Digital bonds: It all comes down to trust
For physical bonds, trust is in the 'teller' and the 'tale'. Can digital bonds pass legal scrutiny and earn trust in its existence and subsequent use?
SGX's recent 'digital bond' issuance hints at the possibilities for debt markets of the future. But without legal certainty, the full digitalisation needed for truly transformative change may remain elusive.
In November 2020, SGX released a White Paper titled Fixed Income Digital Assets laying out the blueprint for a fully digital infrastructure using digital ledger technology to serve the Asia- Pacific bond market, estimated - for corporate bonds alone - to be greater than US$9.5 trillion.
The White Paper followed the successful pilot, earlier in 2020, of a 'digital bond' issuance, achieved by creating an electronic platform that connected the various parties in bond issuances, and using self-executing smart contracts to automate processes such as issuance flows and coupon payments. SGX showed it could cut settlement times in half and eliminate several of the manual processes that inevitably risk human error.
Yet while the pilot offers a glimpse of what might be achievable, what it was not was a truly digital bond - something SGX has itself acknowledged. Creating a truly digital bond entails eliminating any 'paper trail' from the process, specifically, the physical bond - the 'global note' - that is currently deposited with CDP, SGX's depository services subsidiary. As noted in the White Paper, "The elimination of paper trail, especially global notes (representing ownership with the CSD) is required to realise the vision of digitalisation".
Or to put it another way, to achieve the full possibilities of digitalisation, it is not sufficient simply to digitalise processes or records of ownership as SGX have done - or even to create digital 'tokens' to represent underlying securities - one needs also to digitalise the securities themselves.
The technology for such asset digitalisation - and the ideas for how such digital ledger technologies and smart contracts might be used to revolutionise the holding and transfer of such assets - are already with us. That being so, what is still missing?
Certainly, there are practical, 'commercial' challenges - standardisation, interoperability and the like. But there is also a more fundamental issue at play: one which ultimately comes down to trust.
Existing physical, 'paper' bonds comprise a well-established, property asset: something that confers clear legal rights upon the owner against the rest of the world and can be traded, bequeathed, held on trust, used as security, and more.
While ownership of those bonds may be represented in an electronic register, that register is operated by a centralised, regulated depositary - in Singapore, CDP - and is itself established on a firm legal basis. That system - established legal rights and regulated intermediaries - provides issuers, investors and other market participants with certainty and trust in the ownership of bonds, in their value, and even in their 'location'.
Trust, as it were, in both the 'teller' - the legitimacy of SGX and its registry - and the 'tale' - the bonds themselves.
But where a bond (or other security) exists entirely and only in digital form - where the bond and the rights attached to it are no more than a series of (potentially infinitely replicable) bits and bytes, and where they may be 'stored' as a 'digital bond record on ledger' on a digitalised depository - can the same be said to be true?
Can owners of digital bonds be sure that those bits and bytes will have the same legal legitimacy and confer the same rights and protections as other property assets? That their ownership will be recognised? And that they will have recourse against someone when problems arise? In essence, can a digital bond pass legal scrutiny and thereby enable trust in its existence and subsequent usage?
A ROBUST LEGAL BASIS
These legal challenges are not unique to the digitalisation of bonds. A recent IMF Working Paper - Legal aspects of Central Bank Digital Currency (CBDC) - has raised similar concerns, albeit in relation to issuance of digital currency. Some of these concerns - such as whether central banks have authority to issue digital currency; whether CBDC is, in fact, real 'currency'; and whether digital currency should be legal tender - touch upon fundamental 'trusted' relationships between money, the state, and the law.
To establish trust in these innovative technologies, the IMF Working Paper stresses that issuance of CBDC should be founded on a "robust, ideally explicit, legal basis" and suggests that reform of central bank law and/or monetary law(s) may be necessary.
Internationally, we also see governments starting to undertake law reform to address the trust concerns in the debt securities sphere. A notable example is Germany, where laws due to enter into force imminently grant formal legal recognition to electronic debt securities, ensuring that they confer the full protections of 'physical' property ownership.
Importantly, those laws also provide an authorisation system to enable the electronic securities to be held on approved, regulated blockchains or other decentralised crypto-registers, rather than with a centralised depository, and thus create a path to more fundamental transformation of existing market structures. Trust in the tale, therefore, and trust in the teller.
And beyond digital assets, we see a pattern emerging with law reform initiatives pertaining to so-called smart contracts and the extent to which contracting parties have legal certainty as to when such contracts are legally binding, how they will be interpreted, and what the legal consequences are if they fail to operate as intended.
The UK Law Commission has, in December 2020, launched a Call for Evidence on the applicability of current laws to smart contracts and the possibility of law reform, alongside related work on digital assets. The topic of smart contracts is also under active consideration by the Singapore Academy of Law's Law Reform Committee, with a report slated for publication in the coming months.
BEYOND THE SGX PILOT
So, what of Singapore, so often (and rightly) seen as a forerunner in fostering digital financial services innovation? For its part, the Monetary Authority of Singapore (MAS) has made clear that Singapore's securities rules will apply to digital tokens with features of securities, including those that "constitute or evidence" the indebtedness of the token's issuer. Important though that extension of the current regulatory scheme and market structures to digital tokens undoubtedly is, it assumes, rather than ensures, the legal status of any purely digital assets to which it applies. The underlying questions remain unanswered.
There remains a need and an opportunity therefore for policymakers, law reform agencies and entities such as SGX to work together to not only create a Singaporean vision for that paperless future, but also to 'stress test' our laws and identify the reforms needed to provide the certainty and trust fundamental to that future model. The White Paper rightly recognises this critical need for collaboration, and states that SGX will continue to "work with its legal and regulatory partners on an appropriate framework for asset digitalisation".
That appropriate framework may mean a bespoke electronic securities law such as the one proposed in Germany, or it may involve designing some other model, tailored to Singapore's laws and wider context. And, it may require parallel consideration of other legal and policy questions, whether those be around cybercrime, taxation, conflicts of laws, or even the technological tools and skills regulators need to maintain effective oversight.
The technology is there. SGX's recent initiative shows the possibilities and the rewards to be had. It is time to make sure the law provides the trusted conditions to enable SGX's pilot to truly soar.
- The writers are from the Singapore Academy of Law (SAL).
Sriram Chakravarthi is a member of the SAL's Law Reform Committee; Simon Constantine is the deputy research director, law reform, at the SAL.
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