Since DeFi first emerged, users have been looking for an insurance solution that generously protects and rewards them. To date, no one has taken an insurmountable lead in the race to offer innovative insurance capable of covering the enormous amount of capital stored by DeFi protocols and their smart contracts.
Insurance will undoubtedly have an irreplaceable tool in DeFi, but what are some benchmarks we can look for in the near future? Until now, mutual-covered insurers like Nexus Mutual have been the market’s most successful, but their achievements, though impressive, seem limited compared to the exponential growth elsewhere in the space. So, what can we expect to see from insurance solutions that can revolutionize decentralized finance? Here are some of the top DeFi insurance benchmarks for the future.
Blockchain technology has introduced a new standard for information transparency, and insurance is a field that can take advantage of its open, immutable and distributed data. Typically, DeFi insurance platforms have relied on counterparties agreeing to a policy’s terms without fully knowing how much risk they’re taking on. This creates an unsustainable model that breeds distrust by placing one party at a disadvantage.
We can trace this problem back to the inadequate data collection for DeFi risks. As a response to this absence of data, the Steady State team has started work on the Risk Analysis Database (RAD), which we believe could begin a seismic shift in how DeFi approaches insurance. To maintain data transparency standards in crypto, RAD will be accessible to everyone — including other DeFi insurance platforms.
An automated insurance model eliminates disruptive biases, enhances process efficiencies, and allows immutable claims settlements through smart contracts. Two of the most laborious aspects of insurance include actuarial (or risk assessment) and claims processes. These time-intensive procedures are inherently linked since a claim will get approved or not based on the evaluations completed during the risk assessment phase.
Actuarial processes can be long, tedious endeavors in conventional insurance, and that’s with hundreds of years of data at their disposal. How many years of data does DeFi have? About two. However, blockchain’s open dissemination of information presents an excellent opportunity to improve the speed and accuracy of risk scoring. Making risk scoring an automated and transparent process would eliminate human bias and error and prevent second-guessing the conclusions.
The claims process — which determines whether or not an event qualifies under the policy’s terms — can also be modernized with distributed ledger technology. The insurer and policyholder can ascertain the validity of a claim by reading on-chain data and comparing it with historical instances of similar events. In the case of any uncertainty, a governance arm can step in to make a final decision about the claim’s validity.
With DeFi insurance, the policyholder and the underwriter have good reason to ask for better capital efficiency since both parties lock in capital to cover an underlying asset. This means that money put into DeFi insurance needs to work harder and smarter than other types of protocols and yield farms. Offering features like bundled insurance, which allows the coverage of multiple assets against various threats, improves capital efficiency for policyholders, making them more inclined to sign an insurance contract.
Similarly, coverage providers will want to see capital efficiency when they stake their assets. The simplest way to achieve this is by distributing their capital more diversely and rewarding them more dynamically. State State uses index pools (a collection of coverage pools) to reduce risk exposure and distribute more types of rewards, including premium payouts, STDY token mining, shield mining, and asset management rewards.
Covered assets should never have the risk of losing their protection during the policy’s term. Therefore, coverage providers need to lock in their capital when it’s staked. Unfortunately, this is a bad scenario for coverage providers if they want to opt-out or suddenly need their money back. The solution to this dilemma is a secondary market where risk can be traded. Not only does it benefit the coverage providers, but it helps create a healthier market in which risk is distributed more widely.
Steady State will introduce its secondary market, SteadySwap, which allows coverage providers and other parties to buy and sell risk. SteadySwap is an integral part of our vