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An experiment with DeFi for Alternate Risk Transfer instruments: liquidity & additional income.

Updated: Oct 5, 2021

Kirthi Gogulamudi

Mark Richardson

Industry Associate UCL CBT, Civitas Fintech

Finance & Economics Consultant, Bancor


The value of any asset can only be expressed relative to something other than itself. Therefore, a confident valuation of any asset assumes that the market has the capacity to learn that value through free exchange of assets according to their relative desirability. Illiquid assets cannot be quickly exchanged for other forms of value, which introduces an unwelcomed ambiguity into some financial instruments. Such uncertainty is not only detrimental to the individuals and institutions that hold these assets, but also to the stability of the financial system to which they belong.

These issues are likely as ancient as civilisation, and the price discovery mechanisms used in the modern financial world a close homolog of those that arose thousands of years ago. Prices are still determined at an active marketplace, and implicitly under the control of a market maker. The burden of responsibility is profound. Market makers influence the price discovery process through their active management of available liquidity; their influence is irrefutable and is realised regardless of their intentions or awareness. This property of illiquid assets is a consequence of their difficulty to make markets with – a trait that often reflects the aversion of the market maker to be exposed to the asset for any significant length of time.

These issues have recently found a compelling answer from an unlikely source. Early cryptocurrency projects, including the first community currencies established by Bancor, struggled with precisely the valuation challenges outlined in the above paragraphs. Without the approval of professional market makers, the cryptographic tokens of their associated blockchains were essentially denied the means to discover their market value. Thus, the Automatic Market Maker (AMM) was invented. Unlike its human counterpart, the AMM applies a pricing algorithm that unbiased, predictable, transparent, and auditable. Moreover, AMMs permit the exchange of assets only between parties who have agreed to take exposure to the traded assets, thus mitigating the artificial devaluation experienced when such transactions must pass through the hands of a reluctant intermediary. The success of this technology is beyond question. From the outside perspective, the AMM has progressed out of the infancy of its establishing phase and is now immediately recognisable as a bona-fide technological answer to a problem that has existed since ancient times.

The liquidity problems that gave rise to AMMs are not unique to digital assets or decentralised finance. Herein, we demonstrate that AMM technology can be applied within a regulated and permissioned environment to ameliorate the liquidity issues of a critically underserved component of the global financial infrastructure. Inspired by the protocols and business models of its decentralised finance (DeFi) forbearers, Civitas Protocol seeks to establish a ring fenced, centralised AMM for the explicit purpose of creating a novel means of exchange for the insurance-linked security (ILS) between institutional-level players. We show that AMM technology offers a straightforward mechanism for transparent pricing, better risk mitigation and liquidity compared to the status quo. The improved efficiency achieved in our approach helps to maximise the appeal the ILS, and other Alternate Risk Transfer instruments (ART), and could support a broad spectrum of potential investors.

In summary, the technology outlined in this white paper relieves the dangerous inconvenience of an essential financial primitive and permits a productive conversation regarding the functioning of its secondary markets.


What are Insurance Linked Securities?

Alternative risk transfer (“ART”) instruments are the portion of the capital market that allows institutions to outsource risk.

The ILS is a specific product within this category and allows insurance risk to be spread over a large surface area comprising individual investors, other institutions, or combinations thereof. The fastest way to understand the ILS is to examine the ways it can be used to sustain insurance businesses.

  1. Portfolios of low-severity, high-probability insurance policies. Consider an insurance policy for an event that is likely to happen but has a relatively low cost. Assuming the risk for a single policy is a bad idea; even when priced correctly, the likelihood that a single investor to whom the risk is transferred will make a return is unacceptably low. However, when enough policies are bundled together, the law of large numbers begins to dominate and the expected return for assuming the risk on the collection becomes stable. Therefore, an ILS constructed from many such policies provides investors with an acceptable risk/return profile while allowing the insurer to cover more risk than their own capital could realistically underwrite.

