Securitization with Blockchain
High Potential, Hindered by Scale
Introduction: What is securitization?
A good place to start the discussion would be defining what exactly securitization is. According to Investopia, it is defined as “the process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors, and this process can encompass any type of financial asset and promotes liquidity in the marketplace.” This may seem very technical but what it basically means is taking assets that are illiquid and turning that into tradable securities through financial engineering. The most cited example of securitization is mortgage-backed securities (MBS). MBS is a pool of mortgages that are liquid and tradable on public markets. Not all assets are easily securitized as the SEC highly regulates what can be publicly traded on the markets. This is mainly designed to protect individual investors from exposing themselves to high risk investments.
How could securitization work on Blockchain?
Three steps involved:
- Select
- Verify
- Distribute
First two processes that involve selection and verification will require either manual labour which is highly intensive but emerging AI technology has seen some potential in possibly automating these task. The AI can understand the demand of investors and select and construct new assets that are suitable. Next step, another AI will verify to make sure there are no biases in the underwriting so it eliminates agency bias.
The last part of distributing through blockchain requires smart contracts and inter-ledgers to be created. Ethereum would be an ideal candidate for this sort of application as it deals primarily with smart contracts. Since we are working with different assets, they must be stored on different ledgers and that is why there is a need for inter-ledgers. This helps store all the transaction records between different ledgers.
Why would we do this?
Transparency: Different parties finalize transaction details and model the terms of the deal as a smart contract. All parties would approve the model before it is recorded on the blockchain. Consensus would eliminate duplication and reduce misalignment among different parties’ models, creating one “true” model for the life of the transaction.
Cost Reduction: The most obvious reason to implement this is the potential cost savings it will have on the financial industry. AI could easily replace the underwriting process that investment bankers take on as part of the selection phase. The products that are released on the markets are demand determined as the AI figures out what types of assets consumers are demanding and responds with the appropriate offering. Pricing of assets will be more accurate and spread will be reduced. This creates more efficiencies in both the market and the underlying process of the offering.
Problems: Transaction Speed
The idea of a frictionless and trust-less system for securitization is great but the technology behind blockchain still has many problems that hinders the possible implementation of this idea. Stock markets around the world are able to facilitate thousands of trades in a second, making this market highly liquid. To put this into comparison, the transaction speed of Bitcoin currently is roughly 3–4 transactions per second and the faster Ethereum can roughly transact 20 per second. This speed pales in comparison to the speed of Visa, which can process over 1,500 transactions per second. This is one of the biggest issues surrounding the future of Bitcoin and Ethereum and its ability to scale. Blockchain prides itself in being decentralized and trust-less but with this issue right, a centralized system seems to still be the ideal choice. This is not to say faster transaction speeds are never gonna happen for Bitcoin and Ethereum as many developments like the Lightning Network and Plasma are attempting to increase transaction speeds significantly. This is a a major hurdle that blockchain must cross before securitization is even considered possible.
