In her 2024 Mansion House speech, Chancellor Rachel Reeves pledged that the UK would trial a digital gilt within two years. This will likely represent the largest bond issue using a Distributed Ledger Technology (DLT) and Decentralised Finance (DeFi) platform to-date - and the first significant initiative of its type backed by a G7 Government and its Central Bank. A well-structured approach to a digital gilt could usher in: (1) improved capital management and returns, (2) elevated citizen participation in wealth, and (3) AI-led dynamic capital allocation with significantly higher returns, by using fractionalised Real-World Assets (RWAs). In other words, physical assets and Web3 assets, each with their own return, risk and financial ‘fingerprint’ embedded in DeFi protocols. However, in many ways, trialling is a misnomer. For a ‘trial’ digital gilt to be an effective financial instrument tradeable on bond markets, and to function in a way that does not adversely impact traditional gilts, it has to be fully developed, tested and adopted. The groundwork for a UK digital gilt therefore needs to be fully laid out first, covering operational procedures, security and controls, DeFi platforms and tokenisation protocols, and primary and secondary legislation.
TradFi vs DeFi
It’s important to remember that DeFi is not a like-for-like copy of Traditional Finance (TradFi). DeFi has its own actors, ways of trading value and processes, many of which have developed organically through democratised - and often technology-led - governance since the inception of the original DeFi token Bitcoin in 2009. A simplistic translation of TradFi concepts into a DeFi landscape could have seriously adverse effects, making a UK digital gilt untenable. For example, for a digital gilt to be issued, the issuer needs to hold an active token wallet with access to a recognised DeFi platform, such as Ethereum, and to be able to transact through a digital exchange, such as Coinbase. In the DeFi world, a Central Bank issuing a digital gilt is only a singular, equal participant in the DeFi ecosystem. The Bank holds no special role or privileges. Short of implementing its own DeFi platform, it does not control the governance or supply of the tokenisation protocols.
In other words, even the simplest of bond concepts, like issuance, looks very different in a DeFi landscape, redrawing the roles and responsibilities of a Central Bank and its monetary policy toolkit, typically used to manage the gilt market, associated liquidity and interest rates. With such a paradigm shift, it raises the question: “what is a digital gilt for?” With TradFi gilts being a source of capital and a way to enact monetary policy, does the dual of this - the DeFi digital gilt - become more akin to a capital vehicle for tokenised Government physical assets, i.e. Real-World Assets (RWAs)? DeFi digital gilts associated to RWAs will have a capital profile associated with the asset itself. For example, if a hospital has a non-standard payback period with an irregular yield profile, digital gilts will reflect this investment and return characteristics, encoded in the DeFi protocols in which the DeFi gilt is written. This has implications for how Governments raise capital and their repayment obligations, being structured more directly around the characteristics of the tokenised assets rather than a fixed-term period with defined interest characteristics.
Which DeFi path will the Government take?
In any case, it’s important that a Central Bank and Government’s role in the DeFi world is defined at the outset. This decision cannot be overstated. With today’s TradFi-enabled global financial system defined by decisions made nearly 400 years ago at the advent of financial services, a decision on the roles of the Central Bank, Government and digital exchanges could have a similar magnitude and longevity on the way we trade, invest and manifest value. DeFi-only roles - such as those of Oracles, Keepers and Liquidity Providers - all need to be defined, regulated and have sufficient institutional buy-in. DeFi involves the purposeful pursuit of democratised governance - achieved through voting rights associated with governance tokens, issued by a DeFi platform provider relating to its DeFi protocols. But this means that there are no common standards to DeFi layers, typically described as Layers 1-3, with Layer 1 being the ‘base’ protocol, such as Ethereum. The socio-political shift to self-governance, reflected by DeFi, means there are limited common DeFi standards across platform providers. For financial firms, and even more so for Governments and Central Banks, this creates challenges for operational, risk and technology management, with no standard approaches to areas like liquidity management.
Central Banks and Governments could take a few different approaches to digital gilts, depending on how they see their TradFi roles translating into a DeFi world. One route is for the markets to take the lead role in defining the operational, technological and regulatory governance. In this scenario, DeFi could be introduced as quasi-market infrastructure, with rather limited Central Bank and Government involvement.
This would see financial firms collaborating to devise the operating norms, technology architecture and inter-firm contracts, and creating a digital gilt trading solution blueprint. With market forces shaping the accepted practices for the DeFi landscape - which is, notably, the approach taken in many markets to date - financial firms could acquire sufficient governance tokens in a tokenisation protocol or else set up consortia to manage DeFi bond issuance, trade execution, settlement, finalisation and liability management. Yet this approach would mean DeFi exists outside of Central Bank and Government control, limiting their monetary policy effectiveness. Over time and under certain conditions, the lack of Central Bank oversight of DeFi could lead to periods of increased financial instability or volatility. Without a Central Bank and Government taking active DeFi leadership, setting out the regulatory oversight and embracing DeFi and its potential benefits of more diversified capital investing from retail and corporate investors, the digital gilt may never materialise into an investment grade capital vehicle and be quickly retired. For this reason, we see this path as highly unlikely and one that could lead to the UK losing its opportunity to progress to a high-growth, AI-enabled Web3 economy.
