Smart contracts, securitisation and the changing role of the intermediary

These technologies are powering a shift to decentralised finance, or DeFi. DeFi is transforming how financial institutions conduct business, and in particular how intermediaries collaborate with various counterparties and use smart contracts during securitisation transactions.

Securitisation transactions can be complex, often involving several counterparties, including the transaction originator, the structuring bank, law firms, an auditor, investors and the rating agencies, among others. Blockchain-enabled smart contracts can streamline this process and provide other benefits.

Originators, investors and other market participants who want to take advantage of the benefits of smart contracts also must understand their risks. This article explains how smart contracts work and summarises their benefits and risks.

Understanding smart contracts

Smart contracts aren't just an updated version of paper or digital contracts. They represent a dramatically different approach to executing agreements between multiple parties.

Smart contracts are programmable contracts stored on a blockchain network. They’re executed automatically once certain predetermined conditions of the contract are met. Because smart contracts are stored on the blockchain, they can’t be changed, which strengthens validation and provides a verifiable, transparent audit trail.

Smart contracts offer several other advantages. Financial institutions, issuers, service providers and others can use them to facilitate decentralised trading and lending, automate securities trade clearing and settlement, simplify investor know-your-customer (KYC) verifications for future issuances and streamline audits by sharing automated whitelists with auditors.

Smart contracts can moreover accelerate transaction processes, enable the parties involved to collaborate more efficiently and with increased levels of trust, and generate automation-driven efficiencies and cost savings.

To take an example, issuers can use smart contracts to achieve cost savings when redeeming securities, an administratively burdensome process when using traditional contracts. Smart contracts can be programmed to redeem securities automatically when certain triggers are met, simplifying the settlement process.

Smart contracts also offer the promise of disintermediation (though as we’ll see, intermediaries are likely to continue to play a role in the smart-contract process). In certain situations, the parties involved can rely on fewer intermediaries to facilitate securitisation transactions.

As we mentioned, it’s important to keep in mind that smart contracts come with risks. We’ll examine some of those now.

Smart contract risks

One of the biggest risks of smart contracts is that the regulatory landscape is still evolving, and any contract must reflect changing regulations over time. For example, if there's an event such as Brexit or changes to the London Interbank Offered Rate (Libor) that affect interest rates, certain contracts will need to be amended to account for the event. But as we’ve seen, smart contracts are not changeable once they are deployed to the blockchain. As a result, the language of a smart contract must — as much as possible — account for potential changes in areas such as regulations and interest rates. If language must be changed to account for an event, there may be options, such as cancelling the contract and replacing it with a new one.

Another concern is that the parties will continue to need banks for access to fiat currencies, since most of the world still relies on government-issued currency rather than cryptocurrencies. This could change in the future, however, as central banks explore issuing their own digital currencies.

The most obvious challenge is that the process of creating and executing a smart contract is evolving quickly. Smart contracts involve emerging technologies and processes that financial firms, investors, servicers and other stakeholders are still figuring out. What if a contract must be revised to account for errors or regulatory changes, as in the example above?

Finally, smart contracts are only as good as the environment in which they’re executed. Blockchain data breaches, for example, may compromise smart-contract holders. According to Elliptic, a blockchain analytics firm, losses from DeFi-related thefts and fraud surpassed US$10 billion in 2021. Chainanalysis says 2022 is on course for an all-time high record of cryptocurrency hacks.

Managing risk: The value of an intermediary

Many experts believe that rather than eliminate the role of intermediaries, smart contracts and other blockchain-enabled tools will simply change some of the functions performed by intermediaries. After all, some level of human scrutiny will always be desirable to manage risk, particularly in the complex area of securitisations.

In securitisation transactions involving smart contracts, an intermediary may be retained to:

• Conduct due diligence before, during and after a transaction.
• Review what information has been entered into the smart contract to ensure:
  • accuracy of contract terms and deliverables, from the start of the contract and over time.
  • compliance with relevant obligations, such as US SEC obligations or the EU’s Sustainable Finance Disclosure Regulation (SFDR), both at the start of the contract and over time as new obligations are introduced or existing ones changed.
• Ensure the contract has been correctly stored on the blockchain.

As we’ve seen, blockchain technology is changing the securitisation transaction process through smart contracts and other tools. These tools promote transparency and efficiency, but also introduce new and evolving risks. To manage the benefits and risks effectively, issuers, investors and other stakeholders shouldn’t lose sight of the fact that intermediaries will continue to play an important role in this largely automated landscape.

For more information, watch our on-demand webinar on blockchain technology in asset securitisation.