Collateralized Debt Market through Tokenization
The proposed solution to debt cycles and the importance of collateral in the global monetary system.
With a staggering $9.2 trillion in US Treasuries and unprecedented levels of debt due to be refinanced, accumulated during the last 3 debt cycles. The prospect of another looming debt cycle grows more pronounced. I have also tried to highlight the complexities of this debt based system by explaining the Eurodollar system.
Quarterly Financial Report: U.S. Corporations: All Retail Trade: Long-Term Debt, Due in More Than 1 Year: Loans from Banks
This chart might explain a lot about what is going on behind the scenes. As we again advance towards yet another peak in refinancing, the chart above shows each time we hit peak refinancing, liquidity is sucked out of the financial system causing economic contraction. We have the same issue with private credit, as collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs) taken during COVID-19 are all up for refinancing.
This inturn raises the Question, is the Trump administration serious about structural reform, or are the tariffs just another excuse to collapse the economy forcing the Federal Reserve to drop interest rates, as yet another ploy to turn off the printers again?
With 9.2 trillion in US debt needing to be refinanced, the US Treasury and private sector can't afford to pay 5 to 6 percent on that debt. Neither can the private sector. The issues for the Trump administration come from a number of fronts including the carry trade, Triffin's Dilemma and the fact that they are losing some of their hegemonic economic dominance, which in resulting other nations have started to use dollars to settle transactions, losing the ability to control the outcome.
My guess and Trump has said as much, is that they want the Fed to cut rates and the Treasury to turn on the printers. The long-term problem is that you're simply kicking the can down the road. Again as the chart above highlights, everything we hit peak refinancing, we turn on the printers, however it only makes the next debt cycle more pronounced.
This ecosystem of perpetual debt cycles, is eroding the value of pensions, creating economic instability and inflation through excessive money printing. In his magnum opus I want to unpick the problem and create a practical solution. By explaining how societies are teetering perilously on the brink of each debt crisis, creating the weight of accumulated obligations strains against the frailty of Fiat debt based system, we are eroding the standard of living for ordinary people. It is within this crucible of unprecedented fiscal strain and surging debt burdens that the world finds itself on the cusp of a momentous juncture, the so-called Great Reset. Compounded by the echoes of past debt cycles, we must try and create alternative solutions and this is my contribution.
What is a debt cycle?
A debt cycle occurs when borrowers, including governments, take on increasing levels of debt, which can lead to economic imbalances and financial instability. In the global monetary system, where a significant portion of debt is illiquid, the value of debt is closely tied to the collateral supporting it. However I feel we have the potential to mitigate the impact of debt cycles and market fluctuations, by creating closed funds where asset managers can allocate capital over the long term without the influence of debt cycles, and have the possibility of making a more stable financial system.
By establishing closed funds that hold assets for extended periods, asset managers can make investment decisions based on long-term value creation rather than short-term market pressures. This approach helps reduce market volatility, shields assets from credit cycle risks, and enhances returns over time. The stability provided by closed funds is particularly beneficial for the pension fund industry, aligning well with its long-term investment objectives and offering diversification and risk management benefits.
Debt cycles and liquidity constraints are inherent challenges in the global monetary system, with the value of debt intricately linked to the collateral backing it. In a paradigm where 85% of global debt is illiquid, the perceived value of collateral plays a crucial role in determining liquidity levels. With that I believe we can draw inspiration from the successful strategy implemented by the Irish government during their property bubble, a solution emerged which involves transferring assets into long-term closed funds like NAMA.
I believe this approach not only shields against the pressure to hastily sell assets during market downturns but also paves the way for the creation of a secondary derivative market to mitigate counterparty risks. By embracing this model, we can potentially revolutionize the financial landscape by prioritizing collateral stability and strategic asset management.
Understanding to role of collateral
The concept of my solution to debt cycles is that by focusing on collateral and creating a more stable system that reduces counterparty risks during market downturns. During the Global Financial Crisis (GFC), the freezing of interbank lending in the Eurodollar system severely impacted global liquidity. Financial institutions were reluctant to lend to each other due to heightened counterparty risks and a lack of trust in the value of collateral tied to the loans. As a result, liquidity dried up, leading to a credit crunch that amplified the economic downturn.
If the proposed approach had been in place during the GFC, with assets transferred into long-term closed funds as seen in the Irish model, the impact of the freezing interbank lending could have been less severe. By holding onto assets in these funds for longer periods, financial institutions would have less risk of margin calls, reducing pressure to sell off assets quickly to meet short-term liquidity needs.
