KfW has sold Europe’s first blockchain-based bond, although a quirk of German law meant the transaction had to be replicated on paper. While the bond was instantly settled, those involved say a crucial component is missing if this technology is to become part of capital markets’ infrastructure: a cash settlement facility on a distributed ledger.
The German agency sold €100,000 of five day commercial paper to MEAG. It simultaneously replicated the transaction on a blockchain using the Corda platform that was developed by blockchain technology company R3. Commerzbank arranged the transaction, which was traded on its Corda system prototype.
A blockchain, or distributed ledger, is a form of a computer network in which all information is contained in every computer — or “node” — in a network and is updated simultaneously.
Almost since the creation of Bitcoin, which ran on the first blockchain, believers have been touting the technology’s ability to change the world and revolutionise the way capital markets (amongst other things) operate.
The primary advantage stems from the way the information in the network is exchanged. In an environment where one’s cash position is always known through a blockchain, there is no possibility for counterparty risk and therefore no necessity for centralised clearing of transactions and the delays this entails.
Markus Schmidtchen, head of treasury at KfW, said: “The potential advantage is the concept of a shared single record keeping system for each party in the process. When each party is using the same system, it’s fully transparent. We can be 100% clear what happens to securities within the ledger and see who the end investor is. There’s also no need for a reconciliation process between all the various databases. That means it’s a much faster process.”
KfW’s transaction with Commerzbank and MEAG was, to some degree, a vindication that the technology does have the capacity to remove intermediaries and allow instant settlement. It also provided a window to give regulators a live view of the transaction. Although the transaction did need to be replicated on paper, this was not due to a technological limitation but an aspect of German securities law.
Michael Spitz, head of Commerzbank’s main incubator, explained. “Under German law, a physical paper is still required for a securities transaction. However, we are part of a group working with the German Banking Association on getting this law updated to bring it into line with other jurisdictions around the world.”
The drive towards the dematerialisation of assets is distinct from any blockchain development effort. Neither France nor the UK requires the physical transfer of a piece of paper to validate a security transaction.
Cash on the ledger?
There are other obstacles to the adoption of blockchain systems for mainstream securities transactions, which may prove far more difficult to overcome than outdated regulation.
While the distributed ledger technology allowed the transaction to be settled and cleared instantly, rather than the two-day delay necessitated by conventional clearing systems, this was only possible by holding the cash leg of the transaction in escrow.
As yet, there is no simple way of settling cash transactions using a distributed ledger. KfW and Commerzbank’s solution — holding the cash in escrow and sending instructions to transfer it from the distributed ledger — though functional for a prototype case, is not a long term strategy.
The commercial paper instrument was selected because of its simplicity. The bond offered no coupon, meaning that no payment flows were required beyond the exchange of principal.
A key part of the value that distributed ledger technology offers capital markets is the automatic execution of bond documentation through “smart contracts” — sections of code that carry out clauses, including executing payments. For smart contracts to be effective would require a facility within the distributed ledger for settling cash payments.
The joy of blockchain
It is at this stage that the real value of distributed ledger technology can be unlocked.
Charley Cooper, managing director at R3, explained: “When you know the transaction is done instantaneously, it makes risk management hugely easier. When Lehman Brothers went bankrupt on Sunday night, billions of dollars of trades and exposure to Lehman was in progress and unclear. Distributed ledger technology makes that clear immediately. Additionally, the need for reconciliation incurs capital charges under Basel. If you remove the reconciliation step, you could potentially free up that capital.”
Market participants and startups are exploring a variety of approaches to solving the missing link of blockchain cash settlement.
A consortium of banks, including Barclays, Credit Suisse, Canadian Imperial Bank of Commerce (CIBC), Deutsche Bank, HSBC, MUFG, Santander, State Street and UBS, is working on a Utility Settlement Coin. In contrast to Bitcoin and most other cryptocurrencies, the Utility Settlement Coin would be fully collateralised by fiat currency held with a central bank and would maintain a 1:1 exchange rate.
The settlement coin would only be available to financial institutions and could be accessed and transferred by a distributed ledger.
Central banks are also flirting with the idea of creating their own digital currency. Bank of Canada and the Monetary Authority of Singapore are likely the furthest along this road, but Sweden is experimenting with a digitalised version of its currency that would be available to consumers.
“A central bank digital currency would be ideal,” said Schmidtchen. “If blockchain turns out to be a dominant technology, it makes sense for a central bank to support its development.”
Spitz at Commerzbank agreed that a central bank digital currency would be suitable.
Worth the bother?
Not everyone is convinced that the digitisation of cash is necessary to unlock the instant settlement benefits of distributed ledger technology.
Dan Conner, chief executive of Disledger (a fintech startup, working with Mastercard and Intel, with an initial coin offering in progress), believes that even the transfer of assets via blockchain is unnecessary.
His company offers software that allows users to set up a distributed ledger between themselves and a counterparty. Rather than transferring tokenised versions of assets and cash within a system, Disledger simply maintains a ledger of a company’s available assets. Because the information is shared between counterparties (and a regulator), settlement can take place immediately because a transaction cannot take place if sufficient funds are not available. Conner believes that blockchain-based systems will never be able to handle the sheer number of transactions involved in cash transfers or equity and derivatives markets.
Spitz of Commerzbank does concede that there is “a long way to go” to make blockchain systems scalable.
Conner believes that cryptocurrency solutions will “lose steam” and be accepted as an unnecessary feature. “Assets are already dematerialised. Some 98% of currency is already digital. We don’t need to make tokenised versions of them to have instantaneous transactions. The accounting system is sufficient.”
James Godfrey, head of capital markets at BlockEx (a fintech startup that expects to transact its first blockchain bond within six weeks), also believes that digital currency solutions are unnecessary. “There are no technical barriers,” he said. “It’s technically a simple addition, but people aren’t prepared to accept it and regulators don’t trust it.”
Blockex’s platform will provide instant settlement of bonds, but will require accounts to be pre-funded. This means that, to be a significant part of an institutions’ capital markets operations, it would need to store sufficient cash within BlockEx’s infrastructure, where it could not be used for any other purpose.