Collateralizations: tried, true and tested
Collateral occurs when a company behind financial assets obtains a loan, such as a line of credit, in exchange for the lender’s guarantee of a security interest in the assets. In the majority of loans, the value of the asset is received by collateral. This is how the Federal Reserve Banks, Federal Home Loan Banks, and many leasing companies provide funds. Collateralisations are proven and tested and are an important driver of capital market activity.
Here is a typical workflow for collateralization:
- A two-party agreement occurs between the originator/obligor and the bank/secured party, which is most often a warehouse or line of credit lender.
- The originator pledges digital assets as collateral for funds borrowed from the bank/secured party.
- The collateral is transferred to a safe deposit box under the administration of the bank/secured party. The bank/secured party has direct control over the collateral.
- Upon repayment of debt by the originator/debtor, the bank/secured party returns the collateral to the control of the originator/debtor under its collateral agreement.
- In the event of default by the principal/debtor, the bank/secured creditor exercises its right to the guarantee under its direct guarantee agreement with the principal/debtor.
The Role of Electronic Collateral Control Agreements
An Electronic Control Collateral Agreement (ECCA) protects the lender’s principal for funds loaned to an originator. eOriginal supports over 678 ECCAs, of which about half are direct with lenders and the rest are securitizations. Although ECCA flow may seem similar to warranty, there are some key differences.
First, let’s give some information about ECCAs. An ECCA is a multi-party agreement between eOriginal, a Customer and certain Affiliate Customers, and a third party, such as a secured creditor or fiduciary, with a unilateral right to take control of the collateral. On instructions from the secure party, eOriginal may terminate senders’ access to the eVault and, through spring control, simultaneously transfer access and control to the secure party.
When the debtor holds the security, there is always an element of risk that he will not perform or will become a bad actor. This has become a bigger concern as digital deals have grown in popularity. As a result, eOriginal has created ECCAs to enable rapid adoption of digital transactions and digital collateral security interests by lenders without them having to negotiate or implement a software license or administer operations.
Another benefit of an ECCA is that it provides originators and lenders with a range of simple to complex financial structures to manage digital assets without friction. ECCAs are available in different formats (Standard, Letter, Servicer, Purchase Agreement, Mecca and Mecca Joiner), depending on the roles of the parties and the interests protected.
The advantages of securitization
Securitization – the process of bundling certain types of assets into interest-bearing securities – is one of the many areas of capital markets that are benefiting from digital transformation. Digitally creating the underlying assets and then securitizing those assets increases efficiency, improves transparency, and enhances security. It also delivers better experiences for originators, issuers, rating agencies, trustees, investors, law firms, underwriters, and regulators. Most securitizations enabled by the Wolters Kluwer eOriginal ecosystem included an ECCA to protect investor rights.
Financial institutions derive many benefits from securitization. They can reduce risk by removing debt from their balance sheets. They can increase regulatory capital – the assets that regulations require institutions to hold to remain solvent. And they can get higher credit scores and lower financing costs.
In most cases of securitization, a legal entity known as a special purpose vehicle (SPV) purchases the assets from the originator, creates securities by pooling the assets, and sells the asset-backed security (ABS) to the investors. In the context of securitization, the SPV is important because it is far from bankruptcy. The SPV helps protect investors by isolating the assets from the risks of the originator who created or owned the assets. In the event of default by the originator, the cash flows from the securitized assets remain the property of the SPV and the investor retains the value of the asset. The certainty of future cash flows makes it advantageous for investors.
Issuers are also interested in SPVs primarily because they offer some of the most efficient means of financing available today. An SPV can make it possible to unbundle the credit quality of the originator. So, if you are a low-rated originator with poor credit quality, it will be profitable to fund your high-quality prime loans through securitization. Issuers may also be interested because of liquidity and balance sheet diversification, but funding efficiency is often the primary reason.
The evolution of digital securitizations
eOriginal provides the platform and legal expertise to all participants to enable fully digital securitizations. A digital securitization can range in value from $80 million to over $1 billion and have loan volumes between 1,500 and 300,000, depending on the type of loans. A digital securitization may also include:
- Digital Loans that have been created or transferred to the eOriginal platform
- One or more additional safes set up and finalize a securitization
- A opinion of the legal adviser of the issuer supported by an eOriginal system description
- Evaluation by a credit rating agency – all five major agencies have accepted the eOriginal platform
- Expert legal assistance of eOriginal – internal advice and interaction with the legal advisor of the issuer and the insurer
- In the majority of eOriginal securitizations, a ECCA is used to protect investors
Digital securities are poised to gain popularity as more originators, asset managers and investors recognize their benefits. Market participants who invest in the right enabling technology will reduce the time and cost of securitization, increase transparency, maintain and even improve regulatory compliance, and mitigate risk.
Invest in the right digital platform
The right eClosing platform will give lenders leverage and scale in the secondary market. Look for an eClosing platform widely accepted by secondary market players such as warehouse lenders, custodians, and investors. The technology should enable seamless integration with and access to these market players.
Lenders who invest in digital platforms to convert assets for more transparent trading will reap many benefits, including faster securitization, greater liquidity and improved transparency. In doing so, they will also position themselves to compete and win in an increasingly digitized financial services industry.