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<h4>Introduction</h4>Fractionalization has captured the imagination of the investing public. The promise is simple - everyone can buy anything. Fractional assets like stock or BondbloX allow anyone to buy a slice of an Apple share even if they don’t have or want to spend the $147 odd that it is currently trading at, or a fraction of the HSBC 6% bond, that is currently available at a minimum investment size (denomination) of $200,000. Fractionalization powers compossibility, which is the ability to create or compose a customized portfolio for each investor. Let’s say that a wealthy investor currently wishes to invest $1 million in Asian bonds. With the $200,000 minimum denomination, their portfolio can only have five bonds, which would make it concentrated. The other option is to put the money in a fund but then you lose the customization. If a private bank or an independent financial advisor wishes to do both diversification and customization, then you need fractionalization. The other big trend being observed is the rise of self-directed investors who trade on online brokerages, which are attracting millions of first-time investors. Many of them like to dip their toes first (invest smaller amounts) and therefore tend to like fractional assets.<h4>How was it done in the past and what are the risks</h4>Fractionalization per se is not new. Pass-through notes have existed for decades. These involve the creation of a special purpose vehicle (SPV) which acquires the assets and then issues the fractional notes. The main disadvantage is that these SPVs are quite often located in offshore tax havens and in the days of the Panama or Pandora papers, keep coming up for scrutiny for their lack of transparency. Less inflammatory but equally worrisome is that they often have many layers of accountants, fund administrators etc. that need to work together to achieve the desired outcome. Such structures typically have a sponsor and only the sponsor makes markets or otherwise sell these notes. This makes them even more illiquid.A broker can also do a simple fractionalization wherein it buys on its balance sheet and sells the pay-off to its clients. The on-balance sheet exposes the buyer to default risk of the broker. Unlike during the Lehman Brothers default saga , buyers generally understand this risk in a much better way today.The modern method of doing fractionalization is with the use of Distributed Ledger Technology (DLT). This method is used by BondbloX and results in the creation of Bond Depository Receipts (BDR). The original full-sized bonds are kept (lock-boxed) with a designated custodian and then the notes are issued by an exchange (un-sponsored) or by the original issuer for raising new money (sponsored). This structure has been in use for many years across the equity markets. In the USA, this structure is called an American Depository Receipt (ADR) (<a href="https://www.sec.gov/investor/alerts/adr-bulletin.pdf">SEC, 2012</a>). While the focus of ADR was to change the currency of the issuance, it also had a fractionalization / aggregation feature to get a meaningful nominal share price.Legally, this structure has been around for a long time. DLT further increases its transparency and reduces both the time and cost for the issuance of the depository receipt. In the new international financial services centre (IFSC) at Gift City, India’s NSE plans to use the un-sponsored DR structure to create liquidity in US stocks for Indian retail investors (<a href="https://www.business-standard.com/article/markets/nse-to-start-trading-in-us-stocks-at-gift-city-list-of-scrips-not-yet-out-121080901677_1.html">Business Standard, 2021</a>).Another major benefit of fractionalization of assets such as bonds with high minimum denominations is the ability for the investor to now create a diversified portfolio with a much lower capital. A minimum trading lot of $1,000 can help an investor build a reasonably well-diversified portfolio with as little as $10,000 and a very well-diversified portfolio with $50,000. This kind of diversification significantly reduces the concentration risk in a portfolio especially with bonds where more focus tends to be on the return OF principal rather than return ON principal. It also improves access to markets that are traditionally not available for all investor types, thereby furthering the democratising of financial markets.Investors with some risk appetite can set-aside small amounts to invest in BondbloX trading at discounts. This should generate a decent capital upside apart from a rich return by way of coupon payment. There are always such opportunities in the fixed income market. Fractionalization allows investors to take smaller bets which they would otherwise not.Four Tests For Perfect Fractionalization• Uniform claim: The claim under the fractional assets should be as per the formula Fractional claim = Value of Asset / Number of fractions. The only thing in the asset that can’t be fractionalized is the voting rights. These rights should then not be sold away.• Bare trusts should be used to convey the rights from the original asset to the fraction• Every entity in the fractionalizing process such as the custodian banks and the issuing exchange should be a regulated financial institution. The entire process should be in the public domain and the entities involved should not take principal positions in the assets, so that there is no conflict of interest.