The securitisation market is already very familiar with the ability to convert illiquid assets into more tradeable products.  Blockchain and tokenisation have the potential to disrupt familiar securitisation mechanics, if not replace them entirely.  We discuss in this article the impact that blockchain could have on securitisation transactions, highlighting some relevant legal and regulatory developments and the direction of travel for digitisation of securitisation.

What is the relevance of blockchain and tokenisation to securitisation?

Blockchain and tokenisation have the potential to streamline processes, lower costs, increase transaction speed, enhance transparency and improve security for all transaction participants in a securitisation from issuer, to paying agent, to investors, and for others such as auditors, third party opinion providers and rating agencies. The promise of blockchain technology lies in the ability to convert less liquid assets into easily tradeable tokens which potentially attract a wider range of issuers and investors to the market.

There are also potential benefits for securitisation in respect of the disclosure and transparency requirements. Particularly as reporting relating to environmental, social and governance (ESG) features of transactions evolves the potential for delivering embedded data, direct to investors and other participants, via tokenisation, will become increasingly attractive.

Whilst use of blockchain in other financial products is becoming increasingly prevalent, especially since the approvals of Bitcoin and other coin ETFs and ETPs in 2024, its use in securitisation remains nascent.  Over the last couple of years we have witnessed certain blockchain activities in the securitisation industry where transactions have been structured with either parts or the entire deal on a blockchain. These have largely been innovative pilot or small transactions; examples of pioneers in this market include the 2023 Zenith transaction involving an issuance by an Italian special purpose entity, 2023 Blockchain Vision S.r.l with a “proof of concept” blockchain using the “Algorand” public platform or the recent Luxembourg Celo blockchain transaction.  Standard Chartered’s securitised trade finance receivables as part of the Singapore Government’s Project Guardian, shows the potential to democratise investments in this market, making them available to a wider audience; this pilot also demonstrates the need to have the support of relevant authorities in propelling the market forward.

We expect, as the technology beds down, and legal and regulatory clarity develops, that larger transactions will evolve; more significant sizes of transaction and volume will be needed for the product to start gaining traction.

What is “Blockchain” and “Tokenisation”?

“Blockchain” is a distributed ledger technology (DLT) that allows for transactions to be recorded in a secure, transparent, immutable and auditable way, without the need (necessarily) for an intermediary to perform or reconcile such transactions.  Although there are permissionless, or public, blockchains, where anyone can write transactions and participate in the consensus process, over the last couple of years we have witnessed permissioned, or "private" blockchains being widely adopted in the context of finance transactions (for example, Securitize which tokenised equities under the EU’s DLT pilot regime or Aspen Coin, which tokenises real estate property for investors). However, we have also seen some platforms experimenting with using “public” blockchain, such as the issuance of a real estate digital security by Gloram Real Estate on the Polygon public blockchain. There are also hybrid structures, such as the EIB's sterling DLT bond issuance in February 2023, which used a combination of public and private blockchains.

The benefits and drawbacks of different technologies are still being explored, but with private models, the ability to control access to information, for example, to allow proprietary or confidential data to be hidden from competitors who may be involved on the same blockchain may be beneficial to investors in the context of a securitisation.  However, investor access and interoperability are also key concerns and ultimately too much technological fragmentation in the space may hinder adoption, so methods to implement appropriate controls but using public blockchains are also being experimented with.

"Tokenisation", the process whereby one asset held by an issuer could be converted into a fixed number of DLT-based tokens (having a fractional value of the original asset) to be acquired by investors (who in turn could further subdivide such tokens) has been used by a number of market participants in pilots to date. The tokens created exist on the blockchain and represent ownership and rights in respect of the tokenised assets.

Such tokens are typically “securities tokens” meaning they constitute regulated financial instruments one way or another and can be issued using different structures: (1) tokens “native” to the blockchain, meaning tokens which are built directly on-chain, exist exclusively on the DLT (this would include cryptocurrencies such as Bitcoin and Ethereum but there are also native security tokens such as the World Bank's English law governed DLT Bond issued in October 2023 on Euroclear's D-FMI DLT platform as a “digitally native note”); and (2) tokens which are “not-native” meaning that  existing securities have been tokenised and issued in digital form in a secondary on-chain.

The main benefits of tokenising assets include increasing the liquidity of the assets which can then be traded on the secondary market. Since tokens are highly divisible, investors can also purchase tokens that represent very small percentages of the underlying assets making investing much more accessible. Finally, because the transaction of tokens is completed using smart contracts, certain parts of the exchange process are automated which can increase speed (including intra-day settlement) and may reduce the administrative burden involved in trading. With fewer intermediaries such as, paying agents, deals can be executed faster and with lower transaction fees.

