Add one more name to the list of industries that blockchain intends to disrupt.
After laying off 14 percent of its staff and splitting its operations into two separate units, Consensys Inc., announced yesterday that it was venturing into the municipal bond market. The Brooklyn-based company announced acquisition of Heritage Financial Systems, a Pennsylvania-based registered investment advisor and broker/dealer for muni bonds. The purchase is intended for Codefi, the company’s blockchain operating system for commerce and finance. According to its website, Heritage is focused on “Moving Wealth Forward” with an “esoteric approach”. Not much is known about its capabilities as a municipal bond broker.
According to a Bloomberg piece, the firm is betting that ethereum’s blockchain will make the fund-raising and bond payment processes more efficient and help tokenize muni-bond offerings. Consensys says blockchain technology can be used to program automatic bond payments for issuers and keep track of debt ownership, processes that are currently handled by middlemen in the industry.
As far as news developments go, the muni bond market (as it is generally called) is the sleepy backwater to its more glamorous and mainstream cousin. It is smaller in size and less susceptible to daily news developments. Besides municipal defaults, the biggest scandal to hit the market in recent times was analyst Meredith Whitney’s 2011 prediction of a massive municipal default in wake of the 2008 financial crisis. (Debate still rages about the prescience of her call).
ConsenSys’ Tall Order
While blockchain cannot prevent defaults or fix fundamentals, ConsenSys wants to streamline issuance of debt and increase the number of investors available for such debt.
That is a tall order considering that the market for municipal bonds is dominated by a couple of institutions. Previous attempts at using technology to drive down costs and attract new investors to the market have not been successful. As the Bloomberg piece points out, Neighborly – a tech startup that folded last year – had pretty much the same idea as ConsenSys and it was funded by top-tier investors.
But several factors contributed to its demise. Profligate spending, a lack of strategic direction from its founder, and an absence of customers for some bond offerings burnt its cash flow and the startup was left without funds to pay its employees. Neighborly also had visions of cutting out (or, supplanting, depending on how you look at it) middlemen through the use of technology. It was planning to enable municipal governments to post documents on its website and replace debt ratings companies with artificial intelligence programs that would analyze documents and rate the riskiness of debt. Not surprisingly, it also pivoted into blockchain, suggested debt tokenization, and introduction of a cryptocurrency configured specifically for the bond market.
The Problem with the Mini Bond Market
As with all things blockchain, ConsenSys also intends to fractionalize bonds into “mini-bonds” that are available to lay consumers. Mini bonds can be purchased for prices as low as $25, as opposed to typical municipal bonds that generally have a minimum investment price of $5,000.
Available evidence from the University of Colorado at Denver suggests that fractionalization of muni bonds might not be such a good idea. A 2016 study there found that issuing muni bonds raises the cost of issuing debt as a share of principal by between 2.5 to 7.8 times.
The primary sources of these inflated costs are marketing and administration. Blockchain and smart contracts may make it easy for people to buy bonds but those same individuals need to be aware about the bonds before purchasing them. In the Marketing costs can add up when they are targeted at a broader investor than investment firms. Ditto with administration of such bonds. “They (mini bonds) are a pain in terms of administering them – city people, brokers, auditors,” the report quotes a bond broker as saying.
Ostensibly, ConsenSys might be able to reduce some of that pain with its use of blockchain. But it will also have to contend with another hurdle in order to realize the crypto pipe-dream of democratizing finance: creating a secondary market for an asset that is considered illiquid, as of now. Mini-bonds are generally bought for their tax benefits and, unlike bonds denominated for higher amounts, they cannot be traded in secondary markets for quick profits. They also do not have regular interest payouts. The firm will have to work with established muni bond brokers and banks to make mini-bonds more popular with investors.