When the European Investment Bank priced its first digital bond in April, it not only signified an inflection point in the digitalisation of the capital markets but represented another example of the bank’s commitment to developing the financial markets.
The €100m note is described as potentially significant as sending the first email.
The EIB has racked up several “firsts” in the bond markets over the years, including the world’s first green bond in 2007. So, it was little surprise to see the European Union’s long-term lending institution make an early appearance in the nascent digital financial markets with a €100m zero-coupon two-year note launched on blockchain. It was an experiment the bank felt compelled to make.
“Given the role of the EIB in terms of market development, we had to be present in this digital world,” explained Richard Teichmeister, the EIB’s head of new products and special transactions. “We had to understand the implications of the technology, and there is no better way to understand something than by doing it yourself.”
And it was no facile exercise: “Blockchain technology has the potential to fundamentally change the way capital markets operations are run,” said Xavier Leroy, senior funding officer at the EIB.
The EIB’s note was not the first digital bond issued using distributed ledger technology, nor the first supranational agency to issue via blockchain, but it was the first to attempt to replicate the normal workings of a syndicated bond transaction.
“The idea was to see how close we could get using blockchain technology to something that we would normally do ‘off chain’,” said Teichmeister. “Which is by issuing a meaningful bond in terms of maturity and amount, involving a syndicate of banks and distributing to external investors.”
The plan was to bring as many features as possible of a traditional, syndicated deal into a blockchain environment. It drew on lessons learned from other proof-of-concept digital transactions to attempt something likely to have a more lasting impact on the market.
“The analogy is that of building a car: somebody builds an engine, somebody else a steering wheel, and somebody designs the brake system,” said Leroy. “We built the car.”
The result being the first digital deal of its type. A bond featuring multiple lead managers - Goldman Sachs, Santander and Societe Generale, targeted to a group of investors unaffiliated with issuer or leads, using a public blockchain, Ethereum, with settlement via a Central Bank Digital Currency (CBDC). The choice of CBDC in this case forming part of a programme of digital currency experiments instigated by the Banque de France.
“It was a defining transaction in the digital space,” said Maud Le Moine, head of SSA DCM at Goldman Sachs.
Chain of events
Getting to the point at which all actors were confident to launch the deal took time, with the project taking over 18 months to be realised.
“Everything took 10 times longer than normal,” said Leroy. “For much of the process, there was no precedent to rely on, so we found ourselves having to create a lot of the concepts.”
And it was not necessarily the technical side that proved the greatest hurdle to the schedule.
“We didn’t know much about blockchain, so we wanted to make sure we had that aspect well under control,” said Leroy. “But when it came to the technicalities – pricing, the settlement and so on – it was very fast and efficient.”
Coming to grips with the technicalities of blockchain may have turned out to be relatively painless but navigating the regulatory and legal framework of a bond proved more complicated.
“A substantial amount of time and work was spent on the legal aspects of the deal,” said Leroy. “We didn’t expect legal and regulatory issues to be so challenging.”
In the end, the EIB chose to issue its digital bonds under French law. Not all European legal systems allowed for a bond defined in purely digital format, but France had passed legislation recognising the concept in 2017.
While much of the bond syndication process could be replicated on-chain, the implications of using digital technology were most noticeable in the clearing stage of the process. Trades can be reported and settled immediately on blockchain, so the role of the central securities depository (CSD), the traditional vehicle for reconciling transactions, was replaced by the platform manager, Societe-Generale Forge.
“Blockchain technology has the potential to change fundamentally the way debt markets work,” explained Teichmeister. “The beauty of digital transactions is the higher efficiency, transparency, transactional speed and opportunities for cost savings.”
“With blockchain, the cost of issuing a bond can be greatly reduced,” said Leroy. “If everything is automated and takes place on blockchain, then you can simplify middle and back office procedures.” Cost reductions of automating multiple sequential processes are material. As well as the more obvious back office savings, faster settlement allows for more efficient balance sheet management.
“The bond market typically works on T+2 settlement, with EIB preferring T+5,” said Mathew McDermott, head of digital assets at Goldman Sachs. “We opted for T+1 for the EIB transaction, but in theory this could have been T+0 given transactions can settle instantaneously on blockchain.”
Cost savings from using blockchain technology could pave the way for a new breed of smaller issuers to enter the market but use of the platform could also herald the appearance of a new class of investor.
“In the longer term, fractionalisation of tokens (aka digital debt) should help broaden the investor base,” said McDermott.
The bank’s first digital bond has gone some way in establishing a benchmark for further syndicated transactions, but it clearly created unanticipated levels of discussion in the market.
“We were surprised at interest this deal uncovered in the issuer and investor community,” said Le Moine. “The market is evolving much faster than we’d expected.”
New working groups have been established to further investigate the application of blockchain to financial markets, but at what speed the technology will be adopted by the wider community remains open to debate. And as to whether issuance on blockchain will have the same impact in the bond market as email on letter writing remains to be seen.
This article was produced in association with the EIB