Fans of the movie The Big Short may relate to how obscure and vague financial instruments — exchanged from one entity to another — created one of the biggest shocks to the modern financial system. The financial crisis of 2008 created a rupture in both how the public perceived bankers and how governments came to realise that the banking industry was indeed something they neither properly understood nor regulated in a highly connected world.
The 2008 events unfolded due to the situation with the U.S. mortgage market — the easy access to liquidity, and the creation and selling of packaged instruments composed of mortgages to institutional investors. This process, known as securitization, enabled the creation of new financial instruments, primarily mortgage-backed securities, which in turn allowed lenders to re-package, offset balance-sheet risk and re-sell the loans to other investors.
Shaken by the 2008 crisis, Europe has responded to the problem with an increased number of strict regulations. But are regulations enough? Can we leverage emerging technologies to ensure a safe and transparent securitization market?
What is asset-backed securitization?
Put simply, securitization is the practice of creating pools of various types of debt — mortgages, credit cards, auto or student loans — and reselling them as tradable securities.
The complexity inherent in the creation of a securitized asset can limit an investor’s ability to monitor the make-up, and hence, the associated risk. Coupled with multiple layers of securitization and lax underwriting standards, investors may not be fully aware of the constituents and performance of the underlying assets, which may lead to a new crisis.
Securitization plays a significant role in allowing banks to transfer the risk of some of their loans off their books, allowing for access to capital for creating and selling new loans. Today, there is an upward trend in bringing new securitized assets to market, albeit with tighter controls.
Current state of play in Europe
The asset securitization market in Europe is considerably smaller than the U.S. market. European securitization markets operate under strict balance sheet requirements.
Data from the Association for Financial Markets in Europe (AFME) shows the securitization market in Europe decreased from €800 billion to just over €200 billion in 2017. Total issuance was €235 billion in 2017, down 1.9 per cent from 2016. According to recent figures, less than 2 per cent of outstanding mortgage loans in Europe are currently funded through securitization.
A changing regulatory landscape
EU regulators are keen to facilitate the market by relaxing the rules associated with capital holdings. The European Commission introduced new and simplified rules for securitization under the “simple, transparent and standardised” (STS) securitization framework.
These new regulations set a general securitization framework and also create a specific STS securitization framework to update required capital treatments and allow favourable capital treatment for some STS securitization products. The aim is to promote a safe European securitization market.
Technology to the rescue
The new EU regulations are introduced just as new technologies, such as blockchain and digital platforms, emerge, providing increased transparency and provenance of the underlying assets. Creating such digital platforms can help increase the efficiency of asset-backed securitization and help regulators, banks and the market to avoid catastrophic financial crises.
When creating such platforms, it is key to address the challenges and opportunities associated with asset securitization. The platform would need to provide a high level of transparency, lower cost to market, and a reduced time to market in the processes traditionally associated with asset securitization. Furthermore, it would need to allow regulators and auditors to have oversight of the underlying tranches and composition, which would help reduce risk for any future investment decisions.
For example, Othera, a FinTech, has created software with a loan origination platform based on blockchain technology, which allows end-to-end loan management and loan sales, enabling loan originators and investors to directly connect and transact debt- or asset-backed securities with greater transparency and lower risk. Othera is now collaborating with DXC Technology to ensure secure deployment of the platform and integration of bank-grade security services.
Using such digital platforms can help digitise and segment the loans, converting them into products that can easily be traded on the marketplace. Using digital platforms can bring multiple benefits, such as faster securitization and greater liquidity, plus cost and time savings, due to an automated process workflow, as well as increased efficiency and transparency — thanks to blockchain — for the entire securitization process.
Interested in learning more about digital transformation in the financial industry? Read more about how emerging technologies can help financial institutions stay ahead in the digital era.