We are still in the early days of Decentralized Finance. However, Ethereum has taken DeFi to a whole new level. Unfortunately, this left us with a bittersweet taste. The Ethereum DeFi ecosystem has sprouted many great projects. However, we’ve seen many smart contract failures, hacks, and scams along our DeFi journey.
As we continue to build with DeFi lego, creating more complex DeFi products, there’s a need for insurance products to reduce the risk for crypto investors. The newly created DeFi hype added a new element of risk to the crypto space, which discouraged many new users from embarking on the crypto journey. Even audited smart contracts still fell victim to complex attack vectors.
By offering crypto insurance products, we reduce risks for investors and better protect users’ funds. Blockchain technology has the potential to transform our financial system. To succeed in this mission, we require crypto insurance products to offset risks.
But first, do you know how insurance works?
The insurance concept is relatively simple. First of all, you can take out different types of insurance, such as life insurance, car insurance, house insurance, or medical insurance.
When you choose an insurance policy, you have to pay monthly premiums to your insurer. This money gets added to a pool which you share with many other users that want to insure themselves for the same policy.
Insurance companies use the money from this pool to pay out claims. Let’s say you subscribed for house insurance, and your house burns down. This policy entitles you to make a claim against the pool of premiums to receive money to reconstruct your home. In other words, the insurance policy makes sure to cover your losses.
To explain the effectiveness of insurance, let’s continue with the house example. This example is fictitious to help you better understand how insurance works and how we can later apply this model to crypto insurance.
Let’s say that there’s a 0.1% chance per year that your house will burn down. This percentage translates to one burned house every 1000 years. You decide to save $100 every year as this will fund a new house after 1000 years. However, what if you are unlucky and your house burns down after ten years? You’ve only saved $1000, which is not enough to build a new house.
This problem is exactly where insurance comes into play to create liquidity. Imagine pooling 100,000 people who all take out the same insurance policy to protect their house. It means that all of these people have to pay the $100 premium, resulting in a $10,000,000 pool of premiums.
Now, 0.1% of the 100,000 houses burn down, which results in 100 burned homes. As users have to pay the premium at the beginning of the year and not all houses burn down at the same moment, we have access to $10,000,000 liquidity, which we can pay out to 100 claims. In other words, every user receives their $100,000 claim.
This example shows the power of pooling together people to offset risks and create liquidity. Insurance policies make sure there’s plenty of liquidity to pay out claims, even for houses that are unfortunate to burn down in the first year of their insurance policy.
As the concept of insurance isn't complicated, a couple of projects started exploring crypto insurance possibilities to protect users’ funds against hacks or smart contract failures.
For example, an exchange can insure itself against hacks if there are plenty of exchanges that want to do the same. The exchange has to pay a yearly premium to protect their investors’ funds. As there aren’t that many exchanges, individual protection is often capped at a certain amount of money. Providing higher tier insurance translates into much higher premiums, which is often not sustainable for an exchange.
Now, your exchange suffers a hack, and you lose all of your funds. This exchange can open a claim with the insurance contract or company to receive money to reimburse those affected.
Besides the traditional insurance model described above, different types of crypto insurance projects exist.
On November 14, 2019, hardware wallet vendor Ledger secured insurance cover for its institutional crypto asset custody service to the tune of $150 million. As more and more institutions are exploring the possibilities of cryptocurrencies, there’s a need for secure crypto storage and insurance coverage.
Ledger's insurance protects users' funds against third-party master seed theft, insider theft, and many other crime types.
On top of that, Ledger Vault offers many attractive security measures:
You might wonder why this is such a big deal? It allows many service providers to provide more secure crypto services, which boosts adoption. Up to this point, there was always an element of risk to lose all your funds. Ledger Vault eliminates this point of risk and allows large institutions to embark on the crypto journey.
More importantly, it allows service providers such as YouHodler to safely store their users’ funds with Ledger Vault. This way, all funds you deposit to the YouHodler wallet are covered by Ledger Vault’s insurance up to $150 million total value.
We’ve seen many DeFi hacks, smart contract bugs, and admin scams, which left investors empty-handed. Opyn solves this problem by providing a smart contract-based crypto insurance platform covering all these attack vectors.
Opyn makes use of protective puts. It’s a well-known risk management strategy for traders who want to guard their investment against the loss of owning a stock or asset. As an investor, you can buy a put option for a fee, called a premium. A put is a great way to protect your investment against price declines or any other type of loss or uncertainty.
Currently, Opyn offers the following types of insurance:
Note that you can also buy call options to insure yourself against an increasing asset value. For example, you can buy a protective call option on Ethereum to protect yourself from an increasing Ethereum price when opening a short trade.
Nexus Mutual wants to reduce the insurance cost for users as traditional insurance companies use up to 35% of the premiums to cover their costs. Using a decentralized model, we can reduce this number to 15 - 18%, making insurance more affordable.
Nexus Mutual focuses on the DeFi ecosystem as this industry can benefit most from crypto insurance. In specific, Nexus Mutual protects you from smart contract failure.
Nexus Mutual allows you to buy coverage for a broad range of DeFi protocols, including Uniswap, 0x, Compound, yEarn Finance, Balancer, Bancor Network, and many others.
You can further choose the length and amount of coverage you want. By filling out those parameters, Nexus Mutual calculates your premium cost to contribute to the premiums pool.
Insurance is a precondition to the mass adoption of innovative technologies and a primary form of consumer protection. Blockchain technology has proven to be an excellent opportunity to transform the insurance industry and reduce costs. Furthermore, blockchain-based insurance provides uninsured populations access to insurance products, which can boost economic growth and act as a safety net.
To give an example, we wouldn't have an aviation industry without the insurance industry backing operational accidents. The same is true for banks. We wouldn't trust banks if they didn’t offer deposit insurance guarantees.
The ultimate goal of insurance, and also crypto insurance, is to spread risks and generate liquidity to pay for claims. Hopefully, the future will show us more easily accessible insurance products, digital-first, that take little time to process and payout claims quickly.
Fun side note: Nothing is free from hacks or smart contract failures, as insurance provider Opyn showed when their DeFi options protocol got hacked on August 5, 2020. This hack again shows how fragile the DeFi space is and why we need strong insurance products to boost crypto adoption.
Want to learn more about what YouHodler does to protect users’ funds? Check out the blog post about our partnership with Ledger Vault that offers crypto insurance up to $150 million for their custody service.