Smart contracts can revolutionize capital markets, but they need to be standardized first

By Ralf Kubli

The bond market represents the largest and most sophisticated division of the global economy. The International Capital Markets Association (ICMA) places the overall size of the global bond market at $128.3 billion – of which 68% is government bonds and 32% corporate bonds, however, this is just the tip of the iceberg. Blockchain technology, more specifically tokenization, could help the bond market operate more securely, efficiently, and faster than ever before, while extending crucial liquidity.

In India, there are a long-standing cash shortage in government bonds due to the exclusion of retail investors. Minimum bond prices are set at an exceptionally high level that excludes regular investors, limiting the liquidity that broader participation would provide.

In specialty or emerging bond markets, liquidity can also be an issue. A indonesia green bond report notes that liquidity is a significant hurdle, and there are concerns even in markets as large and mature as US corporate bonds.

Liquidity is not the end of the story. Costs and speed of settlement are often less than ideal. And settlement times are usually measured in days based on proof of ownership from the seller and transfer of funds from the buyer. In the age of digitalization, these delays feel like the hangover from a bygone age.

Tokenization is not the whole solution

Bond tokenization potentially provides the solution – but not in the way it is currently done, which focuses on digitizing the documents of the bonds rather than digitizing the underlying cash flows they represent.

Tokenization converts bonds into digital tokens that represent the underlying asset and live on a transparent and immutable blockchain. All economic benefits and risks remain intact, with the added benefit of greater transferability and fractionation of the underlying obligation. Through splitting, the value of each token can be set low enough to allow small investors to enter the market, thereby attracting liquidity that many bond markets have been slow to capture until now.

But that’s not all. Today’s bond trading requires a centralized exchange or intermediary between the two parties – a necessary evil to build a layer of trust. The seller cannot be sure that the buyer will pay, and the buyer cannot be sure that the seller has the deposit or will return it after payment. The exchange acts as a trusted counterparty and creates a time buffer to allow proof of ownership and transfer of funds. Naturally, the exchange charges a fee for this.

Tokenized bond transactions, on the other hand, are executed in real time. And, thanks to the distributed and immutable nature of blockchain, they don’t require parties on either side to trust each other, eliminating the need for a centralized third party. There is no risk that the transaction will fail, leaving one side out of pocket. Either the seller gets the agreed price and the buyer the token, or the entire transaction ends. It’s automatic, immediate and, thanks to the elimination of rent-seeking intermediaries, it’s often very profitable.

Cash flow tokenization: the missing piece of the puzzle

There is however a catch. In token bond offerings, certain parameters – including offering volume, coupon rate and duration – can be mentioned directly in a “smart contract”. These self-executing agreements are meant to automatically fulfill the terms of an agreement. However, the smart contracts used in bond tokenization today amount to very little beyond keeping a digital record. They are primarily concerned with how the token can be stored, traded, and accessed, and do not mathematically describe the actual underlying cash flows of the bond.

As a result, cash flows representing the value of tokenized bond instruments are often neither machine-readable nor machine-executable. They are often added as written documents (e.g. PDF or a hash) rather than expressed mathematically in the token. In other words, someone still has to read the documents, decide what they mean, and then do something about it. The result is a process that is slow, inefficient, susceptible to misinterpretation or fraud, involving professional fees and anything but decentralized. It does very little to innovate the current status quo, as multiple intermediaries are still needed.

The tokenization of financial instruments as it occurs today is deeply flawed because it ignores the algorithmic nature of the underlying cash flows of financial contracts. It is only by recognizing the key element of finance – the financial contract, which defines the exchange of cash flows over time – that tokenized financial instruments can become successful.

The discovery that the underlying cash flows of financial contracts can be standardized and described by a limited number of attributes and algorithms is the result of the work of the ACTUS (Algorithmic Contract Types Universal Standards) Research Foundation.

ACTUS is a US-based non-profit organization that emerged in the aftermath of the 2008 stock market crash, an event that laid bare serious shortcomings in risk management and financial regulation, particularly the inability to see and understand the cash flow patterns of the financial instruments that are in the collateralized instruments. ACTUS provides an open source standard for financial contracts with reference implementations in Java.

Financial contracts are mutual agreements between counterparties to exchange cash flows, but written by lawyers in different languages, legal terminologies and jurisdictions. ACTUS addresses this weakness with a global standard for consistent algorithmic representation of financial instruments. It does this by focusing on the cash flow obligations of a financial contract rather than the different legal jurisdictions, as the vast majority of financial instruments are built on a small number of standardizable underlying cash flow models. .

Decentralized finance, cause of the next financial crash?

It is not just token bonds that will benefit from standardization; Adopting ACTUS across the entire Decentralized Finance (DeFi) industry is not only advised but essential. The use of a programming language is a necessary condition, but not sufficient to be able to write a smart contract. Without a standardized algorithmic definition of token cash flows, it becomes impossible to know whether interest payments will be paid or not or whether these cash flows are already guaranteed in another contract. It sounds eerily like the spark that ignited the 2008 financial crisis.

Standardization through financial smart contracts paves the way for compatible, plug-and-play DeFi building blocks that can talk to each other. It will provide a way to tokenize all financial instruments in a consistent way and create interoperable and economically transparent digital assets.

Tokenization is a valuable upgrade for both traditional and DeFi capital markets, but only if it includes a standards-based method to describe, compare, and act on underlying cash flows. Bringing ACTUS-based smart contract standardization to DeFi is essential. Without this, DeFi is unlikely to expand beyond its limited use case of over-collateralized lending and an industry-wide crash is highly likely – which could have implications outside of credit markets. cryptocurrency still niches.

About the Author

Ralf Kubli is a member of the board of directors of Casper Association and an experienced executive with a strong background in blockchain, cryptocurrencies, and decentralized technology. Ralf’s career spans roles in mergers and acquisitions, sales, and leadership positions at large corporations and tech startups. He discovered Blockchain through a Fintech investment in 2015. Since then, Ralf cannot ignore the transformative potential of this technology and has been involved in the blockchain space as an investor, advisor and board member.

Ralf holds an MBA from Cornell and an MA in History from the University of Zurich.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.