While we still may be at an early stage of the evolution of blockchain for securitisation, blockchain along with smart contracts, promises to transform many activities in our securitisation industry. The question becomes not if but when, and when is now.
Blockchain has the potential to streamline processes, lower costs, increase transaction speed and efficiency through automation, enhance transparency and improve security, for all transaction participants, from issuer, to paying agent, to investors, and for others such as auditors, third party opinion providers, rating agencies and regulatory bodies.
As it becomes more mainstream, there will be a period that blockchain and tokenisation co-exist with, and eventually replace, some of the processes that are so familiar to us today. It promises to transform many activities in the securitisation cycle, if not largely replace them. None of our activities are immune to change.
It is inevitable that there will be some overlap with the work that is being done in securitisation and environment, social and government (ESG) issues, with transparency and reporting being key to ESG frameworks and taxonomies.
What are Blockchain, smart Contracts and Tokenisation?
“Blockchain” is a technological system where data is recorded on a number of decentralised ledgers (the so-called "distributed ledgers"), which are maintained on the computers that form part of the blockchain, the nodes. Every time that data is to be added to the blockchain, each node is expected to update the copy of the ledger maintained by it by adding the new 'block' to the existing chain.
A new block is added to the various ledgers only if the blockchain algorithm has positively completed a secure validation procedure involving all the participating nodes (the "consensus protocol"), and once the new block is added, there is no way to delete such entry, for which reason blockchains are considered immutable.
Other important features of blockchain are that any block being added to the ledgers is timestamped and cryptographed, so that data can be recorded in a secure, and auditable way.
The blockchain updates are managed by complex and automated algorithm, so that the risk of human error is minimised and there is no need (necessarily) for intermediaries to manage the blockchain or carry out reconciliation activities on the recorded data.
Finally, it is important to distinguish between public and private blockchains. Public blockchains are also referred to as 'permissionless', as anyone can join the blockchain without obtaining any permission, by making available a computer (node) that offers computing power helping the blockchain perform the required calculations (and by so-doing being involved in the consensus process). Conversely, private blockchains are those where a node can only join the blockchain if granted with a permission to do so.
“Smart Contracts” on blockchains are blocks of code designed to ensure that certain actions are performed within the blockchain or triggered outside the blockchain, upon the occurrence of pre-determined conditions as agreed upon between the relevant parties.
In a structured finance context, smart contacts could for instance be those automated processes that ensure that payments are made on a given payment date, that additional collateral is posted depending on the quality of the portfolio data made available on reports, etc.
"Tokenisation", or the process whereby a typically illiquid asset held by an issuer could be converted into a fixed number of liquid tokens (having a fractional value of the original illiquid asset) to be acquired by investors (who in turn could further subdivide such liquid tokens) has been used by a number of market participants(for example, Aspen Coin, which tokenises real estate property for investors).
The main benefit of tokenising assets is that it increases the liquidity of the assets which can then be traded on a secondary market of the issuer’s choice. Since tokens are highly divisible, investors can also purchase tokens that represent very small percentages of the underlying assets making investing much more accessible. Finally, because the transaction of tokens is completed using smart contracts, certain parts of the exchange process are automated which reduces the administrative burden involved in trading. With fewer intermediaries, deals can be executed faster and with lower transaction fees.
How blockchain could benefit structured finance
There are a number of benefits which blockchain could bring to securitisation:
- immutable, traceable audit trail: from loan origination to primary issuance, and changes in ownership in the secondary market, blockchain can create a chronological and immutable audit trail of all transactions. With this capability, regulators and auditors can get a view of the ownership and title of the underlying securitised assets;
- speed and certainty: blockchain through its disintermediation and simultaneous recording of information across the system, can almost totally eliminate time lags in information and payment flows throughout the securitisation process, including in the secondary market. This increase in speed and certainty could significantly reduce counterparty risk, release capital, and reduce the return thresholds that investors require;
- security: blockchain’s capacity to increase the security of transactions and data, and mitigate fraud could be appealing to the securitisation (and indeed generally the financial services) industry, where integrity of data is paramount, especially if compared to an industry that is essentially based on exchanges of emails and all security issues relating to them. One important aspect to consider is that given the interconnectivity of all segments within the blockchain, wrong entries (because of their erroneous or malicious nature) would automatically reverberate in several layers of the blockchain and the validation protocols would prevent such mistake from going unnoticed; and
- data: information could be presented to all relevant stakeholders for due diligence, monitoring and execution purposes. In a structured finance context, data recorded on the ledgers tends to correspond to financial transactions, and for such reason it is more likely that blockchain securitisations will be "private" blockchains; however, they may be designed so as to have different permissioned rights so that depending on the type of user (and its role within the securitisation) different levels of disclosure may be applied (e.g. a security trustee required to notify the underlying borrowers may need to have access to personal data, rating agencies may need to have access on reports as well as certain information (e.g. around swap pricing) which may not be disclosable to all transaction parties). Better and more frequent data could also create more business opportunities - for example, making granular information available on a daily basis could help arrangers cut the securitisation pool in a more precise way and eventually result in better pricing in the interest of all parties.
