Blockchain: how smart contracts disrupt traditional cat bond structures

Think about the way financial instruments are structured. Large parts of the paperwork and administration exist solely to ensure trust between all participants, thereby trading efficiency for security. Seeing it this way, today’s solutions may not exist because they are the best ones, but because as of now, they are the only ones and they work equally well for everyone.

One could argue that digitising processes in the value chain would increase efficiency, while reducing costs, but to quote Marcus Schmalbach, chief executive officer of Ryskex: “If you have an inefficient process and digitise it, you have a digitised inefficient process.”

Blockchain to the rescue? Not necessarily! The two main reasons this technology is said to be highly disruptive are because it 1) provides fully digitised global ecosystems, and 2) manages to ensure trust between all users, both by nature. If it was used just to digitise old structures, the gains might not be worth the effort. In some cases, it would even dramatically increase complexity while not being as beneficial as it could be, to achieve the same result.

Assuming that Ockham was right and the simplest solutions to a problem are the best ones, think about what makes up a basic cat bond. Try to think outside of old structures and extract only the intentions behind it, assuming that calculations have been made and everyone always plays by the rules. The issuer wants $100 million in case an earthquake with a magnitude equal to or greater than 5.0 hits Sacramento, California. He is willing to pay 8 percent premiums to his investors, if there is no incident within one year. The data required to evaluate the trigger is provided by the US Geological Survey (USGS), which receives a fee of $50,000 for its services. In case of a covered event, all affected assets have to be generally assigned to the issuer.

Typically, in traditional implementations, the first steps would include establishing a Special Purpose Vehicle (SPV) in a tax-efficient jurisdiction, to act as a middleman between issuer and investors and then establish agreements between them (Figure 1).

Also, to neutralise the issuer’s credit risk, investments must be fully collateralised, with the collateral account being managed by the SPV. Depending on the collateral structure, this might leave the investors still exposed to credit risk in addition to the expected insurance risk itself.

Figure 1: Traditional cat bond structure

Again, assuming that the simplest solutions are the best ones, the following section will describe a way to implement the California cat bond example above, using smart contracts. While this is just one specific use case, its implementation will also clarify a mindset, to get from traditional structures to future ones as well as what a smart contract really is and what parts of traditional value chains it effectively disrupts.

Implementation
In a volatile, uncertain, complex and ambiguous world, solutions should be implemented that have adaptability and customisation as well as interoperability in mind. Use cases can change or become redundant rather quickly and business partners can be swapped. But what does that mean for the use case?

The Smart California cat bond can be seen as a template to implement cat bonds in general. The idea is to design the solution, so that the definition of risk is as variable as possible, while still ensuring high levels of trust and efficiency. While the California cat bond uses a parametric trigger, switching to indemnity, industry or modelled loss should be as easy as possible, without impacting other parts of the solution.

The same goes for the collateral structure, which could range from no risk-no return to low risk-low return—again, as variable as possible, yet providing the highest amounts of trust in its implementation.

Blockchain technology
A blockchain network can be described as the infrastructure to create a whole new ecosystem. The infrastructure by itself does not implement use cases, however. Instead it defines a set of rules, establishing how members of the network must exchange and manage data.

Data in this context is immutable and can always be retraced. These rules also allow members to create smart contracts, that implement actual use cases. If the plan is to implement use cases with financial purposes, it makes sense first to create some sort of virtual currency for the network, which can later be used by the members.

Smart contracts
Basically, a smart contract is a piece of program code, executed by the members of a blockchain network. Members can interact with smart contracts, by sending or requesting data or funds. The technology assures that neither the code, nor data nor funds, managed by the smart contract, can be tampered with. This makes sure that a smart contract always acts according to its program code, leading to highest amounts of trust.

This is a substantial requirement for most financial use cases, where middlemen are often involved, to reduce risk for the contracting parties. In those cases, smart contracts come in handy. They can hold on to funds or release them exactly as programmed and their execution is almost instant. This leads to the idea of creating a smart contract that matches the behaviour of a financial instrument.

