How blockchain tokenization of bonds can increase liquidity and retail participation in the debt markets

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    By Amee Mehta
    Feb 25th, 2022
    In India, there is a strange disconnect in the governance of the debt capital markets. Policymakers and regulators of India continue to express a desire for the depth and liquidity of Indian bond markets to improve. But when it comes to bond market regulations and conventions, a lot of effort is made to keep small retail investors out!

    Ticket size and liquidity

    The face value of most Indian bonds is Rs 10 lakh. Some have it lower at Rs 1 lakh or Rs 10,000, but with larger trading lot sizes. Government bonds are frequently available in more significant face value and trading lots. Any search for smaller ticket sizes inevitably leads to a discussion about "odd lots," implying a lower yield than standard lots and less liquidity when selling. A related problem is a lack of liquidity. There is significantly less trading on either the NSE or the BSE's retail debt market segment. When compared to the markets in the United States, the contrast is shocking. In terms of trading volume and market capitalization , the bond market in the United States surpasses the stock market. The bond market in India is a tiny fraction of the stock market in terms of trading volume. On the ground, these two issues appear to be unrelated. However, there is a strong possibility that they are linked. Large-ticket sizes and the exclusion of small investors may contribute to the lack of liquidity. Consider the Indian stock exchanges, where the vast majority of shares are priced under Rs 1,000. A small investor can easily begin with a small investment. A mid-sized investor can also easily exit a position partially. Bonds can only be used to diversify a portfolio if you have a minimum of Rs 1 crore. Not exactly the foundation of a thriving and deep market!

    Can tokenization on a blockchain solve the issue?

    The process of converting common assets such as bonds into crypto-tokens available on a blockchain is referred to as asset tokenization on blockchain. Given blockchain's distinct advantage of complete transparency and transaction immutability, tokenization is an obvious solution to the aforementioned bond market problems. The token creator must own the government bonds and keep them in a Demat account, the contents of which can be made public later on. The token creator creates tokens on the blockchain that are backed by this ownership. Tokens on the blockchain are essentially the fractional units of the underlying bonds, with the token creator passing on all economic benefits and risks to token owners. Such tokens can be created for as little as Rs 100 per unit. This resolves the issue of ticket size. Can tokenization help with the liquidity issue as well?

    Peer to peer transactions in tokenized bonds

    Usually, a centralized exchange is required because the counterparty of a transaction is unknown to both parties. For example, if I sell my bonds to Ms Singh without first getting to know her, I can't be sure that I will receive my payment on time or not. As a result, Ms Singh and I meet on the centralized exchange, which serves as a counterparty to both of us. Given the exchange's processes, there is little risk to the exchange itself, and given the exchange's size and reputation, Mrs Singhand I accept the exchange's credit risk. This entire transaction could take up to 2 days (T+2 days for settlement) and some fees. Cut to the blockchain-based tokenized bonds. Transactions can take place in real-time and without the involvement of a centralized 3rd party. Whereas in the case of blockchain technology, there is no need for an intermediary. A well-designed transaction either gets completed or fails completely, which means that either I'll have the money and Ms Singh will have the bonds, or I'll continue to hold the bonds, and Ms Singh will have her money.It will never be half-done if one of us has both and the other does not. The worst-case scenario is that no transaction takes place. This dramatically broadens the transaction universe. Bonds can be purchased and sold directly between investors. Several technology-based apps can also assist with transactions. There is no reason to rely on a single extensive monolithic exchange while waiting for encouraging rules.

    Where to?

    Asset tokenization is a promising new investing domain. In particular tokenization for bonds in India can provide significantly greater access and liquidity to small retail investors. If investors can buy and sell PFC, REC, government debt, SBI, and other bonds for Rs 100, it will benefit India's debt markets in general. Hopefully, the regulations will remain neutral or conducive to such innovations!