FinanceMortgagePropertiesRiskTokenised mortgages: A potential solution to prevent future housing crises

10 May 20240
Introduction

The 2008 financial crisis left an indelible mark on the global economy and the lives of millions of people. Triggered by the bursting of the US housing bubble, it triggered a ripple effect that had an enormous cost, both in economic and social terms. Today, fifteen years later, a growing number of experts are proposing an innovative solution involving blockchain technology to prevent such devastation from happening again: tokenized mortgages.
By converting mortgage terms into digitally executable smart contracts, proponents argue that this approach would inject much-needed transparency into the notoriously opaque mortgage industry.
Many industry professionals believe that tokenizing mortgages on public blockchains could make the terms observable, verifiable and enforceable, ultimately preventing a repeat of the catastrophic events of the late 2000s.

The problem of opacity

At the heart of the 2008 crisis was a pervasive lack of transparency on mortgage-backed securities (MBS). Financial institutions bundled home loans into these investment products and secured a AAA rating, despite the fact that they contained ‘subprime’ mortgages with a high risk of default. Investors were blind to the real quality of the underlying mortgages they were buying.
The reason the financial crisis occurred is that they could not observe and verify these payments. No one observed and monitored these payment processes.
This opacity allowed systemic risks to proliferate unchecked. When large numbers of mortgages began to default in regions like Florida, the broader impacts remained hidden from investors exposed to those mortgages through securitisation chains. By the time the reality emerged, it was too late: the housing bubble had burst and the financial crisis was inevitable.

Translating contracts into code

A fundamental problem is that traditional mortgage contracts are written in plain language on paper documents. Transforming complex legal terminology into machine-executable code requires human interpretation, which can vary drastically between analysts and programmers.
Differing interpretations of the same contractual wording have led to inconsistent implementations and a lack of standardisation.
The 2008 crisis highlighted the vulnerability of this process to human error and misalignment. A tokenized mortgage system, powered by smart contracts that directly encode negotiated terms, could help resolve these discrepancies.
For tokenisation to be successful, the token must be ‘intelligent’, which means that the financial protocol must be machine-readable and the code itself must be agreed upon by all parties involved. Otherwise, differences in interpretation and analysis will continue to exist.

The potential of smart contracts

How would tokenized mortgages work in practice? Imagine that all the terms of the mortgage – the principal amount, interest rate, payment schedule, late payment penalties and more – are transformed into an executable, blockchain-based smart contract mutually agreed upon by the lender and borrower. This ‘financial smart contract’ would be observable and verifiable by all counterparties in real time.
In the event of a default or late payment by the borrower, this event would be automatically reflected and enforced through the encoded contract. The tokenized collateral representing the mortgaged property could also be programmatically reassigned to the lender. The potential for human error or concealment would be eliminated.
Tokenisation could also streamline the securitisation process. Instead of repackaging numerous individual mortgage contracts, lenders could effortlessly bundle tokenised smart contracts into a mortgage-backed security at the ‘push of a button’. Investors would have transparent access to verify the terms and payment history of each underlying mortgage.
Some industry insiders argue that eliminating human interpretation could make smart contracts too rigid, lacking flexibility to negotiate terms. However, proponents argue that tokenized mortgages would be preceded by traditional initial negotiations, and the final digitised result would be an authoritative record of the agreed terms.
There are also concerns about the legal and regulatory hurdles of codifying contract law across jurisdictional boundaries. However exceptional, these challenges are not insurmountable, as evidenced by the growing institutional adoption of blockchain technology and digital assets by governments, banks and other major industries.

Steps towards an open standard

For tokenized mortgages to become a reality, advocates insist on the need for an open source technical standard to define digital ‘term sheets’ and enable interoperability between systems. This could accelerate the widespread adoption of the technology in the lending ecosystem.
Some members of the blockchain community are putting this goal into practice through initiatives such as the Algorithmic Contract Types Unified Standards (ACTUS) protocol. The protocol aims to establish the standards and definitions needed to encode various types of financial instruments, including mortgages.
Several companies are already experimenting with ACTUS-compliant products.

The way forward

Although tokenized mortgages have an attractive potential to bring transparency and standardisation to the mortgage industry, critical issues remain before this becomes a ubiquitous reality:
Scalability: Blockchain networks must evolve to securely handle the huge volumes of transactions and data involved in tokenizing millions of mortgage contracts.
Regulatory clarity: Government agencies must establish clear policies and legal frameworks for the recognition of tokenised financial instruments and smart contracts.
Interoperability: Technical standards such as ACTUS need universal industry consensus to enable interoperability of tokenized products across different blockchain platforms.
User experience: The complex process of mortgage tokenization needs to be distilled into user-friendly applications for mainstream adoption by lenders, borrowers and investors.
Despite these hurdles, the potential benefits of tokenization for restoring trust and resilience in the mortgage market drive continued innovation.
In the future, it will be crucial that all stakeholders – innovators, traditional financial institutions, regulators and the public – work together responsibly. If properly implemented together with appropriate policies, tokenized mortgages could be the key to avoiding a repeat of the 2008 crisis, making the mortgage industry observable, verifiable and enforceable for all.

Conclusions

The 2008 housing bubble crisis left an indelible scar, decimating the wealth and livelihoods of people around the world. Although the road to tokenized mortgages is fraught with technological, regulatory and user-experience hurdles, it represents a promising solution to repair the systemic risks inherent in the current system.
By digitising the terms of mortgages into transparent and mutually agreed smart contracts, lenders and investors could finally gain real-time visibility into the performance and risks of securitised loans and products. Automated enforcement of terms such as defaults and collateral reallocation could eliminate human error and concealment.
Realising this vision will require extensive multi-stakeholder cooperation and the definition of robust technical standards for the codification of tokenized debt instruments. Policymakers must also build clear regulations that allow for mass adoption while reducing potential abuses.
Despite the difficulties ahead, it is inevitable that we will face a major new crisis if we do not vigorously address the uncontrolled accumulation of opaque risks. The responsible adoption of tokenized mortgages offers an extraordinary opportunity to restore, or rather rebuild, credibility, accountability and trust in the foundations of the financial system.
By engaging with the innovations offered by blockchain technologies, such as tokenization, we can move closer to the dream of a more transparent, resilient and fair mortgage market. The path will undoubtedly be challenging, but the rewards we could achieve make our commitment essential.

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