Fed Comments on the Challenges Facing Blockchain Technologies in Financial Services

At last week’s SFIG Las Vegas 2017 conference, there were several lively discussions about the application of blockchain or “distributed ledger” technologies to structured finance, with many industry participants suggesting that there are many applications suitable for consideration.  Interesting enough, Federal Reserve Governor Jerome Powell was at Yale University last Friday March 3rd to make a speech about the future of finance and the capital markets.  One of the topics that Governor Powell covered was the challenges that the financial industry faces in implementing these Distributed Ledger Technologies or “DLTs”.

Here is an excerpt from his March 3rd presentation wherein he highlights five significant challenges facing the industry:

Distributed Ledger Technologies

“Let’s turn to another type of new technology that may have important implications for the payments and financial systems: distributed ledger technology, or DLT. Bitcoin helped bring this technology to public attention. Using blockchain technology–which employs a form of DLT–and an open architecture, Bitcoin allows for the transfer of value (bitcoins) between participants connected to its ecosystem without reliance on banks or other trusted intermediaries. This feature has led some to predict that DLT will in the long run render parts of the banking and payments system obsolete, as the intermediation of funds through the banking system will become unnecessary.

Faced with these dramatic predictions, we have seen banks and market infrastructures collaborate with technology firms to explore the use and further development of DLT. In 2016, there was widespread experimentation. Efforts by financial institutions often focused on evaluating the technology, identifying potential uses, and conducting proofs of concept. Prominent examples included the use of distributed ledgers to store transactional data and records in tamper-proof ways, as well as the use of the technology as a primary means to hold and transfer money or assets. By the end of 2016, a few major U.S. clearing organizations had announced plans to use distributed ledger technology in limited ways.

As we have followed developments over the past year, a few lessons have come into better focus.6 First, in contrast to Bitcoin’s open architecture, work by the financial industry has focused on the development of “permissioned” systems, which establish criteria to determine who is permitted access to particular systems, ledgers, functions, or information. In the near term, this approach seems more likely than fully open systems to provide the needed governance and management to address operational, security, and financial risks. Indeed, access is typically permissioned in situations that require the protection of systems and information in the financial and other industries. Even in permissioned systems, some key issues will remain, including whether finality of settlement is to be determined by a central trusted party or by a majority of participants, and whether participants are able to view information on other parties’ transactions. Some argue that movement away from open systems undermines the potential efficiency and the spirit of DLT. At least for now, in payment, clearing, and settlement, safety and confidence must also weigh in the balance.

Second, firms are still grappling with the business case for upgrading and streamlining payment, clearing, settlement, and related functions with DLT. Promoters of DLT offer a vision of streamlined processes that lead to faster processing, reduced reconciliation, and lower long-run operating costs. Some argue that in certain markets, faster and more predictable processing will also reduce the capital and liquidity costs of operations. But upgrades are often costly, lengthy, and risky, particularly if the technology is still being proven, as is the case for DLT. Network effects can also affect adoption, since multiple firms may all need to adopt a particular implementation of DLT in order to justify its use in a specific market.

Third, technical issues remain. Practical issues such as whether a particular version of DLT will work for the intended purpose are still being explored. Issues of reliability, scalability, and security remain very important. Beyond these issues, standardization and interoperability across different versions of DLT will need to be addressed to allow technology integration and avoid market fragmentation. In general, industry members and technology providers recognize these important issues and have taken initial steps to address problems. It will be important to keep these challenges firmly in mind as we move beyond experimentation and into the development and deployment of new products and processes.

Fourth, governance and risk management will be critical. For individual firms or clearing houses that adopt DLT as an internal technology upgrade, the governance and risk-management processes are likely to be internalized within existing organizations and be akin to other technology upgrades. However, if new networks of bilateral payment, clearing, and settlement are established, the new technology may involve tightly coupled protocols and operations. The safety of the overall design will depend on a highly interdependent framework. If automated risk management, smart contracts, and similar tools are deployed across a network, cascades of rapid and hard-to-control obligations and liquidity flows could propagate across a network and the financial system in response to events. This interdependence will likely call for creative organizational thinking to address the need for governance and strong risk management.