Virtual currency
Whenever there is a financial transaction on a blockchain, some sort of cryptocurrency, token or coin is involved. Cryptocurrencies have received a lot of negative attention recently, mainly because of their high volatility and lack of transparency when it comes to who uses them. If implemented properly, however, cryptocurrencies are the perfect virtual currencies.

They can be traded almost instantly, leaving an immutable audit trail behind. They can be pegged to a real-world currency to neutralise volatility and, assuming that only known and verified entities become members of the blockchain network in the first place, their origin is always known.

Smart California cat bond
The structure of this new kind of cat bond, seen in Figure 2, is still quite similar to the traditional one in Figure 1. The major difference is that the smart contract replaces the SPV in its entirety. Also, a third party—an oracle—is included.

The sole purpose of an oracle is to provide data for the trigger evaluation, without being further involved in the agreement. An oracle might not even know what the data transmission results in, or who else is involved. It’s enough to know about the fee it receives when submitting its data. This ensures neutrality when it comes to the claim assessment.

Figure 2: Smart cat bond structure

End-to-end process
Assuming that the parameters for this cat bond correspond to the ones in the introduction, the end-to-end process would start with the issuer, creating the smart contract, accordingly, pushing it into the blockchain and prefunding it with premiums for the investors and fee for the oracle. From this point, the smart cat bond is accessible by other members of the blockchain network.

Note the difference between traditional contracts and smart contracts: traditionally, after the parties agree on certain conditions, a contract is written, signed and sealed. However, when the issuer pushes his smart cat bond into the blockchain, he might not know a single investor, but the smart contract is signed, sealed and even prefunded by him at that point already.

This is similar to how it works with traditional cat bond structures and shows that smart contracts may replace not just an actual contract, but whole entities or structures. Reading further should clarify how this works.
In the next step, members of the blockchain network can invest in the smart cat bond. To be realistic, the issuer most likely made sure there would be investors for his bond, before rolling it out.

Technically, at this point, the issuer must advertise it in some way. Whether there is an online marketplace, or he calls friends and business partners—whoever is a member of the same blockchain network and wishes to invest, can do so by simply sending funds to the smart contract.

Of course, no-one would do that blindly, but since the smart contract is visible to the network in its entirety—including the program code—investors can verify the information advertised by the issuer. Note that smart contracts are capable of moving the highest volumes of funds just as quickly and easily as the lowest amounts. They must be created and assessed by trained experts, to ensure the promised amount of trust.

Also remember that funds in these scenarios always refer to some type of cryptocurrency. It does not matter to a smart contract whether one coin is worth $1, €1, 1yen or 1oz of gold. Users may exchange their coins like chips when entering or leaving casinos and then invest in smart financial instruments, instead of gambling at slot machines.

As a side note: the exact same blockchain infrastructure that supports investment in smart financial instruments might also support completely different smart contracts, such as one to exchange assets without a middleman, or one that works like an auction house. This is what makes a blockchain network an ecosystem by itself.

Coming back to the smart cat bond, investors would have verified the information advertised by the issuer by now and know they will receive 8 percent plus principal after one year, unless there was an earthquake with a magnitude greater than or equal to 5.0. It is enough for them to send the funds, because the smart contract is programmed to handle the rest.

Two things could happen next: the oracle measures an earthquake in Sacramento with a magnitude of 5.0 or more and submits that information to the smart cat bond, or the year passes without an incident and the investors can reclaim their funds plus premium.

In the first case, the smart contract would send the predefined oracle fee of $50,000 to the oracle and all the remaining funds to the issuer. In the second case, the issuer can reclaim the oracle fee, as the investors claim their principal back, plus the promised premium.

There is no way that the issuer, the oracle or the investors receive funds that they are not intended to receive, simply because the smart contract contains no logic that allows them to do so.

