Digital Bond Issuance: How It Works and Why It Matters

In this interview, Stefan Bosshard, Primary Markets Fixed Income at SIX, gives a deeper insight into the issuance structure and process, its significance for digital asset markets, and his views on the future of digital assets.

In November 2021, SDX achieved a world-first: the issuance of a digital bond on a fully regulated, DLT-based exchange and central securities depository (CSD) environment. Furthermore, the issuance was open to a range of investors, and the entire process is fully replicable. The issuance gave investors – including insurance companies, pension funds and asset managers – a taste of the future, allowing them to gain exposure to digital assets in a reduced-risk environment.

The issuer behind this digital bond was the SIX Group’s own Treasury Department. This made sense for various financing reasons: we had acquired the Spanish Stock Exchange last year and wanted to undertake a debt issuance for this and other purposes.

Superficially, at this moment in time, there are not a lot of obvious benefits to the issuer compared to a traditional issuance. But, on the other hand, there weren’t any downsides either, due to how we had structured it! Therefore, we demonstrated the viability of a digital bond issuance, which was an important point to prove and the potential of the technology behind it.

In the future, of course, as the technology and the ecosystem around digital assets develop and evolve, digital issuances will bring many tangible benefits. The issuance process itself will become more efficient and the asset servicing throughout the instrument life cycle. Smart contracts also open up more opportunities for automation. The prospectus, for example, is at present a heavy physical, legal document. As we translate more and more of the prospectus into code within the asset itself, the market will become more efficient, and the costs of servicing assets – and hence the costs of accessing funding – will be lower for issuers.

That’s an excellent question! While we’ve introduced digital assets and built a new regulated exchange and a new regulated central securities depositary (CSD) for trading and settling them, we are very much aware that not all investors are operationally ready or entirely comfortable with the first issuance. We wanted to give these investors the opportunity to participate in the issuance through whatever form of the asset they are most comfortable with. It means that our pool of potential investors is bigger, as it includes both traditional and digital investors, which is good for the issuer. By doing this, we’re eliminating the placement risk associated with a purely digital issuance and also ensuring that funding costs for the issuer aren’t negatively impacted, as the issuer doesn’t need to pay a higher coupon or higher yield to investors in the digital bond to incentivize them.

It was definitely a challenge to implement this dual structure in the prospectus, but worth the effort. While they have the same risk and economic profile and value, these are two separate bonds, both technically and legally. They’re two separate bonds, with two separate ISINs and two separate registries; plus, given that one is traditional and the other is digital, there are also two separate CSDs. We do, however, have an exchangeability feature in place, which means that an investor can transfer, almost frictionlessly, between the two forms of the bond. One of the banks involved in the issuance acts as a conversion agent, guaranteeing that an investor can switch from one to the other.

The two bonds are also not fixed in size so that demand can drive the number of outstanding bonds for each part of the issuance. We were very positively surprised to see that the digital part had almost twice as much take-up as the traditional one, as we had expected it to be the other way round! Hopefully, in the future, we’ll also see more investors switching to the digital bond as they become more confident and develop their operational capabilities to support it.

We can’t share the exact nature or breakdown of the investors in this issuance for legal reasons. However, issuances of this nature are typically taken up by institutional investors. It is also possible for retail investors to participate – they can place an order with their desk at their house bank, which will collate internal and external orders and become part of the allocation process. It’s likely, therefore, that we had retail investors participating. In this instance, due to regulatory restrictions, we were also limited to Swiss domestic investors.

On the secondary market, we are also looking to members of the exchange to stimulate liquidity in the issuance by acting as market makers, liquidity providers and brokers. We’ve currently got three major Swiss banks on-boarded to the SDX exchange, all of which were involved in the digital bond issuance process and all of which are now providing prices – and therefore liquidity – from their trading desks. And so, there are also opportunities for both institutional and retail investors to participate in the secondary market.

The digital bond and its supporting digital market infrastructure (the exchange and the CSD) are built on distributed ledger technology (DLT). This enables us to implement something unique to digital assets: atomic settlement, meaning that you also settle as soon as you trade. The atomic settlement eliminates counterparty exposure and risk since the delivery and payment legs of the transaction occur simultaneously. It does also have broader ramifications for markets and trading practices. For example, it is not possible to borrow or lend between the trade date and settlement date since there is no latency between the two. This means that a participant trading on the exchange must hold the asset they intend to exchange.

While digital assets have the potential to be continuously traded 24/7, we don’t do that at present, as we don’t want our operations staff to be working 24/7 when there isn’t that 24/7 demand! As the network of liquidity pools grows globally, this will become more relevant in the future.

Green bonds, or ESG bonds, are very dear to my heart. As an infrastructure provider, we’re always thinking about where we can add value, as this is such a huge and growing market at the moment and one that we see as very important in the future of financial markets. Greenwashing is also a huge issue. We believe that technology has a significant role in developing effective green bond markets, especially when it comes to tokenization and the use of smart contracts to govern green digital bonds. Using technology in this way can significantly ease the burden for issuers when it comes to reporting against metrics in the prospectus and demonstrating the impact of an investment. For example, we can design the asset so that the development of the issuers’ investments – funded through that bond – can be automatically tracked and reported in terms of CO2 issuance or other metrics. In this example, we could even build a smart contract that can automatically raise or lower the interest rate or bond coupon depending on the CO2 output. There are many more possibilities out there!