What benefits could blockchain bring to securitisation?

There are a number of benefits which blockchain could bring to securitisation:

• Transparent audit trail: From loan origination to primary issuance, and changes in ownership in the secondary market, blockchain could create a chronological and immutable audit trail of all transactions. With this capability, regulators and auditors could get a view of the ownership and title of the underlying securitised assets;
• Transparency on transaction data: An ability to present all the relevant information to other stakeholders for due diligence purposes (including rating agencies) in a more efficient and transparent manner;
• Increased speed and certainty: Blockchain through its disintermediation and simultaneous recording of information across the system, could almost totally eliminate time lags in information and payment flows throughout the securitisation process, including in the secondary market. This increase in speed and certainty could significantly reduce counterparty risk, release capital, and reduce the return thresholds that investors require;
• Security: Blockchain’s capacity to increase the security of transactions and data, and mitigate fraud could be appealing to the securitisation (and indeed generally the financial services) industry, where integrity of data is paramount;
• Cost-efficiencies: Costs typically associated with the issuance procedure and administration of the transaction could be reduced. These benefits could in turn lead to greater efficiency, speed, transparency and safety in the securitisation market, which could lead to a higher investor appetite and improve pricing, volume and spreads, which could lead to more issuers and borrowers using securitisation as a funding means; and
• Liquidity:  wider range of issuers and investors, as well as asset classes together with increased speed and efficiency of transactions, including in the secondary market could bring more capital to the market and increase liquidity. 

What are the challenges with adopting blockchain for securitisation?

There are a number of challenges which have prevented a more widescale adoption of DLT in financial transactions:

• Interoperability: Interoperability and common data standards will be a challenge to the adoption of blockchain in the securitisation industry.  It is yet to be seen how new blockchain-based platforms will integrate with legacy systems. If the old and new platforms are incompatible then the efficiency benefits of the blockchain are undermined.

Similarly, if private, proprietary software models are adopted, different blockchains need to be able to talk to each other if asset tokens are to be able to travel from an originator’s blockchain to others;

• Data security and privacy: With reams of data being stored on the same technology platform, a cyber attack could be devastating. Appropriate fire walls on information access among parties on the blockchain, some of whom will be competitors also need to be established as complete transparency will not always be appropriate;
• Infancy of blockchain technology: Blockchain is a relatively new technology and before it can be widely adopted it needs to win the confidence of all stakeholders and market participants, it needs appropriate grade financial market infrastructure offerings to become fully usable and to demonstrate to participants that it is a credible and better alternative to the existing systems;
• Legal and regulatory uncertainty: Although there have been several developments across jurisdictions, the legal and regulatory  landscape is still evolving in many respects which means that there may still be areas of uncertainty.  Issues such as liability of parties on the blockchain, conflicts of laws, insolvency laws, taking security, capital treatment, amongst others, all need careful assessment in light of new technology.  See below for some of the recent regulatory developments in the EU and UK. 
• The role of intermediaries: A significant focus of the post-2008 financial crisis regulation was the reduction of systemic risk in the financial system; this resulted in regulations requiring that certain financial transactions involve certain types of regulated intermediaries, i.e. that they be formed on regulated exchanges, cleared through central counterparties and/or settled via central securities depositories, in each case in accordance with detailed rules and standards. The aim was, in part, to mitigate certain counterparty risks that arise when a transaction counterparty defaults. This has led to a number of risk-management benefits (including, for example, protection for transaction finality and the rules relating to financial market intermediaries following an insolvency of a counterparty). It is not yet clear how all these requirements are met in transactions using blockchain technology.  Whilst the distribution of information and disintermediation of transactions are attractive in a number of respects, certain centralised securitisation service providers are important for the continued operation of a securitisation structure, such as trustees and custodians who deal with multiple parties. Given the decentralised nature of transactions on a blockchain, it is not yet clear how this would be facilitated on all transactions.

Regulatory developments in the EU and UK

Both the EU and UK have introduced regimes to enable the testing of DLT market infrastructures whilst being temporarily exempted from certain legislative and regulatory requirements which might impede the development of technological solutions.  In the EU, whilst the EU DLT Pilot Regime has applied from March 2023, to date no DLT market infrastructures have been authorised, although this is anticipated soon. In a letter to the European Commission, the European Securities and Markets Association (ESMA) has indicated that 4 official applications have been submitted, with a further 8 potential applications that may be submitted later in 2024 and has suggested that the novelty of the new regime, together with the proposed duration (which is considered too short by many, given the significant amount of investment required to obtain new DLT solutions off the ground), the limited scope and absence of widely spread solutions for on-chain cash settlement, may explain its relatively slow uptake so far.

