Deriveum

Abstract

Deriveum is the first tool that allows debt insurers to guarantee payment to investors in all circumstances. This allows for clear risk distribution and open the ability of investors to calculate with certainty their exposure and return. This in turn mobilizes investment to high-impact projects that create jobs and prosperity, predominately in emerging economies.

Why a renewable energy project in Africa stay unfinanced?

Let us imagine a renewable energy project in Africa. The weather conditions are ideal, the total cost for the project would be around $90 million, creating over 400 jobs in the process and being viable for bond returns of 5% per year. This project has it all – very high return (comparative), green streak, supporting energy generation in the part of the world that desperately needs energy. Still this project will stay unfunded. The reason has to do with mathematics. Fixed income investors (bond purchasers) have a very clear models what return would be required to cover their risk of unsecured (not insured) bonds. In our case that would be at least 7% annual return, on top of the principle. Naturally, if the bond is secured (the risk is mainly in someone else’s court) investors will be willing to finance the project at much lower 1.5%. However, all the project managers can offer is 5% unsecured bond. Unless there is something moving in this story the renewable energy needed to power growth in Africa will stay only on paper.

Credit Default Swaps (CDS) to secure a bond

Fortunately, there are instruments for securing debt called Credit Default Swaps (CDS). A third party – usually financial institution or hedge fund – steps in and takes the risk of default for a premium. This way the investors know that their return is secured and are happy to split the bond yield. Or at least were happy to do it before 2008. The Lehman Brothers and AIG fiascos demonstrated the dangers of CDS deals – that the insurers can go bust in a systemic event. The following G-20 level Pittsburgh Reform (200902016) made the situation for the CDS market even worse. Central clearing houses were introduced, which pushed the small and medium players (especially in emerging economies) out of the market. The result was higher certainty and reduction of the market size with 80% in the period 2007-2019.

Deriveum – the new collateral class tailor made for the CDS market

Deriveum is a new collateral class developed in the regulatory and technical sandbox of the European Central Bank/Bank of Lithuania. It is blockchain based and works in radically new way – hybridizing the currently existing collateral classes and adding a DLT smart contract in a compliant manner. By using Deriveum emerging market financial institutions can safely return to the CDS market gaining competitive advantage over the larger investment banks, as the latter may not provide the level of certainty Deriveum guarantees. We empower financial institutions to provide insurance services in their own market – the place they know best.

Getting 7% yield out of 5% return

To get back to the African renewable energy generation project. It will issue bonds at 5% annual return. The key here is that every bond has residual value in a default. To be secured investors do not need 100% coverage of the bond; in our case we can safely assume that if the first 50% lost is covered the investors will have no problem to sell their bonds at half value. So, should the local Insurer put $45 million as a collateral and collects 3.5% premium on the $90 million bond in essence the return for the Insurer will be 7%. This will make it worth-while for the insurer to back the project as unsecured investment. On the other hand, the investors will be willing to lend money at 1.5% to secured bond. The project managers can now offer the 5% return and have fully funded and viable project. All that is needed for the numbers to click is to have a tool allowing anchoring of risks between the parties. And Deriveum is precisely such a tool.

Scaling up

The statistical database of the Bank of International Settlements can be used to estimate the underserved market – bonds that would benefit from insurance but are currently uninsured due to the market uncertainty. Towards the second half of 2019 there is approximately $7 trillion worth of such projects world-wide, as most are concentrated in developing economies such as South-East Asia, Latin America, and Africa. Still, the ECB following the lessons from the previous crisis will hard-cap Deriveum to maximum exposure of $80 billion, which is around 1.13% of the addressable market. Though we will not be allowed by the regulators to reach the whole market, we can estimate the substantial social benefits that those $80 billion mobilized to support high-impact projects will deliver.

Social benefits

Besides the significant monetary benefits for Insurers, Investors and Issuers the increased investment activity will bring about a number of well modeled social benefits. First, is the creation of over 400 000 jobs across the globe, predominately in emerging economies. Simply putted the mobilized private investment will create sustainable economic activity, which will be powered by sustainable jobs. Secondly, the local exchequers will get over $500 million in additional tax revenue, which is crucial for funding social services in emerging economies post-Covid. Thridly, the increased interest of foreign investors to high-yielding, high-impact projects are likely to drive the financing costs down. Our models suggest that over $450 million a year will be the cumulative cost reduction for projects using Deriveum as risk-managing tool. Overall, we are convinced that Deriveum will have far-reaching implications for millions of people across the globe.

Finastra and Deriveum

We are required by the regulators to split the information our customers will be storing among cloud-based solution (Finastra) and DLT-based one (Corda). We are convinced that Finastra will be a very strong contender to manage and support the technical side of the business that is required to be separate from the DLT solution part of the business. We are looking forward to explore the rich possibilities Finastra provides to developers.

Built With

• corda