How can blockchain be used to trade bonds?

Wall Street is quietly becoming the vanguard of innovation in crypto-based technologies.

A host of start-ups — from FTX to Celsius and Voyager Digital — have tried, and failed, to make a business out of crypto tokens built on top of blockchains. But, now, established investment banks and asset managers — including JPMorgan Chase, UBS and BlackRock — are trying to take the technology underlying crypto and apply it to trading tried and tested, highly regulated assets, such as stocks and bonds.

How can blockchain ledgers be used for bond trading?

The big idea capturing the imagination of Wall Street executives is tokenisation. This involves turning a legal asset, such as a US Treasury bond, into a digital token that sits on a blockchain ledger, which is shared between many parties.

The token represents legal ownership. Coded into it is other crucial information, such as the previous owners and data on its transactions, trading and regulation.

All of this information is immutable and cannot be edited by a single party. To ensure that, the ledger is shared publicly or between a select group of parties.

Almost any asset can be turned into a token, but the focus of development at the moment is on assets that are traded on off-exchange markets, such as bonds and money market funds.

Why focus on blockchain and bonds?

Historically, parts of the bond market have been slower to adapt to newer technologies because they tend to be more illiquid and require more human intervention than others. That is especially true of corporate bonds. As fixed-income assets, bonds also have different maturities, making them more bespoke than a share or futures contract.

Buyers and sellers of bonds usually rely on traders at banks to quote a price for a deal and trades are often struck privately — meaning information about deals is fragmented and opaque.

But fixed-income securities are a crucial part of the global financial market. Sovereign bonds, because they are backed by governments, are regarded as akin to cash and so are accepted as collateral for margin [borrowing], or insurance, that backs daily trading and other activity.

How does blockchain help?

The blockchain allows a select group — the bank’s own clients, which are often other banks — on its network. Each client has access to the tokenised asset and each has its own node, or point on the blockchain network where transactions on the blockchain are verified. Collectively, these tools give them access to the market for tokenised assets.

Take JPMorgan, as an example. The world’s largest investment bank offers trading of fixed income through its Onyx Digital Assets arm. It handles $1bn-$2bn a day of traded tokenised assets, although this is only a fraction of the size of deals that pass across the US bank’s trading desks.

However, JPMorgan isn’t alone. Other banks, such as UBS, are developing their own networks.

Why bother with such a complex system?

Putting bond transactions on a distributed ledger can help with the margin and collateral arrangements that accompany them.

Banks have to be clients of other banks because they need to borrow money temporarily, to meet demands for funds. Often, those can be demands from for margin [borrowing], to cover the cost of trades that are still open.

Usually, the borrowing bank has high-quality assets, such as US Treasuries, that it can borrow against, but it needs cash for the short term. So the bank will have a credit line with another bank, although this may be unsecured. That means the customer can borrow the money without having to put up its own insurance, but it can be costly in other ways.

The bank, as a customer has to meet its own regulatory requirements, to show it can withstand stress in the market and still make payments to its lenders.

A tokenised asset can help, here, as it still represents a legal asset and can be used as collateral for clients to borrow against under a secured loan. That makes it a repurchase, or repo, agreement. This very common agreement in the fixed-income market. It is widely used by banks and investors to find cash for the short term. US Treasuries are widely used as collateral.

The buyer of the repo is the lender and the seller is the borrower. The former has offered financing that is secured; the latter has found the liquid assets it needs.

Putting this deal on a distributed blockchain ledger also means that other parts of the life of the deal can be automated. For example, a smart contract — a computer program that executes actions automatically when certain conditions are met — could return the funds and assets to their original owners when the contract expires. A contract might only last for a few hours.

What are the drawbacks to handling trades this way?

It is still unclear whether there is long-term demand for this new way of handling trades. Many processes are inefficient, but the back office of banks, where the perfunctory business of matching and reconciling trades takes place, has long been ignored by senior managers who focus on more profitable activities.

Banks are also aware that their own privately built platforms will need to operate with each other if the market is to grow.

“This is no different from the way the market has evolved in the past — the banks have always innovated and always dealt with some of these issues,” says Mark Makepeace, chief executive of Wilshire, an index provider.

And the market is, as ever, moving ahead of regulation. Many authorities are still trying to get used to an alternative approach.

At a crypto conference in London recently, Tyrone Lobban, head of Onyx Digital Assets at JPMorgan, admitted: “We still have to get to the point where regulators are comfortable with this technology — and, until we get to that point, it’s going to be slow steps along the way.”