It lets asset holders access liquidity, and investors access value, and it’s the process by which traditional securities are created. It’s also relevant to some of the use cases for security tokens as well as some of the more advanced digital asset financialization processes that are emerging in the NFT and DeFi spaces.
Let’s start with what a security is.
What is a security?
A security is a fungible, negotiable financial instrument that represents some form of underlying value. It isn’t just a title deed; it involves an investment and an expectation of profit.
In the US, the definition of a security is based on a famous test case, Securities and Exchange Commission v. W. J. Howey Co., May 1946, and referred to as the Howey test. Under the ruling in that case, a security:
- Is an investment of money
- Involves an expectation of profit from the investment
- Involves an investment of money in a common enterprise
- Involves an expectation of profit from the efforts of a promoter or third party
Other common-law jurisdictions use similar rules. Under these rules, it’s easy to see how so many of the early ICO pioneers wound up in court! They often didn’t realize their tokens were securities, but the SEC looked at how they worked, not what form they took, and determined that they were selling the right to future profits from the company.
But in most cases, a security isn’t built this way. A typical security is not a way to sell access to future profits; it’s a way to sell access to the income from debts.
Securitization
Most securities are bundled debts. Imagine you have a dozen debtors, each owing $12,000, each repaying at $1,000 per month. You have a bundle of contracts nominally worth $144,000, but you aren’t getting it as a lump sum. And it’s possible that not all debtors will fully repay. It’s also worth less than the full $144,000 because it’s less liquid than cash.
You could bundle all those contracts into a new contract with an investor who was willing to give you, say, $120,000 in return for access to the income from those contracts. The debtors go on paying just the same, you get a lump sum right now, so this month your balance sheet shows $120,000 instead of $12,000, and your investor gets a long-term profitable income flow; assuming every debtor clears their debt in full, your investor just bought $144,000 from you for $120,000.
That’s the idea behind securitization.
Typically, these securities are distinguished by the term “Asset Backed Securities” (ABS) and the underlying asset pool usually consists of assets that are small, illiquid, or both. This might mean credit card receivables or vehicle leases, personal loans or mortgages, or trade receivables — or even income from intellectual property or from movie or show revenues.
Collateralized securities
Normally when simple ABS are created, the originating bank or other financial institution securitizes assets it owns, and sells them. But there’s another, slightly more complex way of doing it.
This is called collateralized securitization and it creates a Collateralized Debt Obligation (CDO).
When a bank creates a CDO, it sets up a separate company, a Special Purpose Vehicle (SPV) to become the security issuer. The bank packages the asset pool and sells it to the SPV, which then sells the packaged assets as securities to investors. The investors are buying the right to the income from the debts.
The bank’s contract is with the SPV, which has already paid its debt to the bank. The debtors owe their creditors, whose contracts with the bank have been bought by the SVP, which owes its investors. Thus, a pool of small, illiquid assets has been removed from the bank’s books and replaced with a single, simple transaction.
Equally important is risk. The bank has removed risky assets based in debt from its books, protecting its credit rating.
These assets can present issues to financial institutions because in reality, not every debt is paid. Bankruptcies and defaults can suddenly remove large percentages from the income stream of a CDO. (This is what happened in the 2008 mortgage crisis, when mortgages were securitized and sold on but homeowners were unable to keep up their payments.)
Because there are risks associated with purchasing securities, and because they are not always easy to predict, tranching is used.
Tranching
Derived from the French for cut or portion, tranching is a way to pool securities by risk or other characteristics in order to market them to different investors.
This might mean seeking investors who are more risk-averse and offering more price-stable securities, while separating the assets most likely to generate poor or excellent returns into another tranche targeted at more risk-tolerant investors.
It also allows the SVP to sell securities that offer higher returns than the underlying assets.
When assets are securitized, something called the preservation principle has to be observed. The income from the underlying assets has to be preserved through to the pool of investors, so if the underlying asset pool generates $1 million, $1 million has to be passed on to the investor pool; but this only has to be true in aggregate.
In other words, it’s possible to assess the risk of the pool, and sell some investors bonds that will yield smaller sums but are guaranteed to fall below a certain floor; other investors can be sold bonds that could yield much larger sums, but which might also fail to offer significant yields.
Securities, tokens, and loans
We’ve already noted that, in the eyes of the SEC and other regulators, many tokens are securities, though of course not all are. However, these tokens are not securities in the sense outlined above. Do these types of securities appear in the digital assets world?
Security tokens had a period of popularity as a way to carry out digital ICOs, and are still used to fractionalize asset ownership. They achieve similar effects to traditional securitization in that they let illiquid asset owners access investment; however, they’re more usually used to break up the value of a high-value asset than to pool the value of several low-value assets. So they work very differently.
Some entities are experimenting with putting securities on the blockchain, with the German government a prominent, if cautious, early adopter. And others, such as the Blockchain Association, foresee a host of use cases for digitized securities.
However, there are some platforms that offer securities based on digital assets, such as NFTfi; it’s a platform that offers loans denominated in digital assets and collateralized with NFTs. As digital assets, loans and tokenization enter the financial market, traditional securitization processes will eventually have to compete; and as we’ve seen in other areas, when this happens, both the traditional and the digital financial worlds will be transformed by the process.