Hong Kong Monetary Authority Chief Executive Eddie Yue: The Potential of Tokenized Bonds is Unlimited

Source: Hong Kong Monetary Authority Official Website

Note: This article was published on February 16.

The Monetary Authority today assisted the government in issuing tokenized green bonds. This is the first tokenized bond issued under Hong Kong's legal system and also the world's first tokenized green bond issued by a government.

This tokenized green bond is issued using Distributed Ledger Technology (DLT). DLT has advantages such as tamper-proof, immutability, and high transparency. Currently, the market and public focus on the application of DLT is largely on virtual assets like Bitcoin and non-fungible tokens (NFTs), as well as central bank digital currencies (CBDCs), but the application of DLT is far from limited to these. Applying DLT to existing products and processes in financial markets, such as bond issuance and trading, is a good example.

In simple terms, bond tokenization involves recording the beneficial ownership of bonds on a DLT ledger, rather than using traditional computer accounting methods. This not only changes the way securities are recorded but also breaks through by consolidating bonds and other transaction-related financial instruments, participants, and activities onto a single digital platform, thereby facilitating interaction among them, significantly reducing related costs, and promoting automation throughout the process. In the long run, this could lead to fundamental changes in the existing market operations and give investors greater control.

Let’s see how this tokenized issuance reflects the benefits of DLT .

Under traditional issuance models, each bond has a physical certificate as its "birth certificate," which is stored in a Central Securities Depository (CSD), in Hong Kong, this is the Central Moneymarkets Unit (CMU). The holding and transfer of bonds are recorded through the CSD's accounting. Meanwhile, the funds for bond transactions are processed through another channel—the real-time payment settlement system. The transfer of cash and bonds must occur simultaneously to ensure smooth settlement and to prevent either party from suffering losses due to the other party's default. This process is known as Delivery versus Payment (DvP). The process is quite complex and places high demands on the operating system.

Tokenized issuance can eliminate most of the steps mentioned above. In the so-called "digital native" issuance, bonds "birth" on the relevant platform. Similarly, cash is also stored on the platform in the form of cash tokens like CBDCs. Transactions simply involve the exchange of bonds and cash tokens between the wallets of buyers and sellers on the DLT platform, which can occur instantaneously, eliminating any settlement delays and risks.

The tokenized bonds issued this time retain some elements of the traditional issuance model. For example, the bonds are first stored in the CMU and born in the traditional way before being tokenized on the digital platform. This is done for prudence and also because certain aspects of fully implementing digital native issuance are not yet in place. Nevertheless, we have significantly improved the efficiency of the entire process, reducing the typical settlement time for traditional bond issuance from 5 business days (T+5) to just 1 business day. If not for market conventions, such as allowing buyers time to arrange funds to complete transactions, the settlement process could be further shortened.

These operational improvements are not limited to the issuance phase. Previous individual digital issuances in other parts of the world primarily targeted the primary issuance segment. The tokenized bonds issued in Hong Kong go further: they cover the entire lifecycle of the bond, including settlement of secondary market trades, coupon payments, and maturity redemptions, all processed on the platform, with the potential to use executable smart contracts to further enhance efficiency.

Careful readers will note that the key to enhanced efficiency and automation lies in consolidating all processes on the platform. Therefore, in addition to tokenizing the bonds, the payment aspect (i.e., cash also needs to be tokenized.)

In this issuance, banks provide legal cash in exchange for Hong Kong dollar cash tokens "minted" by the Monetary Authority, facilitating settlement for primary issuance and secondary market transactions, as well as coupon payments and maturity redemptions.

These cash tokens are similar to wholesale-level CBDCs. Currently, the Monetary Authority is collaborating with the Bank for International Settlements Innovation Hub (BISIH) and central banks from Mainland China, Thailand, and the United Arab Emirates on a cross-border CBDC payment platform called "mBridge." In this transaction, the issuance and redemption of cash tokens follow a mechanism similar to that used by the Monetary Authority in "mBridge." In the future, there could be significant synergies between asset tokenization and the Monetary Authority's initiatives in CBDCs. For example, we will further explore establishing connections between the tokenized asset platform and the "mBridge" platform, which could facilitate cross-border bond settlement and investment.

Given the many benefits of tokenization, one might naturally ask: Why has the industry not been more eager to adopt it?

One reason is that significant investment is needed in infrastructure. Establishing and managing DLT nodes is costly and technically demanding. Secondly, there are still issues regarding standards and compatibility that need to be resolved: in recent years, some commercial tokenization platforms have emerged, operating on their respective (usually private) DLT networks, which can easily lead to fragmentation in product markets and liquidity pools.

Lastly, there are non-technical issues related to operational or institutional arrangements. For example, banks acting as agents may need to provide unprecedented support for issuers on the platform. Additionally, unless end investors can essentially access the platform, long-standing custodial arrangements may need to be updated to allow custodians to hold digital securities on behalf of investors. Thus, to popularize tokenization, investors need to take action to prepare for the adoption of this new DLT technology.

These issues are not insurmountable; cost-effective solutions such as Application Programming Interfaces (APIs) have emerged to address certain problems. However, as with many other new technologies, sufficient adoption is required to fully realize their benefits. Therefore, public institutions, including the Monetary Authority, could play a demonstrative and coordinating role in encouraging industry adoption.

Faced with various challenges, how will we unlock the enormous potential of DLT?

The Monetary Authority's journey into tokenization began with "Project Genesis" in 2021, a proof-of-concept study conducted in collaboration with the Hong Kong Centre under BISIH. This issuance marks a significant step forward based on that project, applying the relevant technology to actual transactions. Looking ahead, we will continue to work with the industry to test other innovative features that can enhance the efficiency and transparency of green and sustainable financial markets, as well as the overall capital market. One possibility is real-time tracking and reporting of the environmental impact of investment projects, collecting and organizing data directly from the assets supported by raised funds and transmitting it to the DLT platform, allowing investors easy access to relevant information at any time. Another possibility is conducting secondary market trading on the platform or even across platforms.

We also hope to encourage other issuers to consider tokenized issuance. We are drafting a white paper to summarize the experiences from this issuance, aiming to provide references for other interested issuers.

At the same time, we must ensure that Hong Kong's ecosystem can accommodate the broader application of tokenization. This pilot issuance demonstrates that Hong Kong's overall legal and regulatory framework is flexible enough to support tokenized bonds. However, we seem to have room to do more and do better. Some overseas regions have provided legal certainty for digital native securities on DLT, as well as for digital securities created on non-traditional CSDs. We will study these developments and outline our next steps in the white paper.

Hong Kong Monetary Authority
President
Eddie Yue

February 16, 2023