Blockchain was introduced in 2009 as the first solution for transferring value and ownership of digital assets without the use of any trusted third party. In its simplest form, the blockchain is a shared database where all transactions of a given asset are registered in cryptographically chained blocks of data in order to become immutable. The system does not require any central authority or any single trusted third party in order to eliminate the related counterparty risk. A number of developments in this technology have enabled the functioning of small programmes such as smart contracts – leading to trusted automation of contractual relations between trading parties.
Since 2009, blockchain has come a long way and offers today numerous (and still evolving) applications in traditional processes. The use of a shared and trusted database layers can support the financing process, beginning with programme setup until the key day-to-day operations. These applications are many and include – post trade processes, compliance activities, invoice approvals etc. One such futuristic use of blockchain lies in securitization processes. In this article, we explore this use in detail and offer insights on the trend blockchain promises in years to come.
But what is securitization?
Securitization offers an option to finance obligations arising from trade relationships. This financing technique allows businesses to avoid the use of bank loans, capital increases or the direct issue of bonds and allows for credit to be provided directly by market processes.
Although securitization was initially used to finance simple self-liquidating assets such as mortgages, it has become a public financing technique using a variety of assets with stable cash flows – such as consumer credit, corporate and sovereign loans, trade receivables, project finance, individualized lending agreements etc. – all of which fall under the broader ambit of asset-backed securities.
Simply put, securitization offers following benefits:
- The enhanced competition of the capital markets results in lower financing rates, particularly when the securities are offered in a book-building or auctioning process.
- Investors that are less regulated (non-banks) have no or fewer restrictions regarding capital backing and can therefore price more aggressively.
- There are fewer transaction costs for investors, because instead of more complicated subrogation, only standard security settlements take place.
- Quicker supplier onboarding exists, as only the entity formed for the purpose of transaction needs to perform KYC (in a multi-bank program, every bank needs to perform supplier’s KYC). Moreover, the extent of the KYC requirements is often far less extensive than for banks. This justifies the onboarding of smaller suppliers because of the reduced compliance costs.
Applying Blockchain in Securitization
The applications and benefits of blockchain technology has caught utmost attention of regulators and policymakers over the past few years. How then, could DLT (distributed ledger technology) frameworks execute securitization processes more effectively and securely than traditional ones?
In early 2016, a leading trade association for the structured finance industry, formed a blockchain task force to educate and engage with members across the entire securitization industry. The key message was simple: by creating a common platform for sharing information among all relevant transaction participants, blockchain technology has the potential to create solutions to problems that typically occur throughout the securitization process.
Goodbye to Credit Ratings
One of the biggest problems identified by policymakers after the financial crisis was the overreliance by many investors on credit ratings to evaluate risk. Without access to accurate and granular underlying asset pool data, it was recognized that individual investors had little choice other than to rely on the work performed by credit rating agencies. Assuming investors have the expertise needed to evaluate the available data, blockchain could substantially reduce the reliance on credit ratings by allowing investors to read and analyze the granular, asset-level data themselves. By placing asset backed securities on a blockchain, the performance of each underlying asset could be tracked by authorized investors and analyzed for payment patterns, interest rates, defaults and all data pertinent to calculating associated risk. An ability to more accurately assess risk directly should lead to increased confidence for investors and, ultimately, greater interest in the secondary market, resulting in improved price discovery and greater liquidity.
Identifying the ownership and status of assets
It is important to note that blockchain platforms can be open to the public (such as the Bitcoin blockchain), or participation in a given ledger can be limited to a set of participants who are granted access through a predefined protocol or the approval of an administrator. Whichever approach is taken, a copy of the ledger (or at least portions of it) is typically saved on every node that is linked to the blockchain network, and any data that are placed on the blockchain are validated by the participants through the specific consensus model adopted by the network.
The use of blockchain can also provide enhanced certainty regarding the ownership and status of assets to be pooled and therefore more comfort about the ability of an originator to securitize the assets. A number of states are looking into providing blockchain-based asset registries, which would greatly facilitate this element.
Data security and reduced fraudulent trading
Blockchain would further allow the trustees, administrators, lenders and attorneys involved in a project to see the composition and ownership history of each pool asset and evaluate their risk in real time. This would also help to minimize the time required to conduct asset level due diligence on the pool and obtain comfort on pool data from external auditors compared with the current long and expensive due diligence process required prior to the securitization of a pool of financial assets. Similarly, the risk of fraud has led to the implementation of several regulatory statutes, which have increased diligence and reporting requirements, as well as the need for certain disclosures and certifications. These rules have created frictions in the securitization process and have compromised the speed and efficiency with which originators bring transactions to market. By providing a high level of data security, not only would blockchain have the primary effect of lowering the risk of fraud, but it would also lessen the need for excess scrutiny and have the secondary effect of eliminating certain regulatory inefficiencies from the process.
Reconciliation through blockchain
On a more basic level, loan origination historically takes a lot of time and requires volumes of paperwork, particularly when consumer lending is involved. Loan agreements, promissory notes, mortgages and ancillary documents are often lengthy and fraught with errors. Often included in a loan file are ancillary documents which could include property appraisals, rent rolls, lease schedules, budgets operating statements etc. – all which need to be continuously updated and checked for accuracy. An automated system of reconciliation of these data via blockchain technology would work not only to decrease the amount of manual work required but also to reduce the cost of origination and the likelihood of errors.
Smart contracts for (smart) securitization
Perhaps most interestingly, smart contracts (computer code that executes on the nodes of a blockchain ledger) can also be used to enhance efficiency throughout the securitization process. As a start, smart contracts can help to consolidate and standardize the complicated pooling and servicing agreements and other securitization contracts currently in use. For example, if a loan does not meet certain conditions that apply to a particular asset-backed security pool, as identified by the programmed blockchain code, the loan would automatically be excluded from that pool. Smart contract code is also ideal for managing the waterfall allocations of cash in an asset-backed security, automatically paying the relevant amounts to the relevant parties and providing a clear audit trail for all activity. During the servicing of a loan, smart contracts can automatically track the servicer’s collection activity, reporting on when payment notices are sent to borrowers. Blockchain can also be used at the level of the asset-backed security issued by establishing a ledger to track current investors and provide selected pool-level information to them.
Put simply, as market participants start to look more closely at all the benefits blockchain technology can bring to securitization, the conclusion will quickly be reached that this approach is indeed the future of the industry. It is strongly encouraged that all interested in securitization must look more closely at blockchain to better understand how this new technology may affect their role in the ecosystem. It may be very beneficial to assets that are currently securitizable and over time may open up new avenues for securitization of nontraditional assets using the blockchain (such as revenue generated from ride-share drivers).