Issuing digital bonds based on blockchain technology – the next milestone in the development of the Pfandbrief.
Since the birth of the Pfandbrief around 255 years ago, the world has advanced technologically in leaps and bounds. Instead of horse-drawn carriages, we can now travel to our destination quickly and comfortably by train on strike-free days and today’s mobile phones have more computing power than the total power available for the moon landing in 1969. However, one thing has remained the same for centuries: for the issue of Pfandbriefe, a physical certificate is required with the cover pool monitor’s personal confirmation of proper cover. Thanks to the introduction of collective safe custody and global certificates in 1972, the creditor no longer has to keep them at home, but the legal character of the certificate still exists. This could now change thanks to blockchain technology and an adapted legal framework.
Blockchain technology offers a wide range of possible applications and has the potential to fundamentally transform global value chains – including in the financial sector. The German government has also recognised this and implemented a central component of its blockchain strategy with the entry into force of the Electronic Securities Act (eWpG) in June 2021, thus creating the legal requirements for the issuance of digital securities in Germany.
In some countries, it has already been possible to issue digital securities for some time. In 2018, for example, the World Bank issued a digital bond entirely via blockchain for the first time. Since then, more than 100 bond issues have been carried out on blockchain solutions, both domestically and internationally. However, a Pfandbrief has not yet been one of them. This is despite the fact that integrating the technology into the issuance process offers numerous advantages. These include, in particular, the completely digital and therefore document-free execution of the issuing process as well as same-day settlement of the transaction (delivery vs. payment). This can generate cost advantages in both settlement and refinancing.
Due to its high level of efficiency and security, it can be assumed that blockchain technology will find its way into the processing of bond issues and their entire life cycle worldwide in the medium term. This article provides a general overview of the topic and shows which steps are necessary for implementation by Pfandbrief issuers. As the existing in-house processes remain largely identical, the expected implementation effort appears to be relatively low.
Legal framework in Germany
With the eWpG, the German legislator created the legal framework for the issue of digital securities in June 2021. This applies specifically to bearer bonds (registered securities could already be issued as digital securities based on the German Civil Code, as the documentary requirement only applied to bearer bonds) and shares. The central point of the law is the dematerialisation of securities law. Issuers are given the option of issuing securities either by means of a physical certificate as before or by digital means. The law is fundamentally designed to be technology-neutral. The decisive factor is that digital respectively electronic securities are issued by making an entry in an electronic securities register instead of issuing a certificate. The electronic securities register can either be a central register at central securities depositories respectively custodians or a crypto securities register.[1] Pursuant to Section 16 (1) eWpG, the latter must be kept on “a tamper-proof recording system in which data is logged in chronological order and stored in such a way that it is protected against unauthorised deletion and subsequent modification.” Anyone operating such a register requires a crypto securities register licence, which is issued by the German Federal Financial Supervisory Authority (BaFin). A crypto custody licence is also required for the custody and management of crypto assets (so-called tokens) for third parties. Since the regulation came into force in January 2020, several large credit institutions in Germany have already applied for and received these licences.
The cover pool monitor also plays an important role in the issuance of Pfandbriefe. As part of the cover pool monitor confirmation, the cover pool monitor testifies that the prescribed cover is in place and that the cover assets have been entered in the corresponding cover register. In order to enable the issuance of digital Pfandbriefe, Section 8 (3) of the Pfandbrief Act was extended following the introduction of the eWpG to the effect that the cover pool monitor’s confirmation and signature can now also be provided digitally.
The blockchain technology
Blockchain technology, which was described in the eWpG as a “forgery-proof recording system” as quoted above, offers one option for issuing digital Pfandbriefe. It offers a high level of security and opens up the possibility of digitalising and automating processes that previously had to be carried out by third parties.
The blockchain is a decentralised database or digital register that records transactions or other data in a continuous list of blocks. Each block contains information about the previous blocks, creating a chain of blocks – hence the name “blockchain”.
