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Many believe that blockchain technology is synonymous with cryptocurrencies, such as bitcoin and ethereum. Yet, cryptocurrency is just one of a multitude of applications of blockchain technology and there are numerous industries, such as financial services and transportation, which will also benefit from this emerging technology.
Similar to artificial intelligence or AI, blockchain, or “distributed ledger technology” as it is more formally described, also has the potential to revolutionize aspects of the financial services industry as seen through the emergence of a wide range of FinTechs. One such area is structured finance where blockchain technology can be utilized to reduce servicing and reporting costs, create data-management efficiencies and increase transaction transparency throughout the securitization process – from asset origination to secondary market trading. This article will explore some of the benefits that would be offered from the application of blockchain technology to the securitization industry, thereby further enabling the monetization of otherwise illiquid long-term financial assets.
The Existing Process of Securitization
In the world of structured finance, securitization is the creation of liquid, asset-backed securities from pools of illiquid assets – such as mortgages, lease agreements, and credit card debt. These asset-backed securities are then sold to investors.
Almost any asset which generates a recurring stream of cash flow payments can be securitized if those payments can be used to fund their maintenance in aggregating structures and regular distributions to security holders. A special purpose vehicle or SPV is typically used to purchase and hold the relevant assets, using the proceeds from the issuance of securities to investors to fund the purchase of these pooled assets. Securitization creates opportunities for both investors and creditors. Investors, in addition to enjoying attractive fixed returns on their equity, enjoy a reduction in risk since the risk is spread over a larger and more diversified basket of assets. Investors can also receive improved returns positively leveraged by debt. Traditional creditors benefit as their capital is freed up, thus increasing the availability of credit and promoting greater liquidity in the marketplace.
For all of its benefits, securitization is a complex process requiring numerous stakeholders relying on different sets of data and information. These stakeholders include legal counsel, accountants, rating agencies and underwriters. As information and data relied on by stakeholders to structure or trade the security is not currently shared between stakeholders, nor in a standardized form, there exists significant inefficiencies which now pervade many aspects of the securitization lifecycle.
A lack of transparency, as well as difficulties in tracing relevant transactions related to the security, creates both reporting and underwriting inefficiencies that lead to increased expense and delay. This lack of transparency can also cause interpretation issues as between stakeholders when performing various tasks surrounding the securitization process, such as valuing the assets and calculating the waterfall of payments that must be satisfied by the securitized asset pool.
Blockchain technology is rapidly evolving, with many adaptations of this technology already in use. Even so, certain features underpin this technology and exist throughout all its variants. Blockchain technology offers an immutable, secure, transparent and immediately verifiable method for performing transactions without the requirement for a trusted intermediary to process and report all transactions. The decentralized nature of this technology makes it considerably more secure than a database with only one single authority. It allows for faster transaction processing as the concept of objective “consensus” to the validity and accuracy of the transactions is built into this technology.
As outlined above, there are many adaptations of blockchain technology. One such variant is permissioned (or private) blockchains. Unlike permissionless (public) blockchains, which is the blockchain technology underpinning cryptocurrencies such as bitcoin, permissioned blockchains can restrict a party’s access to the blockchain and also limit such party’s read and write access to the data stored on the blockchain.
Blockchain applied to Securitization
Administrators of permissoned blockchains can decide what parties may access or write data to the blockchain. This ability to control read/write access offers several advantages over permissionless blockchains as it allows stakeholders to securely input proprietary information relevant to the transaction and ensure that only the appropriate parties have read access to such information. Permissioned blockchains still allow for data stored on the blockchain to remain auditable and traceable. The ability to restrict the read and write access to permissioned blockchains makes it well suited for securitization. This means that the information available to investors can differ from that available to regulators, investors, creditors or credit rating agencies. In this example, regulators may be required to receive access to all information stored on the blockchain, while investors could be limited to accessing only necessary information. This ability to grant regulators with broader access rights is even more pertinent due to the ever-growing compliance obligations required by regulators in this sector.
Blockchain’s potential to establish a single source of information consistent among all parties will ultimately drastically reduce inefficiencies and costs. This leads to traceable, transparent and auditable data at all stages in the securitization lifecycle from loan origination through to secondary market transactions. In addition to minimizing the risk of fraud or error generally, compliance obligations could be more easily met as regulators and auditors can use the blockchain to trace the ownership of the underlying securitized assets and any associated transactions. This single source of information reduces information asymmetry and creates a fairer system for all stakeholders and offers the potential to remove intermediaries, thereby further reducing costs. The information on the blockchain can be used to better understand the available pool of underlying assets, including each asset’s payment history permanently associated with it.
The speed in which blockchain technology can process and record transactions could also reduce efficiencies relating to trading and servicing the security. Trust in the accuracy and availability of information allows for increased certainty and faster payments and even greater trust in the securitization sector as a whole.
Potential Barriers to Adoption
With all its inherent and potential promise, blockchain technology will need to overcome several hurdles on the path to adoption in securitization. There will need to be significant buy-in from all stakeholders due to the upfront costs of developing, testing and implementing blockchain technology for this industry. Stakeholders will need to agree on a standard or “protocol” for all data to be added to the blockchain and set up internal processes and procedures to ensure that it meets these standards. Stakeholders will also need to ensure that their infrastructure can interoperate with blockchain technology.
For securitization transactions, the laws that apply will depend on, and vary in relation to, the underlying assets and the applicable jurisdictions. Due to this complexity, organizations should engage regulators at an early stage to ensure that the technology is compliant with applicable laws. Organizations looking to implement blockchain technology for securitizations should seek advice from legal counsel with an understanding of the technology as well as the relevant applicable legal framework.
While adoption of blockchain technology for securitization will require a significant concerted effort from and education of all stakeholders, including domestic and international regulatory bodies, the range and scope of benefits that this technology enables are substantial. Reduction in time and cost of securitization activities, coupled with greater transparency generally for all stakeholders, means that blockchain technology could indeed be transformational for securitization, if not altogether revolutionary.