This I believe could have created collateral stability and allowed for strategic asset management through the long-term, as the funds are closed, they are not getting inundated with redemptions, forcing asset managers to sell assets, even if the price being offered was below fair value. The second element is to create a derivative market, which can give investors access to capital, without affecting the integrity of the fund.
That's look at the NAMA model
The NAMA (National Asset Management Agency) model implemented by the Irish government was designed to address the fallout of the Irish property bubble and manage distressed assets in a systematic manner. These are the four main elements of the NAMA model:
1. Transfer of Distressed Assets
NAMA was established to acquire high-risk and distressed assets, primarily related to property development loans, from Irish banks. This transfer aimed to cleanse the banks' balance sheets and provide them with much-needed financial capital and stability.
2. Long-Term Management
Rather than immediately selling off these assets at distressed prices, NAMA opted for a long-term approach. The assets were transferred into a closed fund, allowing NAMA to manage and oversee their performance over an extended period.
3. Reduced Pressure to Sell
By holding onto the distressed assets in the closed fund for an extended period, NAMA avoided the need to sell them quickly in a depressed market. This strategy prevented a flood of distressed assets entering the market, which could have further depressed property prices.
4. Asset Recovery and Return
Over time, NAMA worked to recover value from the distressed assets through various means such as restructuring loans, asset management, and disposal strategies. This approach aimed to maximize returns on the assets over the long term..
The ultimate goal of the NAMA model was to generate a net return for the Irish taxpayers. By effectively managing and monetizing the distressed assets over the long-term, NAMA was able to recoup taxpayer funds used to stabilize the banking sector during the crisis.
Turning the NAMA model into a real world model
There is no reason why the NAMA model which focused on strategic asset management, long-term planning, and maximizing returns on illiquid assets cannot be implemented in the private sector. This provides a structured framework for dealing with the counterparty risk of asset bubbles and general stress in global markets. In times of stress investors sell what they can at a price they are given, by removing market risks, portfolio managers can sell in the best interests of their investors, without the risk of liquidations and or margin calls.
Around 85% of global debt is considered illiquid, meaning it cannot be easily bought or sold at times of market stress, without significantly impacting its value. However, creating a closed fund where asset managers can allocate capital over the long-term without counterparty risks from credit cycles offers several benefits that contribute to market stability and can be particularly advantageous for the pension fund industry.
First by establishing closed funds that hold assets for longer periods, asset managers can make investment decisions without the pressure to buy or sell based on short-term market fluctuations or credit cycles. This stability in asset allocation can help reduce market volatility and lessen the impact of sudden shifts in sentiment or liquidity constraints.
Secondedly funds that shield assets from the volatility of short-term market movements, reducing the exposure to counterparty risks associated with credit cycles. This approach allows asset managers to focus on long-term value creation and strategic asset management, rather than being forced to react to short-term market dynamics.
Thirdly, Closed funds can also offer diversification benefits by holding a mix of assets across various sectors and geographies. This diversification helps spread risk and reduces exposure to individual market shocks, contributing to a more resilient investment portfolio for pension funds and other long-term investors.
In the long-term asset allocation strategies can potentially lead to enhanced returns over time as assets are given the opportunity to appreciate and generate value over extended holding periods. This patient approach to investing can result in more sustainable and predictable returns for investors, including pension funds seeking to meet long-term obligations.
One of the biggest beneficiaries of this strategy could be the pension fund industry, which often has long-term investment horizons to meet future liabilities, and can benefit significantly from closed funds that offer stability and sustained growth potential. Such funds align well with the long-term objectives of pension funds, providing a reliable source of returns to support pension obligations over time. By creating closed funds that allow asset managers to allocate capital over the long-term without the influence of credit cycles can promote market stability, enhance returns, and offer valuable benefits to the pension fund industry through risk mitigation, diversification, and alignment with long-term investment objectives.
Creating a Secondary Derivative Market
By establishing a secondary liquid derivative market based on a price that is derived from the fund itself, you can reduce counterparty risks during market downturns, while giving investors access to liquidity. This market would provide additional liquidity and potentially stabilize the system and diversify risks. The best way to do this in my view is by Implementing a tokenized derivative market involving a sophisticated framework that leverages blockchain technology, smart contracts, and liquidity management mechanisms to ensure operational efficiency, transparency, and investor protection.
