The 2008 financial crisis was a devastating time for many, as the collapse of the US housing market impacted the jobs and livelihoods of millions of people.
According for TheStreet, one of the main causes of the crisis was the opacity of the mortgage sector. Mortgages were bundled into bundles called “mortgage-backed securities (MBS)” that could be bought and sold by banks and other investors who relied on rating agencies to determine the risk of the securities.
Banks “sometimes bundled AAA-rated securities with lower-quality ones, and these lots were presented as prime securities when they were sold to investors.” These investors did not necessarily realize that they were buying low-quality, default-prone securities leading to massive losses once the crisis revealed the truth.
According to Casper Association Board Member Ralf Kubli, this fundamental problem that triggered the crisis still exists, but it can be solved through blockchain technology.
Kubli comes from both the traditional financial sector and the crypto industry. He previously held various M&A, sales and management positions at Sika, Starmind International, BCM Europe and other companies. In 2021, he joined the board of the Casper Association, a non-profit organization promoting the Casper blockchain network.
He told Cointelegraph that tokenizing mortgages could allow them to become “observable, verifiable and enforceable” on a public blockchain, making the mortgage industry more transparent and helping to avoid the kind of surprises that occurred during the 2008 crisis.
Interpreting paper agreements in a digital world
When financial agreements are written, they are put on “pages and pages of paper,” Kubli explained. Then they are handed over to analysts and programmers who interpret these written documents as machine-readable code.
However, these analysts often have disagreements, he noted. Under normal circumstances, disagreements are minimal and can be resolved through negotiation. However, situations like the 2008 financial crisis show that disagreements can sometimes be considerable, leading to catastrophic results. As Kubli explained:
“You have a written contract that’s then translated into computer code that then runs in those core banking systems, and after about 40 years when those core banking systems are still running, nobody really remembers exactly what they programmed and how they programmed it (…) and that gives us the world that you saw in the Big Short (movie about the financial crisis).
Kubli agreed that tokenization can help revolutionize the economy, saying “everything will be tokenized in the future.” However, he claimed developers need to be careful how they symbolize mortgages in particular. One way to tokenize mortgages would be to create a PDF of a term sheet and then put a hash of that file into a token contract. But that would be a “dumb token” that’s no better than what we already have in traditional finance.
According to him, for tokenization to be successful, the tokens must be “smart”, which means that the financial agreement must be machine-readable and the various parties involved must accept the code itself. Otherwise, differences in interpretation and analysis will persist, causing future disruptions in financial markets.
DeFi does not solve the problem
Lenders and borrowers are already accepting machine-readable contracts through decentralized finance (DeFi) applications today. When a borrower takes out a loan from a DeFi app like Compound, for example, they never sign a legal agreement to repay the loan. Instead, by using the smart contract associated with the app, the borrower is deemed to have accepted the code executed in the contract.
However, most DeFi applications require the borrower to provide cryptocurrency as collateral to secure the loan, and the value of the collateral must be greater than the loan amount. Kubli argued that this limitation prevents DeFi from competing with traditional finance. “In DeFi you don’t have cash flow over time, in DeFi you only have secured or over-secured loans” but “The world runs on credit, and credit is payment over time “, did he declare.
Some industry experts have argued that “Soulbound” tokens – digital identity tokens representing the characteristics or reputation of a person or business – can extend DeFi to under- and over-collateralized loans.
However, Kubli pointed out that this only solves the problem of “guaranteeing the creditworthiness of a counterparty”. It does not symbolize a cash flow over time.
To ensure transparency of the terms of a mortgage loan, Kubli believes that a “machine-readable, machine-executable and machine-auditable native digital term sheet” must be created and approved by all mortgage counterparties. This agreement must be written in the form of a mathematical formula and concluded in an observable, verifiable and enforceable smart contract, which he calls a “smart financial contract”.
Kubli said that once a digital term sheet is tokenized by a smart financial contract, defaults can be observed transparently on the blockchain. This can avoid situations like in 2008, where mortgage defaults were unobservable to people negotiating mortgages, as he explained:
“The reason the financial crisis happened (is) because they couldn’t observe and they couldn’t verify that none of these payers in Florida who took out all these mortgages were paying ( …) no one has observed these payment streams (…) but the point here is that it gives you financial smart contracts which are a whole different animal, then, for the future of finance.
Since loans are associated with collateral, these can also be tokenized and locked into smart contracts. For example, symbolic title to a house or car can be placed in a smart contract and returned to the lender after a certain period in the event of default by the buyer.
Once a loan is placed in a financial smart contract, Kubli says it can be securitized “at the push of a button.”
For example, say a bank provided loans to plumbers and painters across the United States, and there was flooding in North Carolina and Virginia. A pension fund may want to buy loans from these states because plumbers and painters will be busy there. The fund should be able to easily buy a basket of these loans once they are tokenized, “then the securitization is done,” he said.
Open source standards for tokenization
Kubli argued that for these tokenized financial products to be possible, an open-source standard must be created to define how smart financial contracts can be built. According to him, this has already been done with the creation of Algorithmic Contract Types Unified Standards (ACTUS), available on GitHub.
He said CasperLabs was working on Nucleus Finance, a project to produce ACTUS-compliant financial products. The team has already originated loans for two clients, one of which is said to be a large leasing company and the other “one of the largest capital markets infrastructure providers in Europe”.
Related: What is the global financial crisis and its impact on the global economy?
However, he said these products are not yet “productively used” by customers, but Nucleus is looking to find new customers who can benefit from the technology.
Other symbolic mortgage solutions
Kubli is not the only expert to present symbolic mortgages as the solution to financial crises. Security Token Advisors head of research, Peter Gaffney, has writing a blog post making a similar argument. He claims that if mortgages undergo “double tokenization”, with mortgage tokens wrapped inside a larger token to create mortgage-backed security, it will “provide transparency not only in pricing and ratings of the MBS itself, BUT also of the transparency and ratings of the underlying mortgages.
Gaffney says Security Token Advisors “has seen several promising clients who are working to bring the right technology to this industry” and will announce these initiatives “when they come to fruition.”
Cointelegraph has contacted Security Token Advisors for comment but has not received a response at press time.
Several scholars have recently attempted to symbolize various aspects of the mortgage industry. In March 2022, Cointelegraph Research revealed that real estate had become the top securitized blockchain asset. In June, Citigroup published research suggesting that an increasing number of mortgages could be secured by crypto assets, although the investment bank warned that this practice could carry increased risks.