• Dual Fungibility should exist between the original assets and the fractional assets. While this dual fungibility is a must, it is also ideal that the fungibility happens without economic friction i.e. at zero cost and zero time.Lastly, I leave you with a conundrum, it holds to common wisdom that all told, the fractional asset will be more expensive than the full asset. For example, a piece of sashimi is more expensive per gram than buying the full Tuna. However, financial assets can sometimes behave counter-intuitively if the fractions bring in a new source of demand. This was the original reason of the ADRs. Other reasons or circumstances which may create this is if the demand goes up after fractionalization. Most CFOs with the notable exception of the Berkshire Hathaway shares (currently at $427,700 apiece), keep doing splits to keep the nominal price in balance. In the bond market with the lack of dealer inventory (where buyers can’t buy and sellers can’t sell), the increase in the number of investors are likely to provide a strong improvement in the market efficiency.To conclude, DLT and the depository receipt structure follow a transparent and market-based mechanism to fractionalize assets. Dual fungibility ensures that the additional liquidity is additive and complements extant liquidity. Let everyone buy anything!<h4>References</h4>Modak, Samie (2021, August 10). NSE to start trading in US stocks at Gift City, list of scrips not yet out. Business Standard. Retrieved October 15, 2021, from <a href="https://www.business-standard.com/article/markets/nse-to-start-trading-in-us-stocks-at-gift-city-list-of-scrips-not-yet-out-121080901677_1.html">https://www.business-standard.com/article/markets/nse-to-start-trading-in-us-stocks-at-gift-city-list-of-scrips-not-yet-out-121080901677_1.html</a>OECD (2020). The Tokenisation of Assets and Potential Implications for Financial Markets, OECD Blockchain Policy Series. Retrieved October 15, 2021, from <a href="https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf">https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf</a>SEC (2012, August). American Depository Receipts, SEC Investor Bulletin. Retrieved October 15, 2021, from <a href="https://www.sec.gov/investor/alerts/adr-bulletin.pdf">https://www.sec.gov/investor/alerts/adr-bulletin.pdf</a>Woo. G., &amp; Thiel, S. (2020, December 1). Fractionalizing the future of asset ownership, securely. Nasdaq. Retrieved October 15, 2021, from <a href="https://www.nasdaq.com/articles/fractionalizing-the-future-of-asset-ownership-securely-2020-12-01">https://www.nasdaq.com/articles/fractionalizing-the-future-of-asset-ownership-securely-2020-12-01</a>.

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Fractionalization has captured the imagination of the investing public. The promise is simple - everyone can buy anything. The BondbloX Bond Exchange is the world’s first fractional bond exchange, allowing investors to buy and sell bonds in denominations of SGD/US$1,000 000 instead of the usual SGD 250,000/US$200,000, providing significant diversification opportunities. The article elaborates on the advantages fractionalization brings and how bonds are fractionalized using distributed ledger technology at the BondbloX Bond Exchange.

Honey, I shrunk the bonds! But you can funge them back again!

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<h4>What is BondbloX?</h4>BondbloX represents fractional bonds traded on the BondbloX exchange, and contains fractional interests in the Underlying Bond.Conceptually, BondbloX works exactly like American Depositary Receipts (ADRs) or Global Depository Receipts (GDRs) where an issuer, in this case, BondEvalue Pte. Ltd (a Recognized Market Operator under the Monetary Authority of Singapore), re-lists the original bond (Underlying Bond) onto an exchange in a smaller minimum denomination, thereby allowing it to be traded in fractional sizes.The BondbloX created works using simple pass-through mechanics where the beneficial entitlements to the Underlying Bonds are conferred to the BondbloX holder, based on the fractional size held.<h4>BondbloX Exchange</h4>Structurally, BondbloX exchange works entirely different from traditional bond markets, as it uses an exchange model for all-to-all order matching. This contrasts the over-the-counter model that currently exists with phone dealers servicing individual investors.Settlement also happens instantaneously on blockchain and participants on the blockchain do not face the usual T+2 or T+3 settlement cycles when trading BondbloX.By changing the order flows, order matching processes and allowing BondbloX to trade electronically on an exchange model, we have a great efficiency advantage over the current human-dependent over-the-counter model. All these cost savings translate into better prices and lower fees.<h4>Converting Bonds to BondbloX (and back to bonds)</h4>The BondbloX Exchange, like any other exchange, lists eligible instruments that can be traded on it. The curation of the bond universe is jointly performed by the exchange, its members and market makers, to carefully bring diversification opportunities to investors in terms of industry, tenor, ratings, and also a decent yield pick-up.For any listed BondbloX, investors may deposit with the exchange the Underlying Bond. This will be custodised and safeguarded by one of our Designated Custodians, Citibank N.A., or The Northern Trust Company. Once deposited, the equivalent holdings will be converted to BondbloX and credited to the sender’s BondbloX account, making it available to trade.BondbloX is also dual-fungible, i.e. conversion back to the Underlying Bond is also possible. Investors holding sufficient BondbloX holdings meeting the minimum denomination may choose to convert their BondbloX into Underlying Bonds and have it sent back to their own custodians.<h4>Record of Ownership of BondbloX</h4>Ownership of BondbloX is recorded on blockchain and the blockchain is maintained by multiple parties (including our Designated Custodians) each deploying nodes to run consensus that together share the same data.&nbsp;The debentures register maintained on blockchain provides the definitive record of BondbloX ownership. Blockchain maintains data in an immutable fashion where every transaction is recorded and cannot be altered without other parties knowing.

