New Frontier in Public Financing

This article was originally published in Municipal World.

In the rapidly evolving landscape of public finance, municipalities are continuously seeking innovative ways to fund essential infrastructure projects, improve services, and meet the needs of their communities.

Traditionally, municipal bonds have served as one tool for local governments to raise capital for projects such as schools, roads, hospitals, and utilities. However, a significant shift is emerging with the advent of digital bonds powered by blockchain technology. These digital financial instruments promise to revolutionize how municipalities access and manage debt.

On April 25, 2024, the City of Quincy, Massachusetts completed the first blockchain-based bond issuance in the United States for US$10 million, following on similar successes experienced by Lugano, Switzerland and Hong Kong, China, among others. Which will be the first Canadian municipality to take advantage of this new approach?

Understanding Digital Bonds

At their core, digital bonds function much like traditional bonds but with a crucial difference: they are issued, traded, and managed entirely through digital platforms, often utilizing blockchain technology.

Blockchain is a decentralized and distributed ledger technology (DLT) that records transactions securely, transparently, and immutably (meaning it is unalterable or unchangeable) across multiple nodes, removing the need for intermediaries like bankers and clearing houses.

There are five stages in the digital bond offering process.

1. Issuance of the bond

A municipal digital bond offering begins in a similar way to the traditional approach.

The municipality identifies a capital project or program, such as a recreation centre or a series of bridge replacements and determines how much funding will be needed.

Once the bond is structured, instead of issuing physical certificates or using traditional financial intermediaries, the bond is created and issued digitally through a blockchain platform.

The digital bond is then “tokenized.” Tokenization is the process of representing ownership of the bond in the form of a digital token, which can be securely bought, sold, and traded on blockchain networks.

These tokens are programmed with the bond’s terms and conditions, including interest rates, maturity dates, and coupon payments. The bond is in Canadian dollars and, therefore, does not experience cryptocurrency volatility.

2. Investor participation

Investors (e.g. individuals, financial institutions, and other governments) buy digital bonds through blockchain platforms.

Because blockchain reduces the need for intermediaries, the issuance process is more direct, allowing a broader range of investors — both large and small — to participate. This democratization of access can make it easier for smaller municipalities to attract investors, as bond tokens are divisible and can be purchased in smaller increments.

There is an ability to market the opportunity to residents and local businesses as a way of contributing to and investing in their own community’s success, even attracting socially conscious investors that are aligned with a municipality’s strategic priority for raising funds.

3. Blockchain management and transparency

One of the most significant advantages of using blockchain technology for digital bonds is the real time, transparent management of bond transactions.

Every transaction, from the initial issuance to interest payments and final redemption, is recorded on the blockchain, providing a secure and transparent audit trail.

Municipal administrators and investors alike can access this data in real time, reducing the risk of fraud, improving accountability, and enhancing trust in the process.

4. Smart contracts and automation

Many digital bonds are governed by smart contracts, which are self-executing contracts with the terms of the bond written directly into lines of code.

These smart contracts automatically execute actions such as interest payments or bond redemptions when predefined conditions are met, eliminating manual processing and reducing administrative overhead for municipalities.

5. Trading and liquidity

Once issued, digital bonds can be traded on secondary markets, just like traditional bonds. However, because of blockchain technology, this trading can happen in a more streamlined, cost-effective, and efficient manner.

Increased liquidity — the ability to quickly buy and sell bonds — makes these digital bonds more attractive to investors, as they can easily enter or exit the market without significant delays or transactional costs.

Three Benefits of Digital Bonds

For municipal administrators, digital bonds offer a streamlined, cost-efficient, and highly transparent method of raising capital compared to traditional processes.

1. Cost-efficiency and lower fees

One of the most compelling reasons for municipalities to explore digital bond offerings is the potential for cost savings.

Traditional bond issuances involve numerous intermediaries, such as underwriters, brokers, clearing houses, and registrars, all of whom charge fees for their services. These costs can add up, especially for smaller municipalities with limited budgets.

Digital bonds, by contrast, operate on blockchain platforms, which significantly reduce or eliminate the need for intermediaries.

By using smart contracts and decentralized systems, municipalities can cut down on administrative and transaction costs. In some cases, the cost of issuing digital bonds has been estimated to be 35 to 65 per cent lower than that of traditional bonds.

The costs could be even lower if the provincial and federal governments permitted municipal debentures to be income tax exempt, as is the case in the U.S. The City of Toronto advocated for this over 20 years ago. As a senior advisor with StrategyCorp, Michael Fenn, who has extensive experience in municipal and provincial governments, rekindled that call in 2022.

2. Faster, more efficient processes

A traditional bond issuance can be a slow and bureaucratic process, often taking weeks or even months to complete.

The digital nature of blockchain and smart contracts allows municipalities to accelerate the issuance and settlement of bonds, reducing the time it takes to raise capital.

In some cases, settlements can occur in real time or within a matter of hours. This efficiency can be particularly important for municipalities facing urgent funding needs for infrastructure projects or disaster recovery efforts, where speed is critical.

3. Risk reduction and fraud prevention

Blockchain’s decentralized and encrypted nature provides an additional layer of security against fraud and cyberattacks.

Because blockchain records are immutable, they cannot be altered or tampered with once a transaction has been recorded. This helps ensure that bond issuance, interest payments, and other transactions are secure and verifiable, reducing the risk of fraudulent activities.

Challenges and Considerations

Municipal digital bond offerings represent a powerful tool for local governments looking to modernize their financing strategies. While digital bonds offer numerous benefits, they also come with challenges.

Municipal administrators will need to consider the regulatory landscape, as digital bonds are still a relatively new instrument.

Compliance with local, provincial, national, and potentially, international regulations can be complex, necessitating support from experts in the field. This is a consideration in both traditional and digital bond offering approaches.

Municipalities may choose to partner with other municipalities or public sector entities to share those risks and sector-leading costs.

Conclusion

By leveraging blockchain technology, digital bonds offer cost savings, increased transparency, broader access to investors, and greater efficiency in raising capital.

For municipal administrators, understanding and embracing this innovative approach could provide an important advantage in managing public funds, delivering critical infrastructure projects, and fostering economic growth.

As the digital bond market continues to evolve, municipalities that are early adopters will be well positioned to reap the benefits of this transformative financial approach.