Assessing Blockchain’s Role in Indian Securitization: A Solution in Sight?

Introduction

Securitization is a process by which income-generating assets like mortgages, loans and other receivables are packaged into securities that are sold to investors. Having its origins in the 1970s, asset securitization has consistently been the preferred avenue for banks to handle their risk portfolios. Over time, it has undergone necessary modifications to enhance safety for all stakeholders. One notable global trend observed in countries such as the United States, Japan, Germany, China, and Singapore involves integrating Blockchain technology into the securitization process. Stakeholders seem interested in reaping the benefits from this integration both in the global and domestic market. India’s securitization market as of now is taking baby steps towards its developed future and the proposed integration of Blockchain may act as a catalyst for it. This article goes into the challenges faced by the domestic securitization market at present, whether Blockchain can address these challenges, and if yes, then what steps must be taken by the regulators to enable this integration.

Understanding Securitization in India

Securitization in India is governed by the Securitization and Asset Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) and regulated by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). Launched in 1990, the first securitization transaction occurred in an unregulated environment. It was in 2002 when the SARFAESI Act was passed which dealt with resolving, restructuring and securitization of non-performing assets. Later, in 2006, the RBI issued guidelines governing the securitization of performing assets. However, the progress of securitization in the country came to a halt in 2008 due to the global economic crisis. Fast forward twenty one years, the securitization market has been performing better, with a volume increase of 60% year-on-year to INR 55,000 crore in Q1 Financial Year 2023-24, marking the highest ever for the first quarter of a financial year. This journey, however, has not been without challenges.

Challenges and Limitations

The primary issue during the 2008 crisis was banks offering subpar loans and rating agencies assigning high ratings to these securities, which lured investors to buy mortgage-backed securities without scrutiny. The fundamental problem was a lack of transparency, which persists today despite improved regulations, causing lower investor confidence and awareness, leading to potential for failure of the whole process.

Securitization is a manual and complex process due to the involvement of multiple parties and a lot of documentation, leading to increased costs as each party charges a fee. The stamp duty and registration fees further add to the expense, with rate of stamp duty varying from 3% to 14% depending on the state. Additionally, taxation adds to the burden, as only the securitization trust’s income is exempt, while the investor income is taxed as if invested directly in the underlying assets.

In traditional securitization, there are delays in updating changes in asset value or borrower defaults to the investors. Information lag between the portfolio’s rating and issuance of securities can misrepresent current conditions. Foreign Portfolio Investors (FPI) registered with SEBI are permitted to invest in instruments issued by SPV. But their presence has been nonexistent in securitization transactions due to difficulties in obtaining and submitting documents like PAN, dearth of funds focusing on securitization pools, and reluctance of asset managers to design products for off-shore investors due to high costs.

The 2021 Revamp

The RBI addressed some of the major concerns in its 2021 revamp of the securitization regulatory framework. Some of the most notable changes relevant to our discussion were with regards to transparency and security of the process.Top of Form

The guidelines mandated for a minimum level of clarity in payment waterfalls, sufficient disclosures of initial offering and draft underlying documentation on a continuous basis, disallowed use of liquidity facilities to cover credit losses or help increase excess spread flow to the originator. In order to increase market depth by attracting more investors, the guidelines incentivized making external ratings public and discouraged private ratings. Further, the revamp introduced the Simple, Transparent and Comparable (STC) guidelines under Chapter III that incentivizes issuers to move to simpler transactions with easier compliance rules and lower risk weights. The investor is empowered to verify if a transaction is STC compliant and where exposures are retained by the originator, the determination shall be made by the originator. In 2022, an amendment to the Master Directions made securitization of loans maturing in less than a year ineligible.

In furtherance of the objectives sought by STC guidelines, the integration of Blockchain in securitization would improve the system significantly. Blockchain Securitization, as the name suggests, is securitization done on Blockchain technology. The difference between traditional securitization and Blockchain securitization is that the latter involves tokenizing illiquid assets and selling tokenized units to investors on Blockchain. The tokens represent ownership of each individual security that is issued in the process. The design of a blockchain allows it to be transparent, decentralized, and immutable.

How Blockchain Can Address Challenges in Indian Securitization

Transparency in securitization can be improved significantly by blockchain, offering real-time updates and a secure ledger for immutable transactions. This ensures a single version of truth, simplifies compliance, and boosts investor confidence. Additionally, blockchain streamlines the process by reducing the number of parties involved through automation of tasks like document creation, execution and asset quality assessment by smart contracts.

Due to the above-discussed benefits, many of the unwanted fees and other costs associated with the securitization process can be reduced. Some of the expenses include fees paid to underwriters and lawyers. Further, a ratings monitoring software can keep an eye out for any discrepancies that arise between the security performance and expected cash flows and trigger a rating review. This will ensure accurate ratings of assets. All these features make auditing more efficient and reliable, benefiting credit rating agencies and ensuring transparency.

With blockchain securitization, there will be global connections between clients, companies, and investors. Clients can access securitization services from the international community, and investors can invest in these securities beyond their national borders.

