In the words of Kim Kubbard, “Fun is like life insurance; the older you get, the more it costs.” The Blockchain-based Decentralized Finance industry has come of age – surpassing $3 Trillion at all-time-high in November 2021, while attracting astronomic growth in demand from over 300 million retail & institutional users worldwide.
With 300 million users from virtually every country on earth, and heading to Mars, as some would argue, the global (or interstellar) interconnectedness of the DeFi markets makes it imperative for regulators to come up with laws that are not only investor friendly, but also compatible with the technicality and distinct features of blockchain technology.
It therefore goes without saying that, today, there is a pressing need for effective and holistic macroprudential measures to ensure the safety, and viability of the DeFi industry with such a global reach. And this is where DeFi Insurance comes in.
In this article, we will analyze the growth of DeFi Insurance, inherent challenges as well as specific regulatory interventions that are required to take DeFi Insurance to the next level.
TL:DR – Key Takeaways
- DeFI Insurance has grown steadily but adoption rates remain low. Only 2% of Cryptocurrencies and DeFi projects are Insured.
- DeFi is mostly criticized but majority of Cryptocurrency losses, scams and theft occur on Centralized Exchanges.
- Centralized Exchanges are responsible for 99% of Crypto transactions. Only a fraction of assets in custody of Centralized Exchanges are Insured.
- Regulators around the world have hit a conundrum on Classification of Digital assets and Counterparty identification.
Content
- What is DeFi Insurance
- Key Differences Between DeFi and TradFi Insurance.
- The Growth & Challenges of DeFi Insurance
- Regulatory Interventions Required in DeFi Insurance
What is DeFi Insurance?
Crypto or DeFi insurance is a branch of Decentralized Finance that provides on-chain cover against inherent risks that are peculiar to the cryptocurrency markets. The main premise is to indemnify DeFi protocol users and digital asset holders against specified proximate causes that may be outside the purview of TradFi insurance.
In broad terms, DeFi insurance typically covers against technical vulnerabilities of smart contracts, potential attacks against on-chain infrastructure of platforms that host or store the digital assets such as NFTs, Cryptocurrency or Security Tokens.
Some of the main insurable risks in DeFi include Smart Contract Vulnerability, Custodian risk, IDO event risk, Stablecoin De-Peg risk among others. .
Key Differences Between DeFi Insurance and TradFi Insurance
DeFi insurance seeks to uphold the critical canons of fairness and equity that have guided the TradFI insurance for centuries. However, here are some of the key differentiating factors between both sectors.
Dynamic Cover Limit — DeFi insurance policy typically has a dynamic cover limit that increases or decreases commensurately with the market price of the underlying crypto assets.
Insurable Assets — TradFi insurance focuses heavily on providing cover against losses pertaining to physical assets and commodities, DeFi Insurance mostly tilted towards on-chain digital assets and the technical infrastructure that hosts them.
Operational Jurisdiction — Most TradFi insurance is quite limited in scope by geographical jurisdiction where the parties to the insurance contract are domiciled. While DeFi Insurance protocols are as ubiquitous as the borderless blockchain technology that powers them.
Automation & Litigation — Insurance contracts in TradFi are outlined and enforced by courts of law usually through months or years of complex litigation processes. In DeFi insurance protocols encode the insurance terms in self-executing smart contracts. This enables transparent and dynamic estimation of applicable Premium and streamlines the Claims process.
The Growth & Challenges of DeFi Insurance
The DeFi insurance industry has evolved to provide Cover to investors in diverse blockchain protocols against major DeFi risks while adhering to the core cannons that have guided TradFi insurance for centuries.
Over the last 5 years, DeFi Insurance has grown steadily at a CAGR of 84.9%. In 2018, the blockchain insurance market size was valued at USD 64.50 million in 2018 and is now projected to reach USD $1.3bn by 2023
However, despite the rapid growth, the DeFi insurance industry is clearly still in the early stages of development. Tellingly, the adoption of insurance in DeFi is quite slow, with only 2% of all DeFi assets currently under insurance coverage.
Here some major challenges that have slowed down the adoption of Crypto Insurance
- Lack of Clear Regulatory Clarity around Legal status of Digital Assets
- Lack of Adequate Data
- Limited Pool of Specialized Talent
- Low DeFi Literacy
- Global attempts to govern DeFi with TradFi laws.
While the DeFi Insurance industry continues to navigate its macro-teething issues, its growth prospects remain visible and massive. Specifically, the ~$70bn in (TVL) Total Value Locked-in DeFi protocols present real and promising opportunities for growth of insurance in DeFi.
And the regulators and compliance bodies around the world have a major role to play in unlocking these growth opportunities.
Regulatory Interventions Required in DeFi Insurance
At all-time-high If the blockchain industry were a country, it would be the 4th largest economy in the world. Today, only 2% of the total value of the Crypto Industry is insured across various insurance protocols. This figure is abysmally low. It means that 98% of value in a $3trn* are essentially exposed to varying levels of losses.
