With the legitimacy of loans backing asset based securities coming under scrutiny in the wake of high profile frauds, the structured finance industry is taking stock and mulling its options for fraud mitigation.
The threat of fraud — or the perception of its prevalence in the industry, at least — is widespread enough for the industry’s main trade group, the Structured Finance Association, to commission an anti-fraud task force, which released the findings of its Fraud Mitigation Survey on Tuesday (31 March). Double-pledging was a primary worry for respondents, with 45% citing it as their top concern.
The survey comes as the industry is also looking more closely at an oft-touted solution: tokenization.
Several respondents recommended the industry adopt an “authoritative ‘golden source’ collateral record,” effectively describing what proponents of tokenized assets say the blockchain provides — an immutable, accessible record that would make it more difficult, if not impossible, for bad actors to double pledge or fake assets.
“Those kinds of solutions are probably the best ways of avoiding some of that double pledging risk, if you've kind of built the systems the right way,” said a structured finance attorney at a major US law firm. “We're seeing more clients ask questions about how to do that.”
But not everyone is sold on whether tokenization is a the right approach or if change is even necessary. Several buy-side sources have shrugged off the Tricolor Holdings and First Brands Group frauds as the inevitable but ultimately minimal cost of doing business. They view these cases as isolated, random and not numerous enough to warrant ongoing concern or an overhaul of industry standards.
“I don't think those are an indictment on the industry itself; I think there's great standards in place if they're actually used properly,” said the head of asset-based finance at a US asset manager. “Those industry standards that are in place, they were an afterthought for some of these investors because they just wanted to deploy capital.”
Efforts to tighten paperwork are being broadly if quietly adopted, according to a Latham & Watkins report last week, as 9fin reported. The report found that scrutiny is increasing across the industry, with more stringent pre-close due diligence, more frequent and in-depth audit reports, and broader inspection and bank account access rights.
Tokenization would be a step further, but others say tokenization doesn’t go far enough and wouldn’t be able to entirely eliminate fraud. Valentina Valencia, CEO of auditing software firm Vaas, believes the US should adopt invoice registries similar to those established in several Latin American countries.
“If you’re looking at the tokenized version of an asset, you [still] need to make sure it’s real,” said Valencia. "The US is behind compared to other countries regarding the verification of underlying collateral.”
Trust fall
The US ABS market has historically operated on a system of trust. Auditors examine a small percentage of loans as a matter of due diligence, but relevant parties otherwise trust the information offered by originators is correct.
But cracks in the system have emerged since September, when a pair of ABS borrowers in the automotive sector filed for bankruptcy protection amid allegations of widespread fraud.
Tricolor, a subprime auto lender, allegedly double-pledged $800m of collateral and lied about the value of pledged assets, according to the US Department of Justice, which charged the company’s CEO, COO and CFO with multiple counts of fraud in December. Meanwhile, after auto equipment manufacturer First Brands filed for Chapter 11, restructuring advisors convened a special committee to look into irregularities in the company’s off-balance sheet financing, revealing a tangled web of fake, inflated, or double-pledged accounts receivables. In January, the CEO and his brother were also charged with multiple counts of fraud by the DOJ.
The industry was rocked by a third scandal in February, when UK property lender Market Financial Solutions was accused of double-pledging and widespread fraud shortly after asking for administration.
Given the recent track record, it comes as no surprise that double-pledging was the biggest concern for respondents to the SFA’s antifraud task force survey. The misrepresentation of collateral by originators was next at 23%, followed by servicer and reporting fraud at 20%.
“Respondents noted that oversight and monitoring practices can vary across the stages of the process, which may create inefficiencies or gaps in transparency,” stated SFA’s report.
Token solution
As a result, tokenization has once again become front of mind. Tokenized assets and their ownership histories are immutable because each entity receives a unique, cryptographic hash identity. A book of receivables or an asset could be assigned a singular identity and tracked on-chain, which would eliminate double pledging.
Prior attempts at widespread adoption were hampered by the disjointed nature of regulations in the US, antiquated technology at financial institutions and a lack of motivation within the industry to adapt.
“The finance industry has been slow on the uptake,” said Chris McDermott, senior counsel at Cadwalader, Wickersham & Taft.
