Preparing DeFi for Uncertain Times
The decentralized finance (DeFi) market's inherent risks have stirred intense discussions within the crypto community. Each week, we are bombarded with news of exploits, smart contract hacks, and stable assets losing their peg. It's disheartening to witness these events unfold. To foster widespread DeFi adoption, particularly from an institutional standpoint, implementing strategic risk management practices is absolutely crucial.
DeFi and its Problems
DeFi, or decentralized finance, encompasses a range of financial services utilizing smart contracts on public blockchains like Ethereum. It allows users to engage in activities such as earning interest, borrowing, lending, and trading with the advantages of faster transactions, no intermediaries, and open access for all.
However, there are some drawbacks associated with DeFi, including protocol exploits, hacks, and the lack of regulation, which exposes users to risks such as scams and unreliable projects. Additionally, the decentralized nature of DeFi poses challenges in terms of resolving disputes and recovering lost funds without a central authority. Given these concerns, it is clear that DeFi needs a backup plan: DeFi insurance.
What is DeFi Insurance?
DeFi insurance plays a crucial role in safeguarding against financial losses in the decentralized finance ecosystem. It acts as a safety net, offering preventive measures and protection for the crypto industry(1).
If a loss occurs and coverage is needed, individuals can approach a DeFi asset insurer for compensation. Premiums for decentralized financial insurance depend on factors such as coverage type, provider, and policy duration. It's important for the insureds to understand the specific incidents covered by their policy. Just like with traditional insurance, being aware of the risks involved is crucial when it comes to DeFi.
DeFi insurance operates in a decentralized manner, avoiding dependence on a single entity. Instead, coverage is sourced from investors, like Bob in Figure 1, who contribute to a shared pool of funds. By participating as a liquidity provider, anyone can become a coverage provider and earn rewards. This setup grants providers the flexibility to select specific events or protocols they wish to cover.
However, being a coverage provider, or underwriter comes with its own risks. There's a chance that the underwriter may have to pay out claims if the events they are covering actually occur. To compensate for this risk, the underwriter earns interest on the funds they lock up as a provider. This interest is often partially covered by the premiums paid by insurance buyers.
Figure 1. Illustration of How InsurAce Works
Let's take how InsurAce works as an example. Mary works with the InsurAce protocol as an underwriter. She invests her assets in a pool called the Cover Portal or coverage pool. This pool is used to provide insurance to cover buyers who have purchased insurance.
Now, let's consider Jack, who wants insurance coverage. Jack becomes a cover buyer and has the option to buy one or multiple insurance covers from the Cover Portal. If there is a hack or breach on the platform that has the insurance he bought, Jack has the right to make a claim if it's a claimable risk(2).
How are Claims Verified?
Claims verification in DeFi insurance protocols can be done through community governance or by using oracles (3).
In a decentralized autonomous organization (DAO) structure, token holders have governance rights and can vote to accept or deny claims.
Alternatively, claims can be automatically verified using oracles. Oracles are decentralized information mechanisms that verify external data. They can track the outcome of specific events and distribute this information across the internet. By utilizing oracles, DeFi insurance protocols can minimize the chances of disputes arising and ensure accurate claims verification (4).
DeFi Insurance Use Cases
Smart contract hacks, cyberattacks on exchange platforms, and other incidents have led to substantial financial losses for investors. Even prominent projects like DAO have been unable to prevent devastating attacks that resulted in billions of dollars being lost. DeFi insurance offers various use cases to mitigate such risks.
Given the susceptibility of the cryptocurrency market to theft and cyberattacks, investors are increasingly opting for crypto insurance. This insurance provides a guarantee that investors will be reimbursed even in the event of a major incident. For example, after a flash loan attack on bZx in Feb 2022, Nexus Mutual, a London-based crypto insurance company, provided coverage to certain accounts with assets locked up in bZx's Fulcrum. The incidents highlight the need for a more secure ecosystem that traditional banking often overlooks or disregards.
Protection of Collateral for Loans Backed by Cryptocurrency
Collateral Protection Insurance provides security for loans backed by cryptocurrency. It gives borrowers and lenders peace of mind in the volatile cryptocurrency market. In case the borrower's collateral is lost or stolen, the insurance contract typically covers the loan repayment.
To enhance blockchain adoption, Etherisc, along with Nexo, Sweetbridge, Libra Credit, Celsius, and other businesses, formed a consortium called Collateral Protection Insurance Consortium (CPIC). This consortium aims to protect and secure loans that are collateralized by cryptocurrency, making decentralized insurance an excellent solution for this purpose.
Insurance Policies for Hot Wallets
Hot wallets, which are a type of cryptocurrency wallets, can have insurance coverage in case of security breaches or theft. Coincover is a prominent platform that provides insurance-backed protection for crypto investors. They offer insurance policies specifically designed for popular hot wallets such as Civic, BitGo, and Vesto. By using one of these wallets, users gain eligibility for Coincover's insurance plan. In the unfortunate event of a security failure or theft where someone hacks into users wallet, Coincover will reimburse that users for any losses suffered. The reimbursement amount depends on the level of protection provided by the wallet users have selected.
DeFi insurance is reshaping the DeFi landscape, prioritizing capital safety and creating vast opportunities. As DeFi evolves, decentralized insurance becomes increasingly crucial. Its potential for growth and innovation is undeniable, opening exciting possibilities for investors and users, and ultimately contributing to a safer and more secure DeFi ecosystem.
Established in 2022, M3TA is an AI-enabled data analytics platform dedicated to Web3 & emerging blockchains. Our team, composed of experts from Stanford, MIT, and Fortune 300 companies and seasoned in Defi, NFT, Metaverse & Gaming and Web3, distills over 10TB of data, covering 500+ projects and 5K+ tokens to produce clear insights for all audience levels. Boasting a robust presence in Korea, Vietnam, and South-East Asia, and spanning an evolving partner network, most currently with Google Cloud and FactBlock, M3TA is your trusted partner in unraveling blockchain complexities.
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