  2. Reinsurance for high-severity, low-probability events. Transferring the risk of a catastrophic insurance event from a single sponsor to a group of investors is similarly beneficial. Catastrophe bonds (or CAT bonds) emerged in the wake of Hurricane Andrew (1992) and the Northridge earthquake (1994), after it was realized that widespread damage on such a scale could outstrip invested premiums. Hurricane Andrew resulted in 600,000 insurance claims which led to the bankruptcy of 11 insurance companies; the Northridge earthquake ultimately caused the discontinuation of earthquake insurance for residents of California. The CAT bond allows for very high-value risks to be effectively underwritten with quasi crowd-sourced capital. Investors share the risk between them and receive coupons from the insurer for doing so. The overall risk/return remains the same; however, the dilution of catastrophic losses over a breadth of sourced capital helps to alleviate an impossible burden for a single, or small number of sponsors.

In short, the ILS allows investors and institutions to take on insurance risks via a regulated intermediary. The risk transferred is effective in all circumstances, and its extent is clearly defined and incontrovertible for the duration of the contract. Investors are rewarded for the risk they take on in the form of coupon/dividend/return.

Regulatory Requirements of ART Instruments

  • Assets must be valued in accordance with IFRS or UK GAAP.

  • Insurance Special Purpose Vehicle must always have assets which equal or exceed the aggregate maximum risk exposure and be able to pay amounts as they fall due.

  • Proceeds of debt issuance must be fully paid-in.

  • Cannot use contingent assets.

Opportunity for DeFi

An ART instrument in most cases Leverages a multi-arrangement insurance special purpose vehicle (MISPV), a risk transformer vehicle arrangement. The MISPV structure has a separate cell for each risk transfer contract, and each has a segregated pool of assets and liabilities (record-keeping). Each cell is insolvency-remote from the other cells. Investors in each cell are confined to non-voting securities.

Blockchain technology complements the cell structure. Its capabilities showcase the transparency, immutability, and telemetry required to manage and trade these non-voting securities with high speed and low cost; in full-view of the regulator at arbitrary levels of detail, at any time and without prior notice.



The process of creating these non-voting securities/Insurance linked securities tokens or any digitally represented assets on a blockchain is termed tokenisation. Tokenisation harnesses the immutability The process of creating these non-voting securities/ Insurance linked securities tokens or any digitally represented assets on a blockchain is termed tokenisation. Tokenisation harnesses the immutability and programmability of public or permissioned Blockchains to construct most financial instruments. The term permissioned is used to refer AML, KYC, FATF, compliant actors aka Whitelisted parties. Tokenised assets are not only a fractional representation of the pro rata ownership of their holder; the immutable code (or ‘smart contracts’) from which their properties are derived can also impart features that can guarantee regulatory compliance. Therefore, the regulatory sensitivity of ART instruments in general, and the ILS specifically, makes for a compelling cryptographic token use case.

Token behaviour can vary based on asset class. For example, they can be fungible or non-fungible, freely exchangeable or strictly limited to transfers between known parties. These properties are intrinsic to the token and are automatically enforced with the implicit consent of its holder. Neither the token holder, or anyone, can force the token to behave in any way other than what is defined by its contract.

In the ILS use case, the ILS token is a digital representation of a fungible, non-voting security. HMT/FCA 2021 & FINMA 2021 guidance on cryptographic assets helps us classify ILS as a “Security Token”. Importantly, a tokenised ILS can represent transferrable, fractional digital asset ownership of the risk it underwrites. Moreover, the individuals and institutions permitted to own and trade the ILS token can be rigorously enforced, and their activities can be audited at any time, if need be. This ensures that participants in the proposed ecosystem are vetted and known to the regulator (AML/KYC compliant), who can choose to perform any action they wish with only the minimum of bureaucratic oversight. In short, the system in its entirety can be held to an arbitrary standard of compliance at the contract level, and be allowed to operate essentially unsupervised, with a higher level of legal confidence than is presently the case.


ILS Use Case: Civitas Protocol

The purpose of Civitas Protocol is to ameliorate the recognisable dysfunction of the ILS instrument for everyone involved – the issuer, investor, and the regulator. The expected outcome is an improved capital efficiency, transparency, and liquidity in the insurance capital value chain. Its flagship product is a tokenised, fungible, and liquid alternative to the traditional ILS. Civitas protocol (Project Apollo) is a subset of a large asset digitisation project called Project Athena.

Civitas Protocol is an advanced, low-cost risk mitigation and capital management tool that complements traditional risk management solutions.

Civitas Protocol offers non-custodial liquidity and price sensing for security tokens and is built exclusively for a regulated trading environment. The sponsor journey evolves with the use of cost efficient and operationally resilient technology layer.

