Municipal bonds have played an integral role in funding public infrastructure projects in the U.S. since New York City issued the first general obligation bond in 1812. While the process to issue and trade municipal bonds has vastly improved since then, the now $3.8 trillion asset class remains stymied by outdated and inefficient processes. The antiquated practices of the muni bond market create access barriers for retail investors and high costs of issuance for local agencies. As blockchain technology gains prevalence, some issuers and financial institutions are looking toward this new tech to “disrupt” and streamline the archaic municipal bond market.
What are municipal bonds?
Municipal securities, like bonds or notes, are instruments of debt issued by local governments and agencies, as well as nonprofits. Bonds are issued by local agencies as a method of borrowing money from investors to fund public infrastructure projects. The investors are then paid back in full, with interest, over a set period of time.
What is blockchain?
Blockchain is the most common form of Distributed Ledger Technology (DLT) — a digital ledger that records and manages data, including documents and transactions. Blockchain stores data in a distributed network that is spread across multiple entities and locations, or “nodes,” rather than in one centralized place. These documents and transaction histories are stored in records called “blocks” that are “chained” together in a secure and accurate manner using cryptography. Once the information is stored, it becomes an “immutable” database, meaning the data in a block cannot be altered retroactively without changing all other blocks that follow. Transactions stored on blockchain can be completed and monitored with the use of “smart contracts” discussed below.
What are smart contracts?
A “smart contract” is specialized software that is embedded into the blockchain ledger. The central advantage of smart contracts is that they are “self-executing” and “self-enforcing.” The terms of an agreement are written into code, using “if/then” statements. Once the terms have been satisfied, or upon the occurrence of a triggering event, the contract executes itself according to the coded terms, without the need for human verification.
Putting it all together: Blockchain and municipal finance
The municipal bond market is characterized, in part, by its often cumbersome— and costly— involvement of a multitude of third parties (such underwriters, paying agents, trustees, bond registrars, clearing and settlement houses, and custodians) in the primary issuance process, secondary market, and life cycle management of a bond.
In primary issuance, the need for several intermediaries increases the administrative costs for local agencies seeking access to capital for public projects or short-term financing. These costs of issuance can be just as high for smaller projects as for multibillion-dollar infrastructure endeavors, which can be cost-prohibitive for less frequent issuers. Trustees are needed to authenticate the bonds to make sure that the bonds are in the forms approved by the issuer and conform to the indenture (with the correct interest rate, principal amount, maturity date, etc.). Paying agents are used to transmit principal and interest payments from the issuer to a securities depository. A security depository holds onto the bonds for the benefit of the bond owners and then receives principal and interest payments on behalf of the bondholders, and then remits to them. The involvement of all of these entities, and more, results in substantial costs to the issuer and increases the potential for human error.
By employing blockchain in tandem with smart contracts, bonds could be authenticated using automated processes. Smart contracts can be coded to enforce the terms of a trust agreement, significantly limiting the role, and cost, of certain entities. Principal and interest payments, which are required to be paid to investors on specified days, can be automated via codes written onto the blockchain. Embedding blockchain in the municipal market could result in bonds being issued at a lower cost to both local agencies and investors by cutting out the need for certain third-party-completed tasks. The processing and reconciliation by smart contracts provides the trustee, issuer, and investors with confidence in payments and eliminates the potential for human error. This coding of municipal bonds onto a blockchain also reduces costs by providing efficient and transparent administration and servicing. Potentially, municipal bonds could also be held directly by the investor as a token (a digital representation of the underlying asset) through registration based in the blockchain ledger, thus removing the need to rely on a third party to keep track of which investors own which particular bonds.
In the secondary market, clearing and settlement houses account for additional expenses in the overall life cycle of a bond. Centralized clearing houses, like the Depository Trust Company (DTC), record ownership of debt instruments and clear and settle transactions between buyers and sellers of securities. While proper clearing and settlement ensures that trades are executed promptly and with reduced market risk, these tasks require both money and time.
The equity market is already using blockchain technology to streamline clearing and settlement functions. The blockchain ledger provides a “single source of truth” for reference data about bond terms, disclosure information, ownership, coupon/repayment instructions, and trade and settlement status. DLT and automated tasks eliminate massive reconciliation of data across various custodians and therefore decrease settlement time and clearinghouse fees. Private platforms built on blockchain, like DTC’s Project Ion, are already serving as settlement and trading alternatives for equity transactions.
Moreover, information stored using DLT improves data availability and transparency for investors. While the secondary market is dominated by broker-dealers and underwriters, retail investors experience limited access and may be less sophisticated. Municipalities aim to change this by using blockchain to sell “mini-bonds” directly to local residents. Local agencies already use mini-bonds to fund smaller, more targeted community infrastructure projects, but blockchain could make these smaller issuances less expensive and more tenable.
New technology inherently brings unforeseen complications. And, of course, adopting new technologies while abandoning established structures is an obstacle in and of itself. Mass adoption of blockchain technology remains a significant challenge and the exact cost effectiveness of doing so is still unclear. However, what is clear is that blockchain is here to stay. Municipal issuers and longstanding financial institutions are getting on board the blockchain train, and for good reason.