Andrew Lockley – Exponential Investor (United Kingdom) –
Bonds are one of the world’s oldest inventions.
They outdate currency. They outdate the major religions. They even outdate our oldest surviving language – Sanskrit.
The first recorded bonds were created circa 2,400 BCE.
They form the foundations of our entire financial system, and they are about to undergo their biggest change in over 4,000 years.
This change will have knock-on effects for every market and every asset in the world. And, as you may have already guessed, it will be brought about by the crypto revolution.
A £2.5 trillion market ripe for disruption
If you’re not familiar with what bonds are, don’t worry. They are actually pretty simple.
A bond is basically just like a loan. But instead of it being paid for in small increments, it is paid in full at the end of the term. Between its issuance and repayment date, interest is paid to the holder.
So, say for example a company wanted to raise £100,000.
It could issue 100 £1,000 bonds, each with a five-year term.
It would then set an interest rate on these bonds to encourage people to buy them.
Let’s say it chose a fixed rate of 5% a year.
That would mean, if you bought one of these bonds at the start of the term, you would pay £1,000 for it.
You would be paid £50 a year for holding it, and at the end of the five years, you’d get your initial £1,000 back as well.
Once issued, these bonds can be traded like stocks. Depending on the interest rate and economic outlook, they may trade for more or less than their initial price.
Bonds are a great way for businesses, and even countries, to raise money. And the market for them is huge.
Last year, companies around the world issued $3.5 trillion of bonds. That’s about the same as the entire GDP of the UK.
And that’s before we even get into government bonds. When we take those into account, the total bond market is worth an estimated $100 trillion.
This dwarfs even global stockmarkets, estimated at $64 trillion.
The amount of money in bonds is essentially incomprehensible. To use my favourite perspective tool, if the money in the bond market was converted into £1 coins, and we laid those coins out end to end, the line would reach from the Earth to the Sun ten times over.
At the moment, most of these bonds are handled by investment banks and sold to pension funds and asset managers.
It’s a world, like most of finance, which is controlled by gatekeepers and is largely off limits to individual investors.
It’s centralised, wasteful, outdated, and jam-packed with money. In other words, it is the perfect industry for crypto to disrupt.
And 2018 is the year that disruption really begins.
Why smart bonds will take over the world
So, bonds are currently handled for companies by banks, sold by banks and bought up by banks and fund managers.
In the first instance, a smart bond built on the blockchain would do away with all of these intermediaries and let a company issue its own bonds directly to buyers.
This can be done in much the same way as initial coin offerings (ICOs) work.
The company simply creates its own token, and allows people to buy it directly or allows it to be sold on exchanges.
The big corporations could still buy up these tokens, but everyone else could too.
Not only would this open up a whole new world of buyers for said company, but it would massively cut down on costs too – investment banks don’t come cheap.
Another way smart bonds win out over the current model is because they are programmable.
All the parameters of the bond can be programmed in very, very easily through smart contracts.
These contracts are self-acting. Once set up no one needs to oversee them. They execute on their own.
How smart bonds work
Vincent Launay, of World Bank, writing on Cointelegraph explains the idea well:
- Company V creates a smart contract on the Ethereum Blockchain that replicates how a bond works (i.e., payment of coupons semi-annually and repayment of principal at maturity).
- Investors who wish to participate in the IBO (Initial Bond Offering) send ETH to the contract address and specify the lowest coupon they are willing to receive.
- Once the IBO is over, the smart contract automatically builds the order book with investors willing to accept the lowest coupon first, the marginal investor needed to fill the order book sets the coupon for a bond.
- All the investors who did not make it to the final order book automatically get back the ETH they had sent to the smart contract.
- Every six months, investors receive the coupon (interest) as set in the original smart contract.
- If company V does not want to take the risk that the value of Ethereum increases substantially, payments can be made in ETH but adjusted with the exchange rate of Ethereum with the fiat currency of the bond. Before payment of the coupon, the smart contract will get the exchange rate between the fiat currency and Ethereum from an oracle (data provider) and pay the right amount of ETH such that the bond replicates precisely how a fiat currency bond would have behaved.
- Alternatively, payments of coupons and repayment of principal can be made directly in tokens backed by fiat currency and redeemable with a reputable, audited financial institution.
- At maturity of the bond, the smart contract pays out both the coupon and the principal (either the same amount of ETH or the same amount of US dollar paid in Ether or fiat-backed tokens).
It sounds like a great idea, right? So why isn’t it all over the news, where are the trials?
They have already taken place.
UBS’s smart bond experiment
Since cryptos that allow smart contracts, such as Ethereum, first appeared on the scene, smart people saw smart bonds as a major use case.
And although cryptos have really only been mainstream for six months or so, people have been working on the smart bond idea for much longer.
One of the biggest banks in the world, UBS, saw the potential right away and immediately started trials in London.
In December 2016, UBS reported on this successful trial. Here was its conclusion:
This experiment validated our initial assumptions on smart contracts and virtual currencies, and confirmed the applicability of these logics across our use cases.
It also confirmed the potential benefits for our clients, the regulators and our organization: clearing and settlement on blockchain could be faster, more efficient and transparent while reducing settlement risk and operational cost.
Smart bonds are coming. They will shake up the very foundations of finance. And it seems they will be built on top of the Ethereum blockchain.
As many of the speakers in January’s London Blockchain Week conference stated: 2017 was the year of crypto speculation, 2018 is the year when crypto starts being used for real.
And all of this is before we even start getting into the use of cryptos for smart futures contracts and commodity trading.
This is why, even during the dips, crashes and media scorn poured on cryptos, people who see the full potential of cryptos don’t get worried.
Cryptos will do for finance what the internet did for information. And they will make many people very, very rich in the process.
If you want to be one of them, click here to find out the five cryptos Sam Volkering, Eoin Treacy and I believe will see the biggest gains this year.
Until next time,
Editor, Exponential Investor