Why decentralized finance needs decentralized insurance

By Jonathan Libby

The decentralized finance, or “DeFi”, ecosystem has presented us with one of the most exciting and innovative opportunities in finance for decades. Through a wide and growing global network of cutting-edge platforms and protocols, the ability to save, invest, borrow and lend in a decentralized way is finally being realized.

Since its early days in 2017, the DeFi space has grown to be an $80 billion dollar marketplace, with much of this growth coming over the past 12 to 18 months as platforms and protocols have launched increasingly viable products. Many of these, including DeFi’s leading exchange Uniswap, can attribute much of their success to their high levels of decentralization.

DeFi platforms and protocols are typically free of the hefty infrastructure that underpins centralized exchanges and platforms. Uniswap, for example, runs entirely on digital smart contracts that automatically balance liquidity pools and facilitate trades. These contracts govern almost everything that happens on the exchange.

In this decentralized ecosystem, anyone can participate simply by connecting their Web3 wallets to DeFi’s many web-based and mobile applications. This makes for a simplified, streamlined system that is creating opportunities far removed from traditional finance (TradFi), which has historically placed numerous barriers to entry in front of the average citizen.

A dearth of DeFi risk data

However, some of TradFi’s barriers are there for a good reason — and that reason is often safety. While DeFi is opening up a whole new world of possibilities for millions, the innovative technology it is based on is still in its infancy. As most will know, this has left it vulnerable to hacks and exploits that have drained users of millions of dollars over the past year as its popularity has grown.

For TradFi providers, one solution to mitigate these types of risks is insurance. Banks and asset managers can purchase cover with global insurers that can protect them and their customers against a multitude of commercial and credit-related risks.

These same insurers, however, are yet to cover DeFi: as a nascent asset class, neither the data nor a generally accepted benchmark for analysis yet exist to allow them to make risk assessments that could extend to providing adequate coverage for platforms and protocols in the space.

A centralized sticking plaster

In response to this, a small number of DeFi-focused insurance protocols have emerged that are attempting to provide some level of protection for DeFi users. The largest among these is Nexus Mutual, which accounts for almost the entire DeFi insurance sector with its market cap of $917 million. Its competitors include Etherisc, Cover, Nsure.Network and the yet-to-be-launched Union Finance, which together account for just $96 million.

This high concentration of insured assets is a potential risk factor of Nexus’s dominance in the DeFi insurance sector, as is Nexus’s centralized model. Rather than employing the same type of automated decentralized approach as the platforms and protocols it insures, Nexus’s model relies on a human-led system of claims assessment and arbitration.

Within this system, which closely mirrors “brick and mortar” mutuals in TradFi, those that provide the cover and benefit most from declining claims are those that also decide the results of claims. There is no empirical system of either deciding what might qualify as an insurable or insured event, or what makes a successful claim on such an event.

Moreover, with Nexus and its contemporaries, it is not the platforms and protocols themselves that are insured, but rather the users who take out insurance individually. This is because, much like TradFi insurers, DeFi insurers do not currently fully understand the range of risks the DeFi sector faces, and so have no standardized way to price risks and in turn offer direct insurance at a provider level.

Data-driven, automated insurance for DeFi

The most important task, then, is to build a product that can fully understand and analyze the risks faced by DeFi providers to insure them. This product should be able to generate complex risk models using various data points that can be applied to a provider to price an insurance premium that will give customized, comprehensive coverage. On top of this, we need a claims system that is not subject to human bias and error, but governed by the same secure smart contract technology that it insures.

Only once DeFi is covered by this level of data-driven, quantitative and automated insurance infrastructure can it be seen as a truly safe space for retail investors. In TradFi, the customers of banks and wealth management platforms are not expected to insure their assets, and that standard should be the same in DeFi. Platforms and protocols in this space want to fully protect the assets of their users and communities, and they need the tools to do so.

A DeFi insurance solution that is fit-for-purpose will allow the ecosystem to accelerate toward mainstream adoption, and so this should be one of the sector’s most urgent priorities.

The good news is that this challenge is currently being met by some of the brightest minds and forward-thinking entrepreneurs in DeFi. It is time that DeFi — and cryptocurrency more widely — begins to emerge from its sandbox to apply the best practices of TradFi, while seeking to continually exceed its capabilities. To achieve its full potential, DeFi needs the right insurance solution, and it’s coming.

About Jonathan Libby

Jonathan Libby is a DeFi entrepreneur. Innovation and impact direct where he puts his energy, and that’s what led him to DeFi. Inspired by the transformative impact decentralized finance can have on global financial systems, he is passionate about building an accessible, transparent financial system that can include everyone and keep their assets safe.

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