Implementational Challenges and Solutions

We have seen how Securitization can benefit from the integration of Blockchain. However, there are challenges to implementing this technology both in general and specifically in the context of India.

The first is the complexity of the technology. Blockchain is not simple and requires an expert level understanding in order to use it for various purposes. It involves concepts and terms like cryptography, hashing, nodes, on-chain/ off-chain, etc. which a majority of the population does not have the requisite knowledge to understand. As noted by the NITI Aayog, a majority of India’s population is unaware of the use and concepts of Blockchain technology. To ensure that people grasp these concepts, stakeholders will have to conduct awareness programs on various levels. Additionally, conducting small-scale test runs can build confidence among stakeholders and help in its integration.

The second challenge is interoperability. There are different kinds of Blockchains with each having distinct features to deal with a specific situation, hindering seamless integration between them. The lack of interoperability complicates information transfer from different levels in the securitization process. Due to the possibility of the originator using a different blockchain than the one used by the issuer of the tokens, it will be difficult for information relating to loan repayments to reach the SPV or the investor. To tackle this, it must be ensured that in every step of the process, the information is uploaded to a single blockchain.

The third challenge is crucial to the process of securitization. It deals with the existence of a ‘single source of truth’. It involves ensuring that the recorded information, like repayments, credit ratings, and ownership transfers, is accurate and undisputed. Multiple verifications by various parties will be necessary to prevent false data from being permanently recorded and affecting the entire chain.

The fourth challenge is the resource hungry nature of the technology. To ensure a stable existence of the chain, every block needs to be replicated on every node of the network, demanding substantial computing power. Additional power is required for hash generation and consensus-seeking scripts for every transaction. One possible solution is to employ energy-efficient consensus algorithms or off-chain scaling solutions to alleviate the resource burden.

The last challenge is lack of regulation. As of February 2024, India does not have a legislation dealing with Blockchain, nor has any regulatory body issued regulations. This uncertainty hampers operations. Questions regarding validity of smart contracts, redressal of disputes, whether parties on the chain remain completely anonymous, standards procedures for recording and verifying information, etc. remain unanswered. Unless clarity is provided, neither the organizations nor the investors would be willing to welcome this integration.

To enable faster adoption of securitization through Blockchain, there must be a robust regulatory framework. The RBI could introduce guidelines/ rules that specifically deal with the application of blockchain technology in asset securitization and tokenization, or amendments could be made to the SARFAESI Act. For instance, since assets will be tokenized and investors will be issued tokens, there is no provision for such issuance in the SARFAESI Act. Section 2(1)(z) of the Act, while defining “securitsation”, states that funds are raised by the issue of “security receipts” to the qualified buyers. Section 2(1)(zg) defines security receipt as a receipt or other ‘security’, which is further defined by Section 2(h) of the Securities Contracts Regulations Act (SCRA) as “shares, scrips, stocks, bonds, debentures, debenture stock…” Thus, tokens will have to be first recognized as securities in order to enable their issuance for the securitization process.

Apart from this, the uncertainty surrounding the legality of smart contracts will have to be given clarity, so that Courts could provide further clarity on implications of such automated contracts. In order to simplify recording of information electronically, laws like the Uniform Electronic Transactions Act which provides legally binding status to e-documents and signatures, could be passed. For instance, Section 35 of the Information Technology Act, 2000 provides that digital signatures are valid only when they are issued by a certifying authority. This is contrary to the functioning of smart contracts as they are signed using cryptographic keys, which is different from physically ‘signing’ the contract. Unless the validity of digital signatures is established, admissibility of such contracts as evidence under Section 65B of the Indian Evidence Act, 1872 will remain a question mark.

Further, to tackle the issue of FPIs’ inability to make a presence in the market, the regulators will have to incorporate the advantages offered to FPIs for transactions carried out in the International Financial Services Centre (IFSC), GIFT City. FPIs are exempt from taxes, filing returns or holding a PAN card. Asset managers also benefit from 100% corporate tax exemption and other advantages.

Conclusion

Technological advancements like Blockchain and Artificial Intelligence are revolutionizing every industry, including finance. Securitization is just one of the many areas that are being improved using Blockchain technology. Although the technology brings with itself number of advantages, it won’t solve all the problems. The regulators must address issues such as high stamp duty, taxes, fees, and hurdles in cross border transactions to make the debt market of India attractive for stakeholders. With the Indian Debt market still underdeveloped after all these years, regulators must strive to implement the best available practices to instill confidence among all stakeholders, paving the way for substantial market growth.

(This post has been authored by Sambit Rath, a student at Dr. Ram Manohar Lohiya National Law University, Lucknow.)

CITE AS: Sambit Rath, ‘Assessing Blockchain’s Role in Indian Securitization: A Solution in Sight?’ (The Contemporary Law Forum, 16 June 2024) <tclf.in/2024/06/16/assessing-blockchains-role-in-indian-securitization-a-solution-in-sight/> date of access

1 thought on “Assessing Blockchain’s Role in Indian Securitization: A Solution in Sight?”

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