What is blockchain securitization?

What is blockchain securitization?

Cyber Security and Hacking

In blockchain securitization, all cashflow between the parties involved in the securitization process becomes recorded on the blockchain. This results in faster and more accurate cashflow reporting and greater transparency in executions, since every transaction becomes recorded and stored on the blockchain.

Abstract—This paper presents a blockchain-based Securitization Model, which simplifies the transactional  methods. This paper elaborates upon integrating the components of Securitization with Distributed Ledger  Technology (DTL) and provides a process flow of transactions  occurring. The process led to the 2008 Financial Crisis became improved in terms of security and reliability.  Using this revolutionizing model, securities, which were once  considered opaque & risky, will now be informative and  gauged accordingly, thereby smoothening the process of  transforming non-tradable assets into tradable securities. This  paper highlights how blockchain features, i.e., smart contracts,  decentralization, authentication & immutability, will increase  efficiency. Furthermore, the paper explores boons of the  amalgamation, i.e., reduced risk, enhanced transparency,  lower costs, proficient processes and robust authentication  without compromising information asymmetry, high  transactional costs and nebulous portfolio rating. The goal of  this paper is to portray how the integration will augment the  cardinal Securitization process.  

Keywords—Blockchain, Consensus Mechanism, Decentralized,  Distributed, Hash, Immutability, Smart Contracts, Securitization 

I. INTRODUCTION  

 There are two main architectural approaches for a  software system – distributed and centralized. Centralized  software systems consist of nodes that are located and  connected with one central node, which promotes  coordination. On the contrary, distributed software systems  consist of several linked nodes without any central control  node. Blockchain’s primary architecture is based on the latter  approach.  

 Blockchain’s appeal is derived from its ability to support  transparent transactions, optimize business processes, reduce  operating costs, improvements in collaborative efficiency,  and develop a system that aids faceless transactions [1].  Additionally, it has negligible environmental consequences.  

 Blockchain technology, which was invented in 2008, has  depicted the progression it can bring to different businesses.  It has become a reliable and secure base for sectors such as  healthcare, text communication applications, stock trading,  supply chains and their management, and many more  disparate sectors. The ideology of enhanced self-governance  along with decreased centralized dependency is promising.  

 Customers, investors, and banks daily engage in the  process of financial trade – which is in the form of loan  

origination, global trade finance, stock and security trading,  etc – to exploit the gaps in the current economy, leading to  profits and boosting of economies. With the increase in  number of transactions per day, the requisite for an efficient,  smooth, and easy-to-use system has increased. This in turn  has made incorporation of Blockchain technology an alluring  alternative, especially for Asset Securitization.  

 Securitization is an epitome of financial instruments and  products used by corporations to foster trade and commerce.  From reduction in transaction time, overhead costs, and fraud  risk to improvements in trust, credibility, and accuracy, the  ambit of benefits achieved by the integration can be  remarkable. By reducing reliance on third-party  intermediaries & being able to track asset performances  closely, there is an increased interest by investors in the  secondary market. The espousing of Securitization with  Blockchain will remove regulatory inefficiencies from the  process and ignite an interest in securities initially considered  opaque and high-risked. Also, utilization of smart contracts  leads to consolidation and standardization of complicated  agreements.  

 As is the case with applying any new technology, we  must be prepared to battle the obstacles posed by it.  Implementing a widely accepted and followed system with  well-defined industry protocols needs to be formulated. Also,  it must be ensured that all entities which are on-boarded on  the network, leverage its boons.  

 The rest of the paper is organized as follows [3]. Section  II expounds on Blockchain Technology, its types, and  consensus mechanisms incorporated. Section III  encompasses the Traditional Securitization Model. Section  IV delineates the Blockchain-based Securitization process.  Furthermore, Section V elucidates functionalities, benefits, and shortcomings of the integration. Section VI cogitates on  papers which propose the use of Blockchain in handling  finances. The paper is then concluded in Section VII. It also  talks about the future scope of Blockchain in Securitization  and other Financial Models.  

II. BLOCKCHAIN  

A. Distributed Ledger Technology  

 Distributed ledger technology can be considered as an  agreement of copied, shared, and regularly updated digital  knowledge geographically unfolded across multiple sites.  There is no central administrator, unlike in centralized 

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information. The database for the distributed ledger is  extended throughout many nodes, which are nothing but  devices, on a peer-to-peer network, where every device  copies the ledger and updates itself. One of the many  advantages is the lack of central authority. Once a ledger is  updated, each node builds a new transaction, post which the  nodes use the consensus rule to vote on the correct copy.  Once a consensus has been decided on, this correct and latest  copy is updated on every node.  

