Using blockchain to trade and settle securities took a step forward this month with Lombard Odier Investment Management’s purchase of a security over a decentralized ledger.
Its acquisition of a $14.8 million asset-backed security linked to reinsurance contracts is the first secondary-market transaction of insurance-linked securities (ILS) via blockchain.
That contract, covering Texas hurricanes, was created last year by Solidum Re, a Switzerland-based specialist reinsurer that created the distributed ledger, called ILSBlockchain, using Bitcoin Core technology; the actual tech work was done by U.K. Coin Sciences, using an open-sourced protocol, MultiChain.
Cedric Edmonds, Zurich-based director at Solidum Re, says ILSBlockchain was designed for a small community of specialist firms, but the technology could broaden. “We could use the same platform for credit risk, or loans, or other types of asset-backed securities,” he told DigFin.
Small world
Simon Vuille, portfolio manager at Lombard Odier, also in Zurich, says the small world of the ILS industry means the players on the blockchain all know one another.
The ILS market is dedicated to instruments to help reinsurers distribute catastrophe risk. It is niche, estimated to be only $70 billion. Of that, about $30 billion consists of catastrophe bonds. Private club deals comprise the other $40 billion, which includes “lite” deals, built upon floating-rate notes, that try to create bond-like structures.
Yields vary wildly depending on seniority, structure, geography, and the underlying earthquake or hurricane risk, but Vuille, who is an investor in these instruments, says yields on lite deals typically range between 4% and 8% over money-market rates.
In addition to market risks, however, club deals bring operational ones, such as the lack of delivery-versus-payment settlement, which makes them dependent on banks. They are also hard to trade.
Credit fears
The idea of using DLT arose from fears of credit risk with trustees. Large banks such as Deutsche Bank act as trustees for ILS structures, but the small size of these deals means banks only take on the business if they can bundle it with depository, accounting and other functions. When last summer European banks, including Deutsche, suffered potential credit downgrades, ILS players got spooked.
Solidum attempted to renegotiate its trustee arrangements, but banks balked or insisted on other onerous or inflexible terms, and entreaties to work directly with Euroclear went nowhere.
So Edmonds decided to take advantage of decentralized ledgers. The result is to cut out banks, but not entirely: they remain needed to hold ILS-related collateral. A boutique trustee in Guernsey, Artex Risk Services, is acting as trustee for the Dom Re ILS.
But blockchain has allowed the industry to turn “lite” club deals into tradeable instruments with DVP settlement. “Other financial service providers remain involved, but blockchain removes the need for a bank,” Vuille told DigFin.
This kind of tight network of participants made for a good place to try out a blockchain, Edmonds says: “It’s a nice sandbox.” Solidum serves as permissor on the network, on which there are just seven nodes.
Wider acceptance?
How much of a landmark is this for using blockchain in the insurance world?
Vuille says adoption will be slow. “It will take time for traditional actors, who are the backbone of the financial industry, to get used to it. This is not disrupting Euroclear.”
But both incumbents and stock exchanges are in good position to use blockchain. “There are prototypes out there, but no one has the guts to pull the trigger,” Vuille said. “Our industry has proved it’s possible.”
Edmonds says blockchain works well when it’s applied to suitable tasks, such as trading securitized contracts. ILSBlockchain will likely originate and trade four to seven new contracts by the end of February.
But he says other industry prototypes are too ambitious or are expecting too much from blockchain. He doubts, for example, that insurance consortium B3i will achieve widespread adoption of its blockchain initiatives, because it is using it for smart contracts that may be too complex to resolve via distributed ledgers.
“Blockchain’s great for certain things, but it’s not going to make the tea,” he said.
