Why DeFi Insurance Needs a New Design
Decentralized Finance(DeFi) Market
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Why DeFi InsuranceNeeds a New Design
The inherentrisk in the decentralized finance (DeFi) market has been one of the mostdiscussed topics in the last few months in the crypto market. It feels that nota week goes by in which investors are not suffering severe losses in DeFivia technical exploits or disproportional economic vulnerabilities. Robustrisk management is paramount to catalyze the adoption of DeFi, particularlyfrom an institutional standpoint.
DeFi usessmart contracts to automate financial services. The initial wave of DeFiprotocols focused on two fundamental primitives: lending and market making.These two areas account for the vast majority of the value locked in DeFiprotocols, although there have been relevant progress in derivativesand insurance. With the latter, protocols such as Nexus Mutual or Insur Acehave taken an innovative approach to address this problem (see below) in thefirst wave of DeFi protocols. But it’s pretty clear the problem issignificantly more complex and the solutions require more development.
Insurancecan be considered the missing link in DeFi. Every financial market inhistory has had insurance mechanisms. Granted, in traditional financemost insurance models are targeted to protect intermediaries that are absorbingthe bulk of the risk in transactions. Insurance models for DeFicould be drastically different, and that’s what makes this a fascinating topic
Technicalversus economic insurance in DeFi
Establishinginsurance-efficient models in DeFi starts by understanding thefundamental types of risks in the space. While there are many forms of risks inDeFi, from an insurance perspective they can be classified in twomain groups: technical and economical.
A classicexample in DeFi occurred when long-term ether (ETH) holders were earning yieldsin ETH-stETH pools in protocols like Curve or Balancer. The objective ofmany of those investors was to earn additional yield on ETH. But therecent events leading to the staked ether (ETH) de-pegging caused imbalances inthose pools, leaving investors with significant holdings on ETH relative totheir original ETH positions.
Insuringtechnical risk seems more important today given the nascent nature of DeFiwhere positions can be lost in a blink of an eye. A typical technical insurancemodel would guarantee the return of an investor position in case of an exploitagainst a given protocol or other technical infrastructure components likebridges.
Insuranceagainst economic risk in DeFi is trickier to achieve and needs todepart from the traditional models. The decentralized nature of DeFimeans that economic risk can’t be absorbed by trusted intermediaries.
DeFiinsurance with programmability
Adapttraditional financial insurance structures to DeFi protocols means relying onstatic analyses of DeFi risks and intermediaries that evaluate claimsassociated with DeFi protocols. The benefits of this model arethat it can leverage on the insurance infrastructure used by traditionalfinancial markets and would have an easy path from an institutional adoptionand regulatory standpoint. The drawbacks are that it doesn’t quite fit theprinciples of DeFi.
DeFidesperately needs efficient insurance
The DeFimarket has suffered massive shocks in the last few months, leading to alack of trust in its value proposition. Insurance is required now to managerisk and restore the trust in DeFi among institutional and retail investors.Designing insurance policies that target both economic and technical risk ischallenging but certainly doable. Even more exciting is that DeFi offers ablank canvas to reimagine insurance with programmability and decentralizationas core constructs.
The decentralized finance (DeFi) market is one of the most discussed topics in the crypto market in recent months. However, this new trend is not just about the technological aspect – it brings additional risks to the traditional financial market.