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, 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. Tokenisation has the potential to partially replace securitisation if not totally it.
As it becomes more main stream, there will be a period that blockchain and tokenisation co-exist with and then replace some of the processes that are so familiar to us today. It promises to transform many activities in the securitisation cycle, if not 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 & ESG, with transparency and reporting being key to ESG frameworks and taxonomies.
What is blockchain and tokenisation?
“Blockchain” is a distributed ledger that allows for transactions to be recorded in a secure, transparent, immutable and auditable way, without the need (necessarily) for an intermediary to perform or reconcile such transactions. Although there are permissionless, or public, blockchains, where anyone can write transactions and participate in the consensus process, it is more likely that the permissioned, or "private" blockchains, will be more widely adopted in the context of finance transactions.
The ability to have a single permissioned blockchain with different permissioned rights depending on the user and, for example, to allow proprietary or confidential data to be hidden from competitors who may be involved on the same blockchain may be beneficial to investors in the context of a securitisation.
"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 from 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; and
data: An ability to present all the relevant information to other stakeholders for due diligence purposes (including rating agencies) in a more efficient manner.
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 prevented a more widescale adoption of distributed ledger technology 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;
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;
infancy of blockchain technology: the blockchain is a relatively new technology and before it can be widely adopted it needs to win the confidence of all stakeholders and market participants and convince them that it is a credible and better alternative to the existing systems;
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; and
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.
Despite a number of challenges, market participants have progressively started experimenting with various blockchain elements on an incremental basis. Blackrock has recently started using Veris, a distributed ledger network to help firms match and reconcile post-trade data on stock swaps. A number of leading investment banks are starting to use distributed ledger technology for transaction management purposes, such as the use of smart contracts, automatic tracking of invoices and other payments, as well as more advanced real-time payment and settlement contracts. The European Investment Bank's €100m two-year digital notes based on Ethereum (underwritten by Goldman Sachs, Banco Santander SA and Société Générale AG) may also signal a more widespread acceptance of the technology in the capital markets space.
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 (i.e. reporting, due diligence, digitalising certain aspects of transactions, etc) rather than wholesale changes where all aspects of the securitisation are moved onto the blockchain. However, the increasingly positive response from market participants and investors, as well as the increasing role of environment, social and governance (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.
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. Tokenisation has the potential to partially replace securitisation, but it can also replace the traditional securitisation framework altogether.
As it becomes more main stream, there will be 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.
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, Michael Thomas, and George Kiladze.