Cyprus Leading Blockchain-based Securitization
Authors:
Markos A. Kashiouris is the Founder and Chairman of the IronX Exchange and the Notesco Group Founder, Chairman and Chief Executive Officer.
Dr. Theodosis Mourouzis is a Research Fellow at UCL Centre for Blockchain Technologies, PD of Business intelligence at Data Analytics at CIIM and Advisor to the IronX Exchange
Professor Paolo Tasca is a Founding Director of the Centre for Blockchain Technologies at the UCL and the Chief Blockchain Advisor for the IronX Exchange
We explore the multiple benefits of Blockchain-based Securitisation for Cyprus. Aside from creating a clear competitive advantage vs. likely competition, our analysis indicates that capturing a very conservative 2% of the expected Blockchain-based growth in the global Securitisation market will lead to an annual 6% increase in GDP and halving of unemployment.
Executive Summary
This document explains in depth the concepts of Blockchain and Distributed Ledger Technology (DLT) along with their associated impact and future potential for bringing technological innovation and attracting investments to our island.
Cyprus possesses all the characteristics required to become a pioneer and a global leader in the Blockchain arena by opening up the worldwide Blockchain Securitisation sector.
What is Blockchain?
Blockchain or Distributed Ledger Technology (DLT) is a ground-breaking emerging digital technology that has the potential to streamline processes and procedures, lower costs, eliminate extra overheads, improve the speed of transactions, enhance transparency and fortify security by allowing efficient peer-to-peer transactions. This technology first appeared as the accounting ledger supporting the Bitcoin protocol, introduced by Satoshi Nakamoto in 2008 in the paper “Bitcoin: A Peer-to-Peer Electronic Cash System” (Satoshi Nakamoto, 2008).
According to Harvard Business Review (HBR, May 2016) “Blockchain is the technology most likely to change the next decade of business … is not the social web, big data, the cloud, robotics, or even artificial intelligence”. The impact of Blockchain technology is multi-dimensional and has the potential to transform society at different levels: economical, political, societal and many more.
Blockchain and DLT were among the main focal issues of discussion at Davos this year. The World Economic Forum survey suggested that 10 percent of the global GDP will be stored on blockchain by 2027. In addition, several governments and big enterprises have published reports on the potential implications of Blockchain, and the past two years alone we have seen more than half a million new publications on Blockchain, 3.7 million Google search results for Blockchain while more than 2,500 patents on Blockchain have been submitted (Carson et al, 2018).
A significantly increased interest for applications of this technology is observed world-wide. Governments and enterprises discuss how to apply it to different sectors such as: Digital Identity, Payment, Supply Chain, Health Records, Digital Rights Management, Legal Contracts, Land Registry, Transportation, Taxation, and Voting.
Well…What is Blockchain? It is another form of database?
Blockchain is a continuously growing list of records (called blocks) securely linked using irreversible cryptographic functions, called hash functions. As soon as records are approved and stored on the ledger it is computationally infeasible to modify them.
The transactions populated under a block are checked and verified by the whole network and the decision whether a transaction or block is valid arises democratically from the entire network without the need of a trusted third party to oversee the activity. Cryptographic sealing takes place binding all the transactions (present and past) together, resulting in an immutable and transparent version of the ledger. Figure 1 describes how information flows in a Blockchain-based ecosystem.
A new generation (second generation) of Blockchains also allows for the encoding of smart contracts (encoding of terms and conditions into executable code) automating legal procedures in a very transparent and fully auditable way. Lastly, there is a third generation of Blockchains that are considerably improved in terms of scalability, security and automation.
Why is Blockchain important? Its importance arises from its unique combination of properties:
● Decentralisation: No single point of trust and thus no single point of control.
● Auditability: Participants of the network can verify the veracity of records directly, without external querying.
● Construction of direct trust: Unknown (and untrusted) parties can operate without need of third-party intermediation.
● Elimination of Single Points of Failure: No Central Authority or intermediaries are needed to oversee the transactions. A copy of each ledger is stored and maintained by each node of the network.
● Security: Strong cryptographic primitives (hash functions, digital signatures) are deployed to secure the network and the ledger.
● Transparency: The ledger can be public and maintained by all nodes of the network.
● Immutability: It is computationally infeasible to change any records on the ledger due to cryptographic sealing taking place via irreversible hash functions.
● Reliability: Resistance to outages and manipulation.
● Automation via Smart Contracts: Terms and conditions that underpin contracts can be encoded on the Blockchain using scripting languages compatible with the selected framework.
Blockchain, DLTs and Their Potential Impact
Blockchain and DLTs have been applied across many industries and especially the financing sector. The Tokenisation (token generation events) aspect has been extensively applied during 2017 and 2018 for capital raising and subsequent financing of new ventures and startups in a so called Initial Coin/Token Offering (ICO or ITO).
Source: https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp
ICOs have been used by startups to bypass the rigorous and regulated capital-raising process required by venture capitalists or banks. Startups raised over $5 billion in funding through the issuance of new digital tokens in 2017 alone while in the first half of 2018, more than double that amount has been raised (Lielacher, 2018). Figure 2 depicts the top 10 ICOs for 2018 ranked by amount of dollars raised. EOS and Telegram have been the leaders in the space raising more than 4 and 1.5 Billion dollars respectively.
It is worth mentioning that several Blockchain-related ventures with offices in Cyprus have also succeeded in this field and have raised considerable amounts of money to develop their ideas. Such examples are IronX (~$26M), trade.io (~$31M), NAGA (~$50M), PumaPay (~$120M) and others.
Figure 2: Top ICOs ranked by amount of $ raised (vid. BitcoinMarketJournal)
ICOs have opened up more funds for startups, many of which might have struggled to find investment otherwise though traditional Venture Capital raisings. However, ICOs have been scrutinised extensively by the public, governments, regulators and institutional investors since they have been operating in a legal and regulatory gray area. Due to this regulatory uncertainty, many scams have been observed, resulting in investors’ funds being lost.
Despite the above problems, the technology has proven its worth so what remains now is to provide a friendly framework to investors in order to secure the process from a legal/regulatory perspective.
The natural evolution of ICOs, now called STOs (Security Token Offerings) is expected to be the next wave of innovation. The word securities refers to turning tokens (virtual currency/cryptocurrency) into legally compliant securities rather than a bundling of assets (or tokens) to be sold as securities.
US SEC was already using the characterisation of security tokens during the first crypto wave of the ICOs. SEC classifies tokens as securities based on the Howey test. Most of the ventures were trying to avoid the complex regulatory framework and thus they were characterizing their tokens as utilities, wrongly in many cases, leading to huge penalties (SEC Rule 506 of Regulation D, 2017), (Manhattan Street Capital, 2017).
Source: https://www.investopedia.com/terms/s/security-token.asp
Countries like Malta, Gibraltar, Estonia, Switzerland, and Luxemburg have adopted Blockchain friendly legal/regulatory frameworks and this has proved to be very beneficial for their countries since they have attracted substantial foreign investments. Especially, Malta has succeeded in attracting multi-billion players in the Blockchain space, such as Binance, OKEx and Tron. It is worth mentioning that Malta has launched crypto friendly frameworks around ICOs, Exchanges or DLT licenses but they have not considered any crypto friendly regulation for governmental services, especially related to the central bank, leading to huge complexities and confusion.
Transparent Securitisation via Blockchain and DLTs
Securitisation is a financial process that can be used to consolidate a set of (illiquid) assets into tradable securities. Examples of such assets are mortgages, alternative investments, certain types of options, futures and forward contracts, types of bonds and debt instruments, among many others.
The global Securitisation market is $10.4 trillion in size, with the U.S. Securitisation market representing 86 percent (Morgan Stanley Investment Management, 2019) of global financial assets, while the value of all publicly traded stocks (global financial assets) is in the order of $300 trillion. Note this last figure does not include privately traded or illiquid stocks, or non-share stock and bonds securities, like derivatives or other forms of investment like real estate or art. The current trend of cryptocurrencies and especially asset-backed tokens (e.g. those backed by real estate) is an additional market to explore (Robespierre, 2018).
