Uncovering the Value of Blockchain Applications in the World of Finance

Blockchain Apps

By Qiang Cheng

This article discusses the benefits of using blockchain in the context of asset-backed security (ABS) issuance: reducing information asymmetry between issuers and investors, reducing yield spread of ABS, disciplining credit rating agencies, increasing the quality of underlying assets, and reducing issuers’ risk exposure. Such benefits should apply to other blockchain applications in the world of finance.

Depending on the headline of the day, Bitcoin can be a villainous play for rookie investors or a means of becoming an overnight billionaire. Partly because of the volatility of Bitcoin prices, some people regard blockchain as hype. However, beyond volatile cryptocurrencies, blockchain technology can be harnessed by financial institutions, governments, and other commercial enterprises to improve economic activities. As COVID-19 and other forces are galvanising the world of finance and moving financial services into a more digital era, blockchain technology provides a valuable solution to help resolve trust issues more efficiently. Because of the controversy surrounding blockchain applications, many organisations, such as the Organisation for Economic Co-operation and Development, have called for an investigation into the value of blockchain applications.

However, to date, there has been little research on the economic value of such applications in the realm of business. For this reason, my co-authors (Xia Chen from Singapore Management University and Ting Luo from Tsinghua University) and I investigate this issue in the context of asset-backed security (ABS) issuance in China and report the findings in a paper that is forthcoming at Management Science: “The Value of Blockchain Applications – Early Evidence from Asset-Backed Securities”. The findings of our study shed light on the economic value of blockchain applications and can help government agencies and businesses to decide whether to use blockchain applications.

Blockchain can address investors’ concerns about the quality of the underlying assets, which is the most important consideration when investors decide on ABS prices.

An ABS is a financial investment collateralised by an underlying pool of assets – such as loans, leases, and credit card balances. ABS is usually in the form of a bond or note, and disburses income at a fixed rate for a set amount of time. We find that, compared with other ABS, those issued using blockchain technology experience a decrease of 31.4 basis points in the yield spread, which corresponds to a relative decrease of 13 per cent. This is a substantial saving for issuers; we estimate that the total interest payment saving is RMB9.6 million for an average ABS issuer.
Here are five top takeaways on how blockchain applications have shown immense benefits in the area of ABS issuance.

1. Reducing information asymmetry

Currently, there is limited research on the real-world applications of blockchain, as institutions that accept Bitcoins and other cryptocurrencies are at an early stage of adoption. However, asset-backed securities (ABS) issued in China based on blockchain present an opportunity to examine the application of this technology, because, while some issuers have started to use blockchain to issue ABS, others have not.

Blockchain can address investors’ concerns about the quality of the underlying assets, which is the most important consideration when investors decide on ABS prices. Blockchain technology can ensure that the information stored on the chain is reliable and that the issuer cannot change any information stored on the chain, thereby increasing investors’ confidence. See Exhibit 1 for the general benefits of blockchain applications. The benefit of the application of blockchain is even greater for ABS with underlying assets that are less transparent to investors, such as revolving ABS.Exhibit 01

2. Reducing ABS yield

When investors have concerns about the quality of the underlying ABS assets, they are less inclined to buy the ABS, which will drive down the price, and the interest rate that issuers have to pay goes up. Blockchain can increase the reliability of information about underlying assets on the chain, as the issuer cannot alter that information. As a result, it can increase the confidence of ABS investors, thereby reducing the yield or the interest rate of the issuance.

3. Disciplining credit rating agencies

Another benefit of using blockchain in issuing ABS is its ability to discipline credit rating agencies, which assign a rating to an ABS, upon which ABS yield is based. Credit rating agencies adopt a business model similar to that of auditors: the ABS issuers, not the investors, pay the rating agencies. This can lead to a phenomenon of rating shopping, in which issuers will choose the rating agencies that assign higher ratings to their ABS, or rating inflation, in which credit rating agencies tend to provide high ratings that favour the ABS issuers. Both phenomena can lead to conflicts of interest. Using blockchain to issue ABS can address these conflicts, as investors have access to the data related to the underlying assets stored on the blockchain and conduct their own due diligence. Knowing that other market participants, including investors, can conduct their own due diligence, rating agencies are more likely to make objective evaluations of the quality of underlying assets, thereby improving the accuracy of their ratings. This benefit is greater for less-reputable credit rating agencies or rating agencies relying on issuers for
rating businesses.

4. Ramping up asset quality

The benefit of blockchain applications is also greater for an ABS with underlying assets that are less transparent to the investors, for example an ABS with a large number of underlying assets, or revolving ABS, which involves issuers adding assets to the underlying asset pool over time. Investors may face difficulty in understanding the quality of the underlying assets of such products. In addition, issuers might add assets with worse quality to the existing pool of assets of a revolving ABS. Blockchain applications are more useful in reducing information asymmetry and have a bigger impact on the yield spread of these ABS.

5. Reducing issuers’ risk Exposure

The issuer of a securitisation usually retains a percentage of credit risk – typically 5 per cent – underlying its asset-backed securities, and adopts other credit enhancement mechanisms to reduce the risk to investors. For example, ABS issuers may designate a third-party guarantor or provide more assets in the asset pool than the principal amount. We find that blockchain applications enable issuers to reduce their retained interest and the need for multiple credit enhancement mechanisms, due to the enhanced transparency and a reduction in information asymmetry.

Exhibit 02Exhibit 2 illustrates how blockchain technology can be used in ABS issuance to reduce the costs to issuers and increase investors’ confidence.

I would like to conclude with two caveats with regard to the findings of our study. First, the number of ABS issued using blockchain thus far has been relatively small, and so it is unclear whether the benefits are similar in the event of a more widespread application. Second, the number of users of a blockchain in the ABS issuance setting is relatively small, and thus the cost of running and maintaining the blockchain is low. The cost of using blockchain in, for example, a large initial public offering might outweigh the benefits. Nevertheless, our study sheds light on the economic value of blockchain applications, and the findings of the study can help government agencies and businesses better decide on blockchain applications in the future.

This article is adapted from an article published in City Perspectives by the Singapore Management University. Permission is required for reproduction.

About the Author

Cheng QiangProfessor Cheng is Lee Kong Chian Chair Professor of Accounting and Dean of the School of Accountancy at Singapore Management University. He is a prolific accounting scholar and has published over thirty articles in top accounting and finance journals. Professor Cheng has received many best paper and best discussant awards and has been a keynote speaker at many conferences. He served as an editor of The Accounting Review, one of the top-three accounting journals, from 2017 to 2020. Professor Cheng serves on the Research Committee of the American Accounting Association and is a senior fellow at the Asian Bureau of Finance and Economic Research.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.