In a few words, securitization is the process of transforming an asset – usually an illiquid one – into an investable security. These securities can then be easily traded on capital markets. The process benefits both the financing companies and the investors. This article introduces the process, the benefits of the practice, as well as the inherent risks for investors.
Securitization is the financial process by which illiquid assets, or groups of assets, are pooled together and transformed into a set of tradable securities. The underlying assets typically consist of receivables like mortgages, credit card debts, or any other revenue-generating contracts. The primary aim is to enhance liquidity in the market by converting these otherwise immovable assets into securities that investors can buy and sell. This not only frees up capital for the original holders of the assets but also diversifies investment options for market participants.
Securitized products result from the securitization process and include a wide range of asset-backed securities (ABS), mortgage-backed securities (MBS), and commercial mortgage-backed securities (CMBS), among others. These types of products are the most common and the largest in terms of volumes invested. Each of these products is backed by a pool of assets or loans, providing a layer of security to investors. The cash flows generated by the underlying assets, such as mortgage payments, are passed through to investors, offering a return on investment.
Other more exotic assets such as tangible assets (real estate, rare collectibles, etc) can also be securitized. The attractiveness of securitizing these assets lies in a unique value proposition: they often appreciate over time and are less correlated with traditional financial markets, offering diversification benefits to investors’ portfolios. By converting the ownership or revenue streams of these tangible assets into tradable securities, securitization allows investors to gain exposure to assets that were previously out of reach due to high entry barriers or lack of liquidity.
The securitization process can be broadly divided into several steps:
Securitization offers several benefits to both the financial markets and the economy:
While securitization presents attractive opportunities, it also carries inherent risks for investors:
Tokenization — the process of converting rights to an asset into a digital token on a blockchain — complements securitization by adding layers of efficiency and transparency. When traditional securitized products are tokenized, they are broken down into digital tokens that represent fractional ownership or interest in the underlying assets. This combination leverages blockchain technology to streamline the securitization process, reduce intermediary costs, and enhance the liquidity of traditionally illiquid assets like real estate or art even further.
Moreover, tokenization introduces new levels of transparency and security, with blockchain’s immutable ledger ensuring that ownership and transaction histories are accurately recorded and easily verifiable. One could imagine a securitized product where the underlying assets cash flows are also fully transparent on the blockchain, thus reducing opacity.
Finally, by lowering the minimum investment thresholds through fractional ownership, a wider range of investors can participate in markets previously dominated by institutional investors.
In conclusion, securitization is a double-edged sword in the financial landscape. It plays an important role in enhancing liquidity, diversifying risk, and broadening investment opportunities. but it also requires a thorough understanding of the underlying mechanisms and risks. Investors diligence is highly recommended!
