Blockchain and securitisation
A radical change on the horizon?
18 July 2019
2018 has been dubbed the “Year of the Corporate Blockchain Wave.” Predictions about the extent to which blockchain technology will affect financial markets vary widely. Some commentators proclaim that blockchain will radically disrupt entire industries while others claim its benefits have been overhyped and that it is a solution in search of a problem. While use of blockchain has been discussed on deals in the securitisation markets, we are so far not aware of it actually being used as yet. In this article, we explain what blockchain is and consider ways in which it may be applied to securitisations – and whether that means radical change is coming
How blockchain works
A blockchain is a type of distributed ledger. A distributed ledger is a shared set of records that is stored in decentralized fashion by each member of a group of ledger participants. Such participants are known as “nodes”. In a typical blockchain, after all the nodes reach a consensus that updates to their shared record are valid, the record is updated in time-stamped chronological order on the blockchain. An update could be to record that the ownership of an asset has been transferred, or that the characteristics of an asset have changed, or that a payment has been made – the type of data that can be stored on a blockchain is virtually limitless and so the types of related updates is similarly broad. The consensus-based validation scheme required to update a typical blockchain record is in contrast to the way in which updates to traditional records are made exclusively by a trusted record keeper, such as a bank or custodian, who holds a single, central copy of the records. However, as discussed below, we question whether securitisation blockchains will operate with consensus validation.
Because all participants in a blockchain can view the shared ledger, or “golden record”, and because new updates are validated and added in real time, there is no need to engage in reconciliation processes to bring the records that each node holds into conformity with each other, as there is where each transaction participant maintains separate records. The fact that all participants in a ledger are on the blockchain, and that the digital “golden record” is always accurate and up-to-date, can also streamline and speed up transactional workflows by eliminating the need to secure offline consents or approvals from geographically dispersed stakeholders or to compare offline paper records that may be stored in different locations or databases. In addition, because each node stores its own copy of the shared ledger, there is no single point of failure as there is when data is stored in a single centralised database. This makes the ledger resilient.
“Permissioned blockchains” can place restrictions on who can be a node, as well as restrictions on which nodes can access particular data points. This is in contrast to open-to-all blockchains, such as Bitcoin, and is a crucial distinction for ABS transactions that contain commercially sensitive information and which may contain non-public personal information about individuals. We expect that – if, as and when blockchain technology is introduced to securitisations – only permissioned blockchains would be used.
A data point, once added to a distributed ledger, can typically only be changed with extreme difficulty (such as so called “forking”), which makes the data stored in the ledger effectively immutable, increasing confidence in its integrity.
The advantages of using blockchain are therefore generally considered to lie in its potential to simplify and streamline operational processes, eliminate intermediaries, reduce the amount of time needed to complete transactions (“latency”), enhance transparency, and improve the integrity of data and records. Securitisation transactions, with their multiple parties, a wealth of asset data and increasing reporting requirements could benefit from such improvements.
We will now consider some specific areas where improvements could be realised.
Each participant in a securitisation (for example the investor, originator, servicer, custodian, trustee, paying agent, registrar, arranger or rating agency) typically maintains its own records and models and relies on periodic reporting from other participants for current data with respect to the transaction.
Maintaining these separate records and models can result in duplicative processes, increases the potential for inconsistencies between records held by different parties and can create latency while one party updates its records based on a report provided by another party. A shared ledger could eliminate such problems.
If we use the example of a residential mortgage loan, the material terms and characteristics of the loan could be recorded on a blockchain in a ‘token’, which in this context essentially means an electronic file containing information about that loan which is stored in the shared set of records on the blockchain. Information recorded in this manner could include the principal balance, term, interest rate, priority of the mortgage, loan to value ratio, property address, insurance details or any other characteristic of the loan and collateral that is desired.
Proponents of blockchain technology foresee a future where a token will be created to record all relevant information about that asset at the point of the asset’s origination. Thereafter, the token will then travel with the asset as its ownership is transferred, providing a permanent, immutable historical data file for the asset. We think this would require a widespread adoption of blockchain technology that is only likely in the longer term. In the nearer-term, there may be more potential for loan data to be added to a blockchain for a pool of loans that has been identified for a particular securitisation as part of the initial arrangements made in preparation for that transaction. A permissioned and access-controlled decentralized registry for tracking underlying loans used in securitisations using IBM's Hyperledger blockchain technology platform recently launched. Several investment banks and multiple originators, including online lending platforms, have to date reportedly registered over 700,000 loans across multiple credit facilities using this service.
We are also skeptical that consensus validation by all nodes on a blockchain would be used for securitisations. Rather, the permission and ability to update certain data points in a token would have to be granted only to the party that has requisite knowledge; for example, a servicer should be able to record a loan modification but it makes little sense to require the paying agent’s validation in order to update the related token; the paying agent will have no knowledge of the modification. In that sense, blockchains in securitisation transactions may operate as central, shared records but likely will still be updated by the relevant parties rather than by the consensus of all nodes.
