How blockchain-based bond tokenization might boost liquidity and retail engagement in debt markets

Given the high ticket size and lack of liquidity in the debt markets, asset tokenization has the potential to increase bond volumes through smaller lot sizes and cheaper sums.

In India, there is a weird schizophrenia in the governance of debt capital markets. Policymakers and regulators continue to express a desire for the depth and liquidity of Indian bond markets to increase. However, when it comes to bond market regulations and customs, practically every effort is made to keep small investors out!

Ticket size and liquidity

The face value of most Indian bonds is Rs 10 lakh. Some put it lower at Rs 1 lakh or Rs 10,000, but with bigger trading lot sizes. Government bonds are frequently available in bigger face value and trading amounts. Any hunt for smaller ticket sizes always leads to a discussion about “odd lots,” which suggest a lower yield than normal lots and less liquidity when selling.

A related problem is a shortage of liquidity. There is very little trade on either the NSE or the BSE's retail debt market segment. When compared to the marketplaces in the United States, the disparity is startling. The bond market in the United States is larger than the stock market in terms of market capitalization and trading volume. In terms of trading volume, the bond market in India is a minuscule fraction of the stock market.

On the surface, these two concerns appear to be distinct. However, there is a substantial likelihood that they are connected. Large ticket sizes and the exclusion of small participants may be contributing to the lack of liquidity. Consider the Indian stock markets, where the majority of shares trade for less than Rs 1,000. It is not difficult for a small investment to begin small. It is also not difficult for a mid-sized investor to abandon an investment partially.

Bonds can only be used to establish a diverse portfolio if you have at least Rs 1 crore. Not exactly the building blocks of a thriving and extensive market!

Can blockchain tokenization address the problem?

The process of transforming traditional assets such as bonds into crypto-tokens available on a blockchain is referred to as asset tokenization on blockchain. Given blockchain's unique benefit of complete transparency and immutability of transactions, tokenization is a natural solution to the aforementioned bond market difficulties.

The government bonds must be owned by the token developer and kept in a suitable demat account, the contents of which can be made public. The token creator then produces tokens on the blockchain that are backed by this ownership. Tokens on the blockchain are basically fractional units of the underlying bonds, with the token creator passing on all economic rewards and risks to token owners.

Such tokens can be generated for as little as Rs 100 per unit. This resolves the issue of ticket size. Can tokenization assist with the liquidity issue as well?

Tokenized bond peer-to-peer transactions

Normally, a centralised exchange is required because the counterparty of a transaction is unknown or untrustworthy. For example, if I sell my bonds to Ms. Sharma without first getting to know her, I cannot be certain that I will receive my payment on time. As a result, Ms. Sharma and I meet on the centralised exchange, which serves as a counterparty to both of us. Given the exchange's protocols, there is little danger to the exchange itself, and given the exchange's size and reputation, both I and Mrs. Sharma accept the exchange's credit risk (which is still not zero). This entire transaction could take up to two days (T+2 settlement) and some fees.

Cut to the blockchain-based tokenized bonds. Transactions can take place in real time and without the involvement of a centralised third party. Because of blockchain technology, there is no need for an intermediary. A well planned transaction either goes through or fails completely, which means that either I will have the money and Ms. Sharma will have the bonds, or I will continue to have the bonds and Ms. Sharma will have her money. It will never be half-done, with one of us having both and the other having neither. The worst-case scenario is that no transaction is completed.

This considerably expands the transaction universe. Bonds can be exchanged directly between investors. A variety of technology-based apps can also help with the transactions. There is no need to rely on a single monolithic large exchange while waiting for encouraging rules.

Where to?

Asset tokenization is a promising new investment arena. Tokenization, in particular, for bonds in India, can provide much more access and liquidity to small investors.

It would be better for India's debt markets in general if investors could purchase and sell government debt, PFC, REC, SBI, and other bonds at Rs 100. Hopefully, the rules will remain neutral or favourable to such advances!

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