Why Does DeFi Insurance Need a Redesign? Technological Weakness

The inherent risk in the decentralized finance (DeFi) industry has been one of the most hotly debated subjects in the crypto market in recent months. It appears that scarcely a week passes by without investors experiencing significant losses in DeFi due to technological weaknesses or disproportional economic risks. Robust risk management is critical to accelerating DeFi adoption, particularly at the institutional level.

Insurance models are one of the most crucial factors necessary to provide a solid basis for DeFi’s widespread acceptance. While conceptually simple, the mechanics of developing insurance mechanisms for the DeFi sector are quite difficult and do not correspond to what we observe in traditional capital markets.

DeFi automates financial services via smart contracts. The first generation of DeFi protocols concentrated on two basic primitives: lending and market creation. Although there has been significant development in derivatives and insurance, these two fields account for the vast bulk of the wealth trapped in DeFi systems. In the initial generation of DeFi protocols, protocols such as Nexus Mutual and InsurAce took a unique method to addressing this problem (see below). However, it is evident that the problem is substantially more complicated, and that solutions require more work.

Insurance may be thought of as the missing link in DeFi. Insurance mechanisms have existed in every financial market throughout history. To be sure, most insurance arrangements in conventional finance are designed to protect intermediaries who absorb risk.

The most of the risk in deals Insurance models for DeFi might be vastly different, which is what makes this such an intriguing issue.

DeFi’s technical versus economic insurance

Understanding the key categories of hazards in the sector is the first step in developing insurance-efficient models in DeFi. While there are several types of hazards in DeFi, they may be divided into two categories for insurance purposes: technical and economic.

Technical insurance specifically addresses the possibility of smart contract failures or assaults. The most well-known type of technical risk in DeFi systems is smart contract exploits. Some major DeFi exploits in recent months are Nomad, Wormhole, Cream, Ronin, Badger DAO, Horizon bridge, and Beanstalk. These kinds of exploits are certainly unusual In DeFi protocols, this frequently leads to irrevocable losses. They are a natural fit for insurance schemes.

Economic risk is one of the most significant hurdles to entry for investors interested in DeFi technologies. Every day, millions of dollars are lost due to economic inefficiencies in DeFi protocols, and this goes largely neglected.

A typical example of DeFi happened when long-term ether (ETH) holders earned dividends in ETH-stETH pools in protocols such as Curve or Balancer. Many of them investors wanted to increase their return on ETH. However, the recent events that led to the de-pegging of staked ether (stETH) created imbalances in those pools, leaving investors with substantial stETH holdings compared to their initial ETH positions.

A comparable but more extreme example is when significant holders in an automated market maker (AMM) pool remove their entire stake in a single transaction, causing huge slippage to the pool’s remaining investors. Addressing both economic and technological risk is critical from an insurance standpoint.

Given the embryonic nature of DeFi, where positions may be destroyed in the blink of an eye, insuring technical risk is more relevant today. A typical technical insurance strategy would ensure the restoration of an investment position in the event of a protocol exploit or other technical infrastructure components such as bridges. As DeFi evolves and protocols grow more solid, technological risk should become less significant, resulting in cheaper insurance plans.
Insurance against economic risk is more difficult to establish in DeFi and must diverge from previous methods. Because of the decentralized structure of DeFi, trustworthy intermediates cannot absorb economic risk. As a result, DeFi insurance policies should focus on providing protection against temporary loss or slippage in AMMs, liquidations in lending procedures, or even de-pegging scenarios that might lead to economic losses in DeFi holdings. As DeFi advances, the economic risk in those circumstances is expected to increase, making economic insurance plans in protocols increasingly more valuable to participating investors.

DeFi insurance that may be programmed

Adapting standard financial insurance systems to DeFi protocols entails depending on static estimates of DeFi risks and intermediates that analyze DeFi protocol claims. The advantages of this strategy include the ability to harness the insurance infrastructure employed by traditional financial markets and an easier road to institutional acceptance and regulatory approval. The disadvantage is that it does not fully meet the DeFi principles.

The programmable and decentralized nature of DeFi networks constantly challenges traditional financial paradigms. And, much as DeFi pioneered novel lending concepts such as flash loans, there is a chance to reinvent classic insurance arrangements. Consider a world in which economic and technological insurance plans for DeFi protocols are integrated into smart contracts. This technique allows for dynamics that would be unthinkable in typical insurance models.

For example, an investor investing in an AMM such as Curve or Balancer may programmatically seek an insurance policy that protects him against a whale manipulation assault in a certain pool as well as a hypothetical hack on the underlying AMM. After he leaves the post, the policy might be automatically paid and canceled. If a significant token holder leaves the pool, forcing our investor to drop beyond the risk thresholds, he may instantly make a claim and be compensated promptly by the insurance smart contract. Additional claims that cannot be handled right away can be considered through governance votes. All of these interactions are totally programmable and do not necessitate the use of trusted middlemen.

DeFi sorely requires effective insurance
The DeFi industry has been rocked by significant shocks in recent months, resulting in a lack of faith in its value offer Insurance is now essential to mitigate risk and restore trust in DeFi among institutional and individual investors. Designing insurance plans that address both economic and technological risk is difficult, but not impossible. Even more fascinating, DeFi provides a clean canvas for reimagining insurance with programmability and decentralization as essential principles.