Overview of Konomi’s Bad Debt Treatment Procedure from Asset-backed Securitisation’s Perspective

After the initial establishment of the Konomi platform, the team is continuously questioned by investors and community members on whether there is a way to protect the platform itself against a “Black Swan Incident” similar to what took place on 12 March. Unfortunately, after referencing and analysing trading models of popular products and exchanges such as Compound and Uniswap, our team has found that as the firewall between traditional financial markets and cryptocurrencies broke down, the level of correlation between traditional financial assets and cryptocurrency assets has been increasing exponentially. Thus, it has become increasingly challenging to design a platform free from the danger of the “Black Swan Incident” merely through relying on mathematical models.

The Konomi platform was designed with the safety of its users’ assets as the primary concern. Even after the introduction of “Liquidation Mechanism”, “Collateral Mechanism”, as well as “Arbitrageur Mechanism”, the Konomi platform still faces the inherent doubt — what happens if all these mechanisms fail? Using this question as the fundamental framework, the Konomi team will launch an asset-backed securitisation (ABS) product for cryptocurrencies as an important part constituting the risk management sector of the Konomi platform, with reference to traditional ABS products. Today, we will provide an overview of the asset-backed securitisation products in the Konomi platform.

Part 1 Theoretical Foundation of Asset-backed Securitisation (ABS)

According to Frank J. Fabozzi, a professor at Yale University and the father of ABS, the process of ABS is the packaging of loan contracts, receivables and other illiquid assets of a common nature into marketable, interest-bearing securities with investment characteristics. In brief, securitised assets should have three main characteristics:

1. The issuance of an ABS product must be supported by a specific asset. ABS products are supported by the credit of all or part of the return of interest on the asset, which is an important feature that distinguishes itself from conventional bond and equity financing.
2. ABS must involve the transfer of assets and the formation of a risk isolation mechanism. The securitisation process involves transferring assets suitable for securitisation to form securities; therefore, the assets to be securitised must be isolated from the bankruptcy risk of the original owner of the assets.
3. Assets must be more liquified than the fundamental assets after securitisation. Non-performing loan assets are often characterised by long repayment cycles and lack of liquidity. Post ABS solves this problem by recombining and packaging non-performing assets that can generate future cash flows into unitised, smaller securities that can then be sold to investors.

Specifically, the purpose of the Konomi lending platform’s ABS products is to bring together bad debt products that arbitrageurs cannot process into an asset pool. Through structural reform, these bad debt products can be transformed into products that can be sold and circulated in the financial markets.

Part 2 Risk Transfer Stakeholders in Subprime Securitisation

1. Originator: The originator is the financial entity that owns the original property rights of the securitised assets, i.e., the original equity holder. During the initial stage, Konomi will buy the original property rights of the bad debts from the creditors at a reasonable price and hence own the original records of these receivables.
2. Issuer: Konomi will set up a Special Purpose Vehicle (SPV) for the ABS process, directly receiving the pool of funds transferred by the originator and issue asset-backed securities. Its primary role is to serve as a bridge connecting the originator and the investors. Furthermore, it seeks to isolate the originator’s assets from the originator’s insolvency risk so that equity sales or equity financing can be made on the credit of the assets rather than the platform’s credit.
3. Servicer: The Servicer will be responsible for the post-securitisation operational management of the assets. Their main functions include: (1) Reporting on the assets’ operation regularly to investors and the issuer. (2) Ensuring that the beneficiaries are paid, managing the principal and interest of the assets, and delivering the proceeds to the investors regularly.
4. Credit Rating Agency (CRA): The CRA consists of Konomi’s professional rating team who rate independent assets after risk isolation. The focus of the rating is not on the solvency of the bond issuer, instead on the solvency of the securitised financing structure. After the securities have been rated, CRA still needs to follow up and constantly monitor the rating to make necessary adjustments accordingly.
5. Underwriter: The underwriter is the entity that underwrites the securitised product. Konomi will strive to establish partnerships with reputable platforms of good expertise such as Binance, Huobi and Uniswap in the future.
6. Investors: Investors are the major economic entities that invest in ABS. By purchasing high-liquidity, high-yielding and highly rated securitised assets issued by the Konomi team, investors can improve their capital structure and earn margin interests.

