Securitization (ABS/MBS) Basics【Basic Understanding of RWA Tokenization: Part I】
This week we will discuss "Fundamentals of RWA Tokenization"
Good morning.
I am mitsui, a web3 researcher.
Every Saturday and Sunday at noon, we update the web3 Basics Report. This week we will discuss the "Basics of RWA Tokenization". Please read to the end!
1. Introduction
2. players and basic structure
3. Role of SPV
4. waterfall (fund allocation rules)
5. credit enhancement
6. summary
1. introduction
Why you should learn about "securitization" before understanding RWA tokens
In recent years, there has been a rapidly growing interest in Real World Assets (RWA) tokens in the web3 sector. There is a growing effort to tokenize traditional financial assets on the blockchain to create new liquidity and investment opportunities. However, to understand the essence of RWA tokens, it is essential to have a deep understanding of the traditional "securitization" mechanism that underlies them.
Securitization is a financial technology that began in the U.S. mortgage market in the 1970s and has since spread throughout the world. The system of bundling assets, issuing securities based on the cash flow generated from those assets, and distributing them to investors by subdividing the risk is the foundation of modern finance.
Although various reforms were made after the financial crisis of 2008, the basic idea and technology continues to evolve today, and the RWA token is truly an attempt to encode this idea of securitization with blockchain technology.
A mechanism to bundle and securitize assets to visualize and distribute risk
Securitization is a financial technology that bundles assets such as loan receivables and real estate held by banks and financial institutions and issues securities backed by the cash flows generated from these assets.
The crux of this mechanism is to diversify the risk of individual assets by pooling them and dividing them into multiple securities (tranches) with different risk and return according to the needs of investors with different risk preferences.
Traditionally, when a bank lent out a mortgage loan, the credit risk remained on the bank's balance sheet. Through securitization, however, banks can now sell the loans to third parties and transfer the risk. This allows banks to secure new sources of financing and gives investors the opportunity to invest in a diversified portfolio.
The breakthrough of this system lies in the "visualization of risk" and "automatic distribution by contract. The system discloses detailed risk information on individual loans, which was previously buried within the bank, and mechanically distributes the collected principal and interest to investors according to predetermined contractual conditions. This idea of transparency and automation is the foundation of the later RWA tokens.
2. players and basic structure
Securitization transactions are an ecosystem composed of multiple specialized players. Each plays a specific role, and as a whole, provides efficient risk diversification and financing.
Originator (bank/non-bank)
The originator is the initial holder of the assets subject to securitization. This includes the bank that lent the mortgage, the non-bank that provided the auto loan, the credit card company, and the educational financial institution that handles student loans. The originator has a direct relationship with the customer and manages the entire process from credit screening to asset origination.
The originator's role goes beyond a simple asset sale. After securitization, they are required to "risk retain" a portion of the assets in many cases and have ongoing responsibility for the quality of the assets. They also play an important role in maintaining relationships with borrowers and in providing information to investors in securitized products.
SPV
A Special Purpose Vehicle (SPV) is the legal instrument at the heart of a securitization transaction. The most important feature of an SPV is its "bankruptcy protection" function. Even if the originator fails, the assets transferred to the SPV are legally protected and the interests of investors are protected.
SPVs are usually special purpose legal entities formed solely for securitization transactions, and their activities are strictly limited. They are not allowed to engage in any other business and only hold assets, issue securities, and distribute the cash flows generated therefrom. This restriction minimizes the risk of the SPV itself going bankrupt.
Arranger Servicer Trustee
Arrangers are investment banks and securities firms responsible for the overall design and structuring of securitization transactions. They provide comprehensive coordination from upstream to downstream of the transaction, including asset selection, design of the tranche structure, and development of the sales strategy to investors. They must have the expertise to design securities that meet the needs of the market while satisfying complex legal, tax, and regulatory requirements.
Servicers are responsible for managing assets after securitization. They collect principal and interest from borrowers, manage delinquent receivables, and execute legal proceedings as needed. In many cases, the originator itself doubles as the servicer, but in others, the servicing is outsourced to a specialized servicing company. The quality of the servicer's operations directly affects the ultimate performance of the securitization product, making its selection and supervision extremely important.
The Trustee is a fiduciary that oversees the operations of the SPV on behalf of the investors' interests. It monitors compliance with the terms of the agreement and exercises its rights on behalf of investors when necessary. It acts as a "watchdog" in securitization transactions, helping to prevent conflicts of interest and ensure transparency.
Investor (Senior/Mezzanine/Equity)
One of the core innovations in securitization is the creation of multiple securities (tranches) with different risks and returns from a single pool of assets. Investors in securitized products invest in different tranches depending on their risk appetite.
The basic principle of tranche design is the "trade-off between risk and yield. By accommodating the order of loss absorption and the priority order of interest payment, securities can be supplied simultaneously to meet the diverse needs of investors.
The order of loss absorption is usually designed in the following order: equity (most subordinated), mezzanine (intermediate), and senior (highest priority). In the event of a loss to the asset pool, the equity tranche absorbs the full amount first, followed by the mezzanine tranche if that is not enough, and finally to the senior tranche.
