Remember the scene in "Beverly Hills Cop" where Detective Axel Foley discovers stolen German bearer bonds in a safe deposit box? Those paper-based bonds are a far cry from innovative smart bonds—digital debt instruments issued and managed using blockchain technology. In our first smart bond exploration, we compared smart bonds to "Die Hard" and “Beverly Hills Cop” era bearer bonds and demonstrated how these more efficient and transparent digitalized bonds offer several benefits over their traditional counterparts. Now, we’ll consider utility—how smart bonds can potentially benefit developing countries and help contribute to a more sustainable future.
Smart Bonds for Capital Formation
Capital formation is the engine of economic growth, but many developing countries lack essential capital market infrastructure, hindering their resource development. In contrast, countries like the United States have sophisticated infrastructures including central securities depositories (CSDs) that are crucial for well-functioning capital markets. However, numerous emerging economies either lack a CSD or have an inadequate CSD structure. Furthermore, these countries may not have effective laws or regulatory frameworks to support capital formation. This deficiency fuels the demand for a "trustless" system like blockchain. Such a system, powered by decentralized consensus mechanisms, allows market participants to agree on a single version of truth. Such a system may circumvent the need for an overarching authority and eliminate the need for participants to know or trust each other, creating the opportunity for more efficient capital formation.
Navigating this complex issue requires solutions that marry the benefits of sophisticated market infrastructures and blockchain technology. This is where smart bonds come into play. Smart bonds do not require a CSD or investment in additional traditional capital market infrastructure for issuance, trading, and settlement. Instead, if a country establishes a marketplace for private tokenized assets using smart bonds, it could bypass traditional intermediaries like depositories, centralized exchanges, central clearing agencies, broker/dealers, transfer agents, and custody services. Because this new technology does not rely on existing rails, developing nations may be able to “leapfrog” stages of development that developed regions have previously taken, allowing rapid transition and progress.
In September 2021, El Salvador was the first to recognize bitcoin as a legal tender. Now, their congress is the first in the world to pass a digital securities law that will pave the way for bitcoin bond issuance to help El Salvador raise capital to pay down its sovereign debt, fund bitcoin mining infrastructure, and build a tax-free 'Bitcoin City.' El Salvador’s bitcoin-backed bond will be denominated in U.S. dollars, and investors will expect to receive fixed interest payments until maturity. While critics argue the move could expose investors to risks due to cryptocurrency volatility, supporters believe it promotes investment and economic growth.
Further, smart bonds can introduce alternatives to raising funds for capital improvement projects and social development initiatives in emerging markets and municipalities. Issuing bonds on the blockchain can give issuers like governments, public service agencies, and multilateral development banks access to a wider, global pool of investors and make participation in capital improvement projects more accessible. Traditional bonds tend to have higher minimums because of numerous and high processing fees. However, tokenizing bonds can streamline processes by removing intermediaries and relying on self-executing code. This leaner model has the potential to reduce many costs associated with traditional bonds. As a result, issuers could theoretically present bonds with lower minimums, potentially expanding access to a broader scope of investors.
Municipalities in California—for example, the City of Berkeley—are recognizing that tokenized bond issuance can allow governments to “achieve greater transparency, targeted investment, and serve public policy goals of financial inclusion by making bonds affordable.” Municipalities can finance infrastructure and public works projects by enabling people to buy debt in smaller denominations than the standard $5,000 minimum.
Green Bonds as Sustainable Investment Instruments
Corporations, municipalities, or governments issue green bonds to fund projects with environmental benefits, such as renewable energy or energy efficiency initiatives. While these bonds are designed to promote the transition to a low-carbon economy and support sustainable development, fraud or greenwashing can compromise them. For example, JBS was accused of selling green bonds while still producing excessive emissions, and German police raided Deutsche Bank as part of a probe into allegations of misleading ESG claims. Consequently, there is an emphasis on increasing transparency in using proceeds from these bonds.
Smart bonds have the potential to transform green bond issuance by improving transparency and mitigating fraud risks. Smart contracts enable the automated enforcement of conditions to ensure funds are allocated for intended purposes. In addition, blockchain provides real-time monitoring and immutability, allowing all parties to access, track, and verify information that cannot be altered.
Carbon credits, part of a cap-and-trade system, incentivize emissions reductions and promote sustainability. This system allocates credits to countries and companies, permitting a certain level of emissions. Entities can sell their excess credits, creating a financial incentive to reduce emissions and generate income. Credits are traded through emissions trading systems (ETS) and sold through auctions or over-the-counter (OTC) transactions, which can be opaque—companies may make false claims about their emissions reductions or sell credits they do not own. However, with blockchain technology and smart contracts, the carbon credits generated from a green project could be tracked and verified, enabling greater transparency and accountability.
While smart bonds could invigorate the market thanks to this added layer of trustlessness, there are real-world challenges to tracking emissions. Measurement of carbon emissions by suppliers (who are paid through funds raised by bond issuance) and tracking carbon credits requires installing a considerable number of tamperproof emissions sensors. Standardization, reporting, and certification of such green data feeds are still in an early stage, but several newly emerging startups have started installing and collecting such data as green feeds. Connecting such data with smart bonds on a blockchain can help create an end-to-end closed-loop system for funding and tracking sustainability development goals.
As we witness the rapid evolution of the financial landscape, smart bonds are poised to play a transformative role in democratizing investments, fostering sustainable development, and leveling the playing field for emerging economies. It's a brave new world where Axel Foley and John McClane meet Satoshi Nakamoto, and the implications are vast and ripe for exploration. In this dynamic environment, investors, governments, and innovators must remain vigilant and adaptive, embracing the opportunities that smart bonds present while navigating the challenges that inevitably come with trailblazing change.
The information presented is for general educational purposes, based upon publicly available sources believed to be reliable, but unverified. This communication is in no way a solicitation or an offer to sell securities or investment advisory services.
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