Tokenization of assets: on the securitization of the blockchain | Hogan Lovells


Although we are still at an early stage in the evolution of blockchain for securitization, blockchain as well as smart contracts promise to transform many activities in our securitization industry. The question is not if but when and when is now.

Blockchain has the potential to streamline processes, reduce costs, increase the speed of transactions, improve transparency and improve security, for all participants in the transaction, from issuer to transaction. paying agent to investors, and for others such as auditors, third party opinion providers and rating agencies. Tokenization has the potential to partially or even completely replace securitization.

As it becomes more mainstream, there will be a period in which blockchain and tokenization will coexist and then replace some of the processes that are so familiar to us today. It promises to transform many activities in the securitization cycle, or even replace them. None of our activities are immune to change.

It is inevitable that there will be some overlap with the work done in the area of ​​securitization and ESG, with transparency and reporting being essential to ESG frameworks and taxonomies.

What is blockchain and tokenization?

Block chain”Is a distributed ledger that allows transactions to be recorded in a secure, transparent, immutable and auditable manner, without the need (necessarily) for an intermediary to perform or reconcile such transactions. While there are unauthorized, or public, blockchains where anyone can write transactions and participate in the consensus process, it is more likely that authorized, or “private”, blockchains will be more widely adopted in the context. financial transactions.

The possibility of having a single authorized blockchain with different authorization rights depending on the user and, for example, allowing proprietary or confidential data to be hidden from competitors who may be involved on the same blockchain can be beneficial. for investors in the context of a securitization.

Tokenization“, or the process by which a generally 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 subdividing these liquid tokens) has been used by a number of market participants (eg Aspen Coin, which symbolizes real estate for investors).

The main advantage of asset tokenization is that it increases the liquidity of the assets which can then be traded in a secondary market at the option of the issuer. Since tokens are highly divisible, investors can also purchase tokens which represent very small percentages of the underlying assets, making investing much more accessible. Finally, since the token transaction is done using smart contracts, some parts of the trading process are automated, reducing the administrative burden of trading. With fewer middlemen, transactions can be executed faster and with lower transaction costs.

How blockchain could benefit from structured finance

Blockchain could bring a number of advantages to securitization:

  • immutable and traceable audit trailFrom loan origination to primary issuance, including 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 gain an overview of the ownership and title of the underlying securitized assets;

  • speed and certainty: Blockchain, through its disintermediation and simultaneous recording of information through the system, can almost completely eliminate lags in information and payment flows throughout the securitization process, including in the secondary market . This increase in speed and certainty could significantly reduce counterparty risk, free up capital and lower the thresholds of return required by investors;

  • Security: the ability of blockchain to increase transaction and data security and mitigate fraud could be attractive to the securitization industry (and in general financial services), where data integrity is paramount; and

  • The data: An ability to present all relevant information to other stakeholders for due diligence purposes (including rating agencies) in a more efficient manner.

The above advantages could in turn lead to greater efficiency, speed, transparency and security in the securitization market, which could lead to greater investor appetite and improve prices, volume and spreads, which could lead more issuers and borrowers to use securitization as a means of financing. ways.

Some challenges to adoption

A number of challenges have prevented a wider adoption of distributed ledger technology in financial transactions:

  • interoperability: Interoperability and common data standards will be a challenge for blockchain adoption in the securitization industry. It remains to be seen how the new blockchain-based securitization software will integrate with existing software platforms in the financial industry. If the old and new platforms are incompatible, the efficiency benefits of blockchain are compromised.

    Likewise, different blockchains must be able to talk to each other if asset tokens are to be able to travel from an originating blockchain to a securitization blockchain;

  • data security and confidentiality: With tons of data stored on the same technology platform, a cyberattack could be devastating. A blockchain system will also need to be designed with appropriate firewalls on access to information between parties on the blockchain, some of which will be competitors;

  • stammering of blockchain technology: blockchain is a relatively new technology and before it can be widely adopted, it must gain the trust of all stakeholders and market players and convince them that it is a credible and better alternative to 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, primarily around liability issues, which may hinder the widespread adoption of blockchain technology in place of existing transaction frameworks; and

  • the role of intermediaries: A major goal of post-2008 financial crisis regulation was to reduce systemic risk in the financial system – which has resulted in regulations requiring certain financial transactions to involve certain types of regulated intermediaries – that is, – say that they are formed on regulated exchanges, cleared by central counterparties and / or settled through central securities depositories, in each case in accordance with detailed rules and standards. The objective was, in part, to mitigate certain counterparty risks that arise when a counterparty to a transaction defaults. This has led to a number of risk management benefits (including, for example, the protection of the finality of the transaction and the rules of financial market intermediaries following the insolvency of a counterparty). It is not clear whether these intermediaries will have a significant role in a blockchain and, indeed, whether the regulatory advantages of these intermediaries can be recreated with blockchain-based securitization.

And after?

Despite a number of challenges, market players have gradually started experimenting with various elements of the blockchain in an incremental way. Blackrock recently started using Veris, a distributed ledger network to help companies match and reconcile post-trade data on stock exchanges. 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 contracts. more advanced real-time payment and settlement. The European Investment Bank’s € 100 million two-year digital notes based on Ethereum (underwritten by Goldman Sachs, Banco Santander SA and Societe Generale AG) could also signal more widespread acceptance of the technology in the space capital markets.

Due to the fragmentation of the challenges, it is likely that any adoption of blockchain in securitization transactions will initially take an incremental approach for various discrete aspects of securitization (i.e. reporting, due diligence, digitization of some aspects of transactions, etc.) rather than wholesale. changes where all aspects of securitization are moved to the blockchain. However, the increasingly positive response from market participants and investors, as well as the growing role of environmental, social and governance (ESG) themes and the underlying need to disclose additional information in a more concise, user-friendly way. and efficient can accelerate the adoption of such technology.

Blockchain has the potential to streamline processes, reduce costs, increase the speed of transactions, improve transparency and improve security, for all participants in the transaction, from issuer to transaction. paying agent to investors, and for others such as auditors, third party opinion providers and rating agencies. Tokenization has the potential to partially replace securitization, but it can also completely replace the traditional securitization framework.

As it becomes more mainstream, there will be a period in which blockchain and tokenization will coexist and then replace some of the processes that are so familiar to us today. However, over time it can transform many activities in the securitization cycle and have a much more disruptive overall effect on securitization transactions. None of our activities are immune to change.

As one of the largest and most experienced national and international blockchain legal teams dedicated to the virtual currency and blockchain industries, our practice helps clients take advantage of the enormous potential and disruptive impact of blockchain technology, while avoiding falling prey to ever-changing regulatory and legal requirements. . We work with a wide range of clients who are exploring disintermediation, digital currencies, token sales, and new uses of blockchain.

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