On the other hand, the order of yields is opposite to the loss absorption order. The equity bearing the highest risk is entitled to the highest yield, and the safest senior is entitled to the lowest yield. This design allows risk-averse investors to obtain stable low yields and risk-preferring investors to obtain high return potential.
Senior investors are primarily institutional investors such as pension funds and insurance companies seeking stable returns. These investors place the highest priority on safety of principal and are satisfied with relatively low returns.
Mezzanine investors are investors who accept higher risk in exchange for higher returns than seniors. Hedge funds, private equity funds, and some insurance companies and asset managers are typical investor groups.
Equity investors invest in the portion with the highest return potential instead of the highest risk. Often the originator itself owns the equity portion and maintains an ongoing incentive for asset quality.
3. role of SPV
TRUE SALE
In securitization transactions, "true sale" is an extremely important legal and accounting concept. When an asset transfer from an originator to an SPV is legally recognized as a "true sale," the asset is completely removed from the originator's balance sheet. This allows the originator to realize accounting asset reduction benefits as well as regulatory capital savings.
Multiple legal requirements must be met to qualify as a genuine sale. First, ownership of the assets must be fully transferred to the SPV. Second, the originator must not continue to retain substantial control over the transferred assets. Further, the transfer consideration must be based on fair market value.
Accounting standards also have strict requirements for the recognition of a true sale. After the 2008 financial crisis, these requirements have become more stringent, and off-balancing requirements have also been strengthened.
bankruptcy remoteness
Bankruptcy segregation is a core feature of investor protection in securitization transactions. Even if the originator fails, assets properly transferred to the SPV are legally protected from pursuit by the originator's creditors. This protection insulates investors from the credit risk of the issuer and allows them to make investment decisions based purely on the quality of the underlying assets.
In order to achieve bankruptcy isolation, great care must be taken in the establishment and operation of the SPV, which must be established as an independent legal entity and strictly limit its activities to those related to securitization transactions. In addition, a system must be established whereby the originator cannot exercise effective control over the SPV's decision-making.
In practice, to strengthen bankruptcy segregation, SPVs are subject to various safeguards, such as the appointment of independent directors, restrictive covenants on business activities, and strict segregation of duties. In addition, professional verification of the effectiveness of bankruptcy segregation is generally conducted through a legal opinion.
4. waterfall (fund allocation rules)
Cost → Senior → Mezza → Equity Priority
The waterfall is the key rule that defines the order in which funds collected from the asset pool are allocated in a securitization transaction. These allocation rules are contractually defined in detail at the inception of the transaction and then mechanically applied throughout the investment period. Transparency and predictability allow investors to make their own investment decisions appropriately.
In a typical waterfall, the first priority is to pay the various costs associated with the transaction. Servicer fees, trustee fees, rating agency fees, audit fees, legal fees, and other expenses necessary for the continuation of the transaction are ensured to ensure the stable operation of the securitization product.
After expenses are paid, the remaining funds are directed to distribution to investors. First, interest payments and principal redemptions are made on the senior tranche, then the mezzanine tranche, and finally the equity tranche. Within each tranche, interest payments generally take priority over principal redemptions.
Automatic distribution change by trigger (OC/IC test)
The waterfall incorporates various trigger provisions to maintain the health of the asset pool. The most important triggers are the Over-Collateralization (OC) and Interest Coverage (IC) tests. If these tests are violated, the normal waterfall is altered and a more conservative allocation of funds is implemented.
The OC test monitors the ratio of asset pool balance to outstanding securities. If this ratio falls below a predetermined level, additional credit enhancement is deemed necessary and funds normally allocated to equity are redirected to accelerate principal redemptions. This will maintain the level of senior and mezzanine protection.
The IC test monitors the ratio of interest income to interest expense. If interest income from the asset pool declines to the point where it cannot cover interest payments on outstanding securities, the allocation to equity will be suspended to make up the shortfall. In some cases, interest payments to mezzanines may also be suspended.
These trigger mechanisms act as a "self-healing" function for the securitized product. They enhance investor protection for the top tranche by detecting early deterioration in asset quality and automatically switching to a more conservative allocation of funds. For investors, this means that they receive protection based on objective criteria without the intervention of human judgment.
5. credit enhancement
Internal complements (OC, RS, excess spread)
Credit enhancement in securitization transactions is an important mechanism to enhance the credit quality of the securities issued and to achieve better ratings and lower financing costs. Internal credit enhancement is characterized by the fact that it is credit enhancement generated within the transaction structure and does not rely on external guarantees or insurance.
Overcollateralization (OC) is the most basic internal complementation technique. It creates a credit enhancement effect by setting the value of the asset pool higher than the total amount of securities to be issued. For example, if ¥9.5 billion of securities are issued for an asset pool of ¥10 billion, OC worth ¥500 million will be provided. This OC effectively acts as an equity tranche, absorbing the initial loss.
The Reserve Fund (RS) is a cash reserve that is accumulated at the beginning of the transaction or during the investment period. A portion of the recoveries from the asset pool is set aside separately to provide for future losses. The reserve fund is typically invested in highly rated short-term securities or deposits and maintains liquidity that can be used immediately to cover losses if needed.
