Digitalization of promissory notes

Digitalization of promissory notes

Opportunities and challenges for Treasury


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promissory notes

In 2019, nearly 28 billion euros were placed in promissory notes (a.k.a. bonded loans) through 160 transactions. This means an increase of approx. 16% compared to the previous year and a tripling of the volume compared to 2009. Some of the largest transaction were placed digitally. For instance, Deutsche Lufthansa AG collected 800 million euros in digital form only and ZF Friedrichshafen AG settled more than 85% of its EUR 2.1bn promissory notes digitally. Not only is there a steady increase in the total volume of promissory notes, we are also witnessing that this kind of transaction is increasingly handled on digital platforms. However, this not only opens up new options for corporate financing, there are also risks that should be considered before venturing into this territory. 

Traditionally, the process of setting up a promissory note requires a multitude of analog interactions between the three main actors – issuers (companies), arrangers (banks) and investors. To obtain the legally required certificates, promissory notes must be structured and marketed in advance, which is traditionally done by banks. On the one hand, these advise the issuer on how to structure the note and, on the other hand, handle its structuring and marketing. On an average, the issuer is charged between 0.75% and 1.5% of the amount borrowed for the arranger’s work, as well as for fees to the paying agent over the period of the note. Further costs may be concealed in the interest paid by the arranger. The arranger negotiates the interest to be paid with each investor individually in the form of a locked-in interest rate. Because the issuer does not partake in these negotiations, it is impossible for it to precisely quantify the costs incurred in advance. 

The non-transparent cost structure is one of the reasons for choosing digital platforms for promissory notes. Another compelling reason is the simplicity of regulation. A promissory note (provided it has a minimum maturity of more than 397 days) does not meet the necessary characteristics of a financial instrument as defined by the German Banking Act (KWG) and therefore does not require KWG-specific approvals. Since it is neither classified as a security nor traded on stock exchanges, there is no need to prepare an issue prospectus in accordance with the EU Prospectus Directive. Nonetheless, the placement of a promissory note requires a large number of individual manual tasks in addition to preparing and sending certificates by post. It is precisely these individual steps that to a large extent can be performed digitally.

There are three different approaches:

  1. Digital platforms are operated by the banks themselves to digitalize their own processes to make them more efficient. This is the only form that does not involve specialized FinTechs in the process of a promissory note.
  2. Digital platforms operated by FinTechs collaborating with banks. The aim on the one hand is a digital, efficient and cost-saving process and on the other hand the integration of banks and their network in order to reach, for example, the widest possible range of investors. To this end, a platform can work with just one bank or with several banks.
  3. Digital platforms operated by FinTechs, which use their disruptive approach to try to replace banks and thus act as sole arranger. In this case, issuers and investors are meant to meet without the help of any banks, partly or completely taking over the value-generating process from the banks at more efficient conditions.

All three options offer the possibility to structure and place the promissory notes digitally from beginning to end. However, classical back-end processes such as the final certification by a notary public will still have to be done physically. In theory, however, even this step could be performed digitally using blockchain technology. The most compelling argument for block chain, apart from its efficiency, is its tamper-proof documentation. There have already been first successful pilot transactions on private block chains, with the certification performed using a qualified electronic signature. Parallel to this, however, a conventional paper-based certification process was also carried out in order to meet the legal requirements. Other processes that still need to be digitalized are the transfer and termination of promissory notes. In the future, blockchain could even be used for this.

In Germany, setting up promissory notes commercially always requires the written permission from the Federal Financial Supervisory Authority (BaFin), regardless of whether blockchain is used or not. This is the only way for players of any kind (conventional or digital) to professionally structure and market promissory notes.

As long as the legal requirements are met, the use of digital platforms still offers several advantages. For one thing, costs are lower due to an efficient organization; these savings can be passed on to the issuer and result in lower financing costs. In addition, a digital platform is able to reach more investors in less time than an analog process ever could. This can amplify both the investor base and the issue volume. All these factors therefore lead to a shift in the usual volumes, among other things. While conventional promissory notes are usually placed for amounts between EUR 50 and 500 million, digital promissory notes may be placed for amounts as low as EUR 10 million but are not capped.

This shift offers treasurers an attractive financing alternative to equity bonds and traditional bank loans. While the latter often require restrictive collateralization and may also lead to a certain dependency on banks, promissory notes are unsecured bilateral loan agreements with a broad group of investors (such as insurance companies, pension funds, family offices, investment companies, banks). Their advantage over traditional bonds lies in the fact that they do not require an EU-compliant prospectus, on the one hand, and in the relatively short implementation period (promissory notes: approx. 6 to 10 weeks; bonds: approx. 4 to 6 months), on the other. Both factors lead to a noticeable reduction in the cost of promissory notes compared to traditional bonds.

In addition to the opportunities mentioned, there are also risks that must be considered when integrating digital platforms. For example, there is always a certain degree of technical risk associated with digital platforms. No platform, no matter how excellent its design and precautions, is completely immune to technical defects and problems. There may also be a legal risk if a platform has not obtained the statutory permission to issue promissory notes commercially. In the absence of a license, not only could the money collected be frozen, but the reputation of the issuer could also be damaged seriously. This risk can be significantly reduced by obtaining information on the platform from the competent authorities. A potential financial risk may arise if the digital platform does not have access to a sufficiently large investor base, and thus the targeted issue size is not achieved. This may be the case, for example, if only few potential investors use the platform as a general rule. The same situation can also occur if only investors with a certain investment focus (e.g. on individual specific industries) use the platform. Both situations reduce the number of potential investors and can therefore lead to a failure to achieve the desired issue target.

To put it in a nutshell: treasurers do not have to decide for or against digital solutions. They may well opt for a hybrid approach consisting of conventional and digital variants. Here, both approaches are combined to suit individual requirements, thus enabling both the security of a conventional approach with the efficiency of digital platforms. Regardless of which approach is chosen, issuers benefit from more flexible volumes and more efficient cost structures as a result of the move to digital platforms. This ensures that promissory notes remain an attractive source of financing for both SMEs and international corporations.

Source: KPMG Corporate Treasury News, Edition 99, March 2020

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