The above benefits could in turn lead to greater efficiency, speed, transparency and safety on the securitisation market, which could lead to a higher investor appetite and improve pricing, volume and spreads, which could lead to more issuers and borrowers using securitisation as a funding means.
Some challenges to adoption
There are a number of challenges which have seemed to slow down a more widescale adoption of distributed ledger technology (DLT) in financial transactions:
- interoperability: interoperability and common data standards will be a challenge to the adoption of blockchain in the securitisation industry. It is yet to be seen how new blockchain-based securitisation software will integrate with existing financial industry legacy software platforms. If the old and new platforms are incompatible then the efficiency benefits of the blockchain are undermined.
Similarly, different blockchains need to be able to talk to each other if asset tokens are to be able to travel from, an originator’s blockchain to a securitisation blockchain.
However, software providers and other market participants are now analysing how multiple different information sources originating from separate blockchains can be reconciled, creating a single view of transaction data as it moves across systems. For example EY has launched its Blockchain Analyzer Reconciler tool which collects an organisation’s transaction data from multiple blockchain ledgers and can analyse and reconcile the resulting data. In the context of market making, exchanges are now exploring ways to organise trades outside of the various DLT structures involved in a transaction and then reconcile them back into the relevant DLTs afterwards. This method would therefore bypass sections of a transaction which are not ideally located on a DLT structure.
- data security and privacy: with reams of data being stored on the same technology platform, a cyberattack could be devastating. A blockchain system will also have to be designed with appropriate fire walls on information access among parties on the blockchain, some of whom will be competitors.
However, firms are now emerging in the marketplace which can mitigate some of these concerns. One example of this is TRM Labs, a U.S. based blockchain tracing firm which provides blockchain forensic, KYC, and transaction-monitoring services for crypto businesses, financial institutions and the public sector. Firms like this will become increasingly important as the use of blockchain in financial services becomes more widespread and levels of regulatory scrutiny inevitably increase.
- legal and regulatory uncertainty: to date there is no clear and comprehensive legal framework or regulatory oversight of blockchain technology and its application in the financial industry – although different jurisdictions are taking steps to address this issue. There remain a number of unanswered questions, predominantly around the issues of liability, which may stunt the widespread adoption of blockchain technology in place of existing transaction frameworks.
Some legislators have started to take steps to address this legal and regulatory uncertainty. The EU's MiCA Regulation is currently progressing through the EU legislative process at the time of writing, and aims to create a regulatory framework for crypto-assets. The EU's DLT Pilot Regime allows for certain DLT market infrastructures to be temporarily exempted from some of the requirements of EU financial services legislation that would otherwise prevent the trading and settlement of digital assets. The DLT Pilot Regime has now been published in the Official Journal of the EU. Elsewhere, the UK Government has declared its intention to make the country a "global cryptoasset technology hub", and has published its plans to regulate stable coins. The UK Law Commission is also due to report on its proposals to increase legal certainty around the development and adoption of digital assets.
In an effort to reduce regulatory fragmentation, the U.S. President's Working Group on Stablecoins published a report calling on regulatory agencies to ensure that stablecoins become subject to federal legislation. The U.S. Congress has now announced draft legislation establishing a regulatory framework for digital assets.
It remains to be seen how well these pieces of legislation will work in practice, and whether regulators will be able to keep pace with a complex market which is already rapidly developing. For example, as it stands the MiCA Regulation will not address the role of Non-fungible Tokens (NFTs) in the financial system, something which market participants see as a key recent development that regulators will eventually need to address.
