The effect of DLT on the legal framework of sovereign borrowing

Borrowing costs and market access for sovereign debtors

As mentioned in Section 1.1, the Central Bank Governors of Tunisia and Afghanistan have stated that they believe that so-called crypto bonds, the issuance of sovereign bonds using DLT, can attract international investors. No elaborate explanations were provided to explain why ‘crypto bonds’ would have such a positive effect on the demand of the two states’ sovereign bonds. As discussed above, using DLT when issuing bonds can contribute to a reduction in the transaction costs associated with the issuance of bonds because fewerfinancial intermediaries are necessary. Although using DLT may reduce the cost of issuing bonds for the two states, it is not clear that it is sufficient to increase the number of investors interested in acquiring sovereign crypto bonds. One reason for this is that normally, it is the underlying value of the investment asset that makes an investment attractive to investors, not the investment infrastructure in itself. However, if issuing bonds using DLT can increase the chances that the sovereign debtor will fulfil its payment obligations under the debt instrument or that it is easier for the creditor to enforce the contract, this could make investing in ''crypto bonds’ more attractive compared with investing in ordinary bonds (lowering a state’s borrowing costs and improving its access to capital). Therefore, the next question is whether DLT may contribute to a reduction in these two legal risks associated with sovereign borrowing.[1]

First, issuing a sovereign bond on a distributed ledger and denominating it in a cryptocurrency does not in and of itself strengthen the creditworthiness of a state that has a fragile economy. When using DLT technology for issuing sovereign bonds, the purchase of a debt instrument, the transfer of tokens or cryptocurrencies in exchange for a legal and beneficial title of a debt instrument, is securely and efficiently handled on the distributed ledger. However, the use of DLT does not mean that the execution of a debt contract - in particular the payment of principal and interest - is guaranteed and automatically effected. The use of DLT does not mitigate against the risk that the debtor may not have sufficient funds to pay according to the terms of the bond. Consequently, similar legal disputes to those arising in the context of ordinary debt instruments related to the payment of interest and principal, as well as potential debt restructuring, may arise. In such situations, the creditor holding a debt instrument registered on a DLT can easily obtain a judgement confirming her/his rights to payment according to the contractual terms. Rather, the problem lies in enforcing the judgement because of sovereign immunity rules. The latter problem continues to exist, regardless of the use of DLT.

Second, if the distributed ledger is permission-less, no one (including the state) can unilaterally amend the record of the transaction or contracts stored on the ledger. However, the sovereign issuer may still amend the laws governing the instrument if it is governed by the laws of the sovereign (local law). An issue related to this is the exchange risk. One may think that purchasing sovereign bonds denominated in a cryptocurrency is more stable compared with, for example, local currency. So far, established ‘ecosystems’ of both cryptocurrencies and crypto tokens within which investors (and sovereign debtors) can execute transactions and make use of the cryptocurrency as a medium of exchange (for payment purposes) are rare. Therefore, the payment of interest and principal from the sovereign debtor to the investor would have to be exchanged from crypto token to fiat money for the investor to have a functioning medium of exchange. This exchange is associated with a risk for the investor, particularly if the chosen currency is that of the sovereign debtor. The reason is that the sovereign debtor may seek to cause inflation to deflate the real value of its debt burden.

Eased debt crisis resolution for the sovereign debtor

The next question is whether DLT may contribute to casing collective action problems among creditors and improve sovereign debt crisis resolutions. When sovereign debt instruments are denominated in fiat money and in a cryptocurrency and then issued on a distributed ledger, the DLT makes it easier for the sovereign debtor to have an overview over the investors who are actually holding a bond at any point in time, regardless of resales in the secondary market. Moreover, DLT can enable the debtor state to communicate directly with all of its bondholders, if necessary. This can help ease the practical problems related to the need for coordinating creditor action. As described in Section 3.2, this is particularly challenging when a sovereign debtor faces economic problems and is in need of communicating swiftly with its creditors, as well as potentially renegotiating the payment schedule, maturity date, interest rate or principal of its debts (restructuring).

Issuing a bond using DLT can also help the sovereign debtor identify different groups of creditors (investors) more efficiently, which is important when designing a debtrestructuring proposal. A restructuring inherently entails economic losses for a creditor, and it can be very important for the sovereign debtor to understand how different types of creditors will be affected by a potential restructuring. Whether the creditors who participate in a debt restructuring arc institutional investors or small retail investors, hedge funds, pension funds or foreign and domestic banks will influence the domestic economy and the likelihood of solving an economic crisis.[2]

In sum, DLT can contribute by reducing certain transaction costs associated with issuing and trading sovereign bonds. In particular, it will make it easier for first-time issuers who have not yet developed all standard documentation and procedures needed to contract with a number of various financial intermediaries. Moreover, the book-keeping-like records of investors help ease practical collective action challenges because it can serve as a communication tool between the sovereign debtor and the creditors, as well as among the creditors. This is also the reason why international finance institutions, such as the WB, have engaged in developing and testing the issuances of bonds using DLT; they seek to develop the technology, testing how it can also be applied follow- and medium-income countries in a responsible manner. DLT does not reduce the main risks associated with investing in sovereign debt instruments for either the creditor (investor) or the sovereign debtor itself. There are still no insolvency procedures in domestic or international law that protect a sovereign debtor and enable it to implement crisis resolution measures. It is the contractual terms of a debt instrument that are decisive in terms of how a debt restructuring may be implemented. If the contract terms do not provide for any crisis resolution tools, investors holding sovereign bonds are still free to refuse to partake in a debt restructuring and retain their original terms related to the debt instrument.

  • [1] These risks are described in Section 2.3. 2 An overview of the jurisdictions where various cryptocurrencies are accepted as legal tender can be found in The Law Library of Congress, ‘Regulation of Cryptocurrency Around the World’ (2018). 3 The government can influence the inflation rate by creating incentives for growth in the money supply, see, in general, Joshua Aizenman and Nancy Marion, ‘Using Inflation to Erode the US. Public Debt’ (2009) National Bureau of Economics (NBER) Working Paper No. 15562.
  • [2] Lee Buchheit, 'The Search for Intercreditor Parity’ (2002) 8 Law & Bus Rev Am 73. 2 The World Bank (n 5).
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