In comparison, the US Stock market was only worth around ~$400bn in 1970 when the Securities Investor Protection Corporation (SIPC) was established to protect investors and recover assets in the event a broker or dealer becomes insolvent.
Evidently, local & international regulatory bodies today, must intervene to help the DeFi industry instill some level of clarity, standardization in order to drive up adoption rates significantly. Here are some key areas where DeFi regulators around the world need to make changes to make laws that are DeFi-friendly while also achieving critical macroprudential goals.
Regulatory Clarity – Counterparty Identification and Assets classification.
It is important for regulators to avoid governing DeFi assets with TradFi laws. Establish robust counterparty identification and assets classification.
Unlike TradFi where the nature of activity and roles of participants are clearly defined, the roles of participants in DeFi can be fluid. In DeFi One single Individual or Institutional participant may act as an Investor, Miner, Liquidity provider or User all in the same breath.
It is important for regulators and lawmakers around the world to take this into consideration – in order to develop a robust Counterparty identification framework – when developing DeFi laws.
Similarly, the legal status of Cryptocurrencies is another crucial area where the DeFi industry requires regulatory clarity. There has been major controversy around the legal status of cryptocurrencies – either as Securities, Currency or Commodities. Regulatory agencies around the world have hit a conundrum regarding these issues.
Notably, the US-Senate and the European (EU) parliament have recently mooted new Bills to provide a sound legal framework for crypto-asset markets. The debates around this legal framework must consider that there are different cryptocurrencies with diverse features.
And for effective and DeFi friendly regulation, regulatory bodies around the world must identify each of these features and not attempt to lump all cryptocurrencies into a single bucket.
Mandate Centralized Exchanges to Insure Custodial Assets
In 2021, uninsured losses accrued from crypto scams and other cases of hacks totaled $7.7 billion. While the majority of criticisms have been targeted and DeFi protocols, it is important to note that the majority of the biggest hacks in the history of cryptocurrencies have directly involved centralized exchanges. Likewise approximately 99% of all crypto transactions go through these centralized exchanges.
Therefore It is important for regulators to protect DeFi by enacting incentivizing and/or mandating centralized exchanges to insure the assets of their users and investors through available DeFi Insurance protocols.
Professional Indemnity – i.e. Directors & Officers’ Insurance.
Given the nascent nature of the DeFi insurance industry, it is important for regulators to create laws that will drive innovation and protect talented professionals and early contributors from being exposed to rigor and distraction of unbridled litigation.
Regulators should provide relevant coverage solutions against innovation stifling litigation – such covers could include Directors’ and Officers’ (D&O) liability & Professional indemnity – within the confines of commercial crime prevention laws.
Limiting Self-Insurance by Exchanges
Self-Insurance is a broad term that describes an attempt by an (Institutional) party to insure others against specific losses that it might also be inherently exposed to. Today, in an attempt to maximize revenue, many cryptocurrency exchanges are creating their own insurance funds, even diverse DeFi insurance products are available.
While self-insurance might come with a few advantages like Personalized plans and improved data, the downsides are risks significantly higher. Asides from the logistic distractions that come with managing their own self-insurance funds, Self-Insurance of custodial crypto assets by Centralized Exchanges creates a heightened risk of systemic loss. If a large number of users file loss claims within a short period of time, the exchange would effectively be at the risk of insolvency. Thereby leading to a potential systemic collapse, especially if it involves Exchanges with a broad global footprint.
It is therefore important that regulators mandate Centralized Exchanges to eschew self-insurance and procure relevant insurance cover from external providers that are capable of providing specialized coverage against risks
Mandate Institutional Investors to Get DeFi Cover
In April 2022, Fidelity, one of the leading Investment firms, with over $11trn Assets Under Management (AUM), announced that its investors would now be able to allocate up to 20% of their 401(k) accounts to Bitcoin.
This indicates that today, many institutional players are increasingly getting involved in the blockchain space. From hedge funds to retirement fund managers to Investment banks. While most investor funds allocated to TradFi investment vehicles are typically insured by the various National Insurance schemes, the regulations around their Blockchain investments are comparatively lax.
Since blockchain investments are currently outside of the purview of major Private covers & Public Deposit Insurance schemes, one effective way to ensure that investors remain protected is for regulators to mandate Institutional participants to obtain DeFi Insurance covers that is commensurate to the value of investments that they make in on-chain digital assets.
Final Thoughts
The above list of DeFi-friendly insurance regulatory considerations is not exhaustive but does represent some key areas where insurance regulators need to improve to support the growth of DeFi Insurance and the blockchain sector at large.
While these insurance regulatory hurdles may be challenging to overcome, they also present a valuable opportunity for the establishment of a new InsurTech industry where participants can enjoy the tested & trusted canons of TradFi underwriting as well as sophisticated technology of the nascent DeFi space.
Capturing this new market could lead to cross-pollination opportunities across the world in terms of improved service efficiency and new job opportunities as DeFi Insurance protocols seek to expand their operations and broaden the scope of their product offerings.
Disclaimer
Nothing in this article constitutes professional and/or financial advice. If you have any doubts as to the merits of a digital asset investment, you should consult an independent financial advisor.
