Eight difficult problems in DeFi insurance

The booming hype of smart contract-empowered decentralized finance (DeFi) is intertwined with the undue risk of cryptoassets, including fungible tokens (cryptocurrencies) and non-fungible tokens (NFTs). A well-known risk of holding crypto assets is price volatility. For example, in May 2022, Bitcoin and Ethereum fell 27.3% and 38.1%, respectively, in the turbulent month following the collapse of Terra Luna (whose price plummeted 99.9%). Another notorious risk of holding crypto assets is cyber-attack. About $10 billion will be lost to hacks and scams in 2021 alone (Elliptic, 2022).

To mitigate the high risk of crypto assets, an obvious prescription is to resort to insurance, the same as loss insurance for traditional assets in centralized finance (CeFi). However, almost all traditional insurance companies in the world are reluctant to underwrite crypto assets – traditional CeFi industry and government regulators do not even recognize crypto assets as assets (HMRC, 2021). As a result, the DeFi ecosystem is forced to develop its own insurance programs to meet the urgent need to share risks and mitigate losses with the help of smart contracts.

Despite a real need for crypto asset insurance, the development of DeFi insurance has long lagged behind the entire crypto asset market.

As shown in Figure 1, the total value locked (TVL) of insurance accounts for only 1.29% of the total DeFi. In contrast, CeFi insurance’s total assets represent 8.6% of CeFi assets (Statista, 2022). This gap shows that the development of DeFi insurance is extremely uneven, and there must be some unique obstacles hindering the development of insurance in DeFi.

Therefore, this paper aims to address the following two questions:

1. What are the main challenges hindering the development of DeFi insurance?

2. What are the potential solutions to these challenges of DeFi insurance?

Figure 1: Total Value Locked (TVL) in different DeFi sectors in March 2022.

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As shown in Figure 1, at the core of a DeFi insurance project, there are supply-side (developers) and demand-side (users), while market participants such as liquidity providers (LPs) and market makers provide the project with sufficient Funds so that insurance users (policy holders) can be compensated in due course. They are essentially market makers for DeFi insurance, instead market participants like hackers and arbitrageurs use malicious transactions to attack projects, they are effectively market disruptors. In addition to market participants, regulators in financial markets are now closely watching DeFi developments, given its high stakes and expanding scale. Other DeFi projects (especially DEXs), smart contract blockchains (especially Ethereum), and cryptocurrencies (especially stablecoins) provide ecological support (or barriers) to DeFi insurance projects.

Note: Different sections may overlap, so the sum of the shares does not equal 100. Different parts may overlap, so the sum of the shares does not equal 100. The TVL of DeFi is estimated at $227.8 billion.

Data Sources. DeFi Llama (https://defillama.com/categories).

This paper identifies eight major challenges through semi-structured discussions of focus groups consisting of developers, entrepreneurs, investors, researchers and media commentators.

1. The liquidity problem

2. Actuarial problems

3. Verification Difficulties

4. The problem of scale

5. The Yield Conundrum

6. Malicious attack problem

7. Cybersecurity Conundrums

8. Legislative Dilemmas

These identified puzzles can be understood and categorized from the perspective of different players in the DeFi insurance market.

Figure 2: Market Participants and Market Structure of DeFi Insurance

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Remark:

LPs = liquidity providers, arbitr. = arbitrageurs, DEXs = decentralized exchanges, CEXs = centralized exchanges.

The eight main challenges are explained in detail below.

The liquidity problem

[problem] 

DeFi insurance, or the DeFi industry as a whole, is actually facing the number one challenge of liquidity, mostly from a vendor perspective (but also involving market makers and other market participants). In the early stages of DeFi development (the so-called DeFi 1.0), liquidity was mainly provided by liquidity miners, who were constantly switching between different projects to get the highest yield. Therefore, unless a higher yield is provided to compete for liquidity, a DeFi project cannot maintain its liquidity until a Ponzi scheme occurs, such as Curve, Sushi usually provide about 2%-15 on various encrypted assets %APY, while other riskier protocols could have eye-popping yields of 35,000% APY.