Part 3 Advantages of Risk Transfer in Subprime Securitisation

1. Increased liquidity: Most traditional DeFi lending platforms found themselves in a stiff situation when arbitrageurs are reluctant to get involved in non-performing loans. This is mainly due to the reason that such non-performing loans lack the necessary liquidity to be traded in the marketplace. However, through ABS, Konomi will consolidate all the illiquid and non-performing loans currently in its platform into standardised, unitised securities that can be sold in order to reduce its share of non-performing loans successfully. In this way, ABS allows Konomi to increase the liquidity of its assets without changing its main capital structure.
2. Strengthened risk management: The risk diversification and the transfer function of ABS can spread market risks of Konomi’s non-performing assets to a large number of investors, thus achieving the purpose of defusing major risks of the platform. In contrast to traditional token purchase investments, token buyers are generally exposed to fundraisers’ adverse selection risks and moral hazard due to limited professional knowledge in the event of misinformation. The nature of ABS is an innovative form of financing, which guarantees that the bond-backed assets are already isolated from risks. Further, after being rated by CRA, investors’ risks would be significantly minimised under multiple covenant protection.
3. Optimisation of capital structure: ABS is operated through an SPV spun off from the Konomi platform, which allows for a more rational capital structure for the Konomi platform due to its insolvency isolation features. For Konomi, the combination of the two platforms after the spin-off constitutes a better capital structure compared to one platform.
4. Reduced regulatory costs: After ABS is carried out, the originator sells the assets in the form of a true sale to an SPV that is not affected by the originator’s insolvency. In this way, the originator’s insolvency will not affect the principal and interest payments on the securitised product. ABS allows a portion of the risks within the Konomi platform to be transferred outside into the market, vastly reducing Konomi’s excessive exposure to risk.
5. Reduced information asymmetry: ABS will solve the Lemon’s Problem currently plaguing the majority of the DeFi platforms. Konomi will transfer assets with stable cash flows to an SPV, which will then consolidate and repackage these assets for bond issuance. Investors only need to be concerned with the rating of the securities as well as the quality of the supporting assets to invest, without the necessity to pay much attention to the creditworthiness of the originator.

Part 4 Procedure of Risk Transfer in Subprime Securitisation

Typically, Konomi’s subprime securitisation transfer process involves the originator transferring the acquired subprime loans to the SPV, which will then use the cash flows generated by the asset pool to finance the issuance of marketable bonds. The SPV, on the one hand, reimburses the asset seller for the asset consideration with the proceeds of the securities’ sale. At the same time, SPV will also use the capital generated by the asset pool to pay interest and principal on the marketable securities issued, thereby transferring the risk from the originator’s balance sheet to the investor.

1. Sale of underlying assets: Konomi will sell the acquired bad debts “non-recourse” off the platform’s balance sheet to an SPV. SPV is a separate independent entity whose primary business operation is to purchase bad debt assets from Konomi and issue asset-backed securities. The purpose of establishing an SPV is to make the securitised assets utterly independent so that the securitisation is free from the effects of insolvency of the original holder, thereby achieving solvency isolation. By separating SPV from the Konomi platform, investors are not exposed to risks from the Konomi platform and through this mechanism, the non-performing balance sheet is transferred to the SPV balance sheet.
2. Risk recombination: SPV measures the risk distribution of the non-performing assets purchased from Konomi, assesses the value of their collateral security and forecasts future cash flows. Thereafter, SPV cleans, evaluates and accounts for all assets and sets securitisation targets to determine the number of assets. Through this process, the assets are packaged and recombined to build a pool of funds ready for securitisation.
3. Credit rating and enhancement: Once SPV is done recombining the assets, it will rate and enhance the products’ credit to ensure a smooth issuance process and reduce financial costs. As the SPV products have already provided a stable credit basis for the securitised assets through true sales, SPV will perform credit enhancement through internal and external third-party guarantees. Subsequently, a secondary credit rating will be carried out on the enhanced products to ensure they are issued at a reasonable price.
4. Issuance and sale of securities: To avoid moral hazard and problems that may arise from agents, SPVs will not issue and sell securities directly. Instead, they will issue and sell products through public offerings and private placements. Public offerings are mainly held by institutional investors and dealers who purchase all or part of the securities issued with their funds and then offer them to the public. Private placements will be offered to a group of target audiences in a specific manner.
5. Asset after-sale management services: Since asset portfolios are transferred as a certificate of property rights in the ABS process, a team of professional servicers is required to manage the after-sale services of these assets. The servicers’ main functions are to manage the daily operations of the asset portfolio and provide investors with regular reports on topics such as balance sheets and cash flow statements.

Part 5 Conclusion

All in all, this article mainly focuses on the history, advantages and operational mechanisms of ABS while discussing Konomi’s approach in dealing with bad debts. However, due to space constraint, this article has omitted topics such as the theoretical mechanisms of ABS, the amplification effect of risk transfer mechanisms and transfer channels etc. Nonetheless, the Konomi team will uncover these discussion topics in subsequent articles with more in-depth details as the project progresses.