Fragmented ABS Market Turns to Blockchain for Structure
Cognizant of the dangers that drove the global financial crisis.
Friday, October 2, 2020
By John Hintze
In an effort to address the types of inefficiencies in the securitization market that helped fuel the subprime mortgage crisis, a pair of large financial services firms are now employing blockchain - a distributed ledger technology (DLT) that could reduce liquidity and operational risks.
Vanguard, a major asset manager, recently convened key asset-backed securities (ABS) market participants - including BNY Mellon, Citi and State Street - to participate in a pilot in which a special purpose entity (SPE) was structured using technology vendor Symbiont's Assembly blockchain platform. The SPE acts as the sole share registry and repository under the laws of the state of Delaware, using self-executing smart contacts to manage the true-sale requirements necessary for a securitization - while simultaneously automating the transaction's waterfall payments and other functions.
“We anticipate that over time, this pilot will help drive beneficial change, reduce costs and exposure to errors, increase transparency, and ultimately deliver a more efficient business model that becomes the basis for the next generation of capital markets activity,” said Warren Pennington, head of Vanguard's investment management fintech strategies group. He added that the pilot provides the technical and operational foundation critical to supporting an asset issuance on a distributed ledger network, while noting that this could occur within the next 12 months.
ABS typically pool numerous loans in an SPE set up by a bank. Multiple parties (including legal advisors, trustees and custodians) play a role, before the typically over-the-counter (OTC) securities are issued to investors, who in turn may sell them to other investors. “Because there's no modern technology connecting everybody, there's additional overhead required, and delays, errors and unnecessary costs can creep in,” explained Pennington.
Mark Smith, CEO and co-founder of Symbiont, said the vendor's technology enables “actual property right, native issuance” of a securitized transaction, rather than “tokenization” in which tokens represent the value of assets on a blockchain. Tokens have been widely used in other blockchain applications, but they introduce the possibility of man-in-the-middle attacks that enable false information to be introduced.
Blockchain has been applied to improve the transparency and efficiency of other complex systems, including multinationals' complex supply chains and logistics. Deloitte's 2020 Global Blockchain Survey revealed that more than 85% of corporate executives see the technology as broadly scalable and compelling.
Pennington noted that a more connected ABS trading infrastructure can reduce liquidity risk by ensuring that as many of the potential buyers and sellers as possible are able to transact quickly and maximize natural liquidity. The network should also reduce operational risk, he said, by compressing trade negotiation, execution, confirmation and affirmation, and settlement into a single step.
“This reduction in complexity and related reduction in operational risk eliminates a big 'tax' on the market created by the existing set of disparate players and disparate technologies needed to follow the lifecycle of even a single trade,” Pennington said.
Michela Menting, digital security and blockchain research director at ABI Research, noted that the distributed aspect allows records to be replicated and synchronized simultaneously across the ledger holders - each having a copy that updates itself with new addition - and that shortens the reconciliation processes.
“Everyone has the same data all the time. It also makes it difficult for one party to forge entries or details,” she added.
Manual operations and inadequate transparency played a major role in fostering the housing crisis a decade ago. With that in mind, Wilmington Trust has developed a DLT prototype to record the underwriting and servicing guidelines that not only establishes the representations and warranties (R&Ws) created when mortgage loans are originated but also determines which party owns them when borrowers default.
Originators and servicers may change those guidelines over time, hindering their ability to match correct versions with specific mortgages and identifying potential R&W violations. The flood of mortgage defaults during the housing crisis shone a spotlight on that issue, which resulted in a multitude of lawsuits.
Patrick Tadie, senior vice president who heads Wilmington's structured-finance division, said he realized several years ago that much of the mortgage process - from mortgage origination through sales of mortgage-backed securities (MBS) to investors - could be recorded more easily on a blockchain.
“The objective is for all parties, from the mortgage originator to the mortgage-backed security (MBS) investor, to be able to access the originating mortgage documents and to verify they haven't been changed,” Tadie said, adding that Wilmington is looking for a partner to help support the initiative.
That's critical, he added, because investors finding R&W violations may be able to transfer some or all of the losses to earlier participants in the transaction, such as loan originators or servicers. Other types of information (such as servicers' detailed notes) could also be added to the blockchain, Tadie said, to ensure that investors are following certain requirements on the correct timeline after a borrower defaults.
Often involving litigation, these issues can take months or years to resolve while the property's interest accrues and its value declines. DLT can reduce that timeline and the associated costs to weeks.
“From a risk management, as well as legal and financial perspectives, it makes a lot of sense,” Tadie said.