Contrast this approach with one where a Central Bank and Government set out a clear vision and purpose for a digital gilt as a Government-backed financial instrument. This path could see the UK Government and Bank of England lay the groundwork for a fundamental DeFi-enabled change in how we conceptualise and trade value. Well-informed steps could lead to a digital gilt being used to increase capital returns for a sovereign nation and equitable access-to-wealth for its citizens. It could also trigger an AI-powered advanced economy that facilitates the dynamic allocation of capital to illiquid assets, using fractionalisation of high net value Critical National Infrastructure (CNI) assets.
Redefining financial services
This more beneficial path is not for the faint-hearted - but could bring considerable advantages. It calls for the UK to re-imagine the financial landscape in a DeFi world. In particular, DeFi-savvy leaders need to be at the very heart of Bank of England and Government planning, roadmap execution and financial services industry engagement. This involves DeFi-savvy leaders being given the C-level mandates to transform entire investment management divisions. Indeed, as a Ledger Insights reported: “The cost savings on an eight year bond could be 120 basis points or 1.2% of the value of the bond. Hence, using DLT represents an 85% reduction in middle and back-office costs.” Technology platforms for DeFi-enabled digital gilt also to have to be set up with robust and appropriate DeFi tokenisation. This comes alongside the specific protocols being selected (such as Ethereum’s ERC-721), the business and technology architecture for integrating TradFi and DeFi data platforms being designed and validated, and the automated monitoring and risk mitigation approaches being thoroughly implemented. For example, DeFi protocols typically use democratised technology governance using voting tokens, which - in the current DeFi landscape - suggests a Central Bank may need to become the largest holder of voting tokens for the selected DeFi protocol if it is to retain oversight and control.
Beyond this, primary and secondary legislation has to be in place to mitigate threats whilst not eroding benefits of DeFi-enabled instruments. While the current geopolitical environment presents some significant challenges, the world will need globally consistent regulatory frameworks for DeFi sooner rather than later. These should reflect stakeholders’ consultation inputs and be implemented in a way that balances effective checks and controls for fraud, anti-money laundering and sanctions, whilst not being so controlling that the benefits of a DeFi-enabled digital gilt are eroded. For example, the implementation of a DeFi world and a digital gilt will need to consider whether and how to retain DeFi’s inherent data anonymity and confidentiality, whilst putting in place appropriate economic crime controls that align with those in the global financial system. There are natural trade-offs to be made here. Financial firms may well be willing to trade full knowledge of parties and counterparties if, for example, security and compliance enhancements provided by the traceable and immutable nature of recording transactions on a DeFi blockchain mean fraud risks significantly diminishes. For financial firms to truly embrace DeFi, financial rigour and regulation needs to combine with DeFi technology evangelism - DeFi that transforms the financial system and is neither over-governed nor a so-called tech bros’ playground.
A transition period
Whilst the resilience, transaction volume and transaction settlement benefits of DeFi platforms over their soon-to-be legacy TradFi equivalents is significant, a TradFi-DeFi transition period can be anticipated. Prior to adopting a full-blown DeFi-enabled gilt issuance and trading approach, financial firms and retail investors may either take a more risk averse approach and choose to apply TradFi processes and platforms over a DeFi transaction layer, gaining limiting DeFi benefits in the short-term whilst building firm confidence. Or they may create ‘greenfield’ solutions that are wholly DeFi focused, with appropriate operational controls, regulatory compliance and technology leadership and architecture that maximises gains and accelerates DeFi adoption, but with more care needed to avoid introducing unintended risks and consequences. During the transition period, the digital gilt issuance process should be able to accept multiple capital sources from both TradFi and DeFi ecosystems, or else select the digital pound - the DeFi-native currency underpinning a UK sovereign digital gilt - as the sole ‘token of value’ to the exclusion of all other representations, such as other non-DeFi, non-sovereign currencies. Investing in a digital gilt will likely require some deregulation of the current bond market, enabling DeFi-leaning retail investors to be early investors and advocates for the digital gilt. For institutional investment, there may be benefits arising from a given digital gilt issuing being associated specifically with tokenised high-value national capital Real-World Assets (RWAs). In a similar way to Initial Public Offerings (IPOs), a Government may be able to create a ‘buzz’ around digital gilts tied to RWAs perceived as being more innovative and offering liquidity that the underlying asset cannot. AI and GenAI are expected to be essential for truly optimising financing and capital allocation, requiring legislation beyond that set out in the Data (Use and Access) Bill.
Above all, Central Banks and Governments creating digital gilts need to deliver a fully working financial instrument in a DeFi-led world with well-considered operational, technological and regulatory protocols in-place on Day 0. Where protocols allow, the operational, technological and regulatory approaches and safeguards must be coded directly into the DeFi gilt’s protocols and tokens. Only then can the use of a digital gilt as a catalyst for a tokenisation of real-world assets and - beyond that - virtual assets in global, AI-enabled Web3 ecosystems be activated into economic growth engine, heralding the next revolution of the financial services industry.
This article first appeared in Digital Bytes (21st of January, 2025), a weekly newsletter by Jonny Fry of Team Blockchain.