Hybrid model: Best of traditional risk and DeFi

The ILS use case explores a hybrid execution model that bridges traditional risk management solution to a DeFi model.

The structure of the protocol is as follows:

  • The legal process of a counter party contract is kept off chain.

  • A Non fungible token (NFT) of the counter party contract is created on a blockchain.

  • This NFT acts as a trigger mechanism for risk transformation and tokenisation.

  • The token model ensures that capital is ring fenced, compliant and persistently auditable for all cells of the MISPV.

  • Fungible, tokenised fractional representations of the ILS are then sold on the primary market at a fixed-cost, as judged from the total remaining collateral and overall supply of the ILS token at the time of its production. Importantly, new tokens can be purchased until their supply is exhausted, without impacting their valuation. In a sense, the tokenisation model necessarily matches the supply with the demand, such that the issuance of new tokens has no direct consequences on token value.

  • Thereafter, token holders can earn additional, passive revenue from their investment by contributing to a liquidity pool (discussed below) of an AMM. The act of contributing liquidity results in the issuance of a second token, representing the liquidity provider’s share of the pool’s value. This second token (a “pool token” in the common vernacular) is a kind of receipt, or certificate of deposit, and is also fungible and transferable. This document refers to the pool token as ILSX.

  • The AMM provides a robust liquidity mechanism for the secondary market, allowing for other token holders to manage their portfolio with a flexibility and speed previously unavailable to this asset class. At this layer the ILS token is transferred only between primary market participants and the liquidity pool that they control.

  • Outside of the primary market, a secondary market can be established with the ILSX token – the receipt required to withdraw liquidity from the ILS trading pool. The ring-fenced construction guarantees the restricted access to ILS; merely holding the ILSX pool token is insufficient to redeem it for the underlying ILS liquidity it represents. Therefore, it can be traded between primary and secondary market participants, without compromising any of the regulatory criteria. To support such activities, secondary market liquidity can be established with the ILSX pool token, and which will result in the issuance of its own pool token, designated here as ILSXX. In principle, this chain can continue to abstract and dilute insurance risk through an arbitrary number of iterations; however, the usefulness of the process is obscured at any iteration following the issuance of ILSXX tokens.

  • Issuance, redemption, pricing and valuation factors are defined off chain based on the nature of structure; however, improvements in the field of blockchain oracles may allow for these components to also fall under the purview of financial automation in the distant future.

  • The ILS instrument is managed by a core structure of the MISPV, a semi-autonomous organisation (SAO). We will model some of these governance events i.e., issue, redemption, triggers, drawn downs and circuit breakers in the future state by a Centralised Autonomous Organisation (Civitas SAO Model), and which will be the subject of a future submission from us.

The SAO model offers significant cost reduction on fiduciary duties, management and regulatory reporting.


The Automated Market Maker Paradigm

AMM technology replaces the human guesswork of price quoting, usually performed by a professional market maker with the assistance of a centralised order book, with a mathematical function. In a true sense, the price of an asset quoted by an AMM becomes rigorously defined over the infinite spectrum of possible market changes. The convention is to represent the continuity of all possible price points graphically, by plotting the AMMs outputs on a cartesian axis. The result is an algorithmic “bonding curve”, or “price curve”.

The archetypal bonding curve is the “constant product” model, so named because the product of the assets contained within the pool is a fixed quantity. In mathematical vocabulary, a constant product bonding curve is described by a hyperbola, or cone section.

The bonding curve allows for market affects, such as increased demand, to be reflected in the price of any two assets sharing the same liquidity pool. As traders begin removing one asset from the liquidity pool, they do so by providing the other bonded asset. As the number of one asset is diminished relative to the other, its effective price is increased and vice versa. The process is dynamic, allowing for a process of continuous price discovery as determined by the actions of the market participants.

Hybrid configurations of the protocol

The AMM pools can be implemented to operate in a centralised or a decentralised configuration.

In the ILS use case, we use a hybrid architecture of both centralised (ILS/USDC) and decentralised (ILSX/USDC) pools to create a broad distribution of liquidity for both the primary and secondary markets, supporting nimble portfolio management strategies as well as passive income streams for qualified Investors.

The theory and background of AMM is beyond the scope of the present discussion; however, the following points are worth reiterating:

  • All participation, and therefore all collateral backing the ILS token and underwriting the insurance risk it represents, is strictly limited to registered entities.

