Blockchain technology is rapidly evolving and continues to transform many aspects of the financial services industry. One such area is securitization – where blockchain can significantly enhance transaction transparency while reducing operational inefficiencies and costs in the securitization process. This article considers how blockchain can support securitization.
What is blockchain?
Blockchain is a type of digital and distributed ledger which functions in a transparent environment. Blockchain eliminates the need for a central authority to validate transactions.
How does blockchain work?
Transactions on a blockchain are permanently committed to a ledger by groups of transactions called blocks. A blockchain network uses ordinary internet connectivity, and users can access blockchain applications via a browser or specialized desktop applications. Blockchain is a system that facilitates communication between transacting parties while distributing proofs for transaction agreements to all participants. Blockchain incorporates “smart contracts” which are a computer code that is stored on a blockchain and executed when defined terms and conditions are met. Although this revolutionary technology is often linked with cryptocurrencies, it can also contribute significantly to the financial services industry including the securitization process.
What is securitization?
In the realm 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 sold to investors. Securitization creates beneficial opportunities for both investors and creditors. Investors enjoy attractive fixed returns on their investments while benefitting from a reduction in risk because the risk is spread over a large and diversified basket of assets.
The application of blockchain technology to the securitization industry enables the monetization of otherwise illiquid long-term financial assets. As of today, blockchain technology is under serious consideration for adoption in structured finance because of its advantages. The potential advantages of the adoption of blockchain in structured finance are discussed in the following section.
What can blockchain do for securitization?
The following are some of the benefits which blockchain could bring to the securitization process:
Privacy: Administrators of permissioned blockchains can decide what parties may access or write data to the blockchain. This ability to control read/write access offers advantages over permissionless blockchains in that it allows stakeholders to securely input proprietary information relevant to the transaction and ensure that only the appropriate parties have access to such information. 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, creditors, or credit rating agencies.
Enhances transparency: 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 to secondary market transactions.
Minimizes the risk of fraud: Blockchain minimizes the risk of fraud and error. Notably, compliance obligations could be more easily met in that regulators and auditors can use the blockchain to trace the ownership of the underlying securitized assets and any associated transactions.
Reduces cost and inefficiencies in the securitization process: Blockchain serves as a single source of information which reduces information asymmetry, creates a fairer system for stakeholders, and offers the potential to remove intermediaries, and thereby reducing costs in the securitization process. The speed in which blockchain technology can process and record transactions will reduce inefficiencies relating to trading and servicing the security.
An immutable and traceable audit trail. Storing the audit trail of transactions on a blockchain gives timestamp proof of what happened, when and how. From loan origination to primary issuance, servicing, and changes in ownership in the secondary market, blockchain can create an immutable audit trail of all transactions. This capability can enable regulators and auditors to finally get an intrinsic view of the ownership of the underlying securitized assets. An issue that troubled the industry during the global financial crisis—determining who owned the title to some underlying assets—could be more easily resolved.
Better valuation and price discovery. The transparency facilitated by blockchain could reduce the information asymmetry and network disadvantages that some entities, especially smaller ones, currently face in the securitization industry. The resulting market efficiency could raise the investment appeal of securitized assets and deepen the potential pool of investors.
Speed and certainty. The disintermediation feature of blockchain technology and its simultaneous recording of information across the system can virtually remove time lags in information and payment flows throughout the securitization process, including in the secondary market. As such, this benefit of increasing speed and ensuring certainty could significantly reduce counterparty risk, the return thresholds demanded by investors and release capital.
Conclusion
Blockchain has the ability to support larger, homogeneous asset pools in structured finance transactions, which can facilitate statistical analysis and diversification of assets. This may reduce vulnerability to economic stress in such transactions. Although blockchain has the potential to be revolutionary for securitization, time will tell whether it becomes widely adopted in the securitization process. Stay tuned!
Should you have any questions, please reach out to a member of Miller Thomson’s Structured Finance and Securitization Group.
The authors would like to thank Amanjot (AJ) Saral (2022 Summer Student) for her valuable contributions to this article.
