Security tokenisation: this report looks at developments the banking sector needs to understand – beyond collectibles to equity, bonds, and self-custody.
Tokenizing a Bond: Pain or Gain
Tokenized securities are emerging as one of the most promising applications for public blockchains. Within the security universe, interest is strongest in tokenized bond offerings.
This investment category is estimated to be worth ~$2.6 trillion by 2025.39
It is worth looking into the mechanics of tokenized bonds and the challenges that arise in a blockchain context. Overall, the specific advantages that tokenized bonds offer stakeholders compared to their traditional form outweigh these factors.
The main challenges facing tokenized bond offerings are the rules and regulations that issuers and other participants are subject to. None of these are fundamental by nature, but they require more tooling and standardization. One of the main opportunities is the advent of multiple institutions cooperating on bond issuance in a transparent way without reliance on trust
The Tokenised Bond Lifecycle
In a tokenized bond offering, similar to a traditional bond offering, pertinent loan parameters — the offering volume, coupon rate and duration — need to be set. These parameters are directly expressed in the smart contract logic, typically within a contract template. The trustless execution on a public smart contract platform ensures adherence to these terms.
It is possible to move the entire offering, book-building and subscription process on-chain, but it is more common and practical to apply the same procedures as traditional offerings do. The advent of stablecoins, however, has made it more attractive to move the actual bond purchase on-chain. Final delivery of the bond tokens is then trustless and atomic, alleviating the need for payment agents and escrow services, thus reducing issuing costs. However, fulfilling
regulations for Know Your Customer rules in the smart contract functions poses the main challenge here.40 Post-issuance
As for almost all digital assets, bond tokens need to be securely storable, transferable, tradable and recoverable during the bond’s lifetime. Financial institutions have many options for digital asset custody and storage, and these
options are also available for bond tokens. For those purposes, it is an advantage for the smart contract to adhere
to standards, such as the ERC-20 specification. Unfortunately, however, the ecosystem is still in a consolidation phase when it comes to standards supporting more complex functionality, such as permissioned transfers.
Tokens that are not classified as securities typically enjoy completely permissionless transfers. Because the issuing institutions for tokenized bonds are subject to various regulations in virtually all jurisdictions, this is typically unfeasible.
In response, approaches have emerged to reconcile compliant behavior and the censorship-resistant nature of public blockchains from simple whitelisting to flexible just-in-time transfer approval. Finding the right trade-off between the end-user experience and the scalability of the underlying platform remains a challenge.