Why Insurance is Needed for DeFi
Decentralized Finance, more commonly known as DeFi, has the ability to change the world as we know it. However, there are vulnerabilities that lead to many industries and investors being slow to adopt. Insurance is capable of bypassing the issues, especially since centralized finance has been relying on insurance since the dawn of time.
The problem is that insurance in the DeFi market remains elusive.
What You Need to Know About DeFi and the Need for Insurance
DeFi has already attracted over $100 billion in investments, all locked up in smart contracts. Many of these are developed by anonymous teams that aren’t worried about the safety or security of their invested funds. They’re willing to take the risk.
With risk comes those who are willing to exploit those vulnerabilities. Even the most prominent of protocols have been exploited and hacked.
Hackers have been successful, too. In 2020 alone, they were able to take home somewhere around $120 million.
It’s clear that there’s a lack of security in the DeFi space — and that’s a problem when the goal is to lure more investors into the space.
Perspective is critical here. “Only” $120 million was stolen out of the average $50 billion locked into capital. That is “only” a 0.24% loss. With such a low loss rate, however, there’s virtually no insurance that will work with the DeFi protocols and products.
Wait, aren’t there crypto native insurance protocols available? Yes, though there are virtually no coverage options for popular protocols. Even though there are protocols requiring annual premiums in excess of 40% of the insured capital, there are still missing pieces of the puzzle.
There’s an ethos in the crypto industry of accepting crypto natives protocols as a solution. But…is this the right approach?
Why Insurance is Needed in the DeFi Space
Cybercriminals will target anything and everything — from Bitcoin to DeFi protocols. DeFi is gaining in popularity, and that’s drawing attention from the hackers who want to run away with as much as they can get their hands on.
So far in 2021, there’s been plenty of activity to be concerned — and this includes a loss of $11 million to Yearn Finance, one of the most popular DeFi platforms. If they can be exploited, anyone can. It’s not the first time that Yearn has been attacked, either.
All of the events point to a reality that must be accepted: even the most prepared platforms are subject to being exploited and hacked.
Insurance must be instituted as a way to navigate such things. No one is impervious to disaster, which is why insurance is a requirement in so many aspects of life.
Yearn Finance’s CEO told all affected investors who were insured that they would be reimbursed. Their YFI token took a 12% hit, though it’s recovered since. However, it was a wake-up call to DeFi participants that insurance is a must.
It isn’t just malicious attacks that can cause a loss, either. Glitches can cause a loss in funds, too. Nothing in the digital space is bug-free and glitches can and will happen from time to time.
As such, the only way to protect against a loss in an investment is with an insurance policy.
A Look at the Global Insurance Market
Everyone wants to make DeFi insurance into a bigger deal than it really is.
The traditional global insurance market has a value of $6 trillion. This is proof that institutional investors want to have insurance policies. Further, it’s mandated by the government.
While some insurance doesn’t offer protection against losses as a result of stock trading, it will offer protection when assets go missing. Congress has even created the Securities Investor Protection Corporation for the purpose of protecting investments when a brokerage goes bankrupt. Then, the SEC and FINRA will offer assistance to investors when there’s fraudulent activity.
There’s plenty of protection, security, and regulation in place for traditional (centralized) finance. Why is it that the DeFi space doesn’t have the same? This is the question that we’re looking to answer…
While DeFi exploits are rare, we also have to be reminded that there’s vulnerability in the fact that Ethereum is a programmable blockchain.
The government may never mandate insurance for DeFi protocols. That doesn’t mean that it cannot and should not exist. The only way for DeFi to ever overtake traditional finance and provide all of the benefits that it can promise, insurance is critical as people need to feel protected.
This means that there’s an emerging insurance market to welcome.
Welcome Nexus Mutual and Nsure.Network
Nexus Mutual is becoming the go-to insurance in the DeFi market — and this was already hinted at by the CEO of Yearn Finance. The insurance utilizes risk-sharing pools and is governed by NXM, its token that is Ethereum-based and decentralized. As long as a smart contract is public, any loss on Ethereum is covered by Mutual.
There’s certainly research to be done on whether this insurance is worthwhile. The insurance premium is approximately 1.3% of your smart contracts — and with MetaMsk, connecting it to claim insurance is simple.
For those operating in DeFi to remain anonymous, be prepared to be disappointed. Nexus Mutual does require KYC (know your customer) identity verification.
This is where Nsure.Network provides another insurance solution. It is based in capital mining inside of risk-sharing pools. It does not require KYC and it is styled on the Lloyd’s London’s dynamic price model.
With both of these insurance options being open-source projects, they’re utilizing an array of open-source tools.
There’s still one problem: it’s only smart contracts covering smart contracts. And with the way that Cover Protocol was exploited in 2020, it shows that there’s still vulnerability. It may also be why Yearn Finance chose to end their merger with Cover Protocol.
DeFi Insurance is Still Maturing
It seems that the focus isn’t where it needs to be. Why focus solely on the crypto native peer-to-peer alternatives to traditional insurance? The $6 trillion traditional insurance market must have enough capacity (and expertise) to secure the lucrative, growing DeFi market, complete with exploit risks and criminal attempts to defraud investors.
If insurance is covering all of the risks successfully in traditional finance, DeFi is still missing out on a lot.
With the amount of maturing that the DeFi insurance market still has to go, it’s important to look at what’s going on.
The DeFi space, as it sits right now, has approximately $120 billion in locked assets across two dozen protocols. With an average loss of 0.24% for 2021, even with the many sophisticated tools available, it could mean a loss of $300 million — and that’s unacceptable.
Any respectable DeFi protocol asks for approximately 2.6% annual premiums to insure against the risk of losing an investment to a hack. With that rate, available coverage is nearly always sold out.
The rapidly innovating industry is still difficult for many to understand. With a lack of understanding comes the desire to protect against risk — which means that the demand for affordable insurance would be close to 100%. Especially as institutional investors make the jump to DeFi, they demand insurance.
Traditional insurance carriers should be jumping over to the DeFi space to help. After all, if we look at insurance premiums of 2.6%, that will translate to over $3 billion. We just mentioned that the anticipated loss for 2021 is estimated at $300 million. It’s clear that there’s money to be made for the insurance carriers.
This is why it’s taking so long for DeFi to be adopted by traditional investors. There are still concerns –
Is it that DeFi protocols are permissionless? Is it that insurance underwriters lack the technical expertise?
Yes, and yes.
Traditional insurance carriers are conservative. They like data and statistics that they can turn to.
Lloyd’s of London is one of the most widely known underwriters. They cover the regular insurance markets as well as virtually any other risk as long as the premium is right. The underwriting process, however, is multilayers — and it’s impossible to use the Lloyd’s model for the ultra-dynamic space of DeFi. It’s why the Nsure.Network is not becoming the go-to solution in DeFi insurance just yet.
A solution has to be created if the DeFi market is ever going to mature. In order to create a solution, the crypto community has to come together to create their own Lloyd’s of London syndicate. It will ensure that risks are covered and capital contributions are tokenized.
Through the Yieldster project, the goal is to accomplish just that. The platform has been developed for the purpose of institutional and retail investors to participate in DeFi using a regulatory body and compliance. Perhaps, with Yieldster, DeFi can finally leap into mainstream usage.