1. Smart Contract Integration:
By tokenizing funds that are derived from private credit like CDOs CLOs, to which are illiquid in nature, on a blockchain platform, smart contracts can be programmed to automatically enforce restrictions on investor redemptions until the fund reaches maturity, while at the same give transparency to the assets held by the fund and providing access to liquidity in a secondary market. The use of blockchain technology ensures a transparent and tamper-proof record of ownership, mitigating the risk of disputes or unauthorized transactions.
Compliance protocols can be embedded within the smart contract code to verify investor eligibility for redemptions based on predefined criteria, providing an extra layer of security and regulatory compliance.
2. Tokenization Protocol:
The issuance of tradable tokens representing ownership interests in illiquid funds enables investors to participate in a liquid secondary market for buying and selling these tokens. The creation of such a decentralized exchange or a trading platform powered by smart contracts facilitates peer-to-peer transactions of tokens, offering investors controlled and secure trading opportunities.
The Custodian of the fund can deploy automated market-making algorithms to ensure continuous liquidity in the secondary market, narrowing bid-ask spreads and enhancing price discovery mechanisms. Which inturn can enhance Price Transparency and Real-Time Settlement, through blockchain technology, investors can access real-time pricing information, order book depth, and instant settlement of trades, fostering greater transparency and efficiency in the secondary market.
3. Risk Management and Contingency Measures:
The establishment of clear governance structures and risk management protocols for the tokenized fund to monitor and address potential risk factors, such as concentration risk, liquidity risk, and market risk. By Implementing escrow accounts or smart contract provisions to safeguard investor funds and ensure compliance with redemption restrictions until the fund maturity date is reached.
4. Protection of the Custodian and Risk Management Measures
By utilising smart contract technology and multi-signature authorization, the Custodian can establish secure custody arrangements that protect against unauthorised access and fraudulent activities, thereby safeguarding the assets and maintaining the fund's integrity.
Tokenization also allows stakeholders to utilize analytics tools and reporting systems to monitor market trends, investor sentiment, and trading activities in the secondary market, enabling timely interventions and risk mitigation strategies.
By combining these technical elements in a cohesive framework, the proposed concept of a tokenized collateralized debt market with extended duration and a liquid secondary market can provide investors with enhanced liquidity, transparency, and control over their investments while fostering market stability and resilience in the face of volatility and uncertainty.
In essence, the synergy between extended duration, a liquid secondary market, and the Custodian's custodial role creates a harmonious ecosystem that promotes market stability, protects against risks, and empowers investors with transparency, control, and inclusivity. This transformative framework not only elevates individual investment experiences but also fortifies the resilience and integrity of the financial market, laying the foundation for sustainable growth, stability, and prosperity.
Conclusion
NAMA and its successful recovery of distressed assets acquired during the Irish banking sector bailout, the agency's remarkable turnaround and profit generation serve as a testament to the efficacy of a strategic approach to managing distressed assets. NAMA's ability to not only recover the equity injected by the Irish state but also generate a profit can be attributed to its adept handling of duration risk and asset price normalization.
NAMA strategically managed its portfolio by holding onto distressed assets until market conditions improved, thereby enabling asset prices to stabilize and appreciate over time. By strategically navigating duration risk and patiently waiting for the market to normalize, NAMA was able to optimize asset recovery, mitigate losses, and ultimately deliver a profitable outcome for the Irish state. This core principle of strategic asset management underscores the fundamental concept at the heart of concept is the understanding of the importance of extended duration, asset normalization, and strategic risk management in achieving sustainable financial outcomes and market stability.
The tokenization of the collateralized debt market can represent a transformative shift that promises to usher in a new era of stability, transparency, and efficiency in the economy and investment landscape. By leveraging innovation, blockchain technology, and smart contract solutions, this concept can not only address the challenges of market volatility, liquidity constraints, and risk exposure but also unlocks a plethora of benefits that can revolutionise the financial ecosystem.
The tokenization of collateralized debt instruments with extended duration and a liquid secondary market offers a structured approach to enhancing market stability, protecting investor interests, and fortifying the financial system against systemic risks. Through mechanisms such as increased transparency, control over investments, and broader investor participation, this concept fosters a more inclusive, resilient, and liquid debt market that empowers stakeholders, mitigates risks, and lays the groundwork for sustainable economic growth.
As we move into the digital age of innovation and transformation, it is imperative to embrace change, adapt to evolving market dynamics, and harness the power of technology to propel the financial industry towards a future defined by resilience, efficiency, and prosperity. The call to action is clear – seize the opportunity to embrace innovation, catalyze change, and shape a more stable and liquid debt market that benefits investors, institutions, and the economy at large.