DeFi Explained: Decentralized Insurance
Introduction
The world of decentralized finance, as innovative as it is, has brought on a number of new words and concepts. Having to navigate through such unfamiliar and often incomprehensible ideas can be confusing, which is why we are here to do the heavy lifting for you. This week’s edition of DeFi Explained will cover the concept of decentralized insurance (DeFi insurance), the mechanism which protects its users from risks and threats like losses of hacking, smart contract bugs, and other digital fraudulent activities. How does this work? Why is it important? What are the benefits and risks associated with decentralized insurance? These are all questions that will be answered in this article.
How Decentralized Insurance Works
The purpose of decentralized insurance is the same as all other traditional insurance avenues: User protection. Decentralized insurance aims to protect users from account compromises and financial losses in return for a premium. This premium varies according to the platform offering the service and the amount held by the user. The major difference between traditional insurance providers and decentralized insurance agencies is that the former is usually issued by a multinational insurer, while the latter relies on its user community to manage premiums and payments.
Capital providers form the backbone of decentralized insurance protocols, as they are the ones staking their capital to pools. In return, they take a share of premiums. Other integral actors are governance token holders, which vote on future decisions of the protocol, and claimants, who buy the insurance premiums. Again, factors such as type of service, platform, and protocol all affect how this process is carried out.
Use-Cases of Decentralized Insurance
Ever since its inception, the DeFi space has been subject to many risky situations. These range from crimes that breach security like malicious smart contract hacking, cyber-attacks on exchange platforms, and crypto wallet theft, to environmental factors like volatility and flash crashing. These instances often have very expensive consequences, such as the million-dollar loss faced by DAO in 2016. Helping minimize these losses is where decentralized insurance comes in. The following are some use cases of decentralized insurance.
Smart Contract Covers
Developed by the company Nexus Mutual, the Smart Contract Cover is a product that covers the loss if the assigned smart contract address has been compromised by a hacker. The hacker may use this address in the manipulation of funds from the investor’s account, or when transporting funds across other compromised addresses. Smart Contract Cover covers all such instances, even covering losses that are unrecoverable and permanently lost. It is a promising product that provides a sense of comfort to both investors and lenders as they no longer need to worry about the after-effects of being subject to a hack.
Crypto-Wallet Insurance
Crypto-wallets are an integral part of the DeFi space, with the global hardware wallet market valued at $202.4 million in 2020. Essentially, crypto wallets are digital or hardware spaces where you securely keep your credentials for your crypto assets. It stores your private keys and allows you to send, receive, and spend cryptocurrencies like Bitcoin and Ethereum. They exist both as tangible wallets (hardware wallets) and on mobile applications like Coinbase. A protective system to insure these crypto wallets was a dire need of the industry, which is where the concept of crypto-wallet insurance comes in. A series of solutions developed by insurance platform Etherisc attempts to do just that, introducing crypto wallet insurance that protects against risks of theft and attacks of hackers on wallet smart contracts. For the decentralized insurance community, this is a game-changer.
Collateral Protection for Crypto-Backed Loans
In crypto lending, when the borrower’s collateral is compromised-either destroyed or stolen-the default course of action taken is that the loan is paid off by the insurance policy. However, a group of nine companies has recently announced their plans towards introducing Collateral Protection Insurance (CPI), a mechanism that will encourage safe participation in crypto lending. These companies include Etherism, Sweetbridge, Celsius, Nexo, Libra Credit, and others.
Benefits of Decentralized Insurance
What makes decentralized insurance so attractive is the complete protection it provides to an industry infamous for its volatility. With decentralized insurance, any financial and technical risks associated with DeFi are covered, a quality that is attractive to both users and investors. The following are some benefits of decentralized insurance
Protection Against Crypto Volatility and Flash Crash
The entire DeFi industry itself is very volatile in nature, with the price of high-profile cryptocurrencies often fluctuating by the second. Sometimes a flash crash may also occur, which is the rapid decline in the price of an asset. Decentralized insurance protects you from any loss you may suffer as a result of such events.
Immediate Redemption of Tokenized Crypto
Receiving lost funds is very fast with decentralized insurance platforms as compared to traditional insurance platforms where there may be more paperwork and formal processing before you receive your dues.
Protection From Hacks on Exchange Platforms
In recent times, there have been several instances of hacks in the crypto space, with DeFi hacks accounting for 76% of all major hacks in 2021. Often accomplished by hackers exploiting a bug in the protocol of a top exchange platform, these hacks result in the theft of millions of dollars worth of stolen funds. Some of the most trusted platforms, such as DAO and Poly Network have fallen prey to such hacks. WIth decentralized insurance, these lost funds will be available for reimbursement, allowing users to freely use exchange platforms without having to worry about any consequences.
Who Insures the Insurers?
Although decentralized insurance is a great addition to the already very innovative and advanced world of DeFi solutions, it is not without risk. The whole setup of decentralized insurances runs on the assumption that capital provided by insurers is available and impenetrable. However, the protocols themselves that have set up this service are vulnerable to hacks. To combat this, there is work being done towards creating models where providers are also insured, rather than just users. An example of such a solution is Steady State, which aims to measure the dangers of decentralized finance through its Risk Analysis Database. However, this is still in its developmental stages.
Conclusion
In conclusion, decentralized insurance is a novel concept, essentially traditional insurance optimized for decentralized finance. Decentralized insurance is protective, fast, and accessible, and once mainstream, will change the course of DeFi forever.