B. Blockchain Architecture  

Blockchain ledger has three basic concepts: transaction,  block, and chain. The “transaction” in Blockchain is not  restricted to trading. All the valuable information can act as a  transaction to be broadcasted in the blockchain network. The  blocks are storage units to record transactions, which are  created and broadcasted by those users authorized by  consensus mechanism [4]  

The process becomes initialized by the creation of a transaction  between two participants over the same distributed ledger.  The creation of the transaction implies creation of smart  contracts. This is followed by the smart contract verification,  which abides the consensus mechanism followed by the  participants of that network. Once verified, it should be  stored in a block, after which the block is given a hash. On  completion of the transaction, the smart contracts execute  themselves to meet the terms of the transaction.  

Participants of the Blockchain have two keys, one public  and one private, which help perform transactions and  produce a secure digital identity reference. Transactions are  verified and added to the peer-to-peer network by using this  digital signature.  

Fig. 1. Blockchain Structure  

C. Blockchains and its variants  

Blockchain can be categorized into three types – Public  Blockchain networks, Consortium Blockchain networks,  and Private Blockchain networks. In public blockchains,  anyone can participate and join the consensus process.  Contrarily, private blockchains are networks where only a  single organization has authority over the network. Lastly,  Consortium Blockchains are semi-private blockchains wherein multiple organizations govern the platform. Access  is only granted to a specified set of nodes. In this scenario,  access will be granted to banks, investors and smart  contracts governing special purpose vehicles and rating  agencies.  

TABLE I. TYPES OF BLOCKCHAIN [5]  

D. Consensus Mechanisms and its variants  

A consensus mechanism is used to validate the blocks  appended to the chain. It is a predefined, agreed validation  algorithm, which maintains the integrity of the transactions  occurring on the chain, even in the absence of an  authoritative third party. It also aids in synchronization and  setting the chronological order of the chain.  

TABLE II. CONSENSUS MECHANISMS [5]  

III. THE TRADITIONAL SECURITIZATION MODEL A. Current Securitization Process  

In the diagram, the transactions that occur in one  complete cycle of the Securitization process. The current  process involves the intimate involvement of intermediaries  such as credit rating agencies, guarantee & governing  bodies, Special Purpose Vehicles (SPV), and many more.  

Fig. 2. Steps of the Traditional Securitization Model [6] 

A borrower and lender decide upon the loan agreement.  The issuer/originator pools together many such loans and  places them in an SPV. The SPV structures these pools into  securities. Audit firms and rating agencies review the pools.  These agencies are asked to evaluate the securities and  provide a credit rating. The securities are then brought to  market, where investors have the opportunity to purchase  these securities depending upon their risk-reward  predilections. A trustee and rating agencies monitor these  transactions.  

The current process’s cost is higher than the process that  utilizes Blockchain technology, as this process involves  more people. There are multiple parties involved in monitoring and keeping track of the transactions. This cost  is eliminated when adopting Blockchain technology as the  technology takes care of these tasks. Moreover, as multiple  people are involved, the process is lengthier and takes  longer in contrast to the overall turnaround time of the  integrated method.  

B. Pain Points in the Traditional Model  

• Information Asymmetry – The issuer of the securities  knows much more about the accuracy and originality  of the security being sold as compared to the investor  

• Layering of Costs – Each step involves due diligence.  Each party creates an additional hedge/risk cover  

• Portfolio Rating Frozen in Time – Loan portfolio and  underlying tranches are rated at a point in time and in  due course do not appropriately reflect the  underlying asset or the economy  

• Long Timeless and High Transactional Costs – Each  step is substantially manual with lengthy timelines,  high costs, and near-zero inter-operability across  systems  

IV. INTEGRATION OF SECURITIZATION WITH BLOCKCHAIN  TECHNOLOGY 

A. Securitization Architecture  

Blockchain is an elegant and solitary technology. Over  the years, it has gained enormous traction to become the  cornerstone of various sectors. Nowadays, when the goal is  to reduce human interference, automation is catching speed.  Blockchain also focuses on complete automation,  Blockchain aims to automate away the centre [15]. Using  this decentralized property and other technological advantages have cultivated transparent connections between  faceless participants. Hash functions, smart contracts,  consensus mechanisms, and peer-to-peer networks are the  cardinal benefits of this decentralized technology. 

