Digital bond issuance has yet to become mainstream, but there’s been a steady drip of issuances in Europe and Asia. But not so much stateside. Issuing a native digital bond on a blockchain can save considerable cost. Germany’s Cashlink estimates the savings to be up to 1.2% of the bond value. And they should know – their platform is one of the most heavily used in terms of the number of issuances.
That said, the high Cashlink savings figure applied to cross border issuances, with domestic bonds saving 0.52% depending on the bond’s duration.
While there haven’t been many (any?) digital bonds issued in the United States, there have been other digital securities. For example, in some cases, existing Treasury bonds have been tokenized for repo trading platforms operated by Broadridge and JP Morgan. But those are not native digital bonds.
However, there have been a few U.S. digital fund issuances. The likes of Franklin Templeton and WisdomTree grab headlines for being innovative through their blockchain fund issuances. And they are. But in order to keep the SEC happy, they have a parallel set of conventional books.
Given the previously mentioned cost savings, keeping two sets of books rather defeats the object of efficiency. This books and records challenge was one of four issues covered in a recent Hogan Lovells webinar on digital bonds.
Other legal challenges for digital bonds
Another relates to the rule that broker-dealers operating an alternative trading system (ATS) must have possession and control over the assets traded and the cash for settlement. In 2020, the SEC issued a no action letter for digital asset ATS platforms, waiving the requirement where the buyer and seller settle transactions bilaterally.
A third challenge relates to U.S. requirements that securities transactions involve a clearing agent, typically a central counterparty or a central securities depository. However, when DLT is involved, that process is disintermediated through smart contracts, making it a question of how to comply.
The fourth issue is collateral. In the United States, these transactions are covered by the Uniform Commercial Code (UCC), adopted by all states, at least in part. Generally, collateral involving investment securities must be ‘perfected’, which requires filing a UCC-1 statement with the secretary of state. Filing and checking UCC-1 forms is not practical in a fast moving digital environment. This caught out a few people with the flood of crypto bankruptcies in the last two years.
Hence, the UCC was updated in 2022 to support digital assets. One of the changes was to make control over collateral governed by whether someone controls the private keys. Given that the UCC is adopted state by state, ten states are now using the new code.
What’s the solution?
So far, two of the four legal issues have been addressed – the SEC no action letter and the UCC collateral issue. Hogan Lovells said there’s a need for additional legislation.
It recommended following the German model, which compressed some of the conventional intermediaries into a single license. In Germany, Cashlink has a provisional license as a crypto securities registry manager. To complete the entire lifecycle, Germany also requires investment broker and crypto custody licenses. One option might be to merge the broker-dealer and custodian requirements.
The lawyers also noted that the institutional and retail markets could have different treatments, given wholesale markets don’t have consumer protection concerns.
What about the SEC’s custody requirements?
While Hogan Lovells covered the recent SEC review of qualified custodians, another tricky custody issue wasn’t mentioned.
Custodian banks believe the SEC’s staff accounting bulletin 121 (SAB 121) requires them to put all digital assets on their balance sheet. In turn, they think this imposes additional capital requirements to provide custody for digital assets. These requirements don’t exist for conventional bonds. Given most investors will want to custody digital bonds alongside conventional securities, if banks don’t provide custody, that will put a damper on U.S. digital bond issuance.