The Securitisation process is very useful for financial institutions that are looking to increase the liquidity of their assets and free up capital. Financial institutions that own too many long-term non-liquid assets and want to free up capital for new investments can benefit from securitization. This method provides a way to add liquidity to assets that cannot be readily bought or sold. The assets can be pooled together and divided up into securities, which can be publicly traded. Securitisation gives investors an alternative to riskier investments like stocks.
The challenge with Securitisation is that it involves a very complex process and generally requires the input of many parties such as creditors, lawyers, regulators, underwriters and loan officers. Precisely for this reason, it has not been widely implemented yet to its full extent due to inefficiencies in the current technology. Blockchain or Distributed Ledger Technologies (DLTs) can be used to provide more transparency, standardisation, automation and streamlining of the Securitisation process.
How does Tokenisation work?
In its most basic form, the process involves two steps:
- A company with loans or other income-producing asset (the originator) identifies potential assets and pools them into the reference portfolio. Then the company sells this asset pool to an issuer (such as a Special Purpose Vehicle — SPV).
- The issuer finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on — minus a service fee — directly to the SPV or the trustee. In essence, securitization represents an alternative and diversified source of finance.
This process can be streamlined using Blockchain and Smart Contract Technology. The steps needed for Blockchain-based securitization are:
a) Asset or Equity Tokenisation
b) Generated tokens bought by retail and institutional investors
c) Tokens listed on Security Token Exchanges
d) Exchange transactions records stored on the Blockchain
e) Stock ownership Information on Blockchain
f) The Dividends shared using Smart Contracts
Several countries and big players in the space have already expressed their interest in the Securitisation of assets. Good examples are Nasdaq Inc. and Citigroup Inc. that were among firms that invested $20 million in Symbiont.io Inc., a New York-based company that is applying blockchain technology to capital markets, expressing the enthusiasm of Wall Street with respect to the technology. The company is using smart contracts to set pre-programmed agreements that determine how complex financial instruments will behave in different scenarios. It is also using blockchain technology to help speed up settlement times for syndicated loans and to improve efficiency in the mortgage bond market (Marsh, 2019).
The Benefits from Securitisation are Enormous and Now More Achievable via Blockchain Technology:
● Provide liquidity to non-liquid assets: Liquid assets are valued at a higher premium. It stimulates and substantially enhances the global liquidity by underpinning the financial services infrastructure of the future, serving as the global unifying protocol, centered upon compliance, security, and universal interoperability.
● The securitization industry would be lower cost, more efficient, larger, and more resilient to fraud and downturns due to the inherited characteristics of Blockchain technology.
● Frees up capital for lending: securitization provides financial institutions with a mechanism for removing assets from their balance sheets, thereby increasing the pool of available capital that can be loaned out.
● Lowers the cost of capital: a corollary to the increased abundance of capital is the fact that the rate required on loans is lower interest rates promote increased economic growth.
● Spreads the ownership of risk: Pooling and distributing financial assets provides greater ability to diversify risk and provides investors with more choice as to how much risk to hold in their portfolios.
● Provides profits for financial intermediaries: Intermediaries benefit by keeping the profits from the spread, or difference, between the interest rate on the underlying assets and the rate paid on the securities that are issued.
● Creates an attractive asset class for investors: Purchasers of securitized products benefit from the fact that these products are often highly customizable and can offer a wide range of yields.
● Allows international accessibility due to the international nature of the Blockchain since it will be accessible and transparent to international investors.
● New employment opportunities will appear since potential funding will be attracted.
● Trading volume would rise, spreads fall, prices improve, and the growth in safe and stable securitization would increase the supply and lower the cost of credit to the broader economy.
● Eliminate the issues of poor documentation and fraud that troubled the industry during the last great downturn. Macroeconomic conditions, servicers, rating agencies, and investors could all take measures based on verified, real-time data while Blockchain’s immutable data.
Cyprus Embracing Blockchain Innovation and Potential Benefits
The financial sector is undergoing a massive paradigm shift due to Blockchain Technologies and the great financial powers, namely G20, have realised their enormous potential and hence are working hard to establish frameworks and regulations that will facilitate Securitisation via Blockchain and DLTs (Wall, 2018).
