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Around the block, key issues in the encryption space are revealed. In this edition, Justin Mart and Ryan Yi shared an in-depth discussion of DeFi insurance.
Where are all the DeFi insurance markets?
Insurance may not be the most exciting part of encryption technology, but it is a key part missing in DeFi today. The lack of liquidity in the insurance market hinders the maturity of DeFi and hinders the participation of additional capital. Let’s look at the reasons and explore different ways to provide insurance protection.
Insurance: “So what?”
Insurance allows individuals to take risks by socializing the costs of catastrophic events. If everyone nakedly bears all the risks of their lives, we will be more cautious. The readily available insurance coverage gives us confidence in deploying funds in emerging financial markets.
Let us look at the relationship between risk and return. Looking at it, risk and rate of return are inextricably linked, and higher rates of return mean greater hidden risks. At least for an efficient and mature market, this is correct. Although DeFi is not the mature market today, high yields still indicate higher potential risks.
In principle, this risk comes from the inherent complexity of DeFi and programming currencies. Errors hidden in the code are the fuel that investors dream of. To make matters worse, quantifying this risk is combining rare technical skills with seemingly incredible guesses. The entire industry has just started, so that there is no confidence in how high the risk of DeFi is. This makes insurance more important.
Obviously, a strong insurance market is a crucial missing element, and once it is resolved, it will release a large amount of new capital. So, why don’t we see a large-scale DeFi insurance market?
What challenges does the DeFi insurance market face?
There are some challenges in terms of procurement liquidity:
- Who is the underwriter and what is the risk pricing? No matter which model is adopted, someone must underwrite the policy or price insurance premium. The truth is that no one can confidently assess the inherent risks of DeFi, because this is a new field and agreements may be broken in unexpected ways. The best indication of safety may be the Lindy effect-the longer you live among millions of TVLs (total value locks), the safer they prove to be.
- The underwriter’s rate of return must compete with the DeFi rate of return. When DeFi income is subsidized by income agriculture, even “risk-adjusted” positions tend to directly participate in the DeFi agreement, rather than acting as an underwriter or participating in the insurance market.
- The insurer’s income generation is usually limited to the payment of insurance premiums. The traditional insurance market derives most of its revenue by reinvesting collateral into safe yield-generating products. In DeFi, what is considered a “safe” investment of aggregated funds? Putting them back into the DeFi protocol will reintroduce some risks that should have been covered.
There are some natural limitations in designing insurance products:
- The insurance market needs to improve capital efficiency. Insurance works best when the $1 in the collateral pool can cover more than $1 in multiple policies involving multiple agreements. A market that does not provide leverage for consolidated collateral is likely to result in capital inefficiency and is more likely to result in expensive premiums.
- Proof of loss is an important guardrail. If expenditures are not limited to actual losses, then the unrestricted losses caused by any qualified event may bankrupt the entire market.
These are just some of the complications, and there are obviously many nuances here. However, in view of the above, we can begin to understand why DeFi insurance is a very challenging problem.
So, what are the possible insurance models and how do they compare?
We can define different models by looking at the key parameters:
- Discrete policy or open markets: Is it a policy that provides discrete time coverage with clearly defined terms, or is it an open market for the future value of trading tokens or events? These are consistent with liquidity and lock-in coverage.
- On-chain or off-chain: Is Insurance Technician DeFi local (perhaps with some of the same potential risks!) or is it more traditional, structured insurance policies with physical underwriters?
- To resolve the claim: How to deal with claims and who will determine the validity? Is payment manual or automatic? If the coverage is related to a specific event, please pay careful attention to the difference between economic and technical failures. Even if the code runs as designed, the wrong economic design can lead to losses.
- Capital efficiency: Does the scale of the insurance model exceed the promised collateral? If this is not the case, there may be natural restrictions on the amount and price of insurance available.
