US$120 million in total funds was stolen in 2020 across decentralized finance (DeFi) platforms, but there’s a smart way to protect your investments: DeFi insurance.
Over the last few years, one thing has become clear — the future of finance is decentralized. Since the beginning of 2020, the total value locked in DeFi has exploded from US$670 million to now over US$40 billion. For those doing the math, that’s a 6,000% jump.
But the crazy thing is, some experts believe we’re just getting started. Billionaire investor Tim Draper predicted the total crypto market cap could break US$80 trillion in the next 15 years. That’s more than 40 times the present value.
The risks of DeFi’s rapid expansion
The explosive growth of DeFi comes with concerns, including issues of scaling, gas fees, and worst of all, theft. DeFi has become a very attractive hunting ground for hackers. In 2020 alone, hackers attacked 15 DeFi platforms for a staggering US$120 million sum.
See related article: How DeFi’s massive 8-fold growth brings scaling, gas fees challenges
The risk of theft poses a devastating effect on the growth of assets and new investors into the DeFi ecosystem. This is where DeFi asset coverage steps in.
As financial first responders, DeFi coverage providers offer fundamental risk management for investors. Like traditional finance, DeFi coverage platforms are based on pooling, transfer and share of risk. Without coverage, investors have to adopt a lower risk tolerance and accept more conservative returns. DeFi coverage protocols empower investors to protect their assets without a traditional bank.
Why buy DeFi coverage
The traditional insurance market today is valued at over US$6 trillion. As institutional capital flows into DeFi and the risk of theft grows, DeFi insurance will become necessary for more investors.
With flexible liquid coverage and customizable options available, there are packages for every type of investor. Even if you’re someone parking a moderate amount of capital into crypto, consider hedging your risk and protecting yourself for events outside of your control.
Differences between insurance providers
There are big and small coverage providers; most are decentralized but some are centralized. Decentralized providers tend to offer users more transparency as part of their product with permissionless capabilities, staking rewards and voting. The staking process can be pretty lucrative, depending on the protocol. DAO providers are experimenting with governance and community involvement opportunities too.
Centralized providers on the other hand are much like centralized banks: they control the product and there is not much room for community innovation.
Like traditional insurance, DeFi coverage protects users from loss in exchange for a fee. With most providers you can request a free quote and coverage specifics. You can purchase protection against smart contract risk, DAO hacks, multi-sig wallet issues or against stablecoin defaults.
You can choose premium versus pay-as-you-go options. Decentralized providers typically offer dynamic pricing based on supply and demand of the system’s capital and coverage.
When it comes to the fine print, there can be exclusions. With some smart contract coverage policies, for instance, you may not be covered in events like phishing, private key security breaches or malware.
When a user requests a payout, they send a claim to the designated assessors governing the DeFi coverage protocol. These assessors could be members of a DAO, multisig, or a centralized resolver. The assessors then follow the steps required to validate the claim. If approved, the smart contract will issue payment to the claimant, or an approved interested party on behalf of the claimant.
Are Providers Themselves Insured?
Underwriting is also part of the DeFi insurance world. An underwriter assumes the risk of a future event and charges a premium to reimburse a client in the event of loss. In traditional insurance, the policy is issued and underwritten by a giant multinational insurer.
DeFi coverage providers may be partnered with underwriters who have been in the traditional insurance industry for decades because they have a proven track record and a large capital pool availability, which directly translates to low cost of coverage for users .
If you break down the entire system, the main actors in a DeFi insurance ecosystem are:
- The underwriters providing capital (staking) to the pool of the covered protocol.
- The claims assessors and governance token holders, who are in charge of voting on claims and overall governance.
- Decentralized brokerages which leverage proven underwriters to offer permissionless, streamed coverage and algorithmic staking management for capital providers.
- Users and protocols who buy coverage and may claim when incidents occur.
There are not currently any regulatory bodies in DeFi, which is part of the self-regulation oriented ethos of this industry. This is a big difference from traditional finance, which is under the purview of regulatory bodies like the Federal Deposit Insurance Corp. The governance system dictating different DeFi insurance protocols will be specified in their technical documentation and may be coded into the smart contracts. Code is law.
Coverage providers have seen as much as US$1 billion worth of insurance purchased in just a month, so investor awareness is spreading. DeFi insurance alternatives are a critical risk management tool to help safeguard investments. While there are risks to DeFi investing, you can protect yourself with a smart solution catered to your needs.