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The visible hand

CBA’s test of government bond using the blockchain, is just that

It’s too soon to say what advantages there are to issuing government bonds using blockchain technology.

Despite a media statement announcing that Commonwealth Bank of Australia (CBA) and Queensland Treasury Corporation (QTC) have created the first government bond using the blockchain (dubbed the “cryptobond”), no QTC bond had actually been issued.

As reported by Mr. George Confos, executive general manager of business & corporate finance at CBA, this was (yet another) “proof of concept” – a test by the bank’s Innovation Lab.

The bond is a working prototype, is not tradable and does not carry any debt obligation.

In other words, whatever it is, it’s not a bond.

Blockchain has generated an enormous amount of excitement in a short time. But despite the hype, actual use of blockchain in finance has been slight, beyond its current use in digital currencies, such as Bitcoin and Ethereum, and possibly in situations such as equity issuance and loan syndication.

To recap, blockchain is a technology that allows one participant to transfer something of value to another participant by recording the transaction in an immutable “block” on a transparent “chain”. No central authority is involved as blocks are written to a blockchain by consensus among participants.

Consensus is arrived at by each participant holding a complete copy of the chain and agreeing that the next block can be written, because it passes a test of so-called “proof of work”, in Bitcoin, or “proof of stake” in Ethereum.

Technologies such as Lightning can be used to circumvent some of the limitations of these blockchain implementations by requiring only two-party consensus before writing a block. Other implementations, such as CBA’s “cryptobond” use the concept of ‘permissioning’ which restricts access to a small number of participants who trust each other and can impose penalties outside of blockchain, like stopping short term credit.

What has any of this technology have to do with government bonds?

The way that government bonds are issued in Australia is similar to overseas. It usually happens, but not always, by a tender process.

First a government body, such as the QTC, formally publishes a highly technical legal notice to issue (or sometimes buy back) bonds, which is broadcast to the markets. This is important information that affects the flow of debt in the economy, so it’s of interest not only to bond buyers but the whole market. Here is an example of a recent tender issue for the federal government.

Bidding for a chunk of the debt to be issued is restricted to authorised traders, listed as “registered bidders”. These are the usual suspects - the big financial institutions.

Bidders will enter their bids for a piece of the action into the official tender system, based on how they believe rates will move up or down in future. The current access to the official tender system for government bonds is via Yieldbroker.

Obviously, bids are kept confidential, otherwise bidders would try to game the system. The Yieldbroker computer system uses the latest cryptographic tools for ensuring security of bidding and employs some of the latest standards for exchanging information.

Almost everything in a bond tender can be changed, bids can be altered or revoked until the official closing time. An issuer, such as the official Australian Office of Financial Management (AOFM) can also do this on behalf of a registered bidder. An issuer can also postpone or cancel a tender for any reason and also may accept or reject bids if the issue is under-subscribed.

At the close of bidding, bonds are allotted according the highest price bid (like a “best offer” for a house) then to the next highest until the issue amount is exhausted. The successful bidders are then informed of their allotment (which may not be the same as the maximum amount specified in their bid) and then they must pay the issuer (the state or federal government) the amount due.

The bond issuance process is smooth and has worked well for many years. It’s because it’s not small beer, for example, the latest issue by the AOFM is some A$700 million, so the technology had better work.

Now CBA is proposing replacing a system that works exceedingly well by one based on blockchain that has only been shown to work in the lab under very controlled circumstances. CBA has not disclosed details of the process and technology used in the test but sprinkles jargon, such as “smart contract” liberally around.

What are the advantage of the system proposed by CBA? Well, it uses blockchain, so it gets some kudos from those interested in innovation. But it doesn’t use blockchain in the way it was intended.

Blockchain is good at storing immutable blocks. But almost everything about the bid process can be changed, so immutability is not a requirement.

Blockchain abhors the concept of central authority. But in this case, there is no choice, as the issuer is often the federal or state government, which are the most central of all central authorities. The central authority can also change the rules of the game after bidding has started.

Blockchain does not require participants to “trust” one another. In this situation, the bidders may not trust each other but they certainly do trust the issuer, if only because they hold all of their money with the Reserve Bank of Australia. In this case, they can and must trust a central authority.

Blockchain then is not exactly a good match for a system that actually works well, so why change?

The CBA media release on this “crytobond” test says the prototype has “the ability to automatically pay coupons to the current holder when due”. This conveniently ignores the fact that, once issued, the bonds are sold onto a secondary market, such as the ASX, where they are purchased and traded by small and large investors and superfunds. It’s these investors, who are owed the interest coupons from the bond, according to records held in the official bond registry, which is not yet on blockchain.

The blockchain world is full of overblown hype, but that’s no excuse for a respected financial institution to issue a media release that is at best misleading and would lead some to consider the institution to be able to deliver something it cannot, or cannot in the foreseeable future.

Until it provides some verification that its blockchain proposal is indeed “capable of delivering efficiency to issuers, investors and other market participants”, CBA should remove or, at least reword, its over-hyped media release.

It should be noted that the latest AOFM tender process had only 33 bids (the big financial institutions) of which six were successful, and the latest QTC tender was hardly a stampede at 44 bids. Since the actual recording of a bid is only a minuscule part of a highly quantitative bidding process, it would be a stretch to see how the proposed solution could make this process any more efficient - there appears to be no cost-benefit analysis.

And regulators should begin to think about they might clamp down on what amounts to misleading information. But of course the ASX is also caught up in this bubble.

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