  • Whitelisted (AML/KYC compliant with ZKP) participation is enforced automatically at the smart contract level.

  • Counter-party risk is protected.

  • Non-custodial pool design.

  • Continuous, uninterrupted liquidity for the ILS instrument.

  • Telemetry for regulatory reporting.

  • Additional earnings for investors who choose to provide liquidity.

  • Realtime auditability and traceability of all transactions.

Civitas protocol is asset/structure agnostic. It can be modelled to handle various nuances across different asset classes.


ILS Token in Cat Structure

An ILS token is a security token by design. A digital representation of the ownership of proceeds in the collateral pool of the Cat Structure. Its value is denominated in the USDC stable coin – a fully collateralised, digital representation of the US dollar, issued and maintained by Circle. At a fixed future date, a predictable number of ILS tokens can be redeemed for USDC stable coins. The value of the ILS token at redemption is determined by trigger events and accumulated coupons, of which both are both visible to all stakeholders well ahead of the redemption date.

The regularity of available redemptions, the visible existing TVL of the system, and anticipated future redemption all serve to inform token holders of the value of their tokens. The collateral trust account can report the fully diluted value of the ILS token at any time, and therefore acts as a type of price oracle for the system. While this serves to provide useful information to the token holders, it is also a critical component for the establishing the value of the ILS during issuance.

Cat Bond Parameters

We chose a Catastrophe (Cat) Bond as a primary scenario for the protocol simulation. Cat Bonds are issued for an expected maturity with the payment of coupons and retirement of principal dependent on the non-occurrence of a catastrophic event (such as an earthquake or a hurricane).

Trigger Event

If a catastrophe occurs, a cat bond investor receives a reduced yield, and forfeits a portion or the entirety of their principal. Importantly, these consequences are borne entirely in the symbolic representation of the provided collateral – the reported fully diluted market capitalisation of the ILS token is impacted, and which will likely cause an observable market reaction via the trading activity on the ILS and ILSX liquidity pools. However, the collateral that is represented by the ILS token is never exposed to these market forces. Rather, it is held by the insurance trust and has no direct interaction with the liquidity pools.

The advantages offered by the Cat structure are:

  • Risk is structured as an asset.

  • Low basis risk (parametric trigger).

  • Mitigates counter-party risk.

  • Favourable with respect to Risk Capital, Reg Capital and Credit Rating.

  • Improved Capital Adequacy ratio.

Simulation and Modelling

The value of the ILS token, as well as its issuance and redemption, are trivial to simulate. However, the responses of market participants are essentially impossible to accurately anticipate. To proceed with an examination of the proposed ILS tokenisation model, some rudimentary assumptions were required to establish a reasonable test environment and extract meaningful results. The following points summarise the general approach:

  • At the start of the simulation, the price of the ILS token is arbitrarily fixed at $1; changes in its valuation are the result of insurance claims and the accumulation of coupons to the insurance trust over time.

  • Primary market participants are assumed to control approximately three orders of magnitude more capital than secondary market participants.

  • The actions taken by primary market participants are generally more rational and less impulsive than those observed in the secondary markets.

  • The primary ILS liquidity pool is accurately and frequently arbitraged within the primary market, whereas the secondary market should feature more of a random walk around the fair evaluation of the ILSX.

  • The arbitrage activity within the primary market is therefore the only guided activity within the simulation; all other trading decisions, provision and withdrawal of liquidity, and their amounts are determined by a randomised distribution (i.e., Monte Carlo).

  • Insurance claims events and coupon accumulated value affecting the ILS valuation is immediately known to the insurance trust, and observed by the primary markets, which determines arbitrage activity and results in an arbitrary time resolution between the ILS true value, and its spot price inside the pool.

  • The pool fee (a commission paid by traders to the liquidity providers) of 0.5% is assumed for both the primary and secondary markets.

  • No consideration is paid to external influences; for the purpose of the simulation, the primary (ILS/USDC) and secondary (ILSX/USDC) markets are completely insulated from all other markets.

  • Therefore, there are no other forms of value available to the participants inside the simulation, other than USDC, ILS, ILSX and ILSXX.

  • The ILSXX token is used by all entities only as a deposit receipt for liquidity provision within the secondary market; this simulation does not consider tertiary markets with the ILSXX token or higher.

