several asset classes. ‘New technology may make real-time settlement possible, [but] before deciding whether it is the right solution, we should fully analyse the costs and benefits,’ said Peirce.

‘Real-time settlement would address many of the concerns around central clearing and margin calls… Widespread adoption of real-time, or at least near real-time, settlement of transactions in equity securities, however, would require a major overhaul in the way equity markets work and could harm liquidity by raising the cost of making markets. Certain elements of our financial system as it is currently structured work precisely because of the delay between execution and settlement. An expected drop in margin requirements might not make up for the inability to net transactions, much less the operational risks — and ensuing costs — of settling transactions on a gross basis and transferring large amounts of cash and securities throughout the day. In addition, the time built into the settlement cycle now makes error correction easier and allows for human intervention, a feature that a smart contract is designed to eliminate.’

A similar reservation was expressed in a report on the future of securities settlement published by the Bank for International Settlements in March 2020. This noted that ‘Distributed ledgers may shorten settlement cycles by streamlining reconciliation processes and reducing the number of intermediaries. A shorter cycle lowers the exposure to replacement cost risk without the need for a central counterparty. That said, market participants might not want to move to shorter settlement cycles, as this could increase liquidity requirements and give market-makers less time to source the cash or securities needed for settlement.’

Another factor that could delay the benefits that digitalisation may bring to trade processing in bond markets is the lack of standardisation and efficient interoperability across systems and platforms.

‘The financial industry is the ultimate network business, which depends on standardisation,’ said Whelan. He added that the impetus for more joined-up thinking on interoperability across the financial services industry may come from the DLT world. ‘The open source community created standards for itself in a fraction of the time that it has taken the financial industry to achieve standardisation,’ said Whelan. ‘That’s because, to use an Americanism, creating standards is like herding cats. Or to use an Irishism, it’s like chasing squirrels up a tree. It’s difficult.’

Difficult indeed. But the ultimate rewards will make the effort worthwhile. Stenger said that demand for increased efficiencies among issuers and investors across primary and secondary markets is coinciding with a symbiotic digitalisation of cash. This is kick-starting a virtuous circle of innovation. ‘With progress advancing towards the launch of a digital euro in 2025, all the elements within the value chain are converging,’ he said. ‘This will generate exponential growth in the adoption curve and shape the future of capital markets.’


The European Investment Bank put together a two-year issuance on the Ethereum blockchain in April 2021


Total amount raised by the EIB in 2021


Container shipments tracked by TradeLens by early 2022

What the experts say

‘With the pilot regime in place, in less than two years we will start to see the first billion euro deals applying this type of solution’

Jean-Marc Stenger
Chief executive

Société Générale’s Forge

‘From a secondary market point of view, it should be more straightforward to locate bonds and easier and cheaper to manage the admin involved’

David Brickell
Director of institutional sales


There is likely to be a lot of regulatory and political resistance. This is because today, too many people are making a lot of money out of inefficient markets.

Soren Mortensen
Global director of financial markets


‘We regulators should refuse to allow ourselves to be used to block new firms from coming into the industry with fresh, new ways of doing things. We must do what is best for investors and markets.’

Hester Peirce

Securities and Exchange Commission

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