Finally, the legal foundations supporting DLT will need attention. Deployments of DLT will involve firms, perhaps in different jurisdictions, with systems that record and transfer information and assets under existing legal frameworks. Which bodies of law apply to the particular firms, assets, and activities will determine the associated rights and responsibilities when transfers are made, cleared, and settled. For example, whether and how banking, payments, securities, or commodities laws apply in a given context are likely to be important in designing systems and services and understanding their properties. And, as with any new technology, things may go wrong. We will need a thorough analysis of how DLT fits into current legal frameworks and what gaps need to be filled by contractual agreements or new laws and regulations. A robust legal basis that provides certainty across relevant jurisdictions is essential for building strong governance, risk management, and operations.”

More than 6,000 Securitization Professionals to Gather in Las Vegas Next Week

This coming weekend, thousands of industry professionals will begin to gather for next week’s SFIG Vegas 2017 conference at the Aria Resort in Las Vegas.  Co-hosted by the Structured Finance Industry Group (“SFIG”) and Information Management Network (“IMN”), this year’s event is expected to acknowledge the progression to mainstream securitization for several newer asset classes including marketplace lending and solar energy.  Another topic that will certainly be front and center, at least for US market participants, will be the potential impact of changes to the US regulatory regimen, resulting from the recent national elections.

The fact that more than 6,200 names already appear on the conference pre-registration list, is a strong indication that the structured finance industry is alive and well. We wouldn’t be surprised to see that final attendance numbers top more than 7,000.

MERS Posts Yet Another Court Victory

The New Hampshire State Supreme Court handed down the latest in a string of victories for Mortgage Electronic Registration Systems (“MERS”), continuing a trend which has bolstered the legitimacy of the MERS framework, as the primary tool for the recording of residential mortgage files in the United States.

The latest court decision in favor of MERS came this week from the same court which upheld a July 2015 decision that the language in a mortgage granted to MERS as the mortgagee as nominee for the lender and the lenders successors and assigns, evidences an agency relationship between the note holder and the assignee of a MERS mortgage.

In the case of Castagnaro v. The Bank of New York Mellon, the borrower filed a wrongful foreclosure action, claiming that BNY Mellon lacked the authority to foreclosure non-judicially under New Hampshire state law without also proving that it was the holder of the borrower’s note.  The Supreme Court referred the First Circuit Court to its opinion in Bergeron v. N.Y. Community Bank, issued in July 2015, which involved answering similar questions on the law pertaining to foreclosure.  Both cases involved mortgages creating an agency relationship between MERS and the noteholder and granted expressly to MERS (or whomever MERS assigns) “the power of sale and the right to foreclose and sell the mortgaged property,” according to an announcement made by MERSCORP Holdings, Inc.

MERS has won a number of court decisions over the past year, in cases that challenged its right to act as mortgagee.  Last fall, MERS won similar decisions in Montana, Georgia, New York, Texas and Kentucky.  This has had the affect of further solidifying the credibility of this industry authorized platform for enhancing the efficiency of what was historically viewed as a very cumbersome process.

Chalk this up as another victory for rationality!

Several Strong Indicators for Continued Improvement in Securitization Markets

Historically, the end of the summer in the northern hemisphere has been a good time to take stock of new developments and the general health of the structured finance markets.  When we look back on this summer of 2014 a few years from now, we might point to this as a particularly important time for the continuing recovery of securitization, as a viable and necessary financing tool for companies and industries of many stripes and colors.  The industry still suffers from comparison envy (year after year it seems), to the glory (and unfortunately the excesses) years of the early 2000’s.

But this year seems different to us here at Securitization Monitor.  While there has undoubtedly been gradual and steady improvement in the markets in every year since about 2012, the facts are that much of that improvement has been limited to pockets of asset classes and limited to only some markets.  A sampling of some recent headlines supports our renewed optimism……

* On August 21st, Bloomberg reported that the Basel Committee on Banking Supervision made another very positive statement about adjusting bank capital rules to provide better treatment for plain vanilla ABS structures, the results of which would only broaden the global investor base and bring the big banks back into the buy-side, where they have been sorely missed.

* On August 20th, CNBC reported that delinquent residential mortgage payments in the US had fallen to their lowest levels (3.46%) since the first quarter of 2008.

* On August 12th, Infocast confirmed that they are expecting strong attendance at the second major solar securitization conference within the past year, named Solar Securitization 2014, at the end of September in New York.  Perhaps not the flash-in-the-pan asset class that some have called it?

* On August 8th, the Israeli business daily, Globes, reported that a joint task force of the Bank of Israel, the Israel Securities Association, the Ministry of Finance, the Ministry of Justice, and the Israel Tax Authority has announced a major initiative aimed at restarting the securitization market in Israel.  In the announcement they indicated that the legislative/regulatory process should be completed within four months and the market should be reopened for business within the next year.  While Israel is not a big market, the news represents another positive niche opportunity for growth, in a global industry that has always been built on new markets and niche asset classes.

