A digital overhaul is gaining momentum in one of the more stubbornly analog sectors of the capital markets. Digital bond issuance totaled about $1.5 billion over the past year, up from almost nothing a year earlier. S&P Global Ratings expects that trend will continue.

For the time being growth remains tentative, though widely spread. Sovereign and corporate issuers have tapped the nascent digital compartment with small issuances, principally to trial new systems. That has been facilitated by traditional finance (TradFi) intermediaries, such as exchanges and banks, which still have a tight grip on the market, although their roles are evolving.

We rated most of the digital bonds that were issued. Our ratings were, in a large part, underpinned by the reassurance offered by back-up systems, including parallel databases and the ability of digital bonds to revert to analog equivalents should the platform on which they were issued fail. Meanwhile, a lack of established regulations, infrastructure, and digital currency usage were overcome by adapting existing regulatory frameworks and using TradFi-owned platforms for issuance, management, and settlement. That ecosystem will evolve as the digital market matures, but the industry's early response to bond market digitalization suggests that, while some intermediaries will be displaced, much of the issuance work will remain in the hands of banks, at least for now.

The Promise Of Digitalization

The main attractions of digital bonds are their offer of greater efficiency and security for issuers, not least due to their use of the blockchain and streamlined issuance processes. There are other benefits too, though they seem to be secondary, for now. Bond fractionalization, which splits an instrument into smaller portions, could enable smaller investors to buy into bonds, including digitalized versions of traditional bonds. Digital bonds should also be adaptable to smaller issuances, opening the door to the market for smaller and midsized companies.

The digital bond market remains a work in progress. Much of the issuance has clearly been focused on testing, both of demand for primary issuance and of the infrastructure. Some key market features are still missing. For example, the secondary market for digital issuance is still a work in progress, which limits digital bonds' liquidity. We could also see digital bonds denominated in digital currencies or stable coins, though we note that such instruments will be exposed to currency-related risks that will need to be considered in our rating analysis.

While it is still early days, digital bonds' potential in terms of cost, security, and access to new sources of funding is evident. It is thus not surprising that issuers are testing the market (see chart 1).

Chart 1

Digital Bond Issuance Is Expanding

The broad advantages of digital bonds help explain why their emergence has not been concentrated in any specific geography or sector, and why we have seen issuance from both corporates and sovereigns. It is notable, however, that issuance has mainly been in developed markets. That can be attributed to the presence in those markets of intermediaries, which invested time and money (particularly in the past year) to build and test issuance and listing solutions.

The battle for market share among those companies could be fierce. One of the attractions of digital bonds is their promise to reduce the role of intermediaries, and completely remove some, thus simplifying and reducing issuance and management costs. The most obvious way this will be done is by moving transactions to the blockchain--a digital ledger that will automatically (and without room for human error) document deals, payment instructions, and payments as they happen. The blockchain will also enable a real time view of the holders of a digital bond, improving an issuers capacity to interact with them as required.

Digitalization is not without its downsides. The use of digital systems exposes investors and issuers to risks related to digital platform stability and its potential for disruption. For now, those risks are being mitigated by the use of off-chain backups (parallel data systems that don't use the blockchain) and the option to switch from digital bonds to a non-digital equivalent, both which can be activated in the event of a major disruption.

Established Players Are Adapting To Stay Relevant

The threat to established bond market players from decentralized financing (DeFi) solutions promising cost and time savings is evident. Moreover the size of the market threatened with disruption is huge. In 2022, the total volume of bond issuance was about $7.3 trillion (see "Credit Trends: Global Financing Conditions: Bond Issuance Is Set To Expand Modestly In 2023, With Stronger Upside Potential," Jan. 30, 2023).

Yet TradFi appears to have learned from mistakes made in other industries and has proactively offered solutions that leverage the new technology. This has enabled established institutions to play a key role in the recent digital issuance, and set the stage for them to maintain control of the evolving market. That effort has also benefited from recent events, which have caused reputational damage to the wider DeFi sector, including sharp falls in some cryptocurrency prices and the collapse of crypto exchange FTX (see "The FTX Crypto Exchange Crisis Will Sharpen Regulators' Focus," Nov. 10, 2022).

The recent acceleration in digital bond issuance has notably been facilitated by the emergence of new intermediary services. We have observed two models of issuance. The first, uses an issuance and management platform provided by a TradFi intermediary, such as those provided by Goldman Sachs or HSBC Orion. The second model, has seen bonds list directly on a digital exchange, for example Six Digital Exchange (SDX), Deutsche Borse's D7, or Marketnode.

In the first option, the process typically consists of creating a digital representation of the bond (or the beneficial ownership in the bond) which is sold to investors and stored on the TradFi platform. In the second case, the bond is listed and stored on the digital exchange.

