Introduction
In our previous blog, we explored tokenization, its significance, benefits, and challenges.
In this series of blogs, we will delve into institutional use cases across traditional finance, scrutinizing three main areas: capital markets, payments and asset management. This blog focuses exclusively on capital markets, with subsequent blogs focusing on payments and asset management.
Capital markets stand at the forefront of current tokenization efforts. The question is: how can institutional trading landscapes gain from adopting distributed ledger technology, across areas such as bond issuance, repo trading, and collateral? The answer is that tokenization in capital markets represents a significant leap towards more operationally efficient, transparent, and cost-effective settlement.
Understanding Capital Markets
Capital markets are a pivotal segment of investment banking. They focus on the issuance and secondary market trading a wide array of securities. This range spans from straightforward cash bonds to intricate structured derivatives.
The Diversity of Asset Classes
Each asset class in capital markets has its unique market structure, which influences their respective trading mechanisms. Let's break down these differences:
1. Fixed Income: This involves debt securities like bonds and treasuries. Trading in this segment often combines electronic platforms and traditional voice broker-dealer networks.
2. Equities: This covers trading in stocks and equity-related products. It leverages advanced electronic and algorithmic execution for swift and efficient trading.
3. Credit: This includes corporate issued debt instruments. It often requires more nuanced execution strategies, which consider creditworthiness and liquidity dynamics.
4. Foreign Exchange (FX): Spot FX trading is primarily electronic, offering strong liquidity and virtually 24/7 trading.
Capital Markets: Primed for Blockchain Innovation
Even across these four examples, you can see how diverse and dynamic capital markets are. Indeed, understanding the unique trading mechanisms of each asset class is crucial to understanding the potential of blockchain to unlock inefficiencies in these markets.
Consider equities and spot FX markets. They exemplify efficiency with electronic execution, algorithmic trading, and centralized liquidity pools. These markets boast tight spreads and robust liquidity. However, not all asset classes mirror this efficiency.
Whether it be the highly manual booking building process that still forms the foundation of bond issuance or the lack of standardization and settlement efficiency across repo contracts and collateral management - there are areas ripe for disruption.
Blockchain: A Game-Changer
These are the areas where blockchain can truly shine in the next five years. Its potential lies in:
1. Atomic On-Chain Settlement: This ensures immediate and auditable settlement of transactions, a significant improvement from the current T+2 standard.
2. Automated Data Collection: Blockchain facilitates rich data capture, enabling better decision-making and market analysis, as well as regulatory disclosures.
The Emerging Blockchain Wave in Capital Markets
Understanding the potential of blockchain, we have seen banks focus on asset classes with more straightforward market structures, but high automation potential.
Repo trading, bond issuance, and collateral management emerge as initial forays for Tier 1 investment banks:
1. Repo Trading Initiatives:
A repo, or repurchase agreement, is a short-term agreement where securities are lent in exchange for cash before later being repurchased at a higher price.
In repo trading, banks can tokenize both the cash and collateral. Cash becomes a host stablecoin, and collateral turns into a tokenized asset, like a U.S. Treasury. Smart contracts facilitate instant transfers, offering intraday liquidity and eliminating settlement risks.
JPMorgan’s platform, as one institutional example, handles over $1 billion transactions daily for clients.
In another instance in 2022, HQLAᵡ, J.P. Morgan, Ownera and Wematch successfully demonstrated the technical feasibility of executing a delivery-versus-payment (DvP) repo transaction across two different distributed ledger technology (DLT) platforms at HQLAᵡ and J.P. Morgan.
According to the official press release, “The demonstration showed how rights to securities, recorded in digital collateral records (DCRs) on the HQLAᵡ ledger, and digital cash, recorded at J.P. Morgan, could be recorded and transferred using two different DLT platforms. The simulated transaction was negotiated in the Wematch trading front-end. Ownera connected Wematch and the two distributed ledgers using the open-source FINP2P routing protocol, ensuring the visibility of assets in Wematch, and coordinating the DvP settlement across the HQLAᵡ and J.P. Morgan platforms.”
2. Debt Market Innovations:
The debt issuance process, traditionally reliant on manual methods, is ripe for blockchain integration. By issuing bonds directly onto a private blockchain, transactions become faster and more efficient, while the book building process is moved from spreadsheets onto an immutable ledger. Primary market examples include:
- ABN Amro: The Dutch bank issued a €450,000 bond on a public blockchain on behalf of APOC Aviation, an aircraft parts company.
- Societe Generale: In April 2021, Societe Generale issued the first structured product as a Security Token on the Tezos public blockchain, entirely subscribed by Societe Generale Assurances.
- European Investment Bank (EIB): In June 2023, the EIB issued its first ever digital Climate Awareness Bond. Valued at 1 billion Swedish krona (SEK), this digital green bond has a maturity of 2 years and bears a 3.638% fixed rate coupon, with Crédit Agricole CIB and SEB as joint lead managers.
3. Streamlining Collateral Management:
Banks see immense potential in moving clearing and collateral management to blockchains. JPMorgan's “Tokenized Collateral Network (TCN)” exemplifies this. Launched in 2022 on their Onyx blockchain, it allows for efficient use of tokenized assets in financing trades. This approach eliminates settlement failures and maximizes asset utilization.
The city of Lugano issued its first digital bond on SIX Digital Exchange, becoming the first digital asset accepted as eligible collateral for SNB repos, showcasing a major leap in digital bond adoption.
Navigating Challenges and Envisioning the Future in Blockchain-Driven Capital Markets
The journey towards a blockchain-integrated capital market faces challenges, particularly regarding liquidity and market connectivity.
Traders will always emphasize the need for a deep, liquid, and connected market infrastructure. A typical single-bank, private blockchain with limited secondary market capabilities cannot foster the required liquidity. Institutions will continue to seek the best prices across multiple banks, a practice not altered by the shift to on-chain activities.
The Response: Interoperability and Consortiums.
Banks recognize the need to link their blockchains. Tools like Chainlink and Ownera, could play a crucial role. These efforts aim to maintain market share while embracing technological advancements.
Looking to the future, banks don’t intend to limit blockchain use to repos, collateral, and bond markets. They acknowledge evolving market structures, anticipating a future where global markets predominantly operate on-chain.
The ultimate shape of a blockchain-dominant market structure is still forming, yet nevertheless promises a transformative impact on global finance.
Interested in how blockchain can transform your capital market operations? Contact Blockdaemon for insights and strategies tailored to your needs.
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