First, the paper identifies permissioned blockchains in conjunction with permissioned tokens as the most adequate approach to tokenise asset-backed securities. The synergy of both allows to restrict access to selected members and integrate control mechanisms. The configurability of the ledger and tokens is vital for the effective compliance with AML/CFT provisions or for implementing any other transfer rules like eligibility criteria.
Conclusion Permissioned platforms are better suited for this than public blockchains, so it is reasonable to assume that originators and investors prioritise privacy and speed over decentralisation and immutability.
The Swiss Capital Markets and Technology Association identified four functionalities which every smart contract should provide to guarantee regulatory compliance, i.e. issuance, burn, freeze and forced transfer tokens. Switzerland is not subject to Union legislation, but its approach may serve as inspiration for the EU. They created a modular smart contract framework which contains all the mandatory functions above and grants options such as dividend distribution. This path is relatively efficient in terms of standardisation and legal clarity because issuers benefit from a solid foundation stone to construct their offering.
The deployment and maintenance of a security token platform is technically demanding and most likely depends on a DLT servicer who executes functions such as creating or burning tokens. Therefore, the servicing agreement is an essential legal document that should clearly state the servicer’s obligations.
Disclosure requirements and data reporting dominate a large part of this paper because they arise at multiple stages of the securitisation. During the issuance, the offering document needs to disclose the whole tokenisation process and the intrinsic risks of DLT (ALJB, 2020).
The Bitbond prospectus provided insightful clarification about the risks that should be referenced and who is liable if they materialise into losses.
After the issuance of structured products, the SECR establishes transparency obligations which demand the continuous reporting of data to investors and competent authorities (Regulation 2017/2402, Article 7). The stringency and operational manner of information disclosure differs considerably between public and private securitisation.
The paper concludes that it is more convenient to implement DLT for private securitisations than for public securitisation. This conclusion is derived from the SECR and the technical regulatory standards supplementing it. In contrast to public securitisation, private securitisations are not bound to any European regulatory limitations on making data available because they are subject to the law of their domiciliation country. Moreover, private offering documents are less exigent in terms of disclosure requirements than their public equivalent, which require an extensive prospectus and a Key Information Document.
Public securitisation law, on the other hand, establishes rules on how data should be reported to securitisation repositories, which hinder the use of DLT for this matter. In contrast to private securitisation, public offerings are obliged to forward data to securitisation repositories through the secure data encryption protocol sFTP. Hence, the idea of a shared blockchain between the
originator and competent authorities is not possible for public securitisation if the law does not include blockchain as valid communication channel. Originators may still use DLT, but they would be forced to syphon the data and send it via traditional channels, thereby reducing the transparency benefits of blockchain.
Securitisation on a blockchain is massively supported with the entry into force of the DLT Pilot regime. The regime enacted DLT market infrastructures regulating tokenised securities’ exchange and custody, providing potential issuers and investors with a much-needed framework. Thus, entities may choose to act as custodians subject to the CSD Regulation, as trading venues under the form of an MTF or may reunite both activities under the umbrella of a trading and settlement system (DLT TSS). On a side note, the Pilot regime excludes any other type of trading venues such as OTFs or regulated markets from the scope. This deliberate restriction may be analysed in further research, but it surpasses the subject of this paper.
Additionally, the Pilot regime states that market infrastructures are liable for losses if they could not have reasonably prevented them.
The paper concludes that, from a legal perspective, the TSS regime is the most interesting new market infrastructure because it reflects the ambition to nourish and fence financial innovation. Consequently, it is astonishing that regulators segregated the legacy architecture of financial markets by recognising a legal entity that performs both trading and settlement of securities. While this development is certainly not exclusive to securitised instruments, its importance cannot be neglected by omitting to discuss it.