* On August 6th, the SFIG produced their “Green Papers” series outlining the industry’s thoughts and recommendations for introducing standardization and sustainability to the private US RMBS markets.  More commonly known as RMBS 3.0, the initiative represents a major breakthrough in pushing the conversation about the continuing hurdles that have prevented a more robust recovery of this most important of the global securitization markets.

* On August 1st, China Daily detailed the continuing movement being made by The China Securities Regulatory Commission to streamline the issuance of asset-backed securities in the PRC.  While this is not the first such pronouncement, the frequency with which news and progress is being made in this important market cannot be ignored.

A darling of the recovery for the past few years has been the CLO markets.  You may have seen a table like this one that Forbes ran back in May this year…..

US CLO issuance

All said, some pretty strong news for the securitization markets!  As we head into the home stretch of 2014 and the late year conference circuit, including IMN’s ABS East in Miami next month, we envision much more than just talk about new deals and possible structures.  While it’s been a long time coming, it hard to refute that market momentum in many areas is both strong and steady.

EU in Another Push to Revive Securitisation

Michel Barnier, the European Commissioner for Internal Market and Services made the anticipated announcement today that the EU will look to soften capital reserve requirements for European banks and insurance companies that hold structured debt instruments.  Earlier today, Barnier described a renewed initiative to lower these expensive capital controls so that securitization structures will once again be economically feasible for these important segments of the institutional investment community in Europe.  The thought also seems to be that, if the banks and insurance companies can be brought back into the markets, the large private and public pension funds in Europe will also find their way back to the table.

Soewhat disappointing was the roll out of the now tired slogan, that the new rules would be focused solely on the “good kinds” of securtisation and of course not on the “bad kinds” of securitisation.

While we understand that the objective is to assure the general public that this will not signal a return to the reckless days of the past, what drives us a little crazy here at Securitization Monitor is the failure of many to recognize that it’s not the securitization structure that causes problems….. it is always the collateral.  If what the Commissioner meant by his comments is that the new rules will be geared towards better classes of collateral then we applaud the initiative.  On the other hand, we have seen too many cases where the structures and not the collateral are under attack by regulators.  A currently strong example of this is the “across the board” treatment of retention schemes for CLO’s.  We would simply prefer a little more thought behind the selection of culprits (i.e. too often the structures) and a little less of the broad brush approach.  If the regulators could commit to such a strategy, we believe it would have the most important impact on restoring the EU structured finance markets.

It really should not be that hard to come to understand this market well enough to make this important distinction between “structures” and “collateral”.

Securitization 2014: Our Not So Scientific Projections

As we have for the last few years, we conducted an informal poll of several industry professionals over the last several days to solicit feedback on their reactions and findings coming off the big industry gathering in Las Vegas; this year’s event the SFIG which was held late last month. This year, we thought we would pick a few topics that seemed to come up on a repeated basis with the professionals we spoke with and transform them into some predictions for the coming year.

So in no particular order, here are some of more important topics that the industry will be working on and talking about in 2014:

**CLO’s Will Regain Their Footing:  While there have been a few curves thrown on the regulatory side both in the US (Volker) and in Europe (Manager Retention), we think it will be the confluence of a search for yield among investors and the continuing stability in the performance of the underlying bank loan market that will win the day. We’d look for consistently growing demand among both existing and new investors and the pressure from the bank lenders themselves on the regulators to find a way to encourage the growth of the securitization markets in this way, as key ingredients to CLO issuance rebuilding momentum as we move through the year.

** Solar Securitization Will Become Mainstream:  While we are not ready to predict that a large number of transactions will be completed in 2014, if we go back through the history of the securitization industry to examine how other asset class structures developed, we can suggest that there will be some significant progress made in 2014 in bring this asset class into the mainstream. As we have seen in the past, when this many people are spending this much time searching for the right structures, the end result will be one or more variations of a very workable structure, probably developed by smaller or incubation sized originators that will set the foundation. Ultimately this will lead to more investors and then larger banks with larger distribution channels getting into the mix. Now, this may not all happen in 2014 but we believe that the foundation will be set in the coming months. Who knows, within a few years time we will all understand why there was all that talk in 2014 about solar. The fact that this asset class is high profile, does not have the stigma of pre-crisis asset classes and carries a socially conscious banner will all work to Solar’s advantage.