In addition, the EU has also moved to regulate cryptoassets more broadly as the Markets in CryptoAssets Regulation (MiCAR) applies to cryptoassets that are not already regulated by existing EU regulations, such as financial instruments and securitisations. This applies to products such as cryptocurrencies and stablecoins, and may therefore be relevant to on-chain payment legs in settlement of securitisation transactions, which is clearly a key part of the structure, if various benefits like smart-contract automated dealing and automated settlement are to be achieved.

In the UK, the Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 entered into force on 8 January 2024 and established the creation of a digital securities sandbox in which certain entities can test the use of new technology whilst being subject to certain modified or disapplied legislative and regulatory requirements. In April, the Bank of England and the Financial Conduct Authority published a joint consultation paper and draft guidance setting out the more detailed rules that would apply to entities within the digital securities sandbox. The final rules are expected in the summer with the first set of digital securities sandbox entrants being accepted from autumn 2024.  A number of financial market infrastructure providers, using DLT technology as the basis for their offering, are expected to join the sandbox and are likely to develop services that would be relevant to securitisation on blockchain in the future.

We will monitor with interest developments in relation to the UK’s digital securities sandbox and the EU DLT Pilot Regime, particularly as clarity on regulatory analysis will enable confidence in the market. As we have seen with other jurisdictions, the involvement of regulatory bodies and support of governments for pilot projects is key to facilitating innovation in this area and attracting investors.

What about the use of artificial intelligence?

Artificial intelligence (AI) and machine learning (ML) increasingly will combine with blockchain to provide efficiencies. Whilst there are obvious benefits for securitisation transactions, particularly with the monitoring and processing of data, regulators globally are assessing the risks and challenges associated with AI and ML. 

In the UK, the Prudential Regulation Authority published DP5/25 Artificial Intelligence and Machine Learning to consider the risks and benefits of AI in financial services, including potential risks to financial stability, and exploring whether specific regulation is required, and on 21 May 2024 the Council of the EU approved a regulation that seeks to harmonise rules on AI.  There is no doubt that AI can be useful for efficiencies but the market will need to be cautious about the novel challenges that arise from its use.

Final thoughts

Increasingly, securitisation is seen as a force for good in the financial markets, in stark contrast to its reputation following the global financial crisis, with regulators recognising that embracing reforms to improve access to securitisation can free up finance in order to achieve sustainability goals and, in the European Union, capital markets union.  Blockchain technology has the potential to widen the much-needed investor base for securitised assets and we expect that will be an increasing focus for regulators. 

That technological change is coming is in no doubt, with more innovation on transactions expected although it is not yet clear to what extent the new technologies will displace the current technology used on securitisation transactions.

It is likely that any inclusion of blockchain and AI in securitisation transactions will initially be undertaken using an incremental approach for various discrete aspects of securitisation (i.e. reporting, due diligence, digitalising certain aspects of transactions, etc) rather than wholesale changes where all aspects of the securitisation are moved onto the blockchain. However, the increasingly positive response from market participants and investors, as well as the importance of ESG themes and the underlying need to disclose additional information in a more concise, user-friendly and efficient manner may benefit, and influence, the adoption of such technology.  

How can Hogan Lovells help?

As one of the largest and most experienced blockchain domestic and international legal teams dedicated to the virtual currency and blockchain sectors, our practice helps clients take advantage of  blockchain technology's huge potential and disruptive impact, while avoiding falling foul of ever-developing regulatory and legal requirements. We work with a wide range of clients as they explore disintermediation, digital currencies, token sales, and new uses for blockchain.

Hogan Lovells' Structured Finance and Securitisation practice has deep experience advising on the financing of a wide range of classic and innovative asset types, as public and private stand-alone issues, master trusts, programmes, through conduit structures, and on portfolio sales, forward flow and financings of these transactions. We have built the practice across the globe with lawyers in the major jurisdictions of  Europe (including the UK), the United States and Asia, providing an integrated service to our clients on their most complex transactions. We are known as experienced and pragmatic counsel who advise arrangers, lenders, originators, investors, trustees and investors. We are regularly commended by independent market guides, particularly for our ability to advise on new and innovative transactions. We run one of the few practices able to offer dedicated and knowledgeable advice to capital markets trustees.

We would be delighted to discuss any of these issues with you further. Simply call one of us or your usual contact.

This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.

Authored by Bryony Widdup, Isobel Wright, Deborah Giurgola and Jane Griffiths.