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An overview of what is BondbloX, how the BondbloX Bond exchange works, how bonds are converted to BondbloX and how the record of ownership of BondbloX is done. 

How it Works

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This article was originally published on&nbsp;<a href="https://www.hyperledger.org/learn/publications/bondevalue-case-study">Hyperledger</a>.As many industries struggled to find their footing amid the aggressive headwinds caused by the COVID-19 pandemic, the global bond market has managed to thrive.With near-zero interest rates implemented worldwide to ease the financial burdens caused by the coronavirus, the demand for bonds soared with global bond issuances increasing 16% in 2020, according to <a href="https://www.spglobal.com/ratings/en/research/articles/201026-credit-trends-global-financing-conditions-bond-issuance-is-expected-to-finish-2020-up-16-and-decline-in-20-11708610#:~:text=Global%20new%20bond%20issuance%20through,the%20same%20period%20in%202019.">S&amp;P Global</a>. By the third quarter of 2020, the <a href="https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Secondary-Markets/bond-market-size/">International Capital Market Association</a> valued the international bond market at a whopping $128.3 trillion.But for those interested in investing in international bonds, the bond markets in Asia and Europe are particularly hard to break into for two reasons: high investment thresholds and lack of electronic infrastructure.In the international bond markets, the minimum investment is $200,000. “This makes it inaccessible for even fairly wealthy people,” says Rajaram Kannan, co-founder and CTO of <a href="https://bondevalue.com/">BondEvalue</a>, a Singapore-based fintech company that focuses on Asian bond markets. Typically, only those who have $5 million or above can afford to diversify their portfolio, and they pour about one-third of their wealth into bonds.But there are roughly 500 million people who are categorized as “HENRY”-s, or high earners not rich yet, who have assets that range from $100,000 to $1 million. This new class of investors is eager to expand their portfolio, yet they find the bond market impenetrable because of the high barrier to entry. “As a result, the liquidity in the bond markets is not even comparable to where the other capital markets are,” says Kannan. “The opportunity for growth is immense.”Even when investors have the means to invest in the bond market, managing bonds can also be a challenge. “One of the pain points in the bond markets is that the trading still happens over phone calls,” explains Kannan. “If you’re a bond investor who wants to buy or sell bonds, you have to call up your relationship manager in your bank or brokerage and go from there. The workflows are not entirely electronic.” Another pain point in the bond market is the extra costs that accrue because of the number of intermediaries involved between the end investor and the actual market. Everyone takes their cut.Until now! The team at BondEvalue recognized the need to upend the global bond market and create a modern infrastructure that makes managing bonds faster, more accessible, and more technologically advanced.“At BondEvalue, our vision was a solution where investors can actually trade bonds on the go from a brokerage app just like they can trade in equity,” says Kannan.In November 2019, BondEvalue launched the <a href="https://www.bondblox.com/">BondbloX Bond Exchange</a>, replacing the traditional over-the-counter trading experience with the world’s first fully regulated blockchain-based bond exchange that allows consumers to instantaneously and transparently trade bonds in smaller denominations of $1,000 each.Fully licensed and <a href="https://thefintechtimes.com/bondevalue-approved-by-monetary-authority-of-singapore-to-operate-blockchain-based-bond-exchange/">regulated by the Monetary Authority of Singapore</a> as a Recognized Market Operator, the BondbloX Bond Exchange operates under a strategic partnership with <a href="https://www.northerntrust.com/united-states/pr/2019/northern-trust-bondevalue-fractionalised-bond-ownership-blockchain">Northern Trust</a>, which is the global custodian partner for the exchange. Together they deliver integrated asset servicing and digital ownership of fractionalized fixed income bonds on a permissioned blockchain network. And from the beginning, the BondbloX Bond Exchange has attracted powerful players in the financial sphere who have signed on as launch partners such as <a href="https://bondevalue.com/news/the-bondblox-bond-exchange-goes-live/">UOB Kay Hian</a>, one of the largest brokerage firms in Singapore.“Asian bonds remain attractive to local and regional investors despite the global uncertainty and market downturn, and we are confident that this partnership will provide customers access to new sources of returns and opportunities to build a more diversified portfolio,” says Wilhem Lee, Senior Executive Director at UOB Kay Hian.