In April 2021, European Investment Bank (EIB) broke the three-year blockchain drought with the issuance of a €100 million (US$113 million) two-year bond. This transaction addressed several of Bond-i’s issues but presented a raft of challenges of its own. The EIB and World Bank deals also suffered from one key common problem: the lack of a central-bank digital currency (CBDC) for settlement.

While the debt of World Bank’s deal was represented digitally, the cash used to settle was fiat, slowing down settlement and opening investors to tax burdens due to Australian regulation treating the deal as an FX trade. EIB’s transaction solved the cash problem with the use of a customised ethereum ERC20 token. But as a result – and unlike the World Bank deal – secondary trading is not available.

Yuriy Popovych, director, fixed income syndicate at TD Securities in Singapore, says the early deals represent proof of concept. Supranational issuers are innovating to test capabilities and understand the challenges they presented, just as they did with the development of green bonds a decade ago.

“The early deals have been very successful – World Bank in particular managed to tick a lot of boxes, allowing for quite a bit of functionality,” Popovych says. TD was brought in to the Kangaroo transaction to joint lead a A$50 million tap of the line in 2019, shortly before the issuer commenced secondary-market trading in August the same year.

Popovych adds Bond-i’s structure was not set up to attract new issuers. He says: “Its main limitation was settlement via fiat currency, which introduced manual processes – which is not really the point. But as a proof of concept, it worked really well.”

Andrea Dore, Washington-based head of funding at World Bank, says the blockchain bond market requires further development but the benefits can be profound. She adds: “We did many parts of the Bond-i execution on the blockchain platform but the actual cash payments were done ‘off chain’ because we did not have a CBDC. Having the bond and cash ledgers on the blockchain platform would have increased the efficiency gains.”

This may soon be possible. In early December 2021, Australian policymakers released a raft of official communications addressing DLT and the development of a CBDC. Chief among them was the Reserve Bank of Australia (RBA)’s joint Project Atom, a collaborative research project undertaken over the past year with CBA, National Australia Bank, Perpetual and ConsenSys, with input from King & Wood Mallesons. The project examines the potential use and implications of a wholesale form of CBDC.

The announcement coincided with a speech on the future of payments delivered by RBA governor Philip Lowe on 9 December that included a focus on DLT. Federal treasurer Josh Frydenberg on 8 December also released plans to regulate the industry in 2022, aiming to make Australia a leader in the new technology.

Sophie Gilder, Sydney-based head of blockchain and digital assets at CBA, notes the regulatory agenda on DLT and the exploration of a CBDC is encouraging. There was much more scepticism regarding the technology just three years ago, she adds. “When we did Bond-i, ideally we would have had a CBDC to settle so we could achieve an atomic transaction,” Gilder explains. “Within database management, an atomic transaction is an indivisible and irreducible series of operations such that either all occur or none do. This eliminates settlement risk.”

Gilder continues: “The vision is that, in future, there will be digital assets on one side and digital currency on the other, providing all the benefits of the asset and payment being in an interoperable system with embedded rules via smart contract. But they have not developed at the same rate, partly because implementation of a CBDC is very complex. Policy implications have to be well-considered.”

A CBDC is important as the coin could be backed by the full triple-A creditworthiness of the sovereign. Bank-issued coins receive the issuer’s rating unless the structure uses exchange-settlement accounts at the central bank or other structural features to strengthen the underlying.

“An individual commercial-bank-issued currency might work in a some contexts but it is challenging to make it work in the wholesale market, as the institutions and counterparties will reach their counterparty exposure limits quickly due to the credit rating,” Gilder says. “Other decentralised digital currencies, such as bitcoin, are incredibly volatile and are not widely accepted by institutions today.”

Gilder adds the various regulatory announcements in December – particularly Frydenberg’s – are far reaching and exactly what the market needs to accelerate development. “It will enhance innovation if market participants in financial services know where the guardrails are,” she comments. “When the regulatory position is clear it will accelerate adoption in the market because participants will know what is allowed and what is not.”

Dore says World Bank explored several options regarding settlement of Bond-i but was limited without a CBDC. “We considered cash settlement via an exchange of fiat-like tokens but there were constraints that prevented its use, for instance, the requirement of an exchange license to convert fiat currency to token and a tax that normally applies to those transactions.”

The bond market has evolved before and will do so again. Bearer bonds matured into registered securities, streamlining interest payments and increasing security. Some believe DLT could eventually become as dramatic a change-agent to the fixed-income market as anything that has come before, giving issuers the ability to automate the lifecycle of their transactions on the blockchain, making settlements instantaneous, increasing liquidity and cutting out costly custodians. Issuers will also be able to fractionalise bonds, potentially appealing to a wider investor base.

Dore comments: “The transaction went well from launch to settlement. We were also able to reopen the bond, adding new investors and market markers with no operational issues. It was a great success overall.”

Dore says typical settlement time for its Australian dollar bonds is T plus five days. Bond-i reduced this to T plus three days and more improvement is possible.

“If we were able to add the digital currency, we could keep the settlement period to T plus zero,” Dore says. “There is a lot of potential in the technology, whether it is to streamline the processes or improve efficiency by cutting out the tremendous amount of reconciliation that happens in the bond process. DLT provides one source of truth and one record where everybody sees the same thing. It also increases resiliency and security.”

Popovych argues DLT will democratise fixed income, giving smaller issuers greater access to the capital markets they can only achieve currently if they are covered by the larger banks. “If an issuer does not have the same investor following as larger names, it can still do issuance on the chain – being able to access the market and its investors without investing in transaction infrastructure,” he says. “Issuers will not need a massive back office or payments team and they will not need to pay a full range of agents to do the transaction for them.”

While it does not have further deals planned at this stage, Dore notes World Bank has established a blockchain lab and is working with various internal and external market participants to explore several use cases.

She comments: “World Bank issued the first global bond, we did the first swap and the first green bond, and we want to continue this contribution to capital-market development. It is not just about being the first but seeing how these innovations can deepen the market and solve global development challenges through their application.”