As an instrument, bonds are relatively easy to understand, but they can have very complex structures. By digitizing the instrument, we’re already adding much value and reducing the cost and overhead of issuance. This makes the benefits of tokenization and automation more visible to both issuers and investors, as opposed to listed equities, which are already very standardized and liquid. We started with vanilla bonds so that investors can familiarize themselves with digital assets, and then we can move on to more complex bonds. It is possible to tokenize equities, and we have both the license and the technology for that. Naturally, it’s easier to build out the capabilities for asset classes – namely equities and bonds – that are currently supported by our exchange and CSD. That said, we are constantly in discussions with market participants interested in tokenizing other types of assets. Non-traditional investments such as art and real estate are very much of interest and ways in which the value of other balance sheet assets can be unlocked. We have not yet fully defined what will come next in this space!

Interview on SDX's recent digital bond issuance, why this was the world's first and what the future might bring for the digital asset space.

As Product Head for Fixed Income, Stefan Bosshard is responsible for building and running the fixed income offering of the digital exchange. Between 2013 and 2019, Stefan was product manager for the fixed income segment at SDX’s “mother house”, the Swiss Stock Exchange. Prior to that, he was a bond trader at UBS, so he also understands the fixed income space from the “other side”, giving him greater insight into SDX’s client needs.

Stefan’s role at SDX has involved both building and now running the fixed income segment of the digital exchange, bringing innovation to the market, and encouraging market participants to embrace, onboard, and trade using SDX’s innovative platform and products.

What we’ve done is put a digital bond issuance onto a fully regulated, DLT-based exchange and central securities depository (CSD) environment in a way that’s not only replicable but also open to a range of eligible investors. We did not invent digital bonds – they’ve been around for quite some time – but we have brought them to a new, regulated level. It’s the first digital bond in a fully regulated environment, and this gave investors a real taste of the future. It allowed them to gain exposure to digital assets in a reduced-risk environment. The investors include insurance companies, pension funds and asset managers, and demand was so high that the original allocation of CHF 100m – for the digital component of the bond issuance – was oversubscribed.

Our digital bond issuance has a secondary market, with liquidity, both OTC as well as on the exchange in a regulated environment, which is also a world first. Investors can choose – and switch between – holding the digital and traditional forms of the asset, which helps create liquidity for the asset and provides a safety net for the investor. From the issuer’s perspective, it’s about inviting both traditional and digital investors, and giving them the possibility to choose their preferred form of the asset. This helps the whole market, and it helps transition the market towards digital assets as well. Digital bonds are structured and work similarly to traditional bonds, but on a different technology. This technology, however, enables atomic settlement, which can lead to greater settlement efficiencies. It also enables greater automation in the issuance process and the ongoing lifecycle management of the bond, which can introduce more efficiency to the market.

A traditional bond can be supported by up to 700 pages of complex legal documentation on its structure and lifecycle events. With digital bonds, we are gradually bringing more of this legal complexity into the smart contracts that govern the bond. Smart contracts can reflect all the possibilities and details in a prospectus, which opens up a range of possibilities, particularly for ESG. For example, we could have a green bond issuance, where the issuer ties the bond to reduce CO2 output. That CO2 output can be automatically measured and tracked via a data token, linked to or included in the asset token, meaning that the investor can always see if the issuer is fulfilling its undertakings in the prospectus. We could even take this further and say that if these performance targets are not met, the asset might automatically increase compensation to the investor, penalizing the issuer by increasing the coupon by a predefined amount. These are all technically possible things, although they require more work to achieve!

I see the introduction of central bank digital currency (CBDC), particularly wholesale CBDC, as an essential prerequisite to enable the atomic settlement of digital assets using risk-free central bank money. We have a great interim solution at SDX, which allows market participants to transact using tokenized cash, and that has been accepted by Swiss banks and counterparties. However, to realize all the benefits of the technology without adding counterparty risk from SDX or other tokenized cash issuers, we need CBDC.

Creating a new market for digital assets is a collective effort, so we are very much involved with industry initiatives and standards committees. Standardization has a considerable role to play. Equity markets are already highly efficient and liquid, which is largely due to the standardization of contracts, instruments, and data. In the bond world, we are still very manual and paper-based. A bond may be described by two market data vendors in two very different ways, both again differing from the way an exchange describes the same bond. The core details are the same, but the terminology is different. We need a common way to describe bonds before converting them to code and tokenizing them at scale. To help develop this standardization, we work with groups such as the Global Blockchain Business Council and the International Capital Markets Association, which have their own bond standardization initiatives.

I think we will see steady growth. There’s a tendency in the blockchain / DLT industry to expect growth rates of 1000%.; however, this is not entirely what I believe in. We have a significant pipeline of issuers who see the technology’s benefits and clients waiting to be onboarded. Our growth needs to be steady and controlled to maintain our high regulatory standards and market integrity. Ultimately, SDX is an infrastructure provider, and I see us as the orchestrators of the digital markets of the future, taking the financial market on a journey with us.