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Novel Sector within DeFi
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John F. Kennedy once said
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“The time to repair the roof is
when the sun is shining.”
Protecting assets against a future calamity is an essential part
of risk management. Insurance is available for pretty much
anything that has value: your phone, your car, your house, and
even your life.
Decentralised insurance aims to address the inefficiencies in
the conventional insurance industry by reverting the system
back to a community-based model rather than the adversarial
system, currently dominated by large institutions, bringing the
mutual ethos back to insurance.
The utilisation of blockchain technology for insurance
simplifies issues such as fraud detection and removes a lot of
the bureaucracy that plagues the traditional insurance sector:
a third of the total US healthcare spend in 2017 (more than
$800bn) was spent on administration, an incomprehensible
waste of resources.
Insurance premiums are a way of quantifying the risk taken on
by the insurer in the form of regular payments for coverage. In
CeFi insurance, premiums are determined by the insurance
company only after they have assessed the risk, they have
decided when the liability is realised, and they decide when a
payment is issued to the claimant – doesn’t sound good when
you put it like that!
The purpose of DeFi is the disintermediation of the financial
system and so by definition DeFi insurance seeks to remove
them from making all the decisions, providing a medium
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where the setting of premiums and pay out conditions are
made by a collective and/or are algorithmically generated
through intuitive application of smart contracts and blockchain
technology.
DeFi insurance presents an opportunity for participants to
hedge their risk against smart contract failures that have
caused considerable trauma in the past. But it is not just about
protecting capital – insurance is a cornerstone of the CeFi
system and so DeFi insurance is a natural step forwards in the
development and mainstream adoption of the open finance
ecosystem.
Let’s dive in and take a look at some of the projects, how they
operate and what they aim to achieve in the future!
Disclaimer: NOT FINANCIAL NOR INVESTMENT ADVICE. Only you are responsible for any
capital-related decisions you make and only you are accountable for the results.
Nexus Mutual
Nexus Mutual describes its-self as “a people-powered
alternative to insurance”. But what does this mean? Well, the
term mutual when used in a financial context describes an
entity that is owned by, and run for, the benefit of its members
all of whom are actively and directly involved in the business,
rather than being owned and controlled by outside investors.
Currently, Nexus Mutual products include Smart Contract
Cover and Custody Cover for ETH. Smart Contract Cover
provides protection against hacks in value-storing
applications, an example of which would be the Yearn Finance
hack in September 2020. They cover a wide variety of
contracts including Aave, ETH 2.0 and SushiSwap.
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Custody Cover allows protection of funds held in centralised
exchanges in the case of a hack, or if withdrawals from the
exchange are halted for more than 90 days. Currently covered
exchanges include Coinbase, Kraken, Binance and Gemini.
Built on the Ethereum public chain, Nexus allows anyone to
become a member and buy cover – in fact you need to be a
member to buy cover. Membership rights are represented
through their token, $NXM. Participation in the mutual is
incentivised in the form of new $NXM tokens issued to active
members as a reward, similar to how mining works – instead
of providing computing power to a pool you provide your time
and capital.
Claims assessment is carried out by active members using a
voting process, outlined below:
Each assessors vote is weighted proportionally, according to
the amount of tokens they have staked.
Why would members vote to pay the claim, you ask? Claims
Assessors stake a portion of their tokens. In extreme cases,
these tokens are liable to be burned if an assessor is found by
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the Advisory Board to have voted fraudulently. On the other
hand, assessors benefit from voting with the consensus via
token rewards and so the mutual is self-regulating.
If legitimate claims are paid out regularly, the credibility of the
mutual as an insurer is proven; attracting more members and
increasing the capitalisation of the fund as a whole, which is
long term beneficial.
Nexus has a few trade-offs that prevent it from being a truly
decentralised model:
Firstly, to become a member you have to go through
KYC verification. KYC checks are a grey area for crypto
as a whole – how can the system be decentralised if it
still has to conform to regulations set by centralised
authorities?
Additionally, the Advisory Board has quite a lot of
power (I mentioned this earlier with their authority to
burn staked $NXM as punishment and white-listing of
proposals), however there is an ‘Overthrow Control’
which essentially provides a mechanism for the
removal of board members via a membership
consensus.
The Capital Model and Pricing Model are currently run
off-chain due to the high gas costs currently affecting
the whole Ethereum network.
Operational limitations include the fact that coverage can only
be purchased separately for each protocol and for prespecified set amounts. Additionally, once purchased, coverage
contracts cannot be refunded, resold or modified.
wNXM
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As explained earlier NXM tokens are membership tokens only
issued to members (KYC verified), however members are able
to wrap their NXM tokens to the tradable token wNXM. The
latter is traded on the secondary market and does not require
KYC to own. However, it also does not give its holders any
membership rights like NXM holders. Unlike NXM, which can
only be bought and sold on the Nexus Mutual platform, wNXM
is available on exchanges. Under normal circumstances 1
wNXM = 1 NXM.
Let’s have a look at the tokenomics of NXM more in depth.
The price of NXM is determined by a bonding curve which
correlates with the amount of capital available to the mutual
and the capital required to pay out all claims with a certain
probability. The MCR is the Minimum Capital Required
(remember, capital is raised through the purchase of NXM by
members) – if the MCR% () drops to ~100%, then NXM
cannot be redeemed for ETH from the mutual. This creates a
dilemma for members – if I can’t exchange my NXM through
Nexus Mutual, what can I do? They have the option to wrap it
and sell it on an exchange as wNXM.
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For the vast majority of the time the MCR% is above the
required threshold and so NXM is freely exchangeable by
members – wNXM is kept at rough price correlation with NXM
on exchanges by arbitrageurs. However, during periods of
liquidity shortage the price of wNXM can drop substantially
when wNXM floods the market as members, unable to
exchange NXM through Nexus, sell their wrapped NXM on the
secondary market.
180 day price comparison of NXM(left) and wNXM(right), with the MCR%
YTD (top).
"
Note than when the MCR% drops below the required ratio, the
price of NXM drops to incentivise capital providers to invest in
an effort to fill the capital pool to acceptable levels.
Conversely, if the MCR% is too high, the price of the token
increases thus incentivising holders to cash out in order to
reduce the capital in the pool. This simple capital management
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strategy maintains the health of the mutual. Since wNXM
cannot be used in any meaningful way until unwrapped by a
member, its price is always lagging NXM as you can see on
the chart above. This temporary issue would be fixed in full
only once more capital is added into the pool.
Armor.Fi
“A True Smart Cover Solution”, Armor.Fi is a decentralised
insurance brokerage that seeks to build on the Nexus Mutual
insurance model by removing KYC requirements, providing
flexible smart contracts covering consumer funds with
coverage transferrable across a wide range of DeFi protocols.
Examples of covered protocols include Uniswap, AAVE, Maker,
Synthetix and Yearn, to name a few.
It operates a PAYG (pay as you go) model, with flexible options
for duration and the amount of coverage required. Armor.Fi is
partnered with Nexus Mutual, who underwrites the Armor
network coverage.
“Say goodbye to buying static chunks of coverage and
micromanaging cover amounts.…”
Armor has several features that differentiate it from Nexus:
User funds are tracked in real time as they move
across platforms.
Coverage amount can be automatically adjusted
according to changes in user funds per protocol, using
Armor’s ‘Smart Insurance System’.
Coverage is paid for on a second-by-second basis, so
you only pay for it when you need it rather than
purchasing a time-limited contract.
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Billing is calculated separately for multiple wallets and
can be pooled to allow for a single payment that
covers all wallets.
As mentioned previously, the Armor network coverage is
underwritten by Nexus Mutual and so the claims process
incorporates the Nexus claim assessment described above,
with Armor governance replacing the Nexus Claims Assessors
in the first instance of a claim.
InsurAce
Singapore-based insurance protocol InsurAce is another
player on the field looking to attract customers and investors
alike, and aims to provide “reliable, robust and carefree DeFi
insurance services to the DeFi users, with very low premium
and sustainable investment returns.”
InsurAce plans to utilise the same mutual insurance model as
Nexus Mutual in a complementary role, but with some distinct
features:
Ultra-low premiums subsidised by a risk diversified
investment portfolio-based product design.
Similar to Armor, InsurAce plans to cover a broad range
of DeFi protocols and to remove KYC requirements;
however InsurAce will offer Solvency Capital
Requirement (SCR) mining programs allowing
participants to earn $INSUR tokens by staking into the
liquidity pools as well as earning shares from
premiums. This capital will be used in the sustainable
investment portfolio as mentioned above.
Claim assessment, although operating on the same
basic model as Nexus Mutual, will differ from that of
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Nexus/Armor as they are looking to move away from
the extreme “Approve/Deny” model, into a quantitative
approach allowing for partial compensation of claims.
Cover Protocol
Cover Protocol differs from the other protocols mentioned in
that it uses a fungible-token, peer-to-peer system rather than
NFT wrapped contract based coverage. Although this is less
versatile than wrapped contracts, it allows the market to set
coverage prices as opposed to the bonding curve used by
Nexus, Armor and InsurAce.