** REO to Rental Securitizations Will Be a Hot Product: Unlike Solar, this asset class or structure cannot escape some of the pre-crisis notoriety. Nevertheless, with many hedge funds and other distressed investors accumulating properties over the last several years, the slow but nevertheless sustained recovery of the US housing market and employment and the steady return of investors to the private rmbs market place in search of yield, we predict that when we get to November and December, we will all be talking about how fast this market took off in 2014. While there are several market recovery related issues that may cap just how long and robust this market will be, it seems pretty clear to us the several variations of this structure which are being developed will play a major role in absorbing much of the excess capacity in the US housing market that still remains either directly or indirectly on the books of the mortgage originators. Pushing these loans into new structures and bringing new investors into the pool should have a significant effect on liquidity in several important segments.

** Securitization Will Be Recognized as Good for the Markets: Who could have imagined even just 2 or 3 years ago that any politician or regulator would have had a good word to say about the structured finance markets. Unbelievably, now hardly a week goes by when you can’t read a quote from these overseers about how “we need to find a way to revive the securitization markets in both the US and Europe”. Not to be left behind are new pronouncements coming from Asia and Latin America about new and encouraging regulations or general support for these structures. Seems that the days may be gone for demonizing the “shadow banking system” and finally, a broadening recognition that securitization plays a vital role in bringing non-financial investors into the markets of financial assets, thereby creating liquidity and diversifying risk.  Obviously, this only refers to structures and markets that are properly run but isn’t that the case for any market?  Maybe not such a bold prediction but we foresee continuing momentum in 2014 for the return of the structured markets as an acknowledged “key” to the growth and even the stability of the global economy.

There were a few others topics that almost made our list, most notable was the observation that there is still not enough structural innovation going on in the markets right now. Our own view on that topic is that while the observation may be very true, given the long road back for the markets and particularly investor confidence, how can a heavy dose of “plain vanilla” structures be viewed as unexpected.  If you’ve been around the structured markets as long as we have, you can take some solace in the understanding that we have been in similar (if not as severe) cycles in the past. As the recovery continues, investors will look for yield and customization which will feed a push to innovation. This we believe, is inevitable.

2013 Recap: No Stopping Momentum for CLO Market

No other structure or asset class has signaled the return of securitization to the mainstream investor markets more than Collateralized Loan Obligations. 

During the darkest days of the post-Credit Crisis through the end of 2012, when the markets continued to struggle in so many areas, it was the CLO market that continued to perform.  One could argue that this asset class has almost single-handedly lifted the confidence of all sides of the issuance market (investors, issuers and arrangers, alike) in structured finance over the last three years.

Heading into 2014 and off a relatively strong if not historically significant, US$50Billion in issuance for 2012, leading market prognosticators expected new issuance for 2013 to be something in the US$60-70Billion range.  However, it didn’t take too long for the experts to re-forecast as that 2012 level was exceeded before we got through the summer.  The latest projections suggest that the market should exceed US$75Billion before we reach the end of this month, a full 50% increase over 2012 levels.

All this good news despite the presence of some strong headwinds; most notably in the form of CLO Manager Risk Retention Requirements in the Euro zone and the negotiations around the final form of the Volcker Rule in the U.S.  The risk retention rule has its own issues, as in its worst form it could significantly reduce the number of managers that would choose to be active and thereby, the potential to reduce the number of new programs and slow demand for new loan origination from European lenders.  However, it was the potential harm to the investor side of the marketplace that has been creating the biggest stir, as the new proprietary trading restrictions (the “Volcker Rule”) could have had the effect of chasing a large cross-section of the CLO investor base to the sidelines.

While good news related to the Euro retention rules remains elusive, this past week brought an announcement that the final version of the Volcker Rule, while not perfect, will keep the banks in as investors.  The imperfect parts of the final rule, has the banks precluded from buying into CLO’s that also include bonds and other “non-loan” collateral (which many existing programs do) and the Rule does not provide for any grandfather status to programs issued prior to the implementation date of July 2015.  Nevertheless, this final version of Volcker is much better than some expected and another strong validation for the recovery of the securitization markets.

Assuming that the news on Volcker only gets better and there is a rationale resolution to the Euro retention standards, it may be very possible for new issuance levels of CLO’s in 2014 to grow yet another 50%, perhaps exceeding US$110Billion by this time next year, which would represent a historic high for this asset class which topped out in 2007 when some US$92Billion was issued.