Securitization, smart contracts, and the evolving role of the intermediate
The world of finance is evolving as a result of distributed ledger technologies like blockchain.
The transition to decentralised finance, or DeFi, is being driven by several technologies. DeFi is revolutionising the way financial institutions operate, particularly the way intermediaries work with different counterparties and apply smart contracts during securitization transactions.
The transaction initiator, the structuring bank, law firms, an auditor, investors, and rating agencies are just a few of the many counterparties that may be involved in a complex securitization transaction. Smart contracts powered by blockchain can simplify this procedure and offer other advantages.
To fully benefit from smart contracts, creators, investors, and other market participants must also be aware of their hazards. This article describes how smart contracts operate and lists the advantages and disadvantages of using them.
Knowledge of smart contracts
In contrast to paper or digital contracts, smart contracts go beyond simple updates. They propose a fundamentally different strategy for carrying out contracts involving numerous parties.
Programmable contracts known as “smart contracts” are kept on a blockchain network. Once a specific number of the contract’s preset requirements are satisfied, they are automatically carried out. Smart contracts can’t be modified since they are kept on the blockchain, which increases validation and provide a verifiable, public audit trail.
Other benefits of smart contracts are numerous. They can be used by financial institutions, issuers, service providers, and others to simplify investor know-your-customer (KYC) verifications for future issuances, facilitate decentralised trading and lending, automate securities trade clearing and settlement, and streamline audits by sharing automated whitelists with auditors.
Additionally, smart contracts can speed up transactional processes, allow the parties to interact more effectively and with greater levels of confidence, and result in cost savings and automation-driven efficiency.
As an illustration, issuers can save money when redeeming securities using smart contracts instead of conventional contracts, which is an administratively onerous operation. Smart contracts can be set up to automatically redeem securities when specific conditions are met, streamlining the settlement procedure.
Although, as we’ll see, intermediaries are likely to continue to play a part in the smart-contract process, smart contracts also hold the potential of disintermediation. It may be possible for the parties to a securitization transaction to rely on fewer intermediaries in some circumstances.
It’s vital to remember that smart contracts have hazards, as we previously said. We’ll now look at a few of those.
Risks of smart contracts
The fact that the regulatory environment is still changing and any contract must account for shifting legislation over time presents one of the major hazards of smart contracts. For instance, certain contracts will need to be modified to account for an event like Brexit or adjustments to the London Interbank Offered Rate (Libor) that affect interest rates. However, as we’ve seen, once smart contracts are put into use on the blockchain, they cannot be changed. As a result, a smart contract’s language must, to the extent possible, take into consideration anticipated changes in variables like laws and interest rates. There may be options, such cancelling the contract and entering a new one, If language needs to be updated to reflect an event.
Another difficulty is that since the majority of the globe still uses government-issued currency rather than cryptocurrencies, the parties will still require banks in order to access fiat monies. However, as central banks consider launching their own digital currencies, this could alter in the future.
The creation and execution of smart contracts are growing swiftly, which is the most evident challenge. Financial institutions, investors, service providers, and other stakeholders are still sorting out the processes and emerging technology involved in smart contracts. What happens if a contract needs to be changed to reflect mistakes or legislative changes, as in the example above?
Finally, the execution environment for smart contracts determines how effective they are. For instance, smart-contract holders may be compromised by blockchain data breaches. Elliptic, a blockchain analytics company, estimates that losses from fraud and theft related to DeFi will exceed US$10 billion in 2021. According to Chainanalysis, 2022 is on track to set a new record for cryptocurrency hacks.
Risk management: The importance of an intermediary
According to many experts, smart contracts and other blockchain-enabled tools won’t replace the need for intermediaries; rather, they will merely alter some of their functions. Given the complexity of securitizations, some amount of human oversight will always be preferred to manage risk.
An intermediary may be retained in smart contract-based securitization transactions to:
- Before, during, and after a deal, practise due diligence.
- Examine the data that has been added to the smart contract to confirm:
- accuracy of the contract’s terms and deliverables, both at the beginning and throughout.
- At the beginning of the contract and over time as new duties are added or existing ones are amended, compliance with pertinent obligations, such as US SEC obligations or the EU’s Sustainable Finance Disclosure Regulation (SFDR), is required.
- Check to see if the contract was properly stored on the blockchain.
As we’ve seen, the securitization transaction process is changing due to the use of smart contracts and other technologies in blockchain technology. These instruments encourage openness and effectiveness, but they also bring about fresh and changing threats. Issuers, investors, and other stakeholders must keep in mind that intermediaries will continue to play a crucial role in this mainly automated environment if they are to properly manage the rewards and dangers.
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