[solution】

The focus group agreed that a revolutionary solution was needed to solve the liquidity dilemma. An emerging possibility is the so-called DeFi 2.0 solution of creating a fund reserve or “treasury” outside of liquidity pools to support liquidity needs. This solution was originally developed by other DeFi projects such as Olympus (a reserve currency project) and adopted by DeFi insurance projects such as NodeDAO. Through various incentive designs, the vault in DeFi 2.0 can stabilize the liquidity of DeFi insurance projects.

2. Actuarial problems

[problem]

This conundrum is also from a vendor perspective, with actuarial analysts in the focus group suggesting that insured risks (crypto assets) lack a fixed, independent distribution compared to traditional centralized insurance, so the associated risks are very high Difficult to quantify. For example, the famous digital art “The First 5000 Days” will be traded for $69.3 million in 2021, making it the most expensive NFT sold to a single owner. The trading history is not long enough to constitute a reliable, continuous estimate of the price distribution.

[solution]

Insurance is essentially a claim under uncertainty, so the pricing model of risk premium is similar to that of financial derivatives. Actuarial analysts in the traditional insurance industry commented that they typically use Monte Carlo methods to model and estimate fair premiums for insured assets. As more and more price records become available, continuous-time pricing models such as the Black-Scholes formula can also be applied, and an actuarial analyst from NodeDAO responded that the most popular method in existing DeFi insurance is indeed Monte Carlo method, but if the average method (or indexation) can be used to construct the compound hazard, then it is possible to be stabilized and smoothed, so traditional methods like the Black-Scholes formula can also be applied. This can be achieved by averaging NFTs in the same series or by averaging units of the same NFT (for example, The Merge sold 312,686 units to 28,893 collectors for a total of $91.8 million).

3. Verification Difficulties

[problem]

A unique difficulty of DeFi insurance relative to CeFi insurance is the verification of losses. Losses in the real world can be verified by centralized insurance companies and centralized governments at a certain information cost. In the crypto world, however, the anonymous nature of digital wallets makes verifying the validity of claims difficult, sometimes impossible. For example, if a policyholder claims that his NFTs have been compromised, it is nearly impossible to distinguish between true theft and insurance fraud, as the policyholder can simply create another digital wallet and transfer crypto assets without being identified. To make matters worse, due to the lack of regulation, there are no legal consequences for this type of insurance fraud.

[solution]

The focus groups did not reach consensus on solving the verification challenge, but this difficulty is not universal. Public data such as transaction prices and floor prices for cryptocurrencies, NFTs, and even real-world financial assets can be fed into the verification process with the help of blockchain oracles. Smart contracts can then be used to automate verification and compensation. DeFi insurance will likely have to limit its scope to avoid, rather than solve, verification challenges.

The problem of scale

[problem] 

This is a difficult problem from the user’s perspective. The focus group highlighted two possible reasons for the small size of DeFi insurance. On the one hand, there are economies of scale in the insurance industry (including DeFi and CeFi). For the law of large numbers to work, there needs to be a large enough user base. If the liquidity pool is not large enough, few users are willing to insure because the entire DeFi The total value locked in the insurance industry is only around $1 billion (DeFi Llama, 2022), while the market capitalization of NFTs in the art sector alone has reached $840 million (Statista, 2022). A small pool of funds cannot insure a large asset (big fish in a small pond). If the capital pool is not big enough, then it will stay small and never be able to guide itself into a big capital pool. However, if no one is involved, the pool of funds will never grow. This is the Nash equilibrium of the insurance market for a coordination game (Kets et al., 2022). “Bad” Nash equilibria (neither participate) and “good” Nash equilibria (both participate) are shown in the simple coordination game below (Table 1). Without external forces, the DeFi insurance market is always stuck in a bad Nash equilibrium.

Table 1 The coordination game of the DeFi insurance market.

