Digitalisation in the covered bond market: A glimpse of the future

31 May 2021

By Antonio Torío, Strategic Consultant

It has been frequently said that situations of distress bring to the surface the inherent human ingenuity. Few times in our recent collective memories has the world faced challenges like the current pandemic, where most businesses have had to quickly transform how they operate to continue serving their customers. Surprisingly, the digital way, which was already gradually making inroads into our common practices, stepped up to the challenge, making the impossible possible. We could, literally, work from our homes.

The great success of being able to carry out many complex work processes away from the office has strengthened the belief that the adoption of technology not only optimizes costs, but reduces layers of complexity and brings speed, and reliability to the way we transact with each other. In this context, discussing from different angles and in many forums how the next generation of technology can enhance the covered bond. It can promote constructive debate, mutual collaboration and increase its probability of a successful future.

In a well-researched, comprehensive article recently published in the 2020 ECBC Covered Bond Fact Book, our colleague Karsten Ruehlmann from LBBW described exhaustively (link – see page 114) the key concepts behind Distributive Ledger Technology, the so-called blockchain.

This is a technology that is, in my view, called to transform many aspects of the mortgage, and covered bond markets. Artificial intelligence (AI) and data science will also be fundamental analysis and prediction tools that will enhance decision-making at all levels.

I would like to underscore the significance of these innovations and for issuers, dealers, and investors to evaluate different aspects of their adoption in their segments of the covered bond value chain. They will contribute to the enhancement of many of the practices which have been the mantra of the industry, transparency, safety, simplicity, and liquidity. Additionally, the reduction of the carbon footprint related to activities like reduced travel and paperless operations would be also worthy of consideration.

The potential benefits of digitalisation in the lending side are already noticeable, as many fintech initiatives across the globe are transforming the global mortgage market. The evolution of land registers, increasingly accessible to all parties, the adoption of mobile applications to facilitate commercialization efforts, and enhancing competition amongst lenders through easily accessible search tools.

As regard to the funding side, the long-term efficiency gains in its different stages in the life of a covered bond program with the adoption of already available technologies is considerable.

Starting with investor relations, the gradual migration to integrated communication platforms, and away from regular meetings will now be difficult to revert. Issuers, intermediaries, and investors highly value the efficiency of individual virtual meetings rather than the traditional carbon-generating, time-consuming roadshows. In this context, progress made in the last year in the use of video conferencing software is only the beginning of a revolution in communication technology, in which more immersive communication, immediate investor access to credit information and expert analysis will facilitate decision making.

The preparation and registration of covered bond programs, information memos, terms and conditions and other docs in the form of smart contracts in the blockchain, public or permissioned, out of which individual tranches will be drawn could simplify processes considerably and minimize market risk in the execution. The implementation of digital subscription agreements, comfort letters, guarantees, on simple standardized interfaces would facilitate their swift review and approval. The final documentation would immediately be accessible to all relevant parties, irrevocable, and even endowed with biometric controls to guarantee proper security for compliance purposes.

From the point of view of the bond distribution effort, the adoption of DLT technology in the primary market is not that evident. Strong credit analysis, market knowledge and good communication between issuers, banks and investors are hardly replaceable by a computer system. Nevertheless, the support provided by smart contracts could greatly enhance the experience of the distribution process, facilitating order management, allocations, hedging and the settlement of transactions in a quick, secure environment. This level of automation should reduce market risk for all participants involved and similarly help to minimize administration costs and heavy op-risk related capital charges. The tokenization of the settlement process, making delivery of the securities vs payment an almost instantaneous event, with minimal human intervention, should also reduce costs and minimize liquidity and operational risks associated with the transaction.

Liability servicing throughout the life of the securities, especially in an increasingly globalized bond market, would also benefit materially from a DLT upgrade from the simplification of coupon settlements to the automation of tax-related issues such as tax residency certifications. As regards to covered bonds, a well-designed, DLT based system could provide investors with the additional “double check” to confirm that the issuer is meeting cover pool requirements or complying with any ESG requirements derived either from an official taxonomy or commitments made on the issuer’s own ESG issuance framework.

Obviously, the implementation of a digital security issuance models at any scale is quite a formidable task. Currently, there is still a high level of fragmentation in this industry as banks, fintech companies and legal firms compete to address each step of the value chain. We can only hope that the different options that emerge, as in the case of European Covered bonds, share some common characteristics that provide the economies of scale necessary to achieve profitability hurdles. The ECB’s EDDI pan-European initiative to support the integration of the initial ecosystem for the issuance of securities is a clear example of the importance assigned by the European authorities to provide the market with an option for standardization, service provider neutrality and a level playing field among issuers. It conveys the Central Bank’s commitment to the increased digitalisation of this market.

The technological cornerstones for this technology to happen are already on the ground. Different issuances of digital securities settled against forms of tokenized or traditional cash have already been successfully carried out by several notable corporates and financial issuers. Designed by specialist in-house teams at institutions like LBBW, Santander, Société Générale, and a few select others, the transactions have been designed as a test bed for the new technology. Each of them was designed to achieve one step further in the digitalisation process.

It is important to mention that beyond the inherent technological complexity, one of the critical issues around the creation of digital securities is their recognition as legally binding liabilities of the issuer, bearing essentially the same terms and conditions of traditional bonds except for their representation as digital tokens. The new securities will also need to meet the same technical requirements as similarly ranking traditional bonds of the issuer, have a transparent, liquid secondary market with the participation of a meaningful number of counterparties. Thus, full deployment of the digital issuances will only take place when both issuers and investors and their legal advisors know that the bonds meet the legal requirements that guarantee adequate listing, trading and settlement.

The blockchain, however, is not the only technological development to watch that will influence our industry in the immediate future. Data science, the analysis of raw data at our disposal to make better business decisions, will increasingly filter into the market’s day-to-day activity. The application of data science from the asset pools, to better predict portfolio behavior will become an essential management tool for issuers. This will help issuers to analyze customer preferences, better estimating portfolio performance. As the medical diagnostics industry has turned to AI for the identification of anomalous cells, the banking industry will apply these same basic principles to analyze and manage market and credit risk, including the simulation of market reactions to unforeseen events.

The adoption of these technological advances is an evolution, not a revolution. There is already industry-wide collaboration among institutions and an open dialogue with regulators and legislators on to how to bring these developments safely into a market, where digital currencies have already become a common tool for investment, or speculation. Further collaboration between issuers, banks, IPA’s legal firms and the fintech industry will bring about, the emergence of common standards that will facilitate interoperability. The forerunner is already the payments industry, where we are quickly approaching higher levels of supervision from governments to all forms of tokenized cash payments. As a natural development, the securities industry should soon follow, as issuers are able to link their digital cash inflows and outflows, with a stable source of digital long-term liabilities.

Surely, incorporating the above-mentioned technology will be in many cases transformational, as the industry progresses into a simplified, highly automated environment. However, greater automation and streamlined costs simply cannot replace sound investment decisions by investors, good advice and execution on the part of the banks, strong supervision and regulation and good communication and skillful financial management on the part of the issuers. Therefore, the adoption of these new technologies should be regarded as an opportunity to provide our stakeholders with even more robust and cost-effective capital markets funding.