What is DeFi insurance and how does it work

DeFi users are participating in one of the most exciting but unpredictable areas of cryptocurrencies. We have witnessed the emergence of hundreds of blockchain projects, many of which are listed on Coinmarketrate.com. The nature of smart contracts and decentralized protocols means that they are susceptible to exploits and hacks, which sometimes leads to significant losses for affected users. As we have written more than once, these include hacks of flash loans that exploit vulnerabilities or “loopholes” in smart contracts that control protocols, which allows attackers to siphon millions of dollars from liquidity pools.

Therefore, DeFi users are comforted by the fact that now they can insure themselves against such losses. The number of providers offering so-called DeFi insurance is growing, and the largest of them, Nexus Mutual, already boasts a market capitalization of just under $342 million, according to data Coinmarketrate.com despite the fact that it started its activities in July 2020. Meanwhile, the market capitalization of competitors Etherisc and Cover Protocol is about $ 60 million.

How does DeFi Insurance Work

Similar to insurance in the traditional financial world, insurance in DeFi is aimed at protecting users from losses in exchange for a certain premium based on the size of their share and the platform on which they hold it. While a traditional insurance policy can be issued and insured by a multinational insurance company, a DeFi insurance policy relies on a community of users who dictate premiums and arrange payments.

The main participants in the DeFi insurance protocol are underwriters who provide capital to pools for each individual covered protocol and receive a share of premiums (also known as shares). These are claim assessors and holders of management tokens who vote on claims and changes in the protocol, and applicants, or those who buy insurance premiums. Depending on the protocol, underwriting can be quite profitable due to the regular flow of income from bonuses, and rewards in the form of native management tokens also significantly increase the winnings.

Does the insurance premium justify the insurance coverage?

For users or applicants of DeFi insurance protocols, the advantages are obvious: in exchange for a premium, they can protect the value of their digital assets from smart contract exploits. As expected, the riskier the protocol, the more you pay for its security. For example, in Nexus, providing 10 ETH in the Curve Finance protocol for a period of 180 days costs 0.1281 Ether (ETH), while a similar level of coverage for the same share in Acropolis Delphi costs 2.18 ETH (APR about 48%).

While some consider this a fair price, at least for the most common protocols, others question the value of the coverage plaintiffs receive through DeFi insurers. Most of them pay only for technical failures of smart contracts, and then at their own discretion. As a rule, insurance protocols do not provide coverage for numerous situations that can go wrong in various layers of the DeFi protocol, and the lack of a secondary market for trading limits the ability of insurance protocols to grow.

With or without KYC?

In addition, there is some internal conflict in the work of some DeFi insurers who require KYC (Know Your Customer) information before providing coverage, including the dominant Nexus Mutual. As any DeFi user knows (although the ecosystem is not completely devoid of KYC), the meaning of its existence lies in decentralization. In fact, DeFi was conceived as a place where cryptocurrencies could work really independently of traditional finance, as the industry pioneers intended.

However, Nexus Mutual is not alone. Nsure.Network opposes its competitor with a completely permission-free (i.e. without KYC) model based on the Lloyds of London approach. Instead of relying on flows from underwriters, or those who delegate to insurance pools, Nsure premiums are determined by a “dynamic pricing model” based on “capital extraction”, in which prices are determined based on the supply of capital and demand for insurance coverage for products in real time. Nsure claims that this model ensures that valid claims are always paid and systemic risk is controlled.

Insurance solutions at DeFi

As noted above, Etherisc is also on the heels of Nexus Mutual, albeit with a completely different product: a flexible, again completely permission-free tool that helps users create their own insurance products for a wide range of different scenarios. This includes cryptocurrency insurance and collateral protection for loans secured with cryptocurrency, as well as insurance in case of “real” situations, such as flight delays and hurricanes.

Union Finance is another interesting new protocol offering a multi-token model, which, according to them, will avoid the problems that Nexus faced when its NXM token suffered a serious crash in September. Union Finance will also not have permissions and claims to cover users in addition to smart contract failures.

The absence of a secondary market is also to some extent solved by selling non-interchangeable tokens (NFT) on trading platforms where NFT insurance contracts can be traded.

Indeed, Nexus’ problems were compounded by the fact that yInsurance users on the yearn.finance website were able to create an insurance policy without KYC, insured by Nexus Mutual, using a wrapped form of NXM (WNXM) and NFT, which was traded on the Rarible market. A protocol called “Safe” allowed users to mine SAFE tokens using yNFT (from yInsurance) and WNXM. This caused a spike in NXM prices as WNXM is linked to its price. However, APY (RPA) SAFE turned out to be uncompetitive, so users stopped mining it using WNXM, which led to a domino fall of NXM, WNXM and SAFE, which was replaced by COVER through the fork.

Who insures insurers?

Despite the constant search for new solutions, as follows from the above, the market is not without risk. Apart from the scenario that happened with Nexus Mutual, the protocols themselves are vulnerable to hacking. The Cover protocol (formerly SAFE) has already survived this. In December 2020, the hacker “White Hat” used an error in an incentive smart contract to withdraw $3.62 million worth of COVER tokens from the protocol.

The irony is that the insurer that insures users against smart contract failures was used with an error in its smart contract. It is also not confirmed that Binance, from which Cover is insured, compensated its users $ 10 million for the loss of the value of their COVER tokens as a result of the attack.

Thus, DeFi insurance is not perfect. Nevertheless, it remains one of the most interesting and innovative options for using the DeFi model that have appeared to date. If decentralized projects are able to provide secure and scalable insurance products, and DeFi marketplaces, the security that this will provide may lead to wider adoption of DeFi.

In addition, wider application is potentially significant, since DeFi insurance may become a model capable of competing with the notoriously corrupt insurance markets of traditional finance. However, as it always happens in the DeFi sandbox, most likely there will be a series of losses and failures first.