How blockchain technology can transform the mortgage industry
Fourteen years ago, while in the depths of the financial crisis, it was a mystery to many how a mortgage system that was so chronically deficient could have cemented itself as the basis of the US financial system. In the subsequent autopsy examinations and revelations, however, it became clear that this false legitimacy was based on both institutionally authorized opacity and technical backend systems that were only good for hiding critical financial errors. Ultimately, this created an information barrier that made it possible for rating agencies, public bureaucracies and – most importantly – the big banks to reject public interest while following unsustainable financial practices.
Today, mortgages are again in the news, with house prices soaring and average interest rates reaching their highest point since the Great Recession. With these developments – coupled with concerns about price stability, stock market volatility and commodity prices – creating a sense of macroeconomic déjà vu, now is the perfect time to ask what went wrong in 2008, whether we have made adequate structural adjustments to our financial infrastructure , and – if not – how we can use the latest developments in the fintech industry to build a better debt management system.
As for what is to blame for the crash in 2008, it is now clear that there were two primary flaws. One is inherently human, and the other, inherently technical. First, reliable institutions used their legitimacy as a shield while pursuing profit maximization policies and erasing the true instability of the underlying system. Moody’s, S&P and other rating agencies gave subprime bonds AAA rating, despite underlying volatility. The desire of these institutions to maintain market share, delight their financial backers and achieve profitability led to their rankings being artificially inflated. In fact, the government’s financial crisis committee has described credit rating agencies as “essential gears in the wheel of economic ruin” and “key founders for financial amalgamation.” Ultimately, this is just one example of the broader problem: People, as long as they are influenced by ulterior motives, cannot be trusted to openly pursue the interests of society.
Second, as the financial sector began to slide, the underlying technology proved unable to process securitization structures. As a result, potential indicators of the health of the underlying system were hidden in an overly convoluted and bureaucratic system. For example, failure of a single subprime loan will not result in an immediate foreclosure. Instead, failed mortgages would remain in limbo in legal contracts and in backend offices. Ultimately, this meant that the true state of debt market conditions was not translated into real indicators – that is, before the moment of total systemic collapse.
To better understand this, consider this counterfactual: In 2005, foreclosures began to rise after the failure of a series of subprime bonds, and people rushed to get their money out of subprime debt instruments. Although this emigration would still have triggered the collapse of these debt instruments, the consequences would not be nearly as severe as the actual collapse that occurred three years later. Sometimes pressing the brake a few seconds too early can be the difference between a fender bender and a major accident.
Unfortunately, the structures that enabled the previous economic catastrophe are still in place across the debt markets today. While legislation such as Dodd-Frank and the creation of the Consumer Financial Protection Bureau have addressed some concerns, we continue to operate a financial system contrary to the transparent risk assessment that is in our collective interest. What is needed is a system independent of malicious influence and able to provide advanced warning of systemic threats. Fortunately, a single technology can provide answers to both problems: blockchain.
A core innovation in blockchain technology is the implementation of smart contracts, which are immutable and transparent pieces of code, designed for a number of unique applications. A mortgage system built on smart contracts will be superior to self-performing financial transactions, thus enabling faster debt processing, and in turn revealing errors in debt instruments faster. In addition, because public blockchains are transparent and free to see for anyone with an Internet connection, it would no longer be possible for financial institutions to hide the reality behind their reputation. Moody’s may call a bond AAA, but investors will be able to look at the underlying components and make their own evaluations. While under our current system we have to rely on official narratives, blockchain technology would give ordinary people the ability to verify such narratives.
To get here, however, we need to make some fundamental improvements to the blockchain infrastructure. First we need to make blockchains interoperable. A series of incoherent blockchains will be slow and cumbersome in spreading market information across the system, much like our existing financial infrastructure. Having a simple interoperable system will enable greater efficiency in adapting to changing market conditions. Second, we must ensure that blockchain technology is scalable. If we place a huge amount of real-world transactions on digital ledgers, we need to be confident in the system’s ability to handle the volume adequately. Finally, we must ensure that privacy is maintained. Although we want insight into underlying macro trends, it is inappropriate and counterproductive to disclose financial information to specific – and often vulnerable – individuals.
None of the above discussions are intended to deny the significant challenges of integrating open blockchain and smart contract technology into our financial system, but they would hardly be insurmountable. Moreover, the work required would be well worth doing given the broader effects of this technological revolution that would extend far beyond mortgages. For example, debt and equity trading across sectors may become increasingly self-sustaining and isolated from outside interference.
In many aspects of our economic lives, clarity and trust are lacking. By integrating the basic ethos of blockchain technology into our financial system, we can begin to restore faith in the fundamental element of our economy.