Security
The blockchain, or digital register, is usually operated by a decentralised network, with each network participant (known as a validator) owning a copy of the entire blockchain. When a new transaction is entered into the network, the validators check the validity of the transaction on the basis of defined consensus mechanisms and ensure that it fulfils all the necessary criteria. If this is the case, the transaction is included in a new block and added to the blockchain with a timestamp.
The special feature is that the blocks are linked using a cryptographic hash function – so-called hashes. This allows data of any size, such as text, to be mapped in a code with a fixed character length. The slightest change to the input data leads to a completely different hash result and would therefore be detected immediately by the network. For example, the term “Pfandbrief” creates the following hash with the SHA-256 hash function: “7211e5a14cd4ec3f25bcbbf6a940dd98beeb613f13f14eff0e46c8743a8f715c”.[2] This function makes information that has been stored on a blockchain unchangeable at a later date. At the same time, no conclusions can be drawn about the input data using a hash. The result is a secure, seamless and unalterable history of all transactions that can be viewed and verified by every member of the network.
Digital
Digitalisation is achieved through tokenisation, i.e. the representation of an asset on the blockchain, including the rights and obligations it contains. In the case of securities, these are so-called security tokens. The security token represents ownership of the underlying asset and, unlike conventional securities, is not held in a securities account but in a wallet. This means that the holders of a security no longer have a physical certificate, but a digital record.
Automation
Automation can be achieved in particular through smart contracts. Smart contracts are simple programmes that are stored on a blockchain. They are executed when certain contractual conditions are met and can be used to automate the associated process steps (such as payments or transfers of ownership) without the need to involve a third party for processing.
Blockchain technology thus forms the basis for a digital infrastructure that processes transactions and their contractual components securely, cost-effectively and automatically. This makes it interesting for a variety of use cases. One particularly relevant use case is the documentation and transfer of property rights and the processing of the associated rights and obligations. This makes the technology ideal for issuing bonds.
Market development
The first bond to be processed entirely via a blockchain was issued by the IBRD (World Bank) in 2018. Since then, more than 100 projects have been implemented internationally by various issuers and market participants. The European Investment Bank, for example, is represented with several issues, including a green bond. A first covered bond totalling € 100 million was also issued on a blockchain basis by the French Societe Generale SFH in 2019. A comprehensive overview of international projects can be found on the ICMA website.[3] A prominent blockchain-based bond issue from Germany was issued by Siemens AG in February 2023 with a volume of € 60 million.[4] An overview of all crypto securities issued on the basis of the eWpG can be found on the BaFin website.[5] In addition, the technology is already being used more frequently in Germany for registered securities, such as promissory notes and savings bank bonds.[6]
If one takes a closer look at the projects, we can see that they differ not only in terms of issuers and asset classes, but also in terms of their implementation. Firstly, it is noticeable that a large number of different platforms are used, which process the transactions via the blockchain and deposit the security in the crypto custody register. The same applies to the choice of underlying blockchain. A distinction can be made between public (e.g. Ethereum or Polygon) and private blockchains. A public blockchain is accessible to everyone and allows transactions to be sent or validated. A private blockchain, on the other hand, is only available to a select group of participants. However, a uniform standard could soon be established in this area. As regulatory authorities cannot influence public blockchains, the Basel Committee on Banking Supervision proposes that assets that are processed via public blockchains should be assigned higher risk weights.[7]
Other interesting aspects relate to the interoperability between the digital and analogue worlds and settlement. For example, the CHF 375 million issue by UBS and the green multi-currency bond issued by the Hong Kong Monetary Authority (HKMA) for the equivalent of USD 756 million linked the central securities register with the crypto securities register. This hybrid structure has a positive effect on the demand and liquidity of the bonds, as investors were able to subscribe to them both on the blockchain and through traditional channels.[8] In addition, some projects have already achieved “atomic settlement”, i.e. delivery vs. payment in t+0 instead of t+x. This works if money (cash token) is also available on the blockchain in addition to the blockchain-based security token, as is the case with CBDCs (Central Bank Digital Currency’s) or stable coins, for example.[9]
Investors are also becoming increasingly involved in blockchain technology. Larry Fink, CEO of the world’s largest asset manager Blackrock, is very clear about this: “The next generation of financial markets, the next generation of securities, will be the tokenisation of securities.”[10] In a letter to Blackrock shareholders, he also wrote: “the tokenisation of asset classes offers the prospect of increasing the efficiency of capital markets, shortening value chains and improving costs and access for investors”.[11] In Germany, DekaBank, DZ Bank and Union Investment, among others, have already become investors in blockchain bonds.[12] The latter recently launched an investment fund with a blockchain focus that invests up to 20 per cent of its volume in bonds.[13]
This means that there are already a large number of market participants who are actively gathering experience in the field of digital respectively blockchain bonds. However, a digital Pfandbrief has yet to be found. The reason for this may lie in the special structure of the Pfandbrief, or more precisely in the role of the cover pool monitor.
Integration of blockchain solutions for issuers
In order to be able to issue a blockchain bond, a suitable blockchain infrastructure that fulfils the technical, legal and market requirements is necessary. This platform in turn requires access for both the issuer and the investor as well as an interface to a crypto securities registrar, which is managed by an institution with a corresponding licence. This institution should also act as a paying agent as long as the payments associated with the issue take place off-chain.
When issuing digital Pfandbriefe, the special role of the cover pool monitor must be taken into account in comparison to bonds in other categories. In the traditional process, the cover pool monitor certifies compliance with the prescribed cover with his signature, which is then sent by post to the central securities depository. In the context of a blockchain Pfandbrief, an additional role could be created for cover pool monitors on the platform, via which the digital cover pool monitor confirmation is deposited in the crypto securities register. The paper-based issuance of the certificate and the postal dispatch to a central securities depository would thus become obsolete, as would the general involvement of a central securities depository. Instead, the digital Pfandbrief is issued via a security token on the blockchain, which legally represents the security. In this form, the entire issuing process can be handled digitally.
As soon as providers make such an infrastructure available in the form of a web application, the main effort for issuers and investors is simply to introduce it in-house. This means that the implementation effort is relatively low and follows the requirements associated with the introduction of web applications.
As part of the implementation, it must first be checked whether an outsourcing situation exists in accordance with MaRisk AT 9. In this context, MaRisk AT 9 TZ 1 defines that services that are procured from supervised entities and cannot be provided by the institution itself do not qualify as outsourcing. This includes, for example, the use of clearing centres as part of securities settlement, as would also be the case with a digital Pfandbrief. The services are then to be classified as “other third-party procurement of services” and are therefore not subject to the outsourcing requirement.
In addition, it must be checked whether a digital Pfandbrief is a new product. In this case, a new product process (NPP) would be required in accordance with MaRisk AT 8. However, as a digital pfandbrief is still legally a pfandbrief in the traditional sense and the internal trading and settlement processes as well as the risk assessment and reporting system remain basically identical, the need for an NPP is not mandatory for existing pfandbrief issuers.
In addition, the base prospectus must contain a general formulation for the custody of digital securities. Accordingly, the depositary should be included in its own portfolio management system.
General challenges
The many successful bond issues that have already been processed via blockchain show that the technology is very well suited to issuing bonds completely digitally in the future.
Nevertheless, some development steps are still necessary in order to maximise the potential. This primarily concerns scalability, i.e. connecting as many issuers and investors as possible to a blockchain platform, as well as interoperability. The latter applies between the digital and analogue world on the one hand, but also within the digital solution on the other. Current blockchain infrastructures are largely closed systems, meaning that the purchase or sale of bonds is limited to the connected participants. A necessary prerequisite for the interoperability of blockchain platforms is a standardised and machine-readable data definition. As a basis for this, an ICMA working group has developed the Bond Data Taxonomy, which is already in use today.[14]
In order to achieve same-day settlement, a cash token is also required on the blockchain. This component could be supplemented by a wholesale CBDC, e.g. a digital euro for the interbank market. A working group with more than 50 market participants dedicated to this topic was already established by the European Central Bank in 2023.[15]
In order for the technology to ultimately also be used for Pfandbriefe, it is crucial that a way is developed to deposit the cover pool monitor confirmation in the crypto custody register. However, this should only be a matter of time.