Let’s look at some leading companies and see how they stack up:
Specific DeFi insurance model
Mixed insurance market: Nexus Mutual
Nexus Mutual spans DeFi and traditional markets, is a true Insurance Mutual (even requires KYC to become a member), and provides traditional insurance contracts with clearly defined insurance terms to cover leading DeFi agreements. The validity of the claim is determined by the joint members, who use the collective capital model to obtain a capital efficiency of up to 10 times.
This model is obviously effective, and they have the largest coverage in DeFi, today there is a $500 million TVL underwriting $900 million in coverage, but compared to the $50B+ locked in DeFi today, it is still pale .
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Forecast market and futures contracts: Diversified market with Ogul
Bundling these models together, there are several projects that can build prediction markets or futures contracts, all of which can be used as a form of insurance contracts.
As far as futures contracts are concerned, short selling provides a way to hedge the price of tokens by opening the market. Naturally, futures contracts can prevent pure price risk, and if the spot price falls above the option price at expiration, it will be paid. This includes the entire reason why the price of the token may fall, including exploits and attacks.
The prediction market is a subset of the options market that allows market participants to bet on the possibility of future results. In this case, we can create a market that tracks the possibility of certain types of risks, including the possibility that the agreement will be used or the price of the token will fall.
Neither the options market nor the prediction market uses insurance as a use case, which makes these options less efficient than pure insurance businesses, usually in terms of capital efficiency (currently using limited leverage or ensemble models) and expenditure efficiency (prediction markets face a huge problem ) Struggling.
Automated insurance market: Risk port
The utilization in the DeFi protocol is a discrete attack, making the code favored by attackers. They also leave a mark, putting the state of the agreement in a position where it is clearly under attack. What if we can develop a program to detect this kind of attack? These procedures can lay the foundation for spending in the insurance market.
This is the basic idea behind the risk port. Considering that payments are automatic and incentives are consistent and easy to understand, these models are advantageous. These models can also use pooled funds to achieve higher capital efficiency and bear limited management costs.
However, designing such a system can be challenging. As a thought experiment, if we can programmatically check whether transactions lead to exploits, why not incorporate this check into all transactions and reject transactions that would lead to exploits?
Lot-based insurance: Saffron Finance
DeFi’s revenue may be high, and most users will be happy to exchange part of its revenue in exchange for some protection. Saffron pioneered this by letting users choose their preferred risk profile when investing in DeFi protocols. Investors with higher risks will choose the “risk part”, which has a higher rate of return, but in the case of exploitation, the liquidation priority is not as good as the “safe part”. In fact, participants with higher risks subsidize insurance fees to participants who avoid risks.
Traditional insurance
For all other aspects, traditional insurance companies are underwriting specific crypto companies and wallets, and may one day start underwriting DeFi contracts. However, this is usually quite expensive, because these underwriters are principled, and the current data is limited to correctly assess the inherent risk profile of encrypted products.
Takeaway
The fundamental challenges surrounding pricing insurance coverage, competing with DeFi yields, and evaluating claims combined with limited capital efficiency have prevented insurance from gaining meaningful traction so far.
Together, these challenges lead to the biggest bottleneck: obtaining sufficient underwriting capital to meet demand. When deploying $50B in DeFi, we obviously need a lot of capital and a capital-efficient market. How can we solve it?
One way may be through the agreement vault. Most DeFi projects have large balance sheets denominated in their own tokens. In the past, these treasury bills used to act as a fake vault. Once a loophole was exploited, the money could be repaid. We can see the future of formalization of this relationship, and the agreement chooses to use part of its treasury as underwriting capital. This can give the market the confidence to participate, and they will reap the benefits in the process.
Another way may be through smart contract reviewers. As experts in assessing risks, part of their business model may be to charge additional fees for their services and then use the proceeds as underwriting capital to support their assessment.
No matter what path you take, insurance is vital and inevitable. The current model may be lacking in some fields, but it will be developed and improved on this basis.
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