Crypto scams, DeFi hacks, and rug pulls: Why the crypto industry needs insurance tech 🚨 This article is 3 years old...
Crypto scams, DeFi hacks, and rug pulls: Why the crypto industry needs insurance tech
When you have even just $100 in a liquidity pool, you dread the day you awake to it being gone.
3 min read
Updated: Jul. 30, 2021 at 2:33 pm UTC
Cover art/illustration via CryptoSlate. Image includes combined content which may include AI-generated content.
Your bags are gone. How do you alleviate that concern? With insurance. Unfortunately, DeFi users don’t have much choice when protecting their assets, and only an estimated $2 billion of DeFi’s $100 billion TVL is insured. Needless to say, crypto and DeFi are still in the exploratory phase in finding an optimal insurance solution. Exploits have become almost inevitable and hidden in plain sight.
Many great projects have pushed the need for crypto insurance forward. At first, Nexus Mutual paved the way. They realized that when it comes to insuring DeFi assets, there wasn’t enough data to understand the events you’re trying to cover. They built a mutual where people could pool their collateral and vote on which claims to recognize.
The mutual system has been around for centuries. It’s proven to be a good measure when you have limited data and availability to judge, similar to the syndicated pool from Lloyds of London.
Evolving methods for crypto insurance
In the sense of adapting to the blockchain, methods are evolving. All the data is public and transparent. Certain risks are starting to occur, giving us insight into what needs to be covered: flash loans, bugs, rug pulls, etc. Downside risks should be covered through automated systems over mutual insurance because even though mutual coverage is suitable for the start, it has varying effects, particularly when paired with governance.
Even though you’re covered, if people don’t vote objectively, you don’t get the coverage even if an event happens. We should automate the process to remove unpredictable human elements as much as possible. Crypto insurance can be built entirely with code for efficiency and reliability, providing an answer for the cumbersome claims process.
Insurance in crypto today is poorly built. What’s more, the only insurance we have is retail insurance, and it typically relies on the mutual system. Say Bob wants insurance for an event, so he goes to Alice for the $100 worth of coverage he wants. When an event happens, Bob goes to Alice to recover the $100. But first, he must wait for a vote to see if he gets the insurance.
The mutual system is proving to be fundamentally flawed and doesn’t provide optimal coverage for policyholders. We saw its flaws surface last February when a risk event took place for a covered protocol. Everyone was insured, but none of the people in charge of voting or insurance voted. No one got covered for their downside. Ironically, the insurance itself has introduced a new form of risk. If the goal is to decentralize and live on smart contracts, we haven’t done that yet.
Even with insurance, people are trying to share specific risks. Insurance often covers particular risks with particular criteria, but that approach isn’t always ideal. Instead, the process should focus on standardization and generalization while building insurance into an options and derivatives market in the sense where you make an agreement that, if this event happened, then you’re covered.
The current insurance model is fundamentally flawed. In DeFi, we typically see coverage for catastrophic events that arise from systemic failures inherent to protocol composability.
InsureTech
Recently, the Covid-19 pandemic has sparked debate over who should shoulder most of the costs from a messy event which is difficult to model and often left out of insurance contracts. “Parametric insurance” has predefined event parameters and a fixed maximum coverage amount; many believe this to be the best solution.
Parametric insurance is one way that DeFi can embrace a more systemized and efficient coverage model. Parametric insurance, which offers pre-specified payouts based upon a trigger event, can be automated because of the innate transparency of blockchain data. If an event happens to meet the criteria, you get paid for the predetermined amount on the policy.
Of course, this is much easier to automate than insurance that requires loss assessment, which stands to bleed more collateral than necessary to cover the event. Parametric insurance for crypto reduces the demands of risk assessment, loss assessment, and claims processing. By embracing this model, DeFi insurance stands to improve in terms of efficiency and speed.
As highly regulated and sluggish as it is, the conventional insurance industry can look toward InsureTech innovators trying to push the industry toward realizing that new financial systems have unprecedented kinds of catastrophic risk. For DeFi, With smart contracts, coverage can be automated coverage can now be automated with greater ease by using the parametric approach.
Securitization is the future of insurance, and it should be viewed as a new financial asset class that other groups can use. We presume insurers will eventually use it across the board, from reinsurance insurance securities and beyond. And by doing so, blockchain could guide the ancient human tradition of socialized protection to new heights.
