An independent corporate bond rating agency with DNA deep in the risk management and corporate intelligence business believes that blockchain technology has the potential to transform the way the securitization business works.
According to “Applying Blockchain in Securitization: Opportunities for Reinvention,” a report released on April 22 by Kroll Bond Rating Agency, “a distributed ledger that records digital transactions in a secure, transparent, immutable, and auditable manner has the potential to fundamentally change the way in which assets are originated, warehoused, and ultimately securitized.”
KBRA was founded in 2011 by Jules Kroll, who built the well-known corporate intelligence firm Kroll Inc, which the New York Times described as “a sort of private CIA [that] went corporate.” Among Kroll’s jobs was tracking down Saddam Hussein’s assets for Kuwaiti reparations after the first Gulf War.
In fact, KBRA said it has already been approached by issuers seeking ratings for fully on-chain securitization, which is the process by which non-liquid assets such as debt are packaged and resold to investors. But, the rating firm has not agreed to do so yet, as it believes the technology will not be ready for prime time until several fundamental questions can be answered.
While KBRA said it believes the technology will have an impact on every facet of the securitization process—which includes originators, issuers, servicers, rating agencies, trustees, custodians, and investors—its core concern is based on the fact that it believes these security issuers will likely use private, permissioned blockchains.
This introduces a new cog in the securitization process, which relies on two basic safety requirements: what KBRA calls the “bankruptcy remoteness” of the sponsor or seller, and the ability to easily and quickly replace any of the parties in the securitization process. This is necessary so that the credit rating of the security is based solely on the quality of the underlying asset and structure of the transaction. If any of the parties to the transaction are not plug-and-play, the rating agency will have to take their soundness into consideration when determining its rating, KBRA said.
That in turn introduces a new participant into the system: the blockchain administrator. Because while the blockchain itself may be immutable, the nodes and their administrators are not, and in a permissioned blockchain are also limited in number.
Therefore, it will have to be possible to replace the blockchain administrator at a moment’s notice and with minimal disruption.
As the rating agency, KBRA “would need to be comfortable that in the scenario of a complete failure of the entire blockchain ecosystem, it is possible to transition a securitization structure to traditional service providers,” the firm said.
That means the traditional service providers would need to be identified and contracted in advance, and a fee structure negotiated before the security is issued.
“Furthermore, time would need to be spent evaluating the ease of transference and the financial impact to the securitization structure should the administrator or blockchain environment cease to exist at any point following the deal closing date,” according to KBRA.
Nonetheless, the potential benefits of using blockchain technology far outweigh the difficulty of introducing this new element into the securitization process, KBRA noted.
“We believe blockchain technology has the potential to reduce costs, create operational efficiencies, as well as improve transparency and accuracy throughout the securitization market,” the report said.
As a result, KBRA believes that blockchain will be widely adopted in the securitization industry, but over a period of several years rather than in the near term.
“The most likely near-term benefit may come from moving custody of loan documents onto blockchain as the promise of enhanced security, transparency, immutability, and auditability may help to reduce fraud risk—assuming these promises come to fruition,” it added. “Future efficiencies and cost savings may come from the use of smart contracts and more highly automated collection and payment processes, but only as the securitization industry becomes comfortable with the benefits and risks associated with this new technology.”
For a more in-depth look at how blockchain can impact the securitization business, KBRA recommends a 2017 report produced by Deloitte for the Structured Finance Industry Group: “Applying Blockchain in Securitization: Opportunities for Reinvention.”
That report found that blockchain’s “capacity to bring all market participants onto a single platform, where sharing information is simple and all changes leave an immutable audit trail…would create a single source of truth which all participants could use for analysis and forecasts.”
By streamlining processes, lowering costs, increasing transaction speeds and improving security, blockchain has the potential to lower risk throughout the entire securitization market, which would in turn lead to greater interest from investors, Deloitte said.
“This, in turn, would improve prices, volume, and spreads. With better and more transparent information, regulatory compliance could also be simplified and market failures would become less likely,” according to Deloitte.