• Published on 19 February 2020
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Background Notes on Interview with Rehan Ahmed and Pradyumna Agarwal on SGX and Temasek partnership to advance digital asset infrastructure in capital markets

Discussion points

• What can unlock the potential of digital assets?
• Asian fixed income markets at a glance: digital bonds in the Asian market
• SGX digital asset issuance platform
• Regulation & technology considerations for end-to-end digitalisation
• The potential of digital bonds
• SGX and Temasek partnership

Technology: Digital assets can now be deployed to regulated, interoperable, scalable, and enterprise-friendly distributed ledger technologies (DLT), as opposed to the public blockchains. These DLTs can be considered hybrid deployments, as the blockchain ledger is just one component so that those platforms are easier to integrate with company IT infrastructure; for example with R3 Corda, Hyperledger Fabric, or Kaleido. As a result, clear governance, identity, security, and implementation frameworks can be embedded by design. This in turn offers compliance and legal guarantees to financial authorities. The majority of European and US financial institutions have already joined blockchain consortiums that would facilitate the exchange and emission of those assets.

Tokenisation: Cryptocurrencies have no intrinsic, convertible, or pegged value, which explains most of their volatility. On the other hand, digital assets are mainly emitted by tokenising an underlying asset. Tokenisation works by representing an asset with divisible, digital tokens with money-like properties (medium of exchange, storage of value, and unit of account). Those are then deployed to a blockchain network for security and verification purposes. Once the emission is complete, those assets can be swapped on a primary or secondary market exchange that has the necessary infrastructure to realise the trading, settlement, and custody of these assets. Among the leading exchange projects are SIX Digital Exchange (SDX), to be launched in 2021 in Switzerland, Deutsche Börse (in collaboration with Swisscom and Sygnum), or ICE Futures & Clearing (Bakkt) and Fidelity Digital Assets (FDAS) in the United States. All are working on regulated digital asset market infrastructures. Other players are offering the infrastructure as a service like Nasdaq or AlphaPoint, to name a few.

Compliance: Beyond the trading and storing of cryptocurrencies, the legal status of cryptocurrency financial services and operations remains unclear, let alone the various fiscal categorisations between European countries. Therefore, the new foundations and the deployment of the digital asset infrastructure and products are being implemented in a compliant manner by all financial utility providers: market operators, exchanges, banks, technology providers, central banks, and local financial regulators. The green light of the latter is mandatory for the issuance, exchange, and thus institutional adoption of these assets.

Ecosystem: As mentioned, financial institutions, capital market operators, and regulators have gained enough maturity in the tangible benefits and risks of blockchain and DLTs for the emergence of an end-to-end digital asset ecosystem. For exchanges and operators, trading, clearing, and settlement is now possible in seconds thanks to “atomic swaps”. Those smart contracts cryptographically solve the problem of the counterparty risk of a transaction without reconciliation costs: The blockchain ledger offers trust as an independent “triple-entry” accounting system recording all transactions and state changes of the network. Also, banks and other financial inter mediaries see the potential of automating consolidated reporting and compliance, posttrading, custody, and asset servicing. Furthermore, interest is rising as digital assets also offer formidable opportunities in terms of derivative products like options, futures, collateralised lending or staking. For instance, Bakkt Bitcoin futures exchanges, fully regulated and limited to institutional investors, have gained a lot of momentum recently. While still relatively small, volumes are growing ($1.8 billion for Q1 2020, +177% compared to Q4 2019)3 and interest rates are rising. Bakkt has recently launched the equivalent for options. Portfolio and asset managers are observing the low correlation that such assets have with more traditional assets and are starting to understand the unique value and risk drivers of those assets, such as higher security, more privacy, scalability, and a decentralised web.

 Even central banks are now testing their own tokenised currencies, central bank digital currencies (CBDC). For them, digital currencies, such as digital euros, would have the double advantage of enabling exchanges and allowing their customers to keep digital assets in a stable form without converting back to fiat—and at the same time influence the digital asset market stability.

Asian fixed income markets at a glance: digital bonds in the Asian market

-Asia (ex-Japan) bond markets (including local currency) are estimated at more than $15 trillion, with onshore China, South Korea, India as the largest local currency market.

-With more than $1.6 trillion outstanding, Asia G-2 (USD & EUR – i.e. off shore) annual bond issuance is estimated at $355 billion in 2019, with more than 180 participating arrangers

-Short term debt markets have also shown growth with $273 billion of issuance in 2019, largely driven by bank issuer certificates of deposit (CDs)

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.

Digital Bonds is the Asian Market: Although there are several examples of asset digitalisation on and/or use of digital ledger technology (DLT) in the Asia bond market (onshore China, Philippines, Thailand), none has focused on syndicated public corporate bond issue given the complexity due to parties involved (arrangers, legal counsel, paying agents and investor custodians) and engrained processes. Validation on of advantages that asset digitalisation on, tokenisation on and DLT can bring must be tried at scale to truly determine the technology’s applicability to traditional institutional capital markets.

