July 19, 2019/Fitch Ratings
Blockchain distributed ledger technology (blockchain or DLT) has the potential to improve the transparency and execution time of traditional securitizations and covered bonds, says Fitch Ratings. However, blockchain is largely untested in securitization and covered bonds and is currently narrowly applied. While Fitch acknowledges the transactional efficiencies the technology provides, it will be a number of years before these benefits will be fully realized. We anticipate it will take time for end-to-end adoption of DLT and for regulations to be updated.
A significant advantage of blockchain is that data for all transactions could be visible to all parties to a securitization or program and updated in real time. More transparent and consistent data should reduce execution time and the need for certain counterparty roles. Once recorded on the blockchain, data can only be altered by adding a new data ‘block’ that links to the prior records, creating a permanent chronological record. This immutability will help decrease data discrepancies between parties or errors in transferring data, such as between servicers.
Fitch assumes that data verification currently conducted on loan samples is indicative of the overall pools as a whole, and expanded data available through DLT may not initially change our asset performance assumptions. Over the longer term, however, if we observe reduced discrepancies or new correlations as a result of more granular data on all assets, then we may adjust loss calculations accordingly. Furthermore, real time data will allow for timelier asset assumption updates.
The use of blockchain has made the most progress on the liability side, where the benefits are easier to realize compared to the asset side. The technology has been used for sale and settlement of notes, as Fitch has seen in programs in Europe. Weinberg Capital DAC, an asset-backed commercial paper conduit, issued and repaid a pilot CP issuance via its DLT platform, which confirms each trade and creates a smart contract that enables instant delivery of the CP. Digital tokens in the system represent the CP and the placement order within the system. The incorporation of the DLT platform did not have an effect on the conduit’s ‘F1sf’ rating.
Similarly, in the Societe Generale SFH’s issuance of Obligations de Financement de l’Habitat, which was the first covered bond to use DLT, the bonds were issued as security tokens on a blockchain platform. Fitch noted that Soc Gen’s use of DLT to issue obligations under its covered bond program did not add credit risk relative to traditional issuance.
Fitch anticipates that for the foreseeable future, securitization transactions will use modified blockchain as opposed to full or end-to-end blockchain as development of the technology, laws and regulations for different aspects and parties will happen in stages. Certain aspects of securitization, such as note issuance, lend themselves to quick onboarding of the technology, but a more comprehensive application will take time and will likely require changes in laws and regulations across jurisdictions and increased familiarity with the technology among all relevant counterparties.
Based on Fitch’s observations and discussions with market participants so far, it will likely be more costly and take more time for originators and servicers to fully transfer their systems to blockchain. To expand blockchain use for asset administration, issues such as the transfer of the asset/title, the enforceability of security, and the protection of personal data will need to be addressed and legal arrangements will need to be accurately reflected in the coding of smart contracts.
Network security and counterparty exposure will continue to be risks as the technology becomes more widely used. These risks that cause an interruption to cash flow could have a negative ratings effect. Furthermore, replacement of a non-performing counterparty within blockchain has not been tested, but pursuant to Fitch’s Structured Finance and Covered Bonds Counterparty Rating Criteria, timely remedial action upon non-performance is important to mitigate counterparty risk.