This basic solution is designed to avoid credit risk for everyone. First of all, for the investors and oracles, we can see that the issuer already deposited all the premiums and fees, and then for the issuer, because every investor must deposit his funds.

While this ensures the lowest amount of risk, it also means that all the funds managed by the smart contract are literally untouchable over the full period. Other solutions may allow a predefined third party to access the funds and generate returns. The solution space is wide, and how it will be designed depends on how much risk the investors are willing to take.

Regulation
While this topic remains mostly untouched by today’s blockchain discussions, regulators will probably learn to like the technology. Depending on how transparently a blockchain network is operated, regulators can simply be provided access to relevant data. Data in this case are always structured, which makes them easy to be analysed and monitored, leaving no chance for fraudulent behaviour to remain undetected.

One area where regulation and paperwork are indispensable is the inclusion of oracles. Generally, wherever data enters a blockchain environment, it is prone to mistakes or fraudulent behaviour. To take the smart cat bond as an example: the oracle could be paid by an investor to not transmit the data in case of an actual earthquake that would trigger the payout, or simply to submit manipulated magnitudes.

Also, there should be know-your-customer processes that determine who can become a member of the blockchain network in the first place, or which kinds of assets are allowed to be traded. These are things that the blockchain provides no solution for, but which heavily impact use cases as well as the security and even ethical behaviour of all members.

Advantages

​“As long as all the calculations have been made, it takes only a couple of minutes to deploy everything and be ready for investments.”

Assuming that the blockchain infrastructure already exists and there are enough investors as well as funds inside the ecosystem, developing a smart contract like this can take a matter of days. There will be approved and standardised templates, so that issuers just pick one, enter their parameters and then push it into the blockchain.

Unless experts or consultants are involved, the cost to issue another cat bond like this are almost zero and, as long as all the calculations have been made, it takes only a couple of minutes to deploy everything and be ready for investments. This makes it easy to reduce the overall bond terms and also heavily impacts the minimum coupon size.

There is no difference in cost or administration for the smart contract, between moving $10 or $100 billion in assets, or whose account these assets are moved to.

The transfer of any kinds of assets within the ecosystem can happen instantly. Provided that the control over the assets has been passed to a smart contract, it is not exposed to the risk of not happening exactly as intended.

Disadvantages
While the advantages above assume that plenty of conditions are already met, these may be the biggest disadvantage, at least at the beginning. The conditions include a working blockchain infrastructure in the first place.

Based on that, some kind of exchange must be created, so that members can exchange their real-world assets for virtual ones. This step is necessary, in order to trade anything real on a blockchain. International banks or asset managers are predestined for this role.

Then there must be trained experts, first of all to manage the whole infrastructure and then to create or analyse smart contracts. Most likely, software engineers and cryptography experts will fulfil this role.

Last but not least, participants must all agree on certain conditions: which software to use, who operates the network, who can act as an exchange, and so on. All of these might lead to heavy investments of time and money upfront.

Outlook
As of today, there are thousands of blockchain networks up and running. They are usually public ones, allowing everyone to connect via the internet. Private networks, especially between businesses, are much less known.

There are major corporate players working on solutions such as the ones mentioned in this article. For example, the UBS Innovation Lab in London has implemented an experimental platform to issue bonds using smart contracts. JP Morgan has announced the implementation of the JPM Coin, a cryptocurrency pegged to the US dollar. The Deutsche Börse Group has announced a cooperation with Swisscom to implement a financial market to exchange assets on blockchain.

Figure 3 shows a rudimentary implementation of the California cat bond, written in Ethereum’s programming language Solidity.

Figure 3: Smart contract that implements the California cat bond

Simon Kolkmann is co-founder of BlockART Institute, as well as co-founder and CTO of Ryskex. He is a specialist for blockchain use cases. He can be contacted at: kolkmann@blockart.institute