“We believe BondbloX will be an industry game changer,” says BondEvalue founder and CEO Rahul Banerjee. “Once investors have experienced BondbloX, they will take to online bond trading with the same fervor they do for equity trading.”<h4>Powering the “Beast” with Hyperledger Sawtooth</h4>“Exchanges are like big tech animals,” says Kannan. “They are beasts.”The BondEvalue team realized the only way to feed this beast and build an innovative, groundbreaking global bond exchange would be to deploy <a href="https://www.hyperledger.org/use/sawtooth">Hyperledger Sawtooth</a>, the open-source blockchain framework hosted by the <a href="https://www.linuxfoundation.org/">Linux Foundation</a>. As a modular and flexible architecture, Hyperledger Sawtooth allows developers to separate the core system from the application domain so smart contracts can specify the business rules for applications without needing to know the underlying design of the core system.“We are in the space where we need to own and build our own tech,” says Kannan. “And we have to give credit to the Hyperledger community and to the Linux Foundation for creating this framework and making our solution possible.”Thanks to Sawtooth’s model, which uses a single node type, “the deployment is fairly simple. Even if somebody doesn’t host a node, it’s quite easy for anyone to sign and submit their transactions,” says Kannan. “If a bank already has a trading app and wants to connect to the BondbloX Bond Exchange, it is relatively easy using contemporary REST or Websocket APIs.”Sawtooth also has rich support for standard and custom events, which helped to develop the distributed apps using an event-driven framework. Further, the permissioning framework was a great fit for creating a broad but closed network of approved participants.Finally, the Practical Byzantine Fault Tolerance is “the perfect consensus” for the BondbloX Bond Exchange. “The reason for using blockchain is to create a trusted network, and we wanted the right protocol that allows for that,” says Kannan.A Sawtooth PBFT network is permissioned and only an administrator can add or remove nodes. This Hyperledger solution also offers a non-forking ledger consensus, which was a key factor in building the exchange. “We can’t tell people that their trade succeeded and then come back after 10 confirmations and say, ‘Oops, sorry, it didn’t work,'” says Kannan. “We needed a framework where when it’s committed, it’s done.”As the BondbloX exchange continues to evolve, the team at BondEvalue remains committed to developing Sawtooth along with Hyperledger’s open source community. “We are looking at how we can contribute back. We have, in fact, made a couple of contributions that are in the process of being assessed by the community,” says Kannan. “We want to add value to the project.”<h4>How it Works: Lower Minimums, Higher Liquidity</h4>The building blocks of the BondbloX Bond Exchange are the BondbloX themselves.Using depository receipts as a model, traditional bonds are brought into the BondbloX Bond Exchange through designated market makers, member participants, or their end individual clients from the secondary market. A designated custodian on the exchange (in this case, Northern Trust) confirms receipt of the underlying bond into the blockchain, which then triggers the bond to be divided into fractionalized BondbloX worth $1,000 each and backed one-to-one on the blockchain.“When a $200,000 bond comes in, the member receives $200,000 in BondbloX which is fractionalized into 200 BondbloX of $1,000 each and can be traded on the BondbloX Bond Exchange,” explains Kannan.With the blockchain infrastructure, settlement on the BondbloX Bond Exchange is nearly instantaneous, occurring on a T+0 basis. So instead of waiting for the normal two-day settlement cycle for traditional bond transactions, BondbloX trades are final within seconds, reducing counterparty settlement risks for investors.However, members who trade in BondbloX are not necessarily locked into the exchange. If a better opportunity in the secondary market arises, the BondbloX are “dual fungible.” Members can request via the custodian to withdraw the BondbloX from the exchange and deliver an OTC bond to a desired venue, which in turn reduces the quantity of BondbloX available to trade on the exchange. “It’s important that members feel that they’re able to take whatever investment opportunities are available to them,” says Kannan.Ultimately, BondEvalue is confident that the best opportunity is to stay within the BondbloX Bond Exchange. “We believe as an exchange, because you’re able to sell at lower minimums, you’ll actually have a much more liquid market that more investors will be capable of investing and buying in,” says Kannan.<h4>Collaboration and Configuration</h4>On the backend, “our governance model is collaborative,” says Kannan.But there are strict rules of engagement for partners who are hosting nodes on the network. While BondEvalue is responsible for most of the work behind updating the nodes with new software, the governing council meets regularly to review upcoming releases and determine a date that is mutually beneficial so that all members can prepare for the updates.