The excess spread is the excess income generated as the difference between the interest income from the asset pool and the interest payments and expenses to security holders. This excess spread is first used to cover the current period's credit losses, and any residual is used to build up the reserve fund or allocated to equity. The existence of a stable excess spread is an important indicator of a securitized product's ability to provide sustainable credit enhancement.
External Completion (Guarantee, Insurance, Liquidity Supply)
External supplements are credit enhancements provided by third parties and are used to further improve the creditworthiness of a transaction. However, since it depends on the creditworthiness of the external supplement provider, its selection and setting of contractual terms are important.
A guarantee is a mechanism whereby a financial institution or guarantee company guarantees the payment of principal and interest on a security. In particular, guarantees by government financial institutions and highly rated banks can significantly improve the creditworthiness of securitized products. In mortgage securitization, the guarantee program by the Government Housing Loan Corporation (formerly Japan Housing Finance Agency) plays an important role.
Insurance is a product in which insurance companies cover credit losses on securitized products. Specialized insurers, known as monoline insurers, once played a major role in insuring securitized products, but many failed during the 2008 financial crisis and their role is now greatly reduced.
Liquidity provision is a mechanism for dealing with short-term cash flow discrepancies. The bank provides a commitment line to provide liquidity in the event of a temporary cash shortage. This allows the bank to respond to discrepancies between the timing of collections from the asset pool and the timing of interest payments on the securities. Although liquidity provision does not cover credit risk, it is an essential function for the stable operation of securitized products.
6. summary
Essence of securitization = "vessel × risk distribution × rules"
In a nutshell, the securitization mechanism described in detail in this paper can be described as a combination of "vessel × risk distribution × rules".
The interaction of these three elements creates a flexible and efficient financing and investment mechanism that cannot be achieved through traditional financing.
The "vessel," the SPV, protects investors through bankruptcy segregation and ensures asset transfer through a true sale. This legal vessel makes it possible to invest purely based on the quality of the assets, without relying on the creditworthiness of the originator.
Risk sharing" is achieved through a tranche structure. By creating multiple securities with different risks and returns from a single pool of assets, we can meet diverse investor needs. Efficient risk allocation can be achieved by understanding the characteristics of senior, mezzanine, and equity securities and by taking appropriate credit enhancement measures.
The "rules" are embodied by the detailed contractual provisions represented by the waterfall. Transparency and predictability are ensured by clarifying in advance the rules of conduct at every juncture, including the order in which funds are allocated, trigger clauses, early redemption conditions, and so on. The mechanical application of these rules minimizes the intervention of human judgment and ensures fair and efficient operations.
A system that visualizes risk and automatically allocates it according to contract
The greatest innovation that securitization has brought to the financial markets is the "visualization of risk.
The risks of individual assets, previously buried and invisible in banks' balance sheets, are now made explicit to investors through detailed disclosure. A vast amount of data, including borrower attributes, collateral characteristics, geographic diversification, and vintage information, is systematically organized and made available for investor analysis.
Even more important is the "automatic allocation according to contract". Through waterfall and trigger clauses, funds collected from the asset pool are mechanically distributed without the need for human judgment. This automation eliminates conflicts of interest, improves processing efficiency, and ensures transparency. Investors are able to earn returns based purely on the terms of the contract, without being subject to complex human relationships or political decisions.
Post-financial crisis reforms have made this transparency and automation even more sophisticated. Standardized data formats, machine-readable disclosure materials, and ongoing monitoring systems allow investors to efficiently perform sophisticated analyses. Risk retention requirements have also ensured the continued involvement of originators, improving overall market quality.
This philosophy is very compatible with blockchain
The basic ideas of securitization - transparency, automation, and mechanical processing based on rules - are in fact extremely compatible with the characteristics of blockchain technology and smart contracts. Elements such as prior clarification of contract terms, automation of execution, and ensuring transparency of processing are the very values realized through coding.
In traditional securitization, transparency and efficiency have been achieved through complex contract documents and numerous intermediaries. However, by codifying these mechanisms, further transparency, reduced processing costs, and real-time processing can be achieved. Digital technology has the potential to create added value by automatically executing waterfalls, instantly triggering trigger clauses, and providing instantaneous information to investors.
Blockchain technology will also enable smaller lots, 24-hour trading, and global access, which have been difficult to achieve with traditional securitization. Smart contracts will also streamline the process of verifying qualified investors, recording transaction history, and transferring ownership.
Thus, the combination of the basic idea of securitization and blockchain technology has the potential to bring about structural innovation in the capital markets, rather than merely the IT adaptation of existing operations. In the second part, we will explain in detail how this securitization philosophy will be embodied in the form of RWA tokens.
Disclaimer：I carefully examine and write the information that I research, but since it is personally operated and there are many parts with English sources, there may be some paraphrasing or incorrect information. Please understand. Also, there may be introductions of Dapps, NFTs, and tokens in the articles, but there is absolutely no solicitation purpose. Please purchase and use them at your own risk.
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mitsui
A web3 researcher. Operating the newsletter "web3 Research" delivered in five languages around the world.
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