- the role of intermediaries: a big focus of the post-2008 financial crisis regulation was aimed at reducing systemic risk in the financial system – which resulted in regulations requiring that certain financial transactions involve certain types of regulated intermediaries - i.e. that they be formed on regulated exchanges, cleared through central counterparties and/or settled via central securities depositories, in each case in accordance with detailed rules and standards. The aim was, in part, to mitigate certain counterparty risks that arise when a transaction counterparty defaults. This has led to a number of risk-management benefits (including, for example, protection for transaction finality and the rules of financial market intermediaries following an insolvency of a counterparty). It is not clear whether such intermediaries will have a significant role in a blockchain and, indeed, whether the regulatory benefits of such intermediaries can be recreated with a blockchain-based securitisation. However, there are signs that some intermediaries are adapting to the new technological environment and taking advantage of the new opportunities it offers. For example, Charles River has announced a collaboration with Ledger Edge to provide investment firms with access to corporate bond liquidity and trading services based on DLT technology. Euroclear has also announced a new partnership with the blockchain payments consortium, Fnality International, with the aim of increasing the speed, efficiency and resilience of post-trade operations including collateral trades and servicing interest payments.
- institutional buy-in: in order for market participants to start using DLT in securitisation transactions on a significant scale, there needs to be a clear and demonstrable improvement versus the technological status quo. For example, Figure issued the first ever securitisation backed by loans originated, serviced, financed and sold on blockchain, resulting in a 100 basis point saving for investors. However, it is also possible that some intermediaries may push back against having their fees reduced, thus delaying institutional buy-in for similar transactions.
How has the structured finance industry been impacted so far?
Despite the relatively early stage of the blockchain technology and a number of challenges that market participants have to face to update their systems in a coordinated manner, we have witnessed a progressive tendency in experimenting with various blockchain elements in Europe and globally. Some notable examples are:
- A Spanish bank concluded a synthetic securitisation, the first European transaction negotiated and signed on blockchain. One interesting feature of this transaction is that notwithstanding all transaction information was recorded on blockchain, only part of it has been made available to the transaction parties, due to duties of confidentiality.
- A major Spanish bank, a major French bank and The European Investment Bank (EIB) participated in the structuring and issuance of certain digital bonds. As much as the digital bonds issued by such French and Spanish banks were based on the Ethereum and Tezos (public) blockchains, of particular importance is the EIB digital bond issuance as unlike the other two (where bonds were issued to affiliates of such banks), the digital bonds were placed with external investors.
- From an asset-based perspective, in collaboration with an external provider, Hogan Lovells has developed Drive Chain, a pioneering blockchain-enabled technology platform that drives efficiencies within commercial transactions for clients. Upon entering into a contract, DriveChain (a) extracts certain pre-identified information from it and automatically produces a summary of the contract (e.g. a commercial lease); at the same time it (b) supplies the relevant parties with an embedded, unique QR code that allows them to securely retrieve and consult the original document as well as its summary. DriveChain is designed to ensure that the data is recorded using blockchain technology so that, at the appropriate point in time, it can help analyse the underlying assets (e.g. the commercial leases) as part of the due diligence process (e.g. to review the terms, or to compare and contrast such terms with those of other assets). The relevant data can also be used for audit, monitoring and reporting purposes in the context of a securitisation transaction. This technology could provide significant benefits to the securitisation process. For example, when specific contracts are securitised they could be located on the blockchain along with the relevant metadata. This would eliminate the need to find originals of the documents, minimise costs of due diligence exercises and simplify certain servicing processes as the case may be.
- In the U.S. a number of companies (including the above mentioned Figure, or Liquid Mortgage) connect borrowers and lenders using blockchain technologies, are funded by investors using blockchain securitisation technologies (like Redwood Trust). The technology that they can offer helps minimise transaction costs and provides more detailed and real-time reporting facilities, which would help investors and structurers identify different portfolio segments for servicing, restructuring or re-securitisation purposes and could eventually result in far more accurate pricing and the ability to create further opportunities in the capital markets. In the U.S. major commercial banks like JP Morgan, Bank of New York, Citibank and many others are investing and or have migrated a substantial part of their operations to blockchain, and also for structured finance purposes.
- The Luxembourg Stock Exchange (LuxSE) admitted three digital bonds (i.e. "security tokens") issued by SG Forge that were registered on a public DLT. Despite the European legislator attention to blockchain (as to which see above 3(c) above), the current regulatory framework (e.g. MiFID II or CSD) as a matter of fact prevents security tokens from being traded on regulated markets; to accommodate the market needs, the LuxSE have allowed security tokens to be listed (but not traded) on LuxSE’s Securities Official List (LuxSE SOL) and issued internal guidance, which hopefully allows security tokens to achieve more market visibility. The additional disclosure requirements associated with DLT financial instruments also provide more comfort to potential investors, as well as sending a strong market signal. The tokens consisted of two digital covered bonds and a structured product that were issued natively on the Ethereum and Tezos public blockchains.