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On the other hand, the risk appetite of the cryptocurrency market is very high, the largest group of the cryptocurrency community is young men (18-29 years old) with high technical enthusiasm, these people are known for their high risk tolerance and risk-loving investment attitude known (Fairley & Sanfey, 2020). Therefore, they are in the cryptocurrency market for high risk, high reward, not risk mitigation, moderate reward. Intrinsic demand for insurance may be limited at first, reinforcing that the DeFi insurance market is trapped in a “bad” Nash equilibrium.

[solution]

Unlike traditional insurance, the capital used by DeFi insurance cannot be expanded with external forces because all insurance purchases are voluntary, not mandatory like vehicle insurance or national insurance in the real economy. But the focus group agreed that there is an inherent need for DeFi insurance from miners, LPs, stakers and NFT investors. As users in the cryptocurrency market grow, so does the demand for insurance, as new entrants tend to have lower risk appetites than incumbents. The only solution to the scale conundrum seems to be time, DeFi insurance projects must wait for users and the cryptocurrency ecosystem to grow naturally, before that, DeFi insurance projects cannot be purely an insurance for crypto assets, it must generate a diversified business model to support growth. For example, NodeDAO proposes a comprehensive insurance model called NICE (N=NFTs, I=Investment, C=Cryptocurrencies, E=Events). It covers not only the spot market (N and C), but also the future market (I and E). Additionally, stablecoins (like USDC) connect cryptocurrencies with real money, while reserve coins (like Olympus) and NICE (like NodeDAO) connect cryptoassets with real-world assets. 

5. The problem of profitability

[problem]

This conundrum reflects the view of market makers, such as LPs and stakers, that the DeFi market cannot function without liquidity provided by market makers, however they also caused serious liquidity problems in DeFi 1.0, as high-risk users always is to seek the highest APY (like hot money in international financial markets), as mentioned in the liquidity puzzle. Once higher yields appear in alternative projects, users pursuing higher yields have an incentive to withdraw funds from existing projects, which leads to a rapid drain of old liquidity pools. This is why in DeFi 2.0, there is always a reserve of funds to control the liquidity of funds and lock the liquidity in the same project. For DeFi insurance, users who pursue high yields must choose their roles between LPs and stakers. If you choose to become an LP, your funds will be locked in the liquidity pool for a short period of time, but every year Interest rates are lower. If you choose to be a policyholder, your fund is locked into the equity pool for a longer period of time, but with a higher annual interest rate, along with some management rights. Some DeFi insurance protocols also offer a third option to become a “bond holder” and buy bonds with a fixed APY from a fund pool or “vault” (e.g., Olympus, NodeDAO). Also, they need to compare APY between DeFi insurance projects and other DeFi projects such as DEX and DeFi lending. All of these choices involve complex information that takes time to digest. This puzzle is interrelated with other puzzles, such as the liquidity puzzle and the scale puzzle.

[solution]

This conundrum affects DeFi insurance more than other DeFi projects, because insurance tends to have a lower APY, so its risk is lower. In order to attract users, insurance projects need to creatively provide products with different income types to meet different risk preferences and investment needs. For example, NodeDAO offers three alternative ways of investing: (i) buy bonds and earn fixed interest from a “treasury”; (ii) provide liquidity and earn a share of premiums from a liquidity pool; and ( iii) Stake tokens and earn backtesting bonuses from the stake pool. The APY of shareholders is often higher than that of LPs and bonders, so it encourages users to stay in the project for a longer time, and the basic logic to ensure the feasibility of generating income is the continuous growth of insurance premiums. It is not a Ponzi game as long as the intrinsic growth in insurance demand can support increased token issuance and yield repayments.