A direct consequence of this recognition should be reduced broker fees, whose compensation includes clearing and settlement costs. The entire post-trade activity is enhanced due to automated clearing and intraday settlement of securities. Deloitte (2019) considers that up to 95% of trade processing and settlement can be executed by smart contracts.
Other general benefits of DLT are the fractionalisation of assets and the audibility feature of blockchains. Audibility and transparency are crucial for all parties of a securitisation which explains why the SECR dedicates so many articles to disclosure and transparency.
The benefit of securitising assets on blockchain consists inter alia of improving the manner of disclosing information about these exposures. As the crisis of 2007 has vividly illustrated, the fair value measurement of a structured product is immanently connected to the quality of the data fed to the calculation models. Independently of the adequacy of the risk models, they are in dire need of accurate and timely data. While time may not be as important in a stable environment, continuous updates are vital when the underlying exposures are deteriorating rapidly, and investors need to calculate their product’s actual value. Thus,
Conclusion blockchains could effectively provide real-time data to valuation models, such as the level of liquidity of the securities.
In contrast to securitisation, the main advantage of tokenisation is the programmability of smart contracts (Wandmacher & Wegmann, 2020). Smart contracts allow to automate and standardise the life of a securitised product. During the pooling of exposures, they can effectively structure the assets into the right tranches if they are provided with the respective credit scores and maturities. Contractual and legal provisions can be built into smart contracts, such as the cash flow structure or performance triggers. The predominant factor herein is the influx of reliable data from an off-chain server. Since investors and regulators would have access to the same information set, blockchains could substantially increase the standardisation of data. Thus, DLT reinforces the verification of the STS label, which requires, amongst transparency and simplicity, the standardisation of securitisations.
To conclude, DLT and tokenisation can optimise the whole securitisation process.
Fractionalisation boosts liquidity and financial inclusion, transparency and audibility strengthen faith in the quality of the investment, and programmability allows to automate clearing, settlement, structuring and even dividend distribution. These benefits should show that securitisation on a blockchain is an upgrade to traditional infrastructures.
Nonetheless, the tokenisation of financial instruments faces multiple challenges which do not necessarily arise from the legal compatibility of DLT and securitisation. The nascency of blockchain technology and the adjacent lack of trust is just one illustration of this thought.
The current state of DLT could be described as probationary. Market participants have identified the potential, and some are actively deploying it, but mainstream adoption is yet to come. Like most innovations, the adoption process is incremental, and so is the legal framework. Thus, it can be expected that once the growth of DLT stagnates, regulators will fully catch up, and legal clarity will not be a problem anymore.
Another major challenge is the interoperability of DLT with traditional software infrastructure and other blockchains. The paper recognises that the adoption of DLT as a general data layer for financial transactions relies on its capacity to cooperate with other digital ecosystems. Financial institutions and investors will be more inclined to use blockchain if it connects to their traditional interfaces, which they are familiar with.
Before adopting a multi or cross-chain ecosystem where every financial transaction runs on different blockchains, the first stage may be interoperability with legacy software.
Ultimately, the decision to replace traditional software with DLT may be contemplated outside the simple balancing of pros and cons. A hypothesis from evolutionary theory may
provide food for thought. The Red Queen Effect refers to the idea “that organisms must constantly adapt and evolve” not only to have a competitive advantage but to survive (Sridharan, 2022). The concept is derived from the sequel Through the looking glass of Alice’s Adventures in Wonderland, where Alice and the Queen ran hand in hand, but the trees did not change around them (Sridharan, 2022). The Queen eventually pulls Alice aside and tells her to
“run at least twice as fast” to get somewhere else (Sridharan, 2022).
This allegory may illustrate that relying exclusively on proven mechanisms is insufficient to survive. It is necessary to run fast to stay in your place and run even faster to have a competitive edge over others. Today, Distributed Ledger Technology may provide a competitive advantage, but tomorrow, it might be indispensable for the continuity of the business.
In the words of Jim Rohn, “Make measurable progress in reasonable time”.
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