- A number of leading investment banks are starting to use DLT for transaction management purposes, issuance of letters of credits processes, use of smart contracts, automatic tracking of invoices and other payments, as well as more advanced real-time payment and settlement contracts, which securitisations and structured finance transactions can certainly benefit from, in particular with regard to settlements. With Fnality1, Nivaura2 and Adhara3, we have seen consortia of major banks (e.g. Natwest and Santander) involved in the issuance of tokenised securities on public blockchains, with the payment leg conducted through a DLT-enabled payments system.
- The Singapore Exchange (SGX) in collaboration with HSBC Singapore and Temasek, issued a digital bond which eliminated settlement risk, reduced primary issuance settlement time from 5 to 2 days and automated coupon and redemption payments.
As a result of the fragmentation of challenges, it is likely that any adoption of blockchain in securitisation transactions will initially adopt an incremental approach for various discrete aspects of securitisation both at an asset and at an issue level (i.e. reporting, due diligence, settlement, digitalising certain aspects of transactions, etc) rather than wholesale changes where all aspects of the securitisation are moved onto the blockchain. In terms of asset classes, it appears ABS transactions are currently better placed to take advantage of blockchain technology. However, the increasingly positive response from market participants and investors, as well as the increasing role of ESG themes and the underlying need to disclose additional information in a more concise, user-friendly and efficient manner may accelerate the adoption of such technology. For example, the Japan Exchange Group (JPX) has conducted research into issuing a tokenised green bond that uses blockchain to improve data transparency and the efficiency of data collection.
Blockchain has the potential to streamline processes, lower costs, increase transaction speed, enhance transparency and improve security, for all transaction participants, from issuer, to paying agent to investors, and for others such as auditors, third party opinion providers and rating agencies. It is unlikely that these factors will be disregarded in a world of high cost inflation and rising interest rates. We expect that governments will be pushed to create value to their voters and that surely digitalisation has the potential to be a powerful tool to such aim.
As tokenisation and the developments of NFTs, along with the ability to attach assets to tokens become more mainstream we expect a period that blockchain and tokenisation co-exist with and then replace some of the processes that are so familiar to us today. However, over time, it can transform many activities in the securitisation cycle, and have a much more disruptive wholesale effect on securitisation transactions. None of our activities are immune to change, and changes can happen very quickly (as for instance happened to the document execution processes during COVID when most market players started accepting the use of digital signatures).
As one of the largest and most experienced blockchain domestic and international legal teams dedicated to the virtual currency and blockchain sectors, our practice helps clients take advantage of blockchain technology's huge potential and disruptive impact, while avoiding falling foul of ever-developing regulatory and legal requirements. We work with a wide range of clients as they explore disintermediation, digital currencies, token sales, and new uses for blockchain.
Hogan Lovells' Structured Finance and Securitisation practice has deep experience advising on the financing of a wide range of classic and innovative asset types, as public and private stand-alone issues, master trusts, programmes, through conduit structures, and on portfolio sales, forward flow and financings of these transactions. We have built the practice across the globe with lawyers in the major jurisdictions of Europe (including UK), the United States and Asia, providing an integrated service to our clients on their most complex transactions. We are known as experienced and pragmatic counsel who advise arrangers, lenders, originators, investors, trustees and investors. We are regularly commended by independent market guides, particularly for our ability to advise on new and innovative transactions. We run one of the few practices able to offer dedicated and knowledgeable advice to capital markets trustees.
We would be delighted to discuss any of these issues with you further. Simply call one of us or your usual contact. For more information about our practice, please check out our Blockchain hub.
Authored by Sharon Lewis, George Kiladze, Andrea Salsi and Patrick Evans.
 A blockchain payment consortium of Banks (Banco Santander, BNY Mellon, Barclays, CIBC, Commerzbank, Credit Suisse, ING, KBC Group, Lloyds Banking Group, Mizuho Bank, MUFG Bank, Nasdaq, State Street Corporation, Sumitomo Mitsui Banking Corporation and UBS) in which also Euroclear has invested.
 A FinTech company involved in digitising, automating and optimising workflows involved in capital markets transactions.
 A software company that builds liquidity management, FX and payments solutions for banks.