Conspicuously absent from all the chatter around blockchain’s potential place in structured finance has been much discussion around the thorny matter of consensus. Consensus is at the heart of all distributed ledger networks and is what enables them to function without a trusted central authority. Consensus algorithms are designed to prevent fraud and error. With large, public blockchains, achieving consensus—ensuring that all new information has been examined before is universally accepted—is relatively straightforward. It is achieved either by performing large amounts of work or simply by members who collectively hold a majority stake in the blockchain.

However, when it comes to private (or “permissioned”) blockchains with a relatively small number of interested parties—the kind of blockchains that are currently poised for adoption in the structured finance space—the question of how to obtain consensus takes on an added layer of complexity. Restricting membership greatly reduces the need for elaborate algorithms to prevent fraud on permissioned blockchains. Instead, these applications must ensure that complex workflows and transactions are implemented correctly. They must provide a framework for having members agree to the very structure of the transaction itself. Consensus algorithms complement this by ensuring that the steps performed in verifying transaction data is agreed upon and verified.

With widespread adoption of blockchain in structured finance appearing more and more to be a question of when rather than if, SmartLink Labs, a RiskSpan fintech affiliate, recently embarked on a proof of concept designed to identify and measure the impact of the technology across the structured finance life cycle. The project took a holistic approach, looking at everything from deal issuance to bondholder payments. We sought to understand the benefits, how various roles would change, and the extent to which certain functions might be eliminated altogether. At the heart of virtually every lesson we learned along the way was a common, overriding principle: consensus is hard.

Why is Consensus Hard?

Much of blockchain’s appeal to those of us in the structured finance arena has to do with its potential to lend visibility and transparency to complicated payment rules that govern deals along with dynamic borrower- and collateral-level details that evolve over the lives of the underlying loans. Distributed ledgers facilitate the real-time sharing of these details across all relevant parties—including loan originators, asset servicers, and bond administrators—from deal issuance through the final payment on the transaction. The ledger transactions are synchronized to ensure that ledgers only update when the appropriate participants approve transactions. This is the essence of consensus, and it seems like it ought to be straightforward.

Imagine our surprise when one of the most significant challenges our test implementation encountered was designing the consensus algorithm. Unlike with public blockchains, consensus in a private, or “permissioned,” blockchain is designed for a specific business purpose where the counterparties are known. However, to achieve consensus, the data posted to the blockchain must be verified in an automated manner by the relevant parties to the transaction. One of the challenges with the data and rules that govern most structured transactions is that it is (at best) only partially digital. We approached our project with the premise that most business terms can be translated into a series of logical statements in the form of computer code. Translating unstructured data into structured data in a fully transparent way is problematic, however, and limitations to transparency represent a significant barrier to achieving consensus. In order for a distributed ledger to work in this context, all transaction parties need to reach consensus around how the cash will flow and numerous other business rules throughout the process.

A Potential Solution for Structured Finance

To this end, our initial prototype seeks to test our consensus algorithm on the deal waterfall model. If the industry can move to a process where consensus of the deal waterfall model is achieved at deal issuance, the model posted to the blockchain can then serve as an agreed-upon source of truth and perpetuate through the life of the security—from loan administration to master servicer aggregation and bondholder payments. This business function alone could save the industry countless hours and effectively eliminate all of today’s costs associated with having to model and remodel each transaction multiple times.

Those of us who have been in the structured finance business for 25 years or more know how little the fundamental business processes have evolved. They remain manual, governed largely by paper documents, and prone to human error.

The mortgage industry has proven to be particularly problematic. Little to no transparency in the process has fostered a culture of information asymmetry and general mistrust which has predictably given rise to the need to have multiple unrelated parties double-checking data, performing due diligence reviews on virtually all loan files, validating and re-validating cash flow models, and requiring costly layers of legal payment verification. Ten or more parties might contribute in one way or another to verifying and validating data, documents, or cash flow models for a single deal. Upfront consensus via blockchain holds the potential to dramatically reduce or even eliminate almost all of this redundancy.

Transparency and Real-Time Investor Reporting

The issuance process, of course, is only the beginning. The need for consensus does not end when the cash flow model is agreed to and the deal is finalized. Once we complete a verified deal, the focus of our proof of concept will shift to the monthly process of investor reporting and corresponding payments to the bond holders.

The immutability of transactions posted to the ledger is particularly valuable because of the unmistakable audit trail it creates. Rather than compelling master servicers to rely on a monthly servicing snapshot “tape” to try and figure out what happened to a severely delinquent loan with four instances of non-sufficient funds, a partial payment in suspense, and an interest rate change somewhere in the middle. Putting all these transactions on a blockchain creates a relatively straightforward sequence of transactions that everyone can decipher.

Posting borrower payments to a blockchain in real time will also require consensus among transaction parties. Once this is achieved, the antiquated notion of monthly investor reporting will become obsolete. The potential ramifications of this extend to timing of payments to bond holders. No longer needing to wait until the next month to find out what borrowers did the month before means that payments to investors might be accelerated and, in the private-label security markets, perhaps even more often than monthly. With real-time consensus comes the possibility of far more flexibility for issuers and investors in designing the timing of cash flows should they elect to pursue it.

This envisioned future state is not without its detractors. Some ask why servicers would opt for more transparency when they already encounter more scrutiny and criticism than they would like. In many cases, however, it is the lack of transparency, more than a servicer’s actions themselves, that invite the unwanted scrutiny. Servicers that move beyond reporting monthly snapshots and post comprehensive loan activity to a blockchain stand to reap significant competitive advantages. Because of the real-time consensus and sharing of dynamic loan reporting data (and perhaps of accelerated bond payments, as suggested above) investors will quickly gravitate toward deals that are administered by blockchain-enabled servicers. Sooner or later, servicers who fail to adapt will find themselves on the outside looking in.

Less Redundancy; More Trust

Much of blockchain’s appeal is bound up in the promise of an environment in which deal participants can gain reasonable assurance that their counterparts are disclosing information that is both accurate and comprehensive. Visibility is an important component of this, but ultimately, achieving consensus that what is being done is what ought to be done will be necessary in order to fully eliminate redundant functions in business processes and overcome information asymmetry in the private markets.  Sophisticated, well-conceived algorithms that enable private parties to arrive at this consensus in real time will be key.

One of the enduring lessons of our structured finance proof of concept is that consensus is necessary throughout a transaction’s life. The market (i.e., issuers, investors, servicers, and bond administrators) will ultimately determine what gets posted to a blockchain and what remains off-chain, and more than one business model will likely evolve. As data becomes more structured and more reliable, however, competitive advantages will increasingly accrue to those who adopt consensus algorithms capable of infusing trust into the process. The failure of the private-label MBS market to regain its pre-crisis footing is, in large measure, a failure of trust. Nothing repairs trust like consensus.