Advantages of shared records
From an operational perspective, a central record that is available to all parties could help create operational efficiencies. For example, it might allow a paying agent to know what collections are available for distribution on a payment date without waiting for a servicer report. There are also blockchain-focused companies that have been working towards automating the cash flows of securitisations. Using collection information, note balances, coupons and fees and expenses due (all details that would be stored on the blockchain) they aim to automatically generate payment reports that set out the payments to be made on each payment date.
Other companies go further and are working towards a shared blockchain with a smart contract that would automatically run deal waterfalls and effect payments. A “smart contract” is a computer code that is embedded into the blockchain and runs a computer program. In this case, a smart contract would be programmed to apply collections in accordance with the pre- determined priority of payments. This could remove certain intermediary functions from transactions. If all parties to the deal were using the same blockchain, it would also eliminate the risk that their separate proprietary models for the waterfall may inadvertently have different terms and behaviors. In addition, triggers (including ratings triggers) could be embedded into the code to flag if the transaction is diverging from modeling forecasts or assumptions.
In addition to operational efficiencies, as lawyers, we see potential advantages from a legal perspective.
Reporting requirements: With a central record that contains granular information about every loan in a securitisation, compliance with asset level reporting requirements such as Reg AB II, central bank loan-level data requirements, or the coming loan-level data disclosure requirements under the EU Securitisation Regulation could all be near-automated. It would also be easier to monitor compliance with loan-level representations and to track and report breaches of such representations and related buybacks because the characteristics of a loan and the ownership of the loan would be recorded on the blockchain.
Any shared ledger would, however, have to be carefully constructed to ensure that only parties who need to (and are legally allowed to) see particular information have access to it. Concerns about the handling of commercially sensitive and/or non-public personally identifiable information that already exist in traditional deals will only be amplified if data is stored on a shared ledger to which multiple parties have access. Needless to say, the data protection implications under the EU’s General Data Protection Regulation (“GDPR”) would need to be carefully considered and managed. In the event of any mishandling of information on a shared ledger, it will be necessary to determine which party is legally responsible as concepts such as that of a data “controller” under the GDPR would continue to apply.
Title: There are already examples on local levels of title to real property being recorded and transferred on blockchains. If this were to become the norm, it could greatly simplify the process for transferring title and make securitisations more efficient. In jurisdictions where beneficial title, rather than legal title, is initially transferred to an issuer, there would still be advantages to having the token for a loan easily updated to note the new beneficial owner.
Collateral Pledge: Although not a widespread problem, there have been instances where assets have been fraudulently pledged to more than one creditor. If a token was created for each loan, and systems were designed such that it was only possible for one token to exist for each loan and each token contained a flag if the loan had been previously pledged, that would create greater certainty in respect of collateral pledges. A smart contract could go further and make it impossible to pledge an asset that had already been pledged.
General capital markets infrastructure could also be changed by blockchain technology and used in securitisations. For example, rather than using traditional clearing systems to hold global notes and effect secondary trading, ownership of securities could be recorded and updated on a blockchain. Jurisdictions such as Delaware have already passed laws to expressly permit an issuer to issue securities that are evidenced solely by a record on a blockchain. There are a number of complexities associated with such a development that are outside the scope of this article – for example, whether geographic transfer restrictions could be adequately policed – and which mean that we expect the existing infrastructure to remain for the foreseeable future.
Hurdles to the adoption of blockchain in securitisations
The single biggest hurdle to blockchain’s adoption in the securitisation industry is the fact that it remains untested as an enterprise-grade platform. This does not mean that blockchain is a purely theoretical construct that has never moved past the proof-of-concept stage but permissioned, financial industry consortia do not yet have a time-tested track record of reliable operation. Before blockchain can be widely adopted in the securitisation industry, it will need to win the confidence of all stakeholders and market participants that it is a credible alternative to existing systems.
Interoperability and common data standards will also create challenges. What degree of compatibility, for instance, would new blockchain-based securitisation software have with existing financial industry legacy software platforms? If there is no compatibility between old and new, many efficiencies would be lost; non-interoperable software platforms would be as incompatible as analog systems are to digital ones.
Likewise, different blockchains would have to be able to talk to each other if asset tokens are to be able to travel from, say, an originator’s blockchain to a warehouse blockchain to a securitisation blockchain. There are a number of interoperability protocols in development. For blockchain to be universal, one such protocol will have to prevail and be adopted universally. The analogy of the shipping container is a good one: before the adoption of a simple, standardised shipping container, goods had to be unloaded and reloaded between truck, train and ship and then again in reverse when they reached their destination. The humble shipping container revolutionized that process, allowing goods to be packed up at source and transferred seamlessly. Separate blockchains represent different ports before the shipping container. A simple, standardized protocol will be required to allow data to move freely between different blockchains.
So is blockchain technology something that will radically disrupt the securitisation industry or is it an overhyped solution in search of a problem?
It may be both: in the short- to medium-term, a shared ledger could be used to make legal compliance more efficient and accurate and it could eliminate certain operational processes and intermediaries from securitisation transactions. However, that makes blockchain only a slightly better toolkit which market participants can use to do things incrementally better than they are done today. More far-reaching disruption will require asset data tokens, interoperable blockchains and smart contracts, all of which are longer-term propositions.
Change is coming but it seems unlikely that it will be radical…yet.