Securitization: A Potential Use Case For Ethereum
Blockchain technology has the potential to revolutionize the financial sector. The securitization industry is just one facet of finance that could benefit from utilizing Ethereum. Keeping track of assets on Ethereum’s public ledger would lead to an increase in transparency, and less reliance on “trusted” third parties, which would be particularly beneficial to investors.
Securitization is all about creating liquidity from illiquid assets. Any asset can be securitized, but the most common ones are those with periodic cash flow like an asset-backed security. A popular example of an asset-backed security would be a collateralized debt obligation made of mortgages. These mortgage-backed securities are built from pooled mortgages. A bank is able to group together or package mortgages they’ve originated and then sell that as a security to an investment bank on the secondary mortgage market.
An investment bank buying a security would often use tranching, basically layering, to split the risk into different tiers for investors. These tiers are then given ratings based on their associated risk, with low risk tranches having low interest, and higher risk tranches with high interest. Pension plans often invest into the low risk tranches, due to their perceived stability, while a hedge fund may prefer the higher risk tranche due to its associated higher rate of return.
An issue inherent in this system is its reliance on credit rating agencies as a trusted third party. For example, the “big three” ratings agencies, Moody’s, Standard & Poor’s, and Fitch Ratings, all gave A ratings to investment banks AIG and Lehman Brothers. Those banks retained their high level ratings until mid-September, 2008; right when they declared bankruptcy. Lehman Brothers declared bankruptcy on Sept. 15th 2008 (the largest bankruptcy filing in U.S. history due to their over $600 billion in assets), and the next day AIG received their first multibillion dollar bailout from the federal government. Both companies looked great on paper, until the moment they collapsed.
Even though trust in those ratings agencies should have been all but destroyed, the consequences were very minor. None of the analysts involved were fired or even disciplined. This lack of accountability in the finance industry isn’t likely to change unless the underlying ecosystem changes. Ethereum has the power to do that.
It’s this same type of poor valuation that led to the subprime mortgage crisis between 2007 and 2009. Pooled securities are complex, specifically in regards to lumping tens of thousands of mortgages into one security. Each of these individual mortgages is a variable, with its own associated risk. Underestimating the actual risk in these mortgage-backed securities is what led to the recession 7-8 years ago. This is where Ethereum’s blockchain could really help: if every mortgage is stored in the blockchain, then calculating risk could be handled by software designed to look at the big picture.
If a mortgage-backed security was hosted on a public ledger, it’d be possible to look at not only each tranche, but also the individual mortgages in each tier. Going deeper, it’d even be possible to look at the transaction history of an individual mortgage, since its inception, to track critical information like defaults, late payments, interest rates, and amortization types. A well written program would be able to track all of this data, as well as assign and aggregate risk across all levels. This would provide a much more accurate valuation of a security at every tier, increasing investor confidence.
This benefit would be greatest when utilizing a public blockchain. If a company were to create a private blockchain, which many banks are currently looking into, the trusted middleman structure remains. While committing fraud on a public blockchain is almost impossible, this risk is higher on a private blockchain, due to its permissioned nature and lack of transparency. A private blockchain is much like a private ledger, where the human element can have more sway. This is mainly in regard to the potential for fraud and reducing moral hazard. Moral hazard being when two parties get involved, but have incomplete information about one another. This could lead a party to enter into a risky situation because the other party is likely to incur the cost should something go wrong. If investment banking were done on the Ethereum blockchain, a public blockchain, the consumer/investor would be better protected. In the future, the incentive to use a public blockchain may come from an immediate increase in trust and reliability, felt by the consumer, for the enterprises willing to operate in this highly transparent environment.
Transparency, traceability, and immutability are all offered through blockchain technology. This eliminates the human element that can lead to fraudulent activities, or just simple error. There is no central point of failure, where an auditor’s judgment call could lead to the overvaluation of a security. Blockchain technology provides accuracy and truth, while an accounting firm might not want to be a whistleblower, lose business from a competitor, or fear repercussions from higher ups. Regardless of the reasons, blockchain technology makes it harder to tamper with records, reducing the risks of fraud and misrepresentation, which benefits the industry as a whole.
When removing the human element, you not only mitigate fraud and human error risks, you also “cut out the middleman” as far as additional fees are concerned. Specifically with mortgages, smart contracts could allow two parties to interact directly, instead of needing a third-party intermediary, who can collect as a commission 1-6% of a property’s value.
On the investment end, using blockchain technology would allow for easy diversification, as far as making different tranches for investments, through creating high risk and low risk tokens. Smart contracts could even be deployed to manage liquidation rights, disallowing certain classes of investors from selling below a pre-set threshold, for example. Smart contracts would also be able to handle payouts, since lower risk tranches get paid before high risk ones.
Furthermore, smart contracts would allow for settlement to move along quickly. A smart contract only initializes the moment a certain set of conditions are met. That means only things pre-determined as conditions to the contract can happen, and once its set requirements are met, the contract is self-executing through automation.
Overall, placing an investment security on the blockchain, specifically Ethereum’s public blockchain, would increase transparency, mitigate risk, and reduce fraudulent activity. This push towards accuracy, transparency and truth through a trustless system would benefit borrowers, lenders, and investors worldwide.