Decentralized finance has many characteristics of previous cryptocurrency bull markets: incredible gains, extreme volatility, and huge risks. In a new report, leading non-custodial cryptocurrency exchange ShapeShift explains the four biggest risks DeFi investors face and why the emerging field of decentralized insurance might offer a solution.
The report, entitled “Distributing the risk: decentralized insurance”, classifies DeFi risk in the following “landmines”: conservation risk, smart contract risk, protocol risk and oracle risk.
The history of crypto is replete with examples of centralized exchanges “losing or running away with user funds,” says report author Kent Barton. For smart contract risk, just consider the ‘DAO incident’ of 2016 in which 3.6 million Ether (ETH) was drained.
The main protocol-level risks have yet to be spotted, but that could change quickly as the market continues to evolve. Oracle risk is in the same category, but that is much more difficult to quantify or predict. Yet Barton reminds readers that the so-called DeFi Summer of 2020 was filled with cases where “flash loans were used to artificially manipulate” the price streams of the oracles.
The report says decentralized insurance protocols, which offer crypto users a way to limit downside exposure, are stepping up dramatically to address these challenges. Barton explains:
“The decentralized, community-based aspect of DeFi means it lacks many of the risk reduction features of traditional financial avenues. However, the DeFi community itself comes to the rescue by creating a decentralized solution. This is an emerging area worth continuing to monitor. “
The author has identified two protocols, Nexus Mutual and Cover Protocol, among the first innovators in the field of decentralized insurance. Neither company is affiliated with ShapeShift.
Nexus Mutual has emerged as the largest player in decentralized insurance, with its total stranded value increasing nineteen-fold to $ 200 million in the past year alone. The Nexus model revolves around creating a pool of funds that can be used to process claims about smart contract bugs and exploits. The Nexus ecosystem consists of three players: risk assessors, claims assessors and decision makers, with the native NXM token being the common thread for participants.
Cover Protocol, a peer-to-peer insurance market, is a more recent entrant into the space, having launched in November 2020. The platform allows users to purchase coverage on virtually anything but its governance token – in this case, COVER – is not used for underwriting risk. Unlike Nexus, Cover issues separate CLAIM ERC-20 tokens for each application and cover expiration date. As Barton notes, it is possible that a decentralized exchange would facilitate the exchange of these ERC-20 tokens for other insurance projects.
Perhaps ironically, both protocols have been the target of hackers in the recent past. The hedging protocol suffered an infinite mining attack in December 2020, causing its token price to drop 97%. That same month, Nexus Mutual founder Hugh Karp lost $ 8 million after an attacker installed a compromised version of the popular MetaMask wallet on his mobile device.
DeFi has been an incredible boon to early adopters who have entered the market in the past 12 months. The DeFi industry has been one of crypto’s biggest success stories in terms of adoption, ROI, and the total value locked away in various ecosystems. Major projects are collectively worth $ 100 billion, about 20% below last week’s peak. The total locked-in value peaked at over $ 123 billion on April 16, according to industry data.
As for ShapeShift, the organization has broadened its scope of research in recent months, having only recently launched a report on derivatives staking. The exchange also made headlines last week after integrating cross-chain swaps through ThorCHAIN. Mobile users can now directly trade Bitcoin (BTC) with Ether and Litecoin (LTC) without resorting to a custodian, counterparty or intermediary.