As previously mentioned the global securitized market is $10.4 trillion in size and the value of all publicly traded stocks (global financial assets) is of the order of $300 trillion (Morgan Stanley Investment Management, 2019). Hence the current Securitisation market is only 3.5% of the global financial markets. In addition to this, the potential pool for illiquid, non-financial and non-publicly traded financial assets is even larger than $300 trillion. These two pools are expected to grow by a minimum of 20% over the next 5 years (i.e. 4% per annum), resulting in a global asset pool of at least $720 trillion.
According to CNBC, the net worth of all traded cryptocurrencies was projected to reach $1 trillion in 2018 (CNBC, 2017). However, institutional pressure and regulatory uncertainty forced this figure to drop to around $115 billion today since investors have lost their confidence. There are strong beliefs that a proper legal/regulatory framework will reestablish confidence to investors leading to an expected ten-fold growth of the space. This will result to a new crypto market of the order of at least $10 trillion within the next 5 years, with the large majority of it being fully securitised.
Globally, Blockchain is being hailed as the new method to facilitate efficient Securitisation of a larger piece, especially related to the illiquid global financial assets, due to its technological innovation, leading to decreased costs through disintermediation and process streamlining. If Blockchain is conservatively applied to a small percentage (circa 3%) of the $720 trillion global asset pool, this will result in an additional growth in the global Securitisation market of the order of at least $22 trillion in the next 5 years.
As a result, our highly conservative projection is that in 5 years the global Securitisation market will reach a minimum of $32 trillion, with $22 trillion being new additional Securitisation offerings. Even at $32 trillion, the Securitisation market will only account for only just over 4.4% of the underlying global (financial and non-financial, liquid or illiquid) assets.
Cyprus should target to become a pioneer and leader in the global blockchain-driven securitization market by setting up a proper legal/regulatory framework and infrastructure. We have undertaken a five year forecast aiming at quantifying the economic impact to its economy: assuming that Cyprus can capture a very conservative average 2% share of the incremental Securitisation market of $22 trillion within the next 5 years, resulting in the creation of a Cyprus-led Securitisation market in the order of $440 billion. Assuming an average fee of 1.5% stemming in the Cyprus Securitisation ecosystem for enabling and implementing such Securitisations (Securitisation arrangement fees 0.5%-0.75%, exchange fees 0.5%, and advisory fees 0.25%-0.5%), an estimated additional GDP of $6.6 billion will be generated for Cyprus in a period of 5 years, i.e. average of $1.32 billion per annum.
Current GDP of Cyprus is around $22bn, the benefits of Blockchain-based securitization will amount to an increase in GDP of the order of 6% per annum as direct impact.
Multiplier effects on the overall economic activity and employment sector will also be observed. Based on Okun’s law (every 4% increase in GDP results in 1% reduction in unemployment rate), we should expect an additional annual job creation for approx. 7,000 people, primarily recent graduates and young professionals. A large part of these jobs will be highly skilled and technical in terms of blockchain specific technologies, hence foreign personnel will have to be imported. However, given overall economic activity growth and new business creation, significant additional jobs for the Cypriot workforce will be created too, while a unique opportunity for young Cypriots to be educated in the new blockchain technologies will arise. Both these factors are expected to result to a reduction by c. 50% in unemployment rate over the 5 year period, allowing Cyprus to reduce unemployment rate from 7.5% to 3.7% and creating c. 7,000 new jobs per annum.
By taking into account (a) 12.5% corporate tax (to be applied to 20% of the additional GDP, i.e. $264mn per annum); (b) 20% Social Insurance contributions by employers and employees (to be applied to the additional employment income, estimated at around $200mn per annum), and © 20% income tax (to be applied to the additional employment income, estimated at around $200mn per annum), this will result in additional direct State cash income of c. $133 million per annum (or $563 million for the five year period) with substantial additional indirect revenues through business establishment and employment. Appendix/Table 1 presents figures of our forecast analysis regarding the impact of Securitisation in Cyprus.
Concrete Use Cases for the Government of Cyprus
● A clear competitive advantage in the competitive landscape for (regulated) financial services.
● Blockchain Securitisation can be an attractive funding source for Banks to support their lending activities. Similarly, companies and startups can sell tokenised equity to increase their capital and fund their operations by reaching a wider international audience.