The common feature of the two systems has been that cash transactions are rarely logged on the blockchain. This is, at least partly, due to an absence of central bank digital currencies (CBDC). Indeed, we have observed only a handful of transactions where a CBDC was used to pay interest and bond principal. Most transactions on TradFi platforms, instead, materialized funds through a native token coupled with traditional payments from a bank--generally the platform's sponsor. Meanwhile, bonds listed on digital exchanges have used traditional payment methods not recorded on the blockchain.

We have also observed a growing number of bonds adapting recently adjusted legislation to replace physical legal documentation with digital versions that are stored electronically.

Fail-Safes Provide Confidence

We rated most of the recently issued digital bonds. Our decision to do that was comforted by either: the existence of an analog bond accompanying the digital version (which issuers could switch between at their sole discretion); or a robust back-up plan that could be activated if the issuance platform failed (such as daily off-chain back-ups). Those measures, combined with cash handling outside of the digital bonds' platform, significantly reduces risk related to the disruption of a platform or a digital exchange where a bond is listed.

The means by which cash transactions linked to digital bonds are kept separate from a platform is relatively simple. In a typical transaction, a digital bond will circulate from the issuer to the investors' wallets. When a bond matures or an interest payment is due, an instruction to pay, and the necessary amount of fiat currency are transferred to a paying agent--typically the same bank sponsoring the platform on which the digital bond is issued. Once the money is received, a native token is minted on the platform and sent to investors' wallets, which can then demand payment in fiat currency in return for cancelling (known as burning) the token. This process is shown in the diagram "Illustration Of Digital Bond Issuance And Repayment" (see chart 2).

In recent digital bond issuance, the platform owner also created an off-chain record of who holds what and what has been paid, which can be switched to if the chain is disrupted or unavailable, for example due to issues with the platform. The absence of cash on the blockchain adds a level of security to transactions compared to bonds that use CBDCs or stable coins. Similarly, if the digital bond is listed on an exchange, the paying agent, which is typically a bank, would play the role of safeguarding money flows.

Chart 2

Toward A Truly Digital Bond

We consider the digital bonds already issued to be only partially digital, notably because they continue to use traditional financial infrastructure and safeguards. Furthermore, DeFi players are unlikely to have had their final say on how the emerging digital bond market will be constructed.

Evolving regulations, the use of CBDC and other stable tokens, and the emergence of tokenized deposits that can circulate on different blockchains will usher in further changes. They could include the listing of digital bonds on decentralized exchanges, and the emergence of digital players with compelling solutions for both bond issuers and investors.

There will be some constants. For example, we expect the bond market's existing regulations (including securities laws, anti-money laundering rules, and Know Your Customer regulations) will continue to apply to digital activities. This may limit the degree to which technology can decentralize the market. Regulators, meanwhile, will continue to act to safeguard financial stability and seek to balance the interests of investors and issuers. Those limitations are unlikely to prohibit bond market participants from securing gains in efficiency, speed of execution, and security--particularly due to the immutability of the ledger in the blockchain.

And digitalization is already delivering other innovations, such as fractional investing in traditional bonds. Singapore regulated BondBlox Bond Exchange, for example, offers investors the possibility of buying a digital slice of an existing, traditional bond. In doing so it has removed the minimum entry ticket, which is typically prohibitively large for average retail investors. We believe that fractionalization services, which use digital bonds to reach new bond investors, could gain traction, especially in the context of rising interest rates. But it remains to be seen what effect regulations, including securities and consumer rules, will have on that potential.

Other innovations may take longer to arrive. We are yet to see, for example, the use of smart contracts, which could calculate and pay interest automatically and effectively sever a digital bonds last link to the analog world. Such bonds would expose their holders to risks related to the quality of smart contract code, and the availability of intermediaries (including oracles) that provide inputs necessary for execution. We expect smart contracts will gain traction in, and disrupt other financial markets well before they are adopted by the digital bond market.

We are also yet to see issuers of digital bonds adopt digital currencies, including CBDCs, stable coins, and cryptocurrencies. In their absence, fiat currency remains dominant and it is unsure if that will soon be replaced. Part of that is due to digital currencies' novelty. Yet bonds issued in digital currency will also come with additional risks, not least those associated with currency stability and permanence. That could give issuers further pause for thought, and would have to be factored into our analysis of an issuance's credit quality.

Related Research

• Siemens AG's First Digital Bond Rated 'A+', Feb 14, 2023
• Credit Trends: Global Financing Conditions: Bond Issuance Is Set To Expand Modestly In 2023, With Stronger Upside Potential, Jan. 30, 2023
• Bulletin: UBS' Inaugural Digital Bond Issuance Diversifies Funding, Nov 09, 2022
• The FTX Crypto Exchange Crisis Will Sharpen Regulators' Focus, Nov 10, 2022
• Stablecoins: Common Promises, Diverging Outcomes, June 15, 2022
• SIX Group AG's Digital Bonds Break New Ground For Global Financial Market Infrastructures, Nov 18, 2021
• Digitalization Of Markets: How Digital Bonds Can Disrupt A $120 Trillion Market, Oct 04, 2021

Writer: Paul Whitfield