6. The Problem of Malicious Attacks

[problem]

There are two types of market disruptors. Moderates are arbitrageurs who exploit business logic errors to make risk-free profits. For example, in October 2020, an arbitrageur used an arbitrage opportunity on the Harvest Financial DeFi platform to manipulate the price of a liquidity pool using a flash loan, a $50 million flash loan that generated 24 million in a very short period of time dollar profit. Another famous example is the “51% attack” on Ethereum Classic in 2020, these things, while immoral, are all effective manipulations that follow the rules. Therefore, if the attacked projects can survive the temporary loss, they can improve the robustness of the business logic. Economists in the focus group raised a possible business mistake in DeFi insurance. Arbitrageurs can use flash loans to buy a large amount of a particular cryptocurrency to push its price up, while buying cryptocurrency insurance to prevent the price from getting too high. This combination can form a risk-free arbitrage opportunity. A robust DeFi insurance protocol must prepare for this self-fulfilling arbitrage.

[solution]

Business logic errors can be largely avoided if internal and external scrutiny is carried out by entrepreneurs, investors, researchers and technologists. The key is to design the project so that there is no systematic divergence between monetary and commercial aspects (Tokenomics). This is similar to the relationship between the money market and the real market in the textbook Monetary Economics. If the growth of tokens/currency exceeds the growth of commerce/GDP, then there will be inflation. As Nobel laureate Milton Friedman said, “Inflation is a monetary phenomenon at all times”.

Seven, network security problems

[problem]

Another category of market disruptors are hackers, who are more ruthless when it comes to illegally stealing cryptocurrencies, the most popular method being infiltrating the security systems of cryptocurrency exchanges. CEXs typically act as custodians, holding private keys on behalf of users who buy and trade cryptocurrencies on the exchange. This custodial structure has the advantages of transaction speed, customer support and insurance verification, just like a stock exchange in a real financial system. However, this centralized control goes against the spirit of DeFi and is vulnerable to cyberattacks. About $10 billion will be lost to hacks and scams in 2021 alone (Elliptic, 2022).

[solution]

A blockchain technician from NodeDAO suggested having the code reviewed both internally and externally before release to alleviate this dilemma. Other proposals include a decentralized autonomous organization (DAO) vote to create a fork to undo the hacker’s attack.

8. Legislative Difficulties 

[problem]

This conundrum is viewed from a regulator’s perspective. Most countries do not have formal legislation on DeFi because it is not limited by sovereign borders in nature, and it is practically difficult to regulate DeFi activity. The exception is that the UK tax authority has added a new chapter on DeFi to its crypto asset handbook, but the regulation only applies to money laundering and terrorist financing (HMRC, 2021). The slow pace of legislation cannot keep up with the rapid growth of DeFi, but the lack of regulation does limit the further development of DeFi insurance in general. 

[solution]

As DeFi grows, regulations applicable to CeFi are expected to be adjusted to impose similar restrictions on DeFi’s peers, but when and to what extent legislation will be made is still uncertain.

The eight puzzles identified by the focus group discussions cover all stakeholders in the DeFi insurance market, but they are not an exhaustive list of DeFi insurance challenges. Other minor issues were also raised and discussed, but the group felt they were of different importance. For example, institutional investors (such as venture capital) are generally not interested in backing long-term projects like DeFi insurance because they are after short-term profits. However, the focus group believes that this issue is less important than other conundrums, as institutional investors’ power in the DeFi market is also decentralized. Another minor technical difficulty is the low consensus speed of smart contract blockchains, but it is considered a temporary problem.

Some of the eight puzzles are not limited to DeFi insurance, but also relate to DeFi in general. For example, the liquidity dilemma (I), the malicious attack dilemma (VI), the cybersecurity dilemma (VII), and the legislative dilemma (VIII) are common problems for all DeFi projects. However, these conundrums pose greater difficulties for insurance compared to other DeFi applications, leading to uneven development.

From the discussion of these eight difficult problems, the growth of DeFi insurance is stable, but it is also slow; the prospect of DeFi insurance is promising, but it will not be smooth sailing. The DeFi insurance market is likely to remain unregulated, leaving the market free to compete by projects featuring DeFi 2.0 fund pools. At the heart of the competition is who can attract and capture the most liquidity from the market without tipping the balance between token issuance and business growth.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/eight-difficult-problems-in-defi-insurance/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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