finance

Current mortgage term sheets lack transparency because they are not machine-readable, according to Ralf Kubli, board member of the Casper Association.

The 2008 financial crisis was a devastating time for many, as the collapse of the United States real estate market caused ripple effects impacting the employment and livelihoods of millions of people.

According to TheStreet, one of the chief causes of the crisis was the opaqueness 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 bundles were passed off as top-rated securities when they were sold to investors.” These investors didn’t necessarily understand that they were buying low-quality securities, which were likely to be defaulted on, leading to massive losses once the crisis revealed the truth.

According to Ralf Kubli, a board member of the Casper Association, this fundamental problem that sparked the crisis still exists, but it can be fixed through blockchain technology.

Kubli hails from both the traditional finance sector and the crypto industry. He has 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 Casper Association board, a nonprofit promoting the Casper blockchain network.

He told Cointelegraph that tokenization of 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 arose 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. Afterward, 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 small and can be resolved through negotiations. However, situations like the 2008 financial crisis show that disagreements can sometimes be considerable, causing catastrophic results. As Kubli explained:

“You have a written contract that then gets 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, no one really remembers exactly what they programmed and how they programmed it […] and that gives us the world that 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 claimed that developers need to be careful with 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 isn’t any better than what we already have in traditional finance.

In his view, for tokenization to succeed, the tokens have to be “smart,” meaning the financial agreement has to be machine-readable and the various parties involved must agree to 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 already accept machine-readable contracts through decentralized finance (DeFi) apps 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 apps require the borrower to put up cryptocurrency as collateral to secure the loan, and the value of the collateral has to be greater than the loan amount. Kubli argued that this limitation prevents DeFi from competing with traditional finance. “In DeFi, you’re not having cash flows over time, in DeFi you’re having collateralized or overcollateralized loans only” but “The world runs 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 into under-collateralized and overcollateralized loans.

However, Kubli emphasized that this only solves the problem of “underwriting the creditworthiness of a counterparty.” It doesn’t allow a stream of cash flows over time to be tokenized.

Digital term sheets

To ensure that the terms of a mortgage are transparent, Kubli believes that a “machine-readable, machine-executable and machine-auditable native digital term sheet” has to be created and agreed upon by all of the counterparties to the mortgage. This agreement must be written as a mathematical formula and entered into 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 through 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 were trading 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 that picked up all these mortgages were not paying […] nobody observed these payment flows […] but the point here is that gives you smart financial contracts which are a completely different animal, then, for the future of finance.”

To the extent that loans have collateral related to them, these can also be tokenized and locked inside smart contracts. For example, the tokenized title to a home or a car can be put inside a smart contract and given to the lender after a certain period should the buyer default.

Once a loan is put into a smart financial contract, Kubli says it can be securitized “with the push of a button.”

For example, say a bank has made loans to plumbers and painters throughout the United States, and there has been 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 lots of work. The fund should be able to easily purchase 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 view, 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 attempting to produce ACTUS-compliant financial products. The team has already produced loans for two clients, one of which is reportedly a major leasing 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 being “used productively” by the clients yet, but Nucleus is seeking to find new clients that can benefit from the technology.

Other tokenized mortgage solutions

Kubli is not the only expert to tout tokenized mortgages as the solution to financial crises. Security Token Advisors’ head of research, Peter Gaffney, has written a blog post making a similar argument. He claims that if mortgages undergo “double tokenization,” with mortgage tokens wrapped inside of a larger token to create a tokenized mortgage-backed security, this will “provide transparency to not only the pricing 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 that are working to bring the proper technology to this industry” and will announce these initiatives “as they come to fruition.”

Cointelegraph has reached out to Security Token Advisors for comment but has not received 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 had become the leading securitized blockchain asset. In June, Citigroup released research suggesting that an increasing number of mortgages may be collateralized with crypto assets, although the investment bank warned that this practice might carry heightened risks.