“The main challenge is that each release has to be synchronized. Since we use all the nodes, they need to have the exact same software and the exact same version of the transaction process for the system to work as designed,” says Kannan. “If a partner hosting a node doesn’t upgrade, then they will go off chain.”For the frontend, the BondbloX Bond Exchange is a cloud-native application hosted on AWS and accessible via distributed apps on the web. “Because of the event-driven framework that Sawtooth supports, we were able to create a completely asynchronous cloud-native environment that provides the same experience for investors and members that they are accustomed to when trading other exchange-based securities,” says Kannan.To do so, the BondbloX app leverages IoT technology. “We integrated an IoT core solution so that we treat your browser like an IoT device that can deliver real-time notifications,” says Kannan.To avoid committing personally identifiable information on the blockchain, the team also implemented an external database so that personalized user and client information sit outside the network while a pseudo-anonymized identifier is leveraged on the exchange.“Within the blockchain, we had to make it really efficient for the transactions we process or the smart contracts we run, but outside the chain we can query in a really rich format” says Kannan. “So, you’re known by an anonymized ID in the blockchain. But then we merge that data with your real identity in the external database, and that information shows up in our app, which delivers a first-class user experience.”The BondbloX exchange is regulated by the Monetary Authority of Singapore (MAS). After less than a year in the MAS regulatory sandbox — a construct in Singapore where fintech companies test their innovative financial service solutions in the marketplace but under regulatory scrutiny — BondEvalue’s blockchain-based bond exchange graduated after successfully concluding the proof of technology and business model in October 2020.“BondbloX is the latest example of a groundbreaking application of blockchain technology in the capital markets enabled by experimentation in the MAS regulatory sandbox,” says Sopnendu Mohanty, chief fintech officer of the Monetary Authority of Singapore. “We are excited to see productionalization of blockchain in the bond trading market and look forward to great adoption in transforming financial services.”&nbsp;<img src="/uploads/Fractionalising_bonds_on_blockchain_diagram_f7f2f95a0e.jpg" alt=""><h4>The Future of Financial Inclusion</h4>When the BondEvalue team first introduced the BondbloX Bond Exchange, troubleshooting was at the forefront of their concerns.“My biggest worry was what if, what if, what if …” says Kannan. “Today we have gone through all the scenarios and we know what to do if there are issues. We know what those issues are, and we know that they’re not going to bring us down.”So, what’s next? Scaling the BondbloX exchange.BondEvalue continues to engage more member participants such as Taurus Wealth Advisors, the leading fee-based, multi-family wealth management firm in Singapore, and Amstel, an institutional fixed-income broker with operations across Asia and Europe. BondEvalue is also expanding its footprint with a joint venture partnership in Mexico. The company’s goal is to empower a more diverse pool of investors and introduce them to institutional-grade opportunities in the bond market through its cutting-edge blockchain solution.“We are excited to be working with BondEvalue to support a blockchain application that will broaden financial inclusion by opening up institutional bond markets to more investor types,” says Justin Chapman, global head of Market Advocacy &amp; Innovation Research at Northern Trust.“Our vision is to have over 25 million people in Asia invest in bonds in the next five years, from 500,000 individuals currently,” says Banerjee. “This is no small ambition, but we are hopeful as we have seen millions of people forced by COVID-19 lockdowns going online in the last six months for their everyday transactions.”With the continued expansion of the BondbloX Bond Exchange, says Banerjee, “our vision of extending bond trading from Wall Street to Main Street is becoming a reality.”&nbsp;<img src="/uploads/BIFT_and_Hyperledger_Sawtooth_diagram_aa786ba3f5.jpg" alt=""><h4>About Hyperledger</h4>Hyperledger is an open source collaborative effort created to advance cross-industry blockchain technologies. It is a global collaboration including leaders in finance, banking, Internet of Things, supply chains, manufacturing and Technology. The Linux Foundation hosts Hyperledger under the foundation. To learn more, visit <a href="https://www.hyperledger.org">https://www.hyperledger.org</a>&nbsp;

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How BondEvalue Launched the World’s First Fractional Bond Exchange with Hyperledger Sawtooth

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