Securitization involves entities such as loan originator (or  bank), customer, and investor. Their activities encompass –  

• The customer places a request to create an asset.  The originator creates the asset, and the customer  receives the loan amount.  

• Originator transfers assets to the asset pool. Asset  pools are divided into securities with the help of  credit rating agencies and SPVs.  

• An investor places an order to buy these securities and makes the payment. The security is transferred  to the investor.  

• The investor can then sell the security after a certain  period and receive the investment along with  interest.  

Fig. 3. Sequence Diagram of the Securitization Process Fig. 4. Read and Write Permissions of the ledger for various entities  

B. Securitization Flow using Blockchain  

Transaction flow of the integration of Blockchain and  Securitization.  

An electronic asset gets created and timestamped when  the borrower and lender agree upon the terms and conditions  for the loan. This cannot be edited unless there is a new  consensus among the parties.  

A smart contract is created which stores the pertinent  code of relevant information. Delays or defaults in payments  are added to the smart contract with timestamps to influence  future servicing decisions.  

All the loans are pooled together and transferred to a SPV  by the issuer. The SPV makes it into securities and records  this transfer on the Blockchain.  

These securities are referenced by rating agencies, trustees, and other relevant third parties to perform the  assessment.  

A new smart contract is created that includes the  transaction of the securities, which is layered over the SPV,  and the smart contract developed for the SPV itself.  

In order to handle discrepancies, a rating monitoring  software is added to the Blockchain to keep in check the  security performance with the expected cash flow. 

Blockchain is used to create market platforms to  interoperate the use of Blockchain with transactions. These  transactions are done by investors who could directly trade  securities on this platform.  

When securities are created and traded, this information  is constantly updated and stored on the Blockchain with  appropriate access to all relevant parties.  

V. INTEGRATION FUNCTIONALITIES, BENEFITS AND  SHORTCOMINGS OF THE INTEGRATED MODEL 

A. Functionalities of the integration  

The principles and main functionalities that undergird  blockchain technology in securitization are as follows:  • Streamlining the Securitization Process by removing third-party delays, increased accessibility, and  enhanced understanding of the available securities in  which one can invest.  

  • Gateway to invest in opaque securities. Securities  once considered inaccurate, facile, and illegitimate  can now be verified and unadulterated.  
  • Blockchain is a decentralized ledger which means  that authorized participants, at the same time, have  access to identical information across a public  network of nodes.  
  • An algorithm which allows users to reach an  agreement about one systematic state of the network to synchronize the ledger via a global election is  consensus validation.  
  • Blockchain networks consist of smart contracts that execute themselves. This, in turn, reduces the costs  of transactions and allows the settlements of bills to  take place automatically.  
  • Cryptography can also be termed as hash functions.  The data is stored in a highly encrypted form by  incorporating a complex cryptographic algorithm to  securely store and process transaction data across the  network.  
  • Only after verification are transaction added in the  chain. These transactions are immutable and  irreversible once they are recorded.  

B. Benefits of the integration  

The benefits of the integration of Blockchain and  Securitization –  

• The issuer of the security and the investor have  similar information about the security. This means  that the buyer makes the purchases with complete  knowledge, and this tends not to influence their  decisions, succumbing to the issuer’s benefit  

• The process of securitization becomes completely  transparent when using blockchain. This makes it  easy to trace transactions related to the security, creates both reporting and underwriting to be  efficient that leads to decreased expense and delay 

• Due diligence is not required at each step as the  elements of the process are embedded in the block  itself  

• The use of smart contracts makes the transactions  more secure and reduces surplus transaction costs  

• The process is semi-automated which reduces  processing time, costs and increases interoperability  across systems  

C. Shortcomings of the integration  

Shortcomings of the integration of Blockchain and  Securitization –  

• Data security and privacy: Sensitive information is spread among multiple nodes as Blockchain adopts a  distributed structure, and thus privacy issues may  arise.  

• Blockchain is a relatively new technology: It is a  nascent technology that has not been fully vetted yet  and has not proved to have undoubtedly reliability. 

• Regulatory and legal problems: Regulators will take time to approve this integration as they need to  consider multiple factors such as financial  institutions, legal shifts for smart contracts, etc.  