Added value
The use of blockchain technology in the bond and Pfandbrief market offers significant potential for improvement in the medium term compared to the current set-up. Same-day settlement (delivery vs. payment) would reduce counterparty risk on the one hand and lower the costs of interim refinancing on the other. There would also be cost reductions through the automation of work processes and the elimination of previously necessary intermediaries, such as the central securities depository. In its report on the influence of blockchain in capital markets, the Global Financial Markets Association (GFMA) refers to a study that estimates the annual global cost savings in settlement and back-office processes at USD 15-20 billion in the area of fixed income and private market assets.[16]
In addition, complete digitalisation of Pfandbrief processing and automation of payment flows is possible without the need for third-party intermediaries. Paper documents and their dispatch by post would therefore no longer be necessary. The process of assigning registered securities in the event of a change of creditor and the associated notification to the issuer could also be carried out more efficiently in this way. But improvements are also possible in the area of ESG bonds. For example, it is conceivable that information from impact reporting could be transmitted directly to investors via the blockchain.
Ultimately, it is conceivable that the tokenisation of assets will lead to the globalisation of financial markets and simplify the tradability of assets across borders.
Conclusion
To summarise, it can be said that the legal framework for issuing digital bonds in Germany is in place. As already demonstrated by many issues, blockchain technology offers a secure and cost-effective infrastructure that has the potential to fully digitalise the value chain across the bond life cycle and make it more efficient, e.g. in terms of settlement times. In the medium term, the ICMA expects “blockchain-based systems to replace established systems with on-chain solutions, leading to efficiency gains and cost savings.”[17] This is offset by relatively low implementation costs for issuers and investors, which are essentially limited to the introduction of a new web application.
The biggest overarching challenges lie in the areas of scalability and interoperability, as it is ultimately crucial for broad utilisation that barrier-free market access and trading is possible regardless of the individual blockchain solution and custodian used. In addition, the specific requirements in the form of the cover pool monitor confirmation must be technically taken into account for use with Pfandbrief issues.
As soon as this is the case, the Pfandbrief’s recipe for success, the combination of tradition and innovation, can also be applied here, because: “The Pfandbrief is so resilient and has lost none of its attractiveness because legislators and Pfandbrief banks have repeatedly managed to combine tradition and innovation in its further development, whereby the Pfandbrief itself has always remained true to its core, but has also demonstrated a high degree of adaptability.”[18] (Jens Tolckmitt, Managing Director, Association of German Pfandbrief Banks)
1: https://www.gesetze-im-internet.de/ewpg/BJNR142310021.html & https://www.bafin.de/SharedDocs/Veroeffentlichungen/DE/Fachartikel/2021/fa_bj_2107_eWpG.html
2 Example: https://www.hashgenerator.de/
5: https://www.bafin.de/DE/PublikationenDaten/Datenbanken/Kryptowertpapiere/kryptowerte_node.html
6: https://www.faz.net/aktuell/finanzen/digitale-sparkassenbriefe-dank-blockchain-sekundenschneller-verkauf-18912985.html & https://www.sparkassetogo.de/betrieb-banksteuerung/deka-schuldscheindarlehen-erfolgreiche-abwicklung-ueber-blockchain
7: https://www.ledgerinsights.com/basel-committee-public-blockchains-stablecoins/
8: https://www.ubs.com/global/en/media/display-page-ndp/en-20221103-digital-bond.html & https://www.ledgerinsights.com/hong-kong-us756m-second-digital-green-bond/
11: https://www.blackrock.com/corporate/investor-relations/larry-fink-annual-chairmans-letter &
15: https://www.ledgerinsights.com/wholesale-digital-euro-dlt-settlement-trials-take-shape/ & https://www.ledgerinsights.com/wholesale-cbdc-digital-euro-real-money/
16: https://www.gfma.org/wp-content/uploads/2023/05/impact-of-dlt-on-global-capital-markets-full-report.pdf P.11.
17: https://www.icmagroup.org/assets/ICMA-DLT-and-blockchain-in-bond-markets-FAQ-220922.pdf P. 9