Cover Protocol utilises a bespoke claim/reward system:
Two fungible tokens are minted when a user interacts with the
smart contract –CLAIM and NOCLAIM. The holders of the
CLAIM tokens receive compensation in the event of an
approved claim and, as you have probably already guessed,
NOCLAIM token holders receive the collateral if the contract
expires with no claims.
CLAIM tokens are worth 1 DAI if an incident occurs; NO
CLAIM tokens are worth 1 DAI if no incident occurs and
the token expires.
As is the case with InsurAce, partial claims are
supported; for example if total locked value (TVL) in a
covered protocol is $20m and $4m is exploited in a
hack, a 20% payout would be redeemable and so
CLAIM token holders would receive 0.2 (20%)
collateral and NOCLAIM holders would receive 0.8
collateral (80%).
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The claims process is similar to Nexus Mutual, with a
CVC(auditor) taking the final decision on whether or not to
approve a claim.
Recent Exploit
Cover Protocol was the subject of a massive security breach in
December 2020. Hackers exploited a coding bug within the
BlackSmith.sol liquidity and farming contract, allowing them to
mint COVER tokens at will to the tune of 40 quintillion (that’s
30 zeros – previous supply was in the thousands at the time).
Some tokens were used to provide liquidity to the balancer
pool resulting in the theft of $4million of WBTC, ETH and DAI,
massive collapse of the price of COVER and made headlines
across the crypto space.
In an odd twist the hackers revealed their identity:
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Grap.finance
@GrapFinance
Next time, take care of your own shit.
@CoverProtocol @chefcoverage
etherscan.io/tx/0xc2fd5094c…
1. No gains.
2. The Obtained Funds from LP has been returned to
COVER.
Ethereum Transaction Hash (Txhash) Details …
Ethereum (ETH) detailed transaction info for
txhash …
0xc2fd5094c1e108f83222a86bd46b35fc0da
etherscan.io
35616385d681964b22003643f982e. The
transaction status, block confirmation, gas
1:51 PM · Dec 28, 2020
1.3K
140
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The hackers returned the stolen funds (4350 ETH), however
massive damage to the reputation and reliability of Cover
Protocol was done. This ethical hack was likely a publicity
stunt, and indeed the price of GRAP surged thousands of
percent in the 48 hours after the hack. However, the exploit
revealed the potential havoc that can occur when the security
of a project is compromised and it is even more damaging
when you consider that it was an upcoming DeFi insurer
subjected to this attack.
Cover Protocol used the returned ETH to reimburse clients
and has since launched a new COVER token with a
compensation plan allowing distribution of the new token to
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those affected.
Please note that since the release of this article, Cover
Protocol has halted operations and is closing down.
Read more here (https://defited.medium.com/projectshutdown-cover-ruler-bb2df50e2a95)
shutdown-cover-ruler-bb2df50e2a95)..
NSure
NSure Network uses a Dynamic Pricing Model to determine
premiums. Supply and demand is used to set premium prices
– the more policies sold the higher the premium price. Regular
payments are controlled by the capital supply, a higher capital
pool equates to a lower regular payment.
Utilising a similar governance procedure as the other
providers, NSure token holders are also able to:
Stake their tokens in un-correlated projects with 4x
leverage on their capital – Aave, SushiSwap,
Compound and Curve Finance and others are
supported.
Hold the tokens to benefit from the growth of the
system
Sell their holdings in the market to realize profit.
Claims assessment also differs from the other systems:
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Looks complex? It’s not really, the only major changes to the
claims process to that of Nexus is that it can be carried out in
3 phases as opposed to two. Here’s a rundown:
A claim is filed, either through a direct claim or a
member finds a claimable incident. The policy holders
(all NSure token holders) vote for a claim request (the
vote must have more than 50% of the policyholder
votes, or 2/3 of all participating votes)
The Agency (5 leading preselected auditing entities,
voted for by NSure token investors) carry out a second
round of voting whereby 3 out of the 5 companies
must reach a consensus to progress the claim – this is
normally the final round of voting and the claim is
settled;
However, at this stage the decision can be disputed
which leads to a third round of voting whereby a 2/3
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consensus must be reached by all NSure token
holders. This is continued until finally a consensus can
be reached and the claim settled.
Conclusion
The world of decentralised insurance is in its infancy with the
potential to dramatically improve not only the fairness of the
insurance industry as a whole, but additionally both the speed
of customer service/payouts as well as the efficiency of
operations that all culminates in cheaper and more effective
insurance for consumers.
Of course there are clear limitations, mainly routed to hacks
and poor product-market-fit, and that is the natural
progression of any innovative product. By far, these protocols
are the most prominent and promising ones today.
Insurance will get decentralised. Watch this space!
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