DeFi Insurance: The Safety Net of the Crowd

As prices for Bitcoin, Ethereum, and even Dogecoin continue to skyrocket, it is really the strength and value proposition of the potential transformative engine called DeFi that is driving the true third wave of crypto. From the initial DeFi craze through the end of 2020, the total value locked (TVL) in DeFi multiplied 13x to $13 billion. The DeFi train shows no sign of slowing, with DeFi’s TVL adding $27 billion, twice what it was in 12 months of 2020, to bring DeFi’s total TVL to around $40 billion.

With larger rewards, though, come even larger risks. Exchanges can be attacked, thieves can sneak into exchange backdoors, crypto holdings can be stolen in the blink of an eye, and while smart contracts might be immutable, that doesn’t mean they can’t be hacked. DeFi services alone lost over $150 million in 2020, mostly due to platform exploits. Hundreds of millions more were laundered through DeFi protocols.

While “move fast and break things” might be a great philosophy for technological and financial innovation, it’s not necessarily so for investing, or for the safeguarding of that investment. So how better to align the massive financial reward DeFi poses with a more stable risk profile?

Well, with the financial safety net that has worked since at least the 14th century, insurance. Not only can the “old trick” of DeFi-based insurance protect against the multiple layers of vulnerabilities and exploit-based attacks currently besieging DeFi and other crypto services, it can be built out as its own DeFi service layer that can capture up to trillions of dollars in value.

A matter of trust

The strongest thing legacy finance has going for it is perception, specifically, the perception of safety and stability. You may not be getting a one-day, Elon Musk Twitter-driven 800% return on your investment like Dogecoin, but you have arguably more valuable peace of mind that you won’t lose 100% of your nest egg.

However, the one advantage crypto has over legacy finance is moving forward with the kind of innovation that can build a new and better peace of mind. What if we were able to take the principles of DeFi and apply them to the concept of insurance?

Here’s how the mechanics of something like that might work for DeFi. You start with two types of users. The first, long integral to the concept of insurance, is the “policy holder” who is covered by and purchases the policy. The second group is where the innovation happens: “stakers,” who provide liquidity and can choose on the basis of an analysis of risk factors which categories of policies they’d like to provide with liquidity. The stakers would receive as a reward a part of the premiums paid by policyholders, as well as other yields generated by the platform’s automatic reinvestment of coverage funds.

Users can purchase different types of policies based on the category of the asset (smart contracts, exchanges, stablecoins, etc). Smart contracts and exchanges are typically protected against hacks, exploits, and rug pulls (a rug pull is when the founding team steals all of the funds from their own token economy through a back door in the code and disappears). Stablecoins are protected against price failure, as their main purpose is to maintain a specific price point. Policies allow for claims up to the policy maximum purchased by the policy holder. The community is responsible for determining whether a coverable event related to the policy took place.

DeFi’s final frontier

While it might seem like the nascent DeFi coverage industry still has a long way to go to capture the insurance market, it might not be as long as you think. In its own coverage niche that essentially started in just the last year, the DeFi coverage market has already moved its market cap from zero to $290M

Yes, that might not seem like a lot compared to the traditional world insurance market, which currently weighs in at around $5T, but like every industry that has been disrupted by technological iterations in the last few decades, much of the infrastructure can easily be converted to DeFi. The $3.7T market currently covered by credit default swaps alone could be digitized and decentralized in the medium term.

Insurance is just a hedge, like many other financial instruments. A company collects premiums, and that company remains viable because the amount collected from premiums is more than claims paid. As with other DeFi tools, this seems like a problem ripe for the wisdom of the crowd instead of a handful of middlemen and large companies, especially when those companies seem to not-so-secretly hate their own customers.

While it won’t be easy, and it won’t happen overnight, DeFi is perfectly positioned to disrupt insurance like no other industry. When it does, it won’t just mean unlocking trillions of dollars worth of value, but a better safety net that has been compromised by an imperfect structure and bad faith providers for far too long.

About the author

Mike Miglio is the co-founder and CEO at Houston based Bridge Mutual, a cross-chain, permissionless and non-custodial risk management platform providing coverage for stablecoins, exchanges and smart contracts.