The financial crisis of 2008 was a devastating time for many, as the collapse of the US real estate market caused ripple effects affecting the employment and livelihoods of millions of people.
According to to TheStreet, one of the main causes of the crisis was the opacity of the mortgage industry. Mortgages were bundled into packages called “mortgage-backed securities (MBS)” that could be bought and sold by banks and other investors who relied on rating agencies to determine how risky the securities were.
The banks sometimes “packaged AAA-rated securities with lower-quality ones, and these packages were passed off as top-rated securities when they were sold to investors.” These investors did not necessarily realize that they were buying low-quality securities that were likely to default, leading to massive losses after the crisis revealed the truth.
According to Ralf Kubli, a board member of the Casper Association, this fundamental problem that caused the crisis still exists, but it can be fixed with blockchain technology.
Kubli comes from both the traditional financial sector and the crypto industry. He previously worked in various mergers and acquisitions, sales and executive management positions at Sika, Starmind International, BCM Europe and other companies. In 2021, he joined the board of the Casper Association, a non-profit 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 emerged 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 given 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 minor and can be resolved through negotiation. However, situations such as the financial crisis of 2008 show that disagreements can sometimes be considerable, leading to disastrous results. As Kubli explained:
“You have a written contract that is then translated into computer code that then runs in these core banking systems, and after about 40 years, when these core banking systems are still running, nobody really remembers exactly what they programmed and how they programmed it. […] and that gives us the world you saw in the Big Short [film about the financial crisis].”
Kubli agreed that tokenization can help revolutionize the economy, saying “everything will be tokenized in the future.” However, he asserted that developers need to be careful about how they tokenize mortgages in particular. One way to tokenize mortgages would be to create a PDF file of a term sheet, then put a hash of that file into a token contract. But this would be a “dumb token” that is no better than what we already have in traditional finance.
In his opinion, for tokenization to be successful, the tokens must be “smart,” meaning that the financial agreement must be machine-readable and the various parties involved must agree on the code itself. Otherwise, differences in interpretation and analysis will continue, causing future disruption in financial markets.
DeFi doesn’t solve the problem
Lenders and borrowers are already accepting machine-readable contracts through decentralized finance (DeFi) applications today. When a borrower takes a loan from a DeFi app like Compound, for example, they never sign any legal agreement to repay the loan. Instead, by using the smart contract associated with the app, the borrower is understood to have agreed to the code running within the contract.
However, most DeFi applications require the borrower to put 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 flows over time, in DeFi you have guaranteed or over-guaranteed loans only” but “The world works on credit, and credit is payment over time” he said.
Some industry experts have argued that “Soulbound” tokens – digital identity tokens representing the characteristics or reputation of a person or company – can extend DeFi to under-collateralized and over-collateralized loans.
However, Kubli emphasized that this only solves the problem of “underwriting the creditworthiness of a counterparty”. It does not allow a flow of cash flows over time to be symbolized.
Digital term sheets
To ensure that the terms of a mortgage are transparent, Kubli believes that a “machine-readable, machine-enforceable and machine-audible native digital term sheet” must be created and agreed upon by all counterparties to the mortgage. This agreement must be written as a mathematical formula and recorded in a smart contract that is observable, verifiable and enforceable, which he calls a “smart financial contract”.
Kubli said that once a digital term sheet is tokenized via a smart financial contract, defaults can be observed transparently on the blockchain. This can prevent situations like in 2008, where mortgage defaults were unobservable to the people who traded the mortgages, as he explained:
“The reason why 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 didn’t pay. […] no one observed these payment flows […] but the point here is that gives you smart financial contracts, which are a completely different animal, so, for the future of finance.”
To the extent that loans have collateral associated with them, these can also be tokenized and locked within smart contracts. For example, the tokenized title to a home or car can be placed inside a smart contract and given to the lender after a certain period if the buyer defaults.
Once a loan is entered into a smart financial contract, Kubli says it can be secured “with the push of a button.”
For example, say a bank made loans to plumbers and painters across the United States, and there was some flooding in North Carolina and Virginia. A pension fund may want to buy loans from these states because the plumbers and painters there will have a lot of work. The fund should be able to easily buy a basket of these loans once they are tokenized, “and then 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 built to define how smart financial contracts can be built. In his opinion, this has already been done with the creation of Algorithmic Contract Types Unified Standards (ACTUS), available on GitHub.
He said CasperLabs has been working on Nucleus Finance, a project trying to produce ACTUS-compliant financial products. The team has already produced loans for two clients, one of which is said to be a major rental company and the other “is one of the largest infrastructure providers in capital markets in Europe.”
Related: What is the global financial crisis and its impact on the global economy?
However, he said that these products are not yet “productively used” by the customers, but Nucleus is looking to find new customers who can benefit from the technology.
Other tokenized mortgage solutions
Kubli is not the only expert touting tokenized mortgages as the solution to financial crises. The head of research at Security Token Advisors, Peter Gaffney, has written blog post making a similar argument. He claims that if mortgages undergo “dual tokenization,” with mortgage tokens wrapped inside a larger token to create a token mortgage-backed security, this “will provide transparency to not only the prices and ratings of the MBS itself, BUT also transparency and ratings to the underlying mortgages.”
Gaffney claims that Security Token Advisors “has seen several promising clients who are working to bring the right technology to this industry” and will announce these initiatives “as they come to fruition.”
Cointelegraph reached out to Security Token Advisors for comment but did not receive a response by the time of publication.
Several researchers have recently attempted to tokenize various aspects of the mortgage industry. In March 2022, Cointelegraph Research revealed that real estate has become the leading securitized blockchain asset. In June, Citigroup published research suggesting that a growing number of mortgages may be secured with crypto-assets, although the investment bank warned that this practice could carry additional risks.