Collateralizations: Tried, true and tested
Collateralization occurs when a company originating financial assets obtains a loan, such as a line of credit, in exchange for the funder pledging a security interest in the assets. In the majority of loans, asset value is received through collateralization. This is how the Federal Reserve Banks, the Federal Home Loan Banks, and many leasing finance companies provide funding. Collateralizations are tried, true, and tested and are a significant driver of capital markets activity.
Here’s a typical workflow for collateralization:
- A bi-party agreement occurs between the originator/debtor 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 an eVault under the administration of the bank/secured party. The bank/secured party has direct control of the collateral.
- Upon repayment of the debt by the originator/debtor, the bank/secured party releases the collateral back to the control of the originator/debtor under their security agreement.
- In the event of default by the originator/debtor, the bank/secured party exercises its right to the collateral under its direct security agreement with the originator/debtor.
The role of Electronic Collateral Control Agreements
An electronic collateral control agreement (ECCA) protects the lender’s capital for funds loaned to an originator. eOriginal supports over 678 ECCAs, approximately half are direct with lenders, and the remaining are securitizations. While the ECCA flow may seem similar to collateralization, some key differences exist.
First, let’s provide some background on ECCAs. An ECCA is a multi-party agreement between eOriginal, a customer and certain customer affiliates, and a third party, such as a secured party or trustee, with a unilateral right to take control of the collateral . Upon instructions from the secured party, eOriginal can terminate the originators’ access to the eVault and, through springing control, simultaneously transfer access and control to the secured party.
When the debtor holds the collateral, there is always an element of risk that they will not perform or become a bad actor. This became a more significant concern as digital agreements grew in popularity. As a result, eOriginal created ECCAs to enable the rapid adoption of digital transactions and security interests in digital collateral 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 Joinder), depending on the parties’ roles and protected interests.
The advantages of securitization
Securitization – the process of pooling certain types of assets into interest-bearing securities – is one of the many areas in capital markets that benefit from digital transformation. Digitally creating the underlying assets and then securitizing those assets increases efficiency, improves transparency, and strengthens security. It also delivers better experiences to originators, issuers, rating agencies, trustees, investors, legal firms, underwriters, and regulators. Most securitizations enabled by the Wolters Kluwer eOriginal ecosystem included an ECCA to protect the rights of the investors.
Financial institutions realize numerous advantages through 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 achieve higher credit ratings and reduce funding costs.
In most securitization cases, a legal entity known as a special purpose vehicle (SPV) purchases the assets from the originator, creates securities by pooling the assets together, and sells the asset-backed security (ABS) to investors. In the context of securitization, the SPV is important because it is bankruptcy remote. The SPV helps protect investors by isolating the assets from the risks of the originator that created or owned the assets. If the originator defaults, cash flows from the securitized assets remain the property of the SPV, and the investor retains the asset value. The certainty of future cash flow makes it beneficial to investors.
Issuers are also interested in SPVs primarily because they provide some of the most efficient means of funding available today. An SPV can allow the credit quality of the originator to be de-linked, so if you’re a low-rated originator with poor credit quality, it will be cost-effective to finance your high-quality prime loans through securitization. Issuers may also be interested because of balance sheet liquidity and diversification, but efficient funding is often the main reason.
The evolution of digital Securitizations
eOriginal provides the platform and legal expertise for all participants to enable fully digital securitizations. A digital securitization can range in value from $80M 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 were originated on or transferred to the eOriginal platform
- One or more additional eVaults to stage and complete a securitization
- An issuer’s counsel opinion supported by an eOriginal system description
- Rating by a credit rating agency – all five major agencies have accepted the eOriginal platform
- Expert legal support from eOriginal – internal counsel and interaction with issuer and underwriter’s legal counsel
- In the majority of eOriginal securitizations, an ECCA is utilized to protect the investors
Digital securities are poised to grow in popularity as more originators, asset managers, and investors recognize their advantages. Market players that 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.
Investing in the right digital platform
The right eClosing platform will give lenders heft and scale in the secondary market. Look for an eClosing platform that’s widely accepted by secondary market players such as warehouse lenders, custodians, and investors. The technology should support smooth integration with and access to these market participants.
Lenders that invest in digital platforms to convert assets for more seamless trading will gain multiple benefits, including faster securitization, greater liquidity, and improved transparency. In the process, they’ll also position themselves to compete and win in an increasingly digitized financial services industry.