This is a guest opinion post from Professor Michael Sung, Co-Director of the Fudan Fanhai Fintech Research Center and Charles Chang, Associate Dean of Academics, Fanhai International School of Finance, Fudan University, China.
There are a number of accelerating trends that will explosively converge in the upcoming year: 1) the advent of digital bonds as a new innovation for capital markets, 2) the eventual regulation of these type of digital assets in China, 3) the global scaling of the green bond market, 4) China’s emphasis and leadership in green finance and sustainable development.
The benefits of digitalizing a bond instrument are numerous, the first and foremost being the ability to unlock liquidity by providing access to global capital and increasing connectivity to alternative investor classes beyond traditional institutions. Digitalization can allow the fractionalization of a bond into smaller minimum investment sizes so that even retail investors can participate. By digitalizing the bond, it is possible to leverage blockchain technology to streamline the coordination processes for issuers, underwriters, investors, and ecosystem participants across the primary issuance and asset servicing.
Beyond that, there can be much more efficient settlement and flexible optionality for payments, with operational and transaction costs that can be 90% less than using traditional platforms. Smart contracts can automate the full lifecycle management of the bond offering and enforce compliance. And big data/AI techniques can reduce risk and monitor for abnormal activity.
The first issuances for digital bonds are now just popping up this past year. A notable example is Asia’s first syndicated digital public corporate bond S$400 million issuance by Olam International, a major food and agribusiness company. This was done in conjunction with Singapore’s SGX stock exchange, HSBC, and Temasek in September 2020.
The commercialization of digital bond innovation comes at a time when China is rapidly gearing up to scale the deployment of one of the first central bank digital currencies in the world. In less than a year, the digital RMB has gone from an announcement in late October 2019 to full-scale stress-testing across most of the economically important regions in China. Official commercialization is planned in time for the Olympics in 2022. The next step will be China’s eventual regulation of digital assets, particularly the asset-backed securitized variety that digital bonds classify as.
These first moves representing the disruptive digitalization of global capital markets come at a critical inflection point where the COVID-19 pandemic is catalyzing a world-wide systemic shift toward the digital economy and sustainable development.
The green bond market
The world has issued roughly a $265 billion worth of green bonds in 2019, and despite the COVID-19 slowdown, 2020 is on track to end up with $350 billion of issuances. Overall, there is an estimated $100 trillion bond market for climate change solutions, according to the Climate Bond Initiative (CBI). Social bonds, also known as Social Responsibility Investments (SRI), which serve a wide variety of social needs, is also exploding as a market due to the COVID-19 pandemic. There were only $20 billion of social bonds issued in 2019, but this market has jumped to over five times the size to $105 billion as of October 2020. Together, green and social bonds are grouped under the larger umbrella of sustainability bonds.
In September 2019, the UN launched the Principles for Responsible Banking where 130 financial institutions with total combined assets under management of $47 trillion (including the likes of JP Morgan and Blackrock and representing one-third of the global banking sector) committed publicly to sustainability and climate action.
There is currently more demand for high-quality green bonds than supply, as there is a high bar for compliance by financial institutions to unlock these allocated funds. Green bonds are rated by a number of alternative guidelines, notably the Green Bond Principles, led by an independent secretariat hosted by the International Capital Market Association, as well as the Climate Bonds Standard set by the CBI. These guidelines are meant to set the standards for the transparency process and disclosure rules to promote the integrity of the green bond market.
Unfortunately, because these guidelines are currently voluntary, there is a problem in the market of “greenwashing,” whereby bonds are labeled as green, but in actuality, the use of funds do not end up in green-certified projects because there is no enforcement. Environmental, Social, and Governance (ESG) tracking is difficult since there is no universal standard or platform to track what happens downstream.
Blockchain addresses the business challenge
The problem of tracking and compliance in the green bond market is the perfect use case for blockchain technology. Thus, digital green bonds are not just a nice-to-have optimization on the traditional bond market. Rather blockchain-based digitalization represents a critical enabling innovation to provide the ESG and green bond standards transparency and tracking capabilities that can unlock the massive global liquidity for the exploding market, which is currently held up by compliance standards.
China is already leading the world in enterprise blockchain adoption across applications such as cross-border payments, trade finance, and supply chain logistics. Blockchain has become a national priority, with high-profile blockchain initiatives such as the Blockchain-based Service Network (BSN) providing blockchain interoperability to drive massive enterprise adoption both on the mainland as well as on the Belt and Road, in particular across the ASEAN countries who are signatories to the newly ratified RCEP free trade agreement. Therefore China is in a very good position to drive the regulation and scaled adoption of digital securities such as bonds and other asset-backed instruments.
Recently President Xi boldly announced China’s intentions to be a carbon-neutral country by 2060 in a UN General Assembly Speech in September 2020. To meet this ambitious goal, China is mobilizing the entire country to issue green bonds en-masse across local governments, SOEs (state-owned enterprises), and private enterprise. China has already become the world’s largest green bonds issuer since establishing the mainland market in 2015. In 2019, China issued $59 billion equivalent in RMB-denominated bonds, according to the South China Morning Post.
However, only around half of these issuances meet international standards, according to CBI. China’s guidelines (the Green Bond Endorsed Project Catalogue under supervision of the People’s Bank of China and the Green Bond Guidelines issued by the National Development Reform Commission) currently allows 50% of bond proceeds to be used for general working capital not specifically dedicated for specific green projects, well above the 5% limit imposed by the Climate Bonds Standard. Converging China’s guidelines to international standards will open up the domestic green bond market to foreign investors.
The bond yield gap
Currently, there is a large yield differential between international bond markets and the China mainland market. In the Eurozone and Japan, interest rates are negative or near zero, whereas in China, the equivalent products can yield upwards of 3%. Given this, there is a lot of international money looking for a place to park capital, with China being the only country with the scale to be able to service the multi-trillion-dollar pent-up demand for qualifying green bond products. Therefore, there will be a perfect storm opportunity for when China issues the first digital green bonds to service the global market. The standards and transparency enforced by blockchain technology can satisfy the more rigorous compliance demands of international investors.
These first moves will fit into a longer-term strategy for China to eventually drive the global scaling of both regulated digital assets and green bond issuances by other economies around the world. 2020 has been a year of great change and turbulence, but one that has also set in motion the dynamics for a great synergistic convergence of digitalization and sustainable financing. The inflection points of these powerful dual movements come just in the nick of time during a universally challenging time for governments, businesses, and families alike. The nations of the world need to pull together to create a more unified and globalized financial ecosystem to rebuild society for a brighter future. Look for China to trailblaze a path for the future of sustainable development that the rest of the world can follow to make a positive impact for humanity.