● Banks can use Blockchain Securitisation for their Non-Performing Loans (NPL) Tokenisation and efficient distribution to investors. For example, create asset-backed tokens using real-estate (such as real estate assets of the NPL portfolios) in order to attract more investors from international pools.
● Companies and startups can sell equity to increase their capital and fund their operations by reaching a wider international audience. Especially, in Cyprus where the investor ecosystem is underdeveloped, access to investment capital will be a crucial ingredient for success.
Apart from the direct economic benefits in terms of additional GDP growth, reduction in unemployment and additional State income, the benefits of Cyprus embracing the Blockchain innovation will be enormous and will transform the country into an intelligent island. Some of the immediate benefits:
● Attraction of foreign investments for startups and SMEs. That will complete the current startup ecosystem since it will attract funding from potential investors.
● New talent will be interested in residing in Cyprus.
● Educating young Cypriots in a cutting edge technology, making them a highly skilled and highly competitive employee force around the world.
● New opportunities for the island’s services industry (legal accounting, corporate services) will arise by adding Blockchain related services to the already established accounting and legal sectors.
● Crypto friendly regulation (regulatory framework) will provide incentives to new businesses (tokenized startups and exchanges) to be established in the island. It is worth mentioning the example of Malta (vid. Figure 3) that has attracted most of the big crypto exchanges (including Binance, OKEx, Tron, etc.) to its jurisdiction after establishing a crypto-friendly legal and regulatory framework (Morgan Stanley Research, 2018).
● Cyprus, as a FinTech hub, possesses deep experience and track record in the online trading industry and this mark of excellence can be directly applied to the token/securities exchange industry.
● A regulated DLT license will allow current trade-related companies to be involved in the token/security trading industry and subsequently bring more maturity into the space. This will establish Cyprus as a pioneer in the Securitisation industry.
References
● Adrian Robespierre. Asset-Backed Tokens will lead to the first truly valuable Utility Tokens. Link at: https://medium.com/@RobespierreBran/asset-backed-tokens-will-lead-to-the-first-truly-valuable-utility-tokens-65156b9defd3 . 2019
● Alastair Marsh. Nasdaq, Citi Join Novogratz in Funding Blockchain Firm Symbiont. Link at: https://www.bloomberg.com/news/articles/2019-01-23/nasdaq-citi-join-novogratz-in-funding-blockchain-firm-symbiont 2019
● Alex Lielacher. Top 10 Biggest ICOs (by Amount Raised). Link at: https://www.bitcoinmarketjournal.com/biggest-icos/. 2018
● Andreas Jobst. What is Securitisation. Link at: https://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf . 2018
● Brant Carson, Giulio Romanelli, Patricia Walsh, and Askhat Zhumaev. Blockchain beyond the hype: What is the strategic business value? McKinsey Reports. June 2018.
● CNBC. Cryptocurrency market will hit $1 trillion valuation this year, CEO of top exchange says. Link at: https://www.cnbc.com/2018/02/13/cryptocurrency-market-to-hit-1-trillion-valuation-in-2018-kraken-ceo.html . 2017
● Jeremy Wall. G20 Leaders Agree To Establish Regulatory Framework For CryptoAssets. Link at: https://www.investinblockchain.com/g20-regulatory-framework-cryptoassets/ . 2018
● List of Countries by Projected GDP. Link: http://m.statisticstimes.com/economy/countries-by-projected-gdp.php 2018
● Manhattan Street Capital. How to determine if a token is a security — the Howey test. Link at: https://www.manhattanstreetcapital.com/faq/for-fundraisers/how-determine-if-token-security-howey-test . 2017
● Morgan Stanley Investment Management. An Overview of the Global Securitized Markets.Link at: https://www.morganstanley.com/im/publication/insights/investment-insights/ii_anoverviewoftheglobalsecuritizedmarkets_en.pdf . 2018
● Morgan Stanley Research. Where are Exchanges Based? 2018
● Harvard Business Review. The Impact of Blockchain goes beyond Financial Services. May 2016
● Satoshi Nakatomo. “Bitcoin: A Peer-to-Peer Electronic Cash System”. Technical paper. 2008
● SEC Rule 506 of Regulation D.
Link at: https://www.sec.gov/fast-answers/answers-rule506htm.html . 2017
Appendix