• Lack of resources to migrate to Blockchain: Start-ups  or low-profitable corporations might not be able to bear the initial costs of changing internal data  systems and work processes to prepare for  integration with Blockchain.  

VI.RELATED WORK

Sr. No. Paper Name Paper Synopsis Drawbacks of Existing System Blockchain Integrated Method
Design and Implementation of a  Loan System Based  on Smart Contract [7] The paper talks about a loan  system which utilizes Blockchain  technology to innovate an  automated loan signing system.  This system uses decentralization  and immutability to connect  customers and loan originators,  and complete the loan process. Involvement of third party, Payment delays,  Multiple versions of the  truth, Duplicative bills. The system uses Ethereum Blockchains and Ethereum Virtual Machine smart  contracts. This system implements three  main required functions – borrowing,  lending and repayment – in an application  that facilitates the loan process. In such a  system, smart contracts play the role of a  loan contract. 
Application of  Blockchain in Asset  Backed  Securitization [8] The paper analyses the leading  issues in the asset backed  securitization process. It then  proposes a blockchain integrated  method which involves on boarding of vital entities on the  consortium distributed ledger. The authenticity of the underlying asset quality,  information asymmetry,  data processing and  crediting, unable to meet  rapid expansion needs. An originator registers a new blockchain and imports the asset on the ledger. The  ledger is then updated by entities such as  credit rating agencies, guarantee agencies,  SPVs. After updating, the final Blockchain  is accessible by the investor to carry  transactions. 
RemBit: a blockchain based solution for  remittances to  Ethiopia [9] The paper proposes an innovative payment solution  aimed at improving the  remittance flows by exploiting  the potential of blockchain  technology. Long and slow transaction times, Lack of  transparency, High  transaction costs,  Insecure system prone to  money laundering. The sender’s cryptocurrency will be  converted into the recipient’s country’s  fiat currency. The transaction is verified  using a decentralized peer-to-peer  network. Security services have  specialized access to verify any suspected  activities. Furthermore, the adoption of  advanced cryptographic methods ensures  transaction security. 
Blockchain Application in Food  Supply Information  Security [10] To demonstrate how blockchain  technology can be used as a  large-scale collaboration  platform, the article uses the  PEST analysis approach.  Following that, a blockchain integrated supply chain strategy  is proposed, which will aid in the  tracking of providers of  contaminated goods and services. Manual contract creation,  faceless dealers, delayed  timeline, delayed  payment. All entities on the distributed ledger are  added to the blockchain. Supplier,  manufacturer & processor, seller,  customer, and appreciation are among the  entities. A private and public key is given  to each entity. Furthermore, the  consensus must validate every transaction  recorded on the blockchain. The  transactions are monitored by the  administrative department. 
ChainIDE: A Cloud Based Integrated  Development  Environment for  Cross-Blockchain  Smart Contracts [11] The authors suggest ChainIDE, a  cloud-based solution for creating  Blockchain-based smart  contracts on a variety of  blockchain systems.  Furthermore, cross-chain  creation of smart contracts on  several blockchain systems is  possible without the need to  spend time setting up an  environment. The system is time consuming, the Setup  process is slow,  developing a cross-chain  is very expensive. They set up a cache so that uncompiled  code would be stored if the Internet went  down. Cloudflare is used to speed up the  compilation process in some network  conditions. Furthermore, as long as they  have an Internet connection, users can  program on any digital device without  having to prepare created environments. 

VII. CONCLUSION 

In this paper, we presented how Blockchain technology can become used to transform the Securitization  process. We looked into understanding blockchain  technology, its types and consensus mechanisms. We then  moved to comprehend the Traditional Securitization Model,  its drawbacks and how Blockchain has streamlined  transactional processes, in the financial domain. Further, an  in-depth analysis of the integrated model and its  functionalities, benefits and shortcomings carried out.  The aim of this paper, which is to describe the benefits of  integration, is justified.  

The integration of Blockchain technology to the  cumbersome Securitization process has laudable benefits  ranging from tamper-proof and decentralization to the  removal of third-party entities and trustworthiness.  Blockchain can become imitated to result in novel results in  processes such as healthcare, supply chain management,  syndicated loans, voting, etc. Blockchains’ heterogeneous  features such as smart contracts, distributiveness, consensus  validation, real-time review and updates, transparency and  much more discrete functionality will enable Blockchain built applications to flourish and become an inveterate part  of their established systems.  

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What is blockchain securitization?