  • The primary market participants can access both the ILS and ILSX liquidity pools, whereas the secondary market participants may only access the ILSX liquidity pool.

  • The simulation covers a period of 1000 days, or nearly three years.


Simulation Results Summary

The precise results vary between runs; however, the results presented here can be considered a typical case.

  • A total of $11,983,234.19 in collateral was processed, of which $8,807,863.50 was redeemed at maturity by the primary market, concomitant with the destruction of 6,581,467.50 ILS tokens.

  • Immature policies at conclusion of the simulated time had $3,156,470.71 of locked collateral. At the conclusion of the simulation, $18,899.98 of unclaimed, redeemable USDC was available at a rate of 1.89 USDC per ILS token burned.

  • A total of 358,190 token swaps were executed across both liquidity pools, comprising a combined trade volume of $468,163,694.70 and generating 1,336,758.64 USDC, 527,165.29 ILS and 281,777.74 ILSX in fees for liquidity providers.

  • A total of 7767 discrete liquidity provision/removal events were performed. At the conclusion of the simulation, the primary liquidity pool contained 2,892,612.72 ILS and 4,398,427.32 USDC, and could support up to $100,000 trades in a single transaction with less than 5% price impact; the secondary liquidity pool contained 2,009,641.49 ILSX and 6,363,745.20 USDC, and could support up to $100,000 trades in a single transaction with less than 5% price impact.

What is important to appreciate from this demonstration is that that an asset class from the traditional financial world has been fitted to a tried and proven, new emerging technology from the cryptocurrency frontier. It is plainly apparent that the solution introduced by the pioneers of DeFi can be made to service the liquidity needs of existing financial instruments with superb results. In addition to relieving the frustrated nature of its illiquidity, which may adversely impact the desirability of the ILS at present, we also show that the act of solving this liquidity issue provides an additional, passive revenue stream for liquidity providers.

In addition to relieving the frustrated nature of its illiquidity, which may adversely impact the desirability of the ILS at present, we also show that the act of solving this liquidity issue provides an additional, passive revenue stream for liquidity providers.


Monetisation Strategy

A cursory review of the DeFi landscape reveals that systems such as the one being proposed here can rapidly evolve into a highly lucrative and self-sustaining business model. However, the costs producing and maintaining the contracts, producing and operating the front-end, bootstrapping the system, and marketing its utility to new users each account for a substantial overhead. In short, this is a business with start-up and ongoing costs like any other.

The explosion in DeFi projects provides a wealth of inspiration for a long-term monetisation strategy. There are two main categories of monetisation that apply to AMMs broadly, that are easily implementable, and for which a large reservoir of reference code already exists.

  1. Fee Confiscation. In the descriptions provided above, it is assumed that the commission earned on behalf of the liquidity providers is theirs alone. However, it is trivial to divert a portion of the trade revenue to a business wallet, that can be used to pay developer salaries and other costs, as well as reward seed investors. Under the conditions of the simulation above, a 0.5% business-side fee paid in addition to the pool fee (1% total commissions paid by traders), would equate to $3,030,631.09 in revenue over the simulated period. As stated earlier, it is important to remember that the numbers used in the simulation are ultimately untrustworthy – but serve a valuable illustrative, qualitative purpose. There is very sound basis to justify our conviction that these business models can be highly lucrative, although a precise estimate of future revenues is obscured by the novelty of the ILS in such contexts.

  2. Exit Fees. In addition to, or instead of the confiscation of trade fees, it is also possible to impose a type of service charge on liquidity providers directly. The most common manifestation of this monetisation strategy is to change a small penalty during liquidity removal, equivalent to a fixed proportion of the liquidity provider’s net position. This has the added benefit of encouraging liquidity providers to remain in the pool for longer time periods, thus maintaining a higher floor liquidity level for the ILS and stabilising the ecosystem.


Civitas Protocol offers a strategic cost advantage for the mISPV and significant return on capital invested (ROCI) for qualified investors. The evidence provided here, combined with the stunning anecdotal success of the DeFi sector, substantiates our claim to have developed a significantly improved method for creating and supporting primary and secondary markets for the ILS investment vehicle.

Next Steps

  • Advanced modelling to assess impact of trigger events on token value

  • SAO dynamics

  • Simulations for Price and Size

  • Enhance MVP build

©2021 by Civitas Fintech,



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