David Piesse, Global Insurance Lead, Chief Risk Officer And Member Of Advisory Board For Insurance, Guardtime Ltd
2018 was a year of two parts. In the first half creating assets on a blockchain using tokens took the form of ICO’s (Initial Coin Offering) which netted millions for many on the back of an idea using a crowd funding approach. For financial services, there were some early winners but few took that vision to the insurance sector, as few understand the nuances of an industry that has not changed for decades and regulatory compliance was the biggest hurdle to new entrants. In the second half of the year, regulations and caution caught up with the offerings and the amount of money raised dwindled to a few successes ringing the death knell for the stand alone utility token in financial services. Wise innovators learnt their lessons and went back to the drawing board to move to the next transition that of securitization of assets using security tokens in a regulated way.
The insurance sector especially is aligned with this trend as the industry is naturally moving to capital market risk trading driven by surplus capital, growing natural catastrophes, and emerging digital risks such as cyber and supply chain. Complete misunderstandings about crypto currency and blockchain led to a mistrust of use of bitcoin in insurance because of the volatility around reserving. Moving into the second half of 2019 fiat currency is now recognized as payment in the crypto world, making a move to security tokens more viable. The rise of stable coins and national digital currencies officially exchanged with fiat currency is emerging. The author briefly explores the new world of authorized security tokens, the insurance opportunity, and the STO (security token offering).
Latterly in 2018 live substrates emerged which will change the way we tokenize in the future so InsurTech developers can concentrate on their innovation and not have to develop all the underlying blockchain components necessary to get compliance. One such substrate for the insurance or protection industry was the emergence of InsurWave (EY, Guardtime with Insurance ecosystem) which was targeted at the commercial insurance industry but can be used as a base for other applications bringing in security and privacy by design and the key properties of blockchain as the foundation. However, there must also be a compliant tokenization platform to issue, manage, and trade regulated security tokens to handle to and exchange fiat currency. Such platforms are emerging globally to supply end-to-end exchanges with interoperability to the blockchain substrate.
As utility tokens now need to be issued in conjunction with security tokens, then we must understand the properties of securitized tokens, the mechanism of an STO (security token offering) and the compliance issues.
"It is absolutely imperative that tracking of ownership is done on a blockchain architecture but with a true representation of an asset subject to the same rules as traditional security"
Serious key domiciles are emerging to make this viable in 2019/2020 not only in the USA but the Cayman Islands, Bermuda, Luxembourg, Liechtenstein, Malta, and Switzerland.
Three kinds of basic tokens can be generated as assets on a blockchain first the Currency Token, which is a payment method, secondly the Utility Token, which is a service or a product and thirdly the Security Token, which is a financial instrument with revenue comparable to the traditional securities. That means the security token is fungible with monetary value covering equity, debt, and funds allowing investors to gain access to what is essentially a diversified special purpose vehicle (SPV) using tokens. They can be used as closed offerings with a specific number of shares or open with no limit and have to meet the regulations in the particular jurisdiction of origin.
Blockchain is utilized as it has data provenance and accepted as a legal proof so can be used as the primary registry for securities (certain standards will be required such as KYC, AML, and data integrity. If a jurisdiction does not accept blockchain in this manner, then it will only be a mirror representation of a regulatory registry and not compliant. It is absolutely imperative that tracking of ownership is done on a blockchain architecture but with a true representation of an asset subject to the same rules as traditional security. However, the benefits of blockchain technology apply with trusted data sharing, automating compliance as part of the ecosystem, removing the dependency on third parties, applying measurable truth with immutability on ownership of security complying to GDPR all of which combine to make governance and ownership more reliable.
This allows global reach, lower fees, and fractional ownership of assets to investors. The difference between this and utility tokens is that security tokens require accredited investors. The diversity can be applied to large insurance risk pools, financial inclusion mutual pools, and especially pension funds looking for non-correlated portfolios. In short, this approach is all about liquidity and the ability to move illiquid assets in insurance quickly to a constantly trading market.
This is a fast moving tsunami for the financial services industry, and the status quo will only be able to resist and slow it down for a short period. Regulatory risk is a challenge as technology moves faster than regulation, and we need to achieve global regulation through international standards. The other challenge is fiscal and based on the global borderless ecosystem and how cross border transactions are handled to avoid regulatory arbitrage and keep control and visibility. Transparency at issuance time will be of essence. A security token is a regulated financial product, so the usual rules apply to protect investors and to avoid market manipulations.
Once the insurance risks are placed and pooled, they can be securitized, and risk transfer can take place to an accredited third party such as investment banks and hedge funds. The insurance solvency rules such as Solvency II apply, so that risks may be adjusted by risk charges depending on rating rules of jurisdiction. The ecosystem can know how to handle the trade through the security token architecture stack. The INTERNET has a stack of protocols to enable operability. However, it lacks security and provenance by design, so we need to add the blockchain layer over the INTERNET to make it attributable and immutable. The tools already exist to create these underlying stacks, so no one has to reinvent the wheel. It is essential to lower the cost and time overhead of compliance while at the same time ensuring the investors get more liquidity with reduced barriers and the regulators get more visibility. We are in a position to create new asset classes in a low-interest environment and diversify portfolios. The die is cast.