The European bond market is making great strides when it comes to figuring out how to issue and settle a bond digitally. But the market is trying to run before it can walk when it comes to mass adoption of the technology.
The ECB is deep in the second wave of its distributed ledger technology trials, which run until November. The central bank is experimenting with three different forms of settling bonds using digital central bank money. As part of this, Slovenia sold the first eurozone sovereign bond using distributed ledger technology last month.
Meanwhile, KfW and Berlin Hyp tested public and private blockchain settlement, respectively, this year with the launch of the first blockchain-based securities under the German Electronic Securities Act.
Investors are clearly engaging with the product. Berlin Hyp spoke to 135 accounts during its two week roadshow in late July, with savings banks showing particular interest. Meanwhile, KfW engaged with “around 110” investors during its eight week marketing period, its treasurer Tim Armbruster told GlobalCapital last month.
For many, it looks like the dawn of the digital bond is coming as issuers, investors and dealers across the board dip their toes into the water.
But all this work and interest is a moot point if the central banks do not sort out where these bonds sit within its regulatory framework.
KfW and Berlin Hyp both said after pricing their deals that the lack of ECB eligibility suppressed investor appetite for the note. Many investors, although interested in the technology, were not willing to buy either note as the bonds could not be used as collateral at the central bank.
And furthermore, despite being near identical to a standard Berlin Hyp Pfandbrief in terms of asset quality, the recent digital bond does not qualify for liquidity coverage ratio purposes, again putting pressure on demand.
Similarly, KfW and Berlin Hyp’s trades were not listed on a stock exchange — a fundamental characteristic of a high quality liquid asset (HQLA) under Basel III. For now, it is not possible to list blockchain-based deals as regulations require the paper to be deposited at a central securities depositary.
If these concerns are not addressed, then they could slow down the development of the whole sector. For now, digital deals are fine as small — and short — deals that test out the technology in a safe way.
Of course, the ECB is taking small steps towards equalising the treatment of digital and conventional bonds. Listing deals, for instance, could be explored in the ECB trials, KfW notes.
The digital bond market needs momentum and size to grow if it is ever to supplement — or even supplant — the traditional bond market. And these deals cannot do so without fitting into regulatory regimes.
Although investors are willing to play around with the technology in small sizes now, they will be less willing to do so when issuers begin to look for benchmark sizes if such deals do not offer the same benefits as traditional issuance.