A thought provoking paper from the European Banking Institute explores the potential for tokenized collateralized loan obligations (CLOs). Or more specifically, the risks of these asset backed securities (ABS) and how legislation might address them. It doesn’t just look at the risks to investors but also the potential systemic risks given securitizations triggered the Great Financial Crisis (GFC). While opacity was a big issue during the GFC, we analyze why that should no longer be so.
Many of the perils of the CLOs have nothing to do with blockchain. For example, it’s well known there’s a moral hazard in securitizing loans. That’s because the loan originator sells on the loans, so it is not exposed to payment delinquency. Hence, they may be motivated to lend to riskier borrowers.
The paper notes, “More and more institutional investors, like insurance companies, are investing in CLOs which are rated with high credit ratings, although their underlying loans may not be of the same quality.”
Blockchain can offer various benefits. There’s a multi trillion funding gap for SMEs. A bigger pool of investors could help. From the lender’s perspective, it could expand its investor base, especially if it sells CLO tokens to retail investors. And investors get access to a new type of high yield investment. Additionally, it could allow investors to hedge or diversify risks, reduce transaction fees and increase liquidity.
The risks of CLO tokens
However, unsophisticated investors may not understand the risks involved in the investment. Leverage could be a dual issue, both if the credit fund has used too much leverage and if the token holders leverage their investment.
If the fund initiator becomes insolvent, the underlying loans might no longer be serviced, so the tokens don’t receive the expected cash flows. The token is likely to be an equity security rather than a debt instrument. Hence, the investors are at the back of the queue. And there are some technology risks specific to blockchain. While the paper mentions cybersecurity or the failure of the blockchain itself, perhaps the biggest blockchain risk is looking after private keys controlling the tokens.
A major part of the paper explores various potential regulatory paths in the EU. For example, limits on leverage and restricting retail investor exposure to 10% of their investable assets.
Analysis: expanding access versus retail investors
Two topics explored here (beyond the paper) are the issue of retail investors and how to mitigate risks using technology.
At Ledger Insights, we’ve already reported on the tokenization of various higher risk securities. In many cases, they broaden investor access. But often the investor base expands from institutional investors to high net worth individuals. In other words, the investors are not entirely unsophisticated.
In contrast, the public blockchain DeFi protocol Centrifuge is not regulated. Even so, it restricts access in the US to accredited investors, but we believe there are no such limits in other jurisdictions. Centrifuge’s core product is very similar to a CLO. So there are risks to retail investors in Europe – the jurisdiction that the paper covers.
Analysis: using blockchain, tech to mitigate risks
The opacity of the CLO was a key risk in the Great Financial Crisis, and continues to be, according to the paper. What loans underpin the CLO? Are the repayments on time?
For transparency, there’s an argument that the disclosure requirements could be exponentially more arduous for tokenized securitizations. That’s compared to current disclosure requirements or the ones suggested in the paper.
Depending on the jurisdictions, securitizations often report quarterly or annually. With the right technology, it should be real time or daily.
Here are four examples:
- Liquid Mortgage allows investors to view payment activity on mortgages daily.
- Figure Technologies has issued asset backed securities backed by loans it originated. We believe it also provides real time access to servicing data.
- Another startup, Intain, has an administration solution that uses blockchain to automate the on-chain administration of asset backed securities.
- Plus companies like Inveniam combine expert consultants, AI and blockchain to provide real time data and token pricing solutions.
Opacity was a major cause of the problems during the Great Financial Crisis. That was 15 years ago, and technology has moved on.
That’s not to say there are no risks, including leverage. But opacity should not be one of them.