There has been no shortage of words written about the applicability of distributed ledger technology (DLT) to the securitization market, and the recent Sequoia Mortgage Trust deal suggests it may finally be happening, if just the first and least challenging step.
Securitizations involve multiple parties exchanging critical information, increasing the likelihood of delays and errors and related costs. DLT, also referred to as blockchain technology, should securely encrypt that information in the timeline it was submitted, so that all parties with permission can access it quickly, significantly reducing today’s shortfalls.
In what appears to be the first instance of DLT used by an issuer that routinely taps the non-agency, residential asset-backed securities (RMBS) market, Redwood Trust, Inc., announced Sept. 22 pricing a securitization leveraging the blockchain. It tapped Liquid Mortgage, a digital-asset and data platform in which the specialty finance company holds a minority interest, to act as distributed ledger agent on the transaction.
The $431 million Sequoia Mortgage Trust (SEMT) 2021-6 deal was split into five AAA-rated tranches, according to Finsight, with all but one tranche carrying credit enhancement (CE) of 15% and four pieces priced for a coupon of 2.5%. A $49 million piece had a CE level of 4% while maintaining the 2.5% coupon, while a $95 million piece has a coupon of 2% with CEO of 15%.
Digital Mortgage will provide end users with daily reporting of loan-level payments of principal and interest on the underlying mortgages, instead of after a one-month delay, which is the routine industry practice.
"This inclusion of enhanced payment and prepayment reporting within the Sequoia (SEMT) securitization platform is the first step on a path to putting an entire RMBS transaction on the blockchain,” Fred Matera, managing director and head of residential at Redwood Trust, said in a statement.
In fact, the notion of using DLT to make the securitization market more efficient and secure has been around for years. In 2017, the Structured Finance Industry Group (SFIG) and Chamber of Digital Commerce commissioned Deloitte to explore how blockchain could reinvent the securitization market, resulting in a 34-page report. S&P Global Ratings published a report in February 2019 about what blockchain could mean for structured finance, and in September 2021 it published a follow up titled, “Distributed Ledger technology Prepares for Takeoff.”
The report notes that once a securitization embeds DLT, the special purpose entity (SPE) can continue to house the assets, but DLT technology “smart contracts” could facilitate the cash flow waterfall.
“Provision of asset data and performance from servicers and other relevant parties would potentially be available in real time on the distributed ledger, improving timeliness and possibly reducing errors,” the report says.
The S&P Global Ratings report does not mention Redwood’s transaction, but it does note that some structured-finance transactions have employed DLT, including three Société Générale covered bonds between 2019 and 2021, and some privately placed Chinese bond deals.
“These securitizations use permissioned blockchains primarily to record and verify asset data and cash flows,” S&P Global Ratings says.
In the U.S., the report notes, Figure Technologies issued RMBS last year on a blockchain governed by partner company Provenance. On March 11, 2020, the firm announced that it had issued the “first ever securitization backed by loans originated, serviced, financed and sold on blockchain,” claiming that use of the blockchain resulted in more than 100 basis points of savings. Jefferies Group and Nomura Securities were lead underwriters, Tilden Park Capital contributed loans and purchased the subordinated portion, and a large asset manager purchased the senior note, according to S&P Global Ratings.
Provenance published a white paper around that time, noting that the deal was split into a $127 million portion carrying a 4.0% coupon and credit enhancement of 15%, and a $22 million subordinated piece with no credit enhancement.
The firm’s approach “represents an implementation of blockchain across a complex, end-to-end value chain rather than its application to a discrete business process,” according to the white paper. A Figure Technology spokesperson did not respond to an inquiry about whether it has since completed additional ABS offerings.
[DELETE--Figure Technology begins applying the blockchain—DELETE] The Liquid Mortgage blockchain solution starts post-loan origination, whether the next day or years into the loan’s maturity. It creates a unique digital asset referencing each loan with a loan-level account on the blockchain, assigns a digital footprint – or hash – to documents related to the loan, and then places them into the loan account.
“Information and documentation will always be with the loan, and you can always validate loan, document and payment data,” said Ian Ferreira, founder and CEO of Liquid Mortgage.
The technology also receives payment data from servicers and mirrors it on a public blockchain through the digital asset accounts, encrypting payment and balance information when payments arrive, the amounts.
“The goal for this first phase is to create ultimate transparency at the loan level,” Ferreira said, adding that investors will get daily access to payment information, instead of waiting the typical 55 days.
Matera said the inclusion of enhanced payment and prepayment reporting within the SEMT securitization platform is the first step toward putting the entire RMBS platform on the blockchain.
“By leveraging the speed and accuracy of [DLT] we believe we can drastically increase transparency and reduce the points of friction in the life of a residential mortgage loan, including legal documents and contracts, diligence, reporting and data,” Matera said.
As an example, he added, loan-level payment reporting may provide greater insight into borrower payment and prepayment activity on a more frequent basis than is traditional available.
Ferreira said the second phase, currently aiming for completion in mid-2022, will be to work with servicers to create payment rails via the blockchain for borrowers to make payments that will be distributed directly to the portfolio or trust that owns the loans. In the third phase, he added, the firm aims to build a trading platform for digital assets backed by loans or fractionalized loans.
“The ultimate goal is to be able to trade these digital assets on a blockchain, where parties can easily trade assets back and forth within seconds,” he said.
The arrival of last two phases, which go beyond providing access to information and provide transactional capability, may depend in part on regulators.
“Everybody wants to stay within the guardrails, and I think there’s still an element of working out what those are,” said Tom Schopflocher, senior director, global structured product research at S&P Global Ratings.
S&P Global Ratings analyzed the potential risks of putting ABS on a blockchain within the context of its “five pillars” approach to rating structured finance transactions. It determined that the two biggest risk types are “legal and regulatory,” followed by “operational and administrative.”
Severity risk and portability risk follow, and credit risk is the fifth and least worrisome risk type.
“We do not expect asset performance to be affected initially should blockchain be adopted, nor do we expect borrower behavior to be influenced by the use of blockchain,” S&P Global Ratings said. “As such, we believe the credit quality of the assets would be the least affected pillar of our analysis.”