The digital asset issuance platform is a fully integrated infrastructure that connects ecosystem participants such as issuers, arrangers banks, investors, legal counsel, settlement and custodian banks.

Security information is captured directly at source with rights and obligations modelled, while smart contracts trigger processes such as issuance flows, coupon and redemption payments.

Need for Asian market infrastructure: Given the market size (described in Asia fixed income legend) and increasing interest by global participant base, the Asia bond market will require supporting infrastructure to keep up with its increasing size. Cross-border investing will require real time (and Asia time zone) settlement for issuers, arrangers and investors while ensuring depository and asset servicing costs remain competitve. A good example of this is lack of USD & EUR clearing capability during Asia time zone.

An end-to-end digital infrastructure: whereas the digital issuance process validated several downstream efficiencies (versus analog issuance process), the prospect for upstream efficiencies during the bond issuance process remain high, in particular (a) real-time synchronised issuance data (b) order-taking, bookbuilding & allocation on process (c) availability of consistent buyside identifiers (d) lack of sellside system integration and (e) platfoorm communication capabilities for other ecosystem participants such as paying agents and legal counsel. SGX is actively evaluating upstream platform partnerships in this space for use in conjunction with the asset digitalisation infrastructure and will be approaching market participants with intended solutions.

Regulation & technology considerations for end-to-end digitalisation

Global E-Securities Regulation:The elimination of paper trail, especially global notes (representing ownership with the CSD), is required to realise the vision of full digitalisation. We see this shift occurring in two phases, (a) acceptance of electronic (versus physical copies) by downstream infrastructure such as CSD and (b) a move to eliminate physical copies altogether with securities records on electronic records maintained by CSDs. Within ASEAN, both Philippines and Thailand have implemented such regimes (to facilitate issuance processes) whereas Germany has a draft Electronic Securities Act (a legal framework for issuance of paperless bearer bonds) expected to be passed by the end of 2020. SGX continues to work with its legal and regulatory partners on an appropriate framework for asset digitalisation.

Smart Contracts and Bond Terms & Conditions (T&C): Smart contracts can capture bond economics relatively easily for vanilla bonds and standard issuance/coupon fl ows and standard payment profiles (e.g. fi xed rate coupons,); however they have yet to manage the complexities of plain language T&C such as high yield covenants, which requires upstream capabilities (e.g. issuer financial reporting) to be built into the Platform.

Business Logic Dictates Technology Choice: For the digital issuance process, the focus was on capturing the business logic of the bond lifecycle in smart contracts and DAML was chosen as the ledger-independent modeling language to digitalise the multi-party agreement. For sake of expediency and cost effi ciency for the pilot, these were recorded on a conventional database versus a DLT solution. As DLT continues to evolve, this outcome-driven modelling approach allowed the team to extract the most value while also preparing to integrate to a DLT in the future.

DLT considerations: Despite some consolidation and progress on industry wide capital market initiatives, cost effi ciency remains at the forefront of future financial market infrastructure build out (using DLT). SGX continues to evaluate ledgers for future utilisation with ease of integration and costs as key determinants.

Payment Systems Evolution: HSBC’s on-chain payments solution is the first payment solution to be used in conjunction with the platform andSGX intends to add new settlement banks and payment networks to enhance liquidity options for the platform.

Key catalysts would be the implementati on of a major central bank digital currency (CBDC) or commercialisation of market initiatives (e.g. Project Ubin). Successful trials such as Banque De France’s recent issuance (settled through sovereign digital currency) serve as strong precedents.

The potential of digital bonds

TRUST MATTERS

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'.

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, governments are 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, there are 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

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.

SGX and Temasek partnership

The SGX/Temasek venture is called Marketnode and is focused on digital initiatives in the capital markets space. It builds upon a previous initiative between the two groups and HSBC, which led to the issuance of Asia’s first public syndicated digital bond, for Olam International in August.

SGX’s management stated that the joint project aims to be the Asia Pacific or APAC region’s first exchange-managed digital asset venture that’s focused on improving capital markets workflows through DLT-enabled smart contracts, and related tokenisation technologies.

Through the partnership, the SGX and Temasek intend to combine SGX’s multi-asset experience in managing and operating market infrastructure with Temasek’s expertise in blockchain or DLT and related ecosystem connectivity.

The joint venture between the companies will focus on working with fixed income issuance platforms in order to connect to its post-trade and asset servicing infrastructure. This should offer issuers, arranger banks, legal experts, investors and various paying agents a complete, issuance-to-settlement network for handling Asian bonds.

Additionally, the partnership between SGX and Temasek will focus on other emerging asset classes that have seen increasing market demand, such as specialised or dedicated funds and sustainable finance initiatives.

This joint venture aims to further extend the ongoing collaboration between SGX, Temasek and HSBC which led to the issuance of their first public syndicated digital bond for Olam International back in August 2020. SGX’s digital asset issuance, depository and servicing platform has reportedly been leveraged to issue four different digital bonds by various issuers, with a total size of more than SGD 1 billion (appr. $754 million)

SGX said Marketnode will acquire a minority stake in Covalent as part of the partnership.

Under the partnership, Marketnode and Covalent will collaborate and build the Asia-Pacific's first, end-to-end digital infrastructure in the fixed income space, SGX said. The entities will streamline the listing, straight-through processing and settlement of bonds and activities in bond lifecycle management.

The partnership builds on the bourse's efforts in digital bonds, and the use of digital asset infrastructure to improve efficiency in the capital markets.

Olam digital bond

The Singapore Exchange (SGX), with HSBC Singapore and Temasek, has completed its first digital bond issuance.

The bonds were issued by agri-food giant Olam International on SGX's digital asset issuance, depository and servicing platform.

Singapore Exchange (SGX), working together with HSBC Singapore and Temasek, has completed its first digital bond issuance on SGX’s digital asset issuance, depository and servicing platform, successfully replicating a SGD 400 million ($301.70 million) 5.5-year public bond issue and a follow-on SGD 100 million ($75.43 million) tap of the same issue by Olam International.

It uses smart contracts to capture the rights and obligations of parties involved in issuance and asset servicing, such as arrangers, depository agents, legal counsel and custodians, the bourse added.

Olam managing director and chief financial officer N. Muthukumar said: "Going digital will make the entire process more efficient and transparent for all parties - issuers like us receive our funds more speedily, investors get their bonds more quickly, while the arrangers, custodian and banks benefit from the reduced probability of error and speed."

The digital bond used HSBC's on-chain payments solution, which allows for seamless settlement in multiple currencies to facilitate transfer of proceeds between the issuer, arranger and investor custodian.

Some key efficiencies observed within the pilot include elimination of settlement risk, reduced time for primary issuance settlement from five to two days as well as the automation of coupon and redemption payments and registrar functionality.

The SGX said: "An Asia first for a syndicated public corporate bond, this digital bond marks another milestone in SGX's use of digital asset technology, by streamlining processes for issuers, underwriters, investors and ecosystem participants across primary issuance and asset servicing.

About Marketnode

A joint venture between SGX and Temasek, Marketnode is a digital asset infrastructure firm that uses smart contracts, ledger and tokenisation technologies for traditional capital markets products. Marketnode aims to support the future digital marketplace and ecosystem across multiple asset classes, through a trusted market-wide infrastructure, enabling inter-operability and fostering digitalisation in capital markets. Its initial focus is on fixed income, where it will partner upstream bond issuance platforms to create a first-of-its-kind, issuance-to-settlement and asset servicing platform for Asia bonds.

About Singapore Exchange

Singapore Exchange is Asia’s leading and trusted market infrastructure, operating equity, fixed income and derivatives markets to the highest regulatory standards. It also operates Asia’s only multi-partner, multi-asset exchange-led sustainability platform (sgx.com/first).

As Asia’s most international, multi-asset exchange, SGX provides listing, trading, clearing, settlement, depository and data services, with about 40% of listed companies and over 80% of listed bonds originating outside of Singapore. SGX is the world’s most liquid international market for the benchmark equity indices of China, India, Japan and ASEAN and offers commodities and currency derivatives products. Headquartered in AAA-rated Singapore, SGX is globally recognised for its risk management and clearing capabilities.

About Covalent Capital

Covalent Capital (Issue New Bonds, The New Way) is a B2B financial technology company started in 2017 specialising in capital market solutions. It harnesses technology to solve for cost, process and information inefficiencies. Founded by Sanjay Garodia, Mayur Ghelani, TJ Ho and Parag Patankar with a firm belief that primary capital markets processes are ripe for change, the founders offer deep domain expertise having run large franchises for fixed income products with top investment banks, and product teams at global enterprise technology companies.

Covalent Capital’s first product “OMAS”, launched in December 2018, is a full life-cycle product for the issuance of new bonds, a first-of-its-kind in the world, and is supported by the Monetary Authority of Singapore through the Financial Sector Development Fund. Over 200 financial institutions across Asia represented by over 1000 fixed income professionals are ambassadors of OMAS.

Questions

1. The potential and growth trajectory of digital bonds and other digital assets as a new asset class? How is it viewed by issuers and investor, an evolution/extension of an existing asset class or more as a new asset class?
2. What challenges do you face in developing this new infrastructure and ecosystem, especially in getting more institutional investors onboard? What are the long-term prospects and the significance of the Marketnode JV between SGX and Temasek?
3. How does the Olam digital bond actually work? What are the key differences with a traditional bond or fixed income instrument?
4. Who are the participants in the entire ecosystem? What is the role of blockchain and smart contracts when all parties are known? Aren’t all securities already issued and traded electronically/digitally anyway? Is there a premium over traditional securities?
5. Why is Temasek, as a sovereign fund, who is typically at the buyer/investor end, and not a market infrastructure provider involved? And how do you view the development and progress of digital assets as an investment class?
6. Tell us more about the partnership between Marketnode and fixed income issuance and data firm, Covalent Capital (Covalent), to build Asia Pacific’s first, end-to-end digital infrastructure in the fixed income space.