But progress is being made on the regulatory side, which could facilitate a switch to tokenized assets backing securities. On 17 March, the US Securities and Exchange Commission published a joint memo with the Commodity Futures Trading Commission confirming that placing a security on-chain doesn’t change its legal status as a security. The following day, the SEC approved a pilot program proposed by the Depository Trust Company, the country’s central securities depository, to allow institutional traders to tokenize and trade certain securities. The program is expected to begin in the second half of the year.
As the SEC clears a path for trading tokenized securities on regulated exchanges, states have been updating their commercial law frameworks to establish how financial assets are legally owned and transferred. The process for establishing that framework has been slow and disjointed. The framework is guided by the Uniform Commercial Code, a set of guidelines that standardize transactions across states but which are ratified at the state level.
New York’s adoption in December of the UCC’s Article 12, a rule set forth in 2022 that set the framework for establishing ownership and resolving competing claims to a tokenized asset, marked a tipping point for blockchain technology, given the state’s significance in financial markets.
Article 12 allows token owners to establish direct control or to delegate control to a custodian. It also enables the automatic transfer of crypto assets via smart contracts.
But the blockchain on its own can’t fully protect against fraud, if assets aren’t originated on the chain, said McDermott and Valencia. Tokens could in theory be linked to real-world assets that don’t exist.
“Blockchain lets you see everything that’s happening and what’s changed over time. But it doesn’t tell you if it’s true,” said Valencia. “That’s where verification comes in.”
SFA survey respondents expressed similar concerns, separating fraud into two categories: “structural” fraud, which abuses process-related gaps, like the transfer and oversight of collateral, and “disclosure” fraud, which is caused by borrower misrepresentation.
“Task force members recommended SFA prioritize addressing and resolving structural elements of fraud arising from the operations and mechanics of securitization,” states the report.
But Valencia thinks both forms of fraud could be mitigated by a registry system, without the need for blockchains, similar to the ones used in several Latin American countries.
Colombia, Peru and Chile all have government-run electronic invoice registries. Chile’s registry system, run by its version of the Internal Revenue Service, was made mandatory for all companies in 2018. The registry tracks all business credit and debit notes, business-to-business invoices and consumer-facing sales receipts.
Colombia’s DIAN registry was rolled out starting in 2020 and requires all business-to-business and business-to-government invoices to be approved by the government. Reporting requirements for crypto assets went into effect in December. A similar registry for real-world assets became mandatory in Peru for B2B and B2G receivables in 2022.
Greater verification was seen as necessary in those markets due to a less rigorous justice system, said a banker at a major Chilean bank. Major US borrowers are also seen as generally trustworthy.
“In the US, if you break the law and commit fraud, you will go to jail most of the time,” he said, contrasting the US legal system to that of other countries.
Valencia’s company, Vaas, founded in 2022, has developed software that uses those registries to verify the legitimacy of collateral in a securitization down to the asset level by connecting directly to payment gateways and comparing reported receivables to the registries.
Valencia says her company catches double-pledging on a routine basis, though it isn’t clear if those instances are the result of malicious fraud attempts or accidents. Her firm’s first clients were Addi, a Colombian buy-now-pay-later firm, and credit provider PayJoy. Vaas also checked the books on Goldman Sachs’s initial partnership in Mexico with corporate credit lender Clara.
Vaas’s method is a marked departure from standard verification practices in the US, where auditors spend at most two weeks verifying a small percentage of loans backing a deal, one auditor told 9fin.
What now?
Seven months after First Brands and Tricolor, and as the alleged MSF fraud plays out in daily news stories, there has been no broad consensus from the industry or the government on how to react.
Moving away from a trust-based system in the US will be a long and involved process, regardless of worry among market participants about fraud, as the technological adoption would be pricey and operationally intensive and could slow deal flow.
The way forward for mitigating fraud, for now, is up to executives at individual institutions.
After JPMorgan Chase lost $170m in the Tricolor fraud, CEO Jamie Dimon said on his company’s next earnings call that he believes small tweaks, if any, to existing verification procedures are sufficient.
“Whenever something like that happens we scour all process, all procedures, all underwriting, all everything, and we think we’re ok in other stuff,” said Dimon, appearing to refer to the bank’s other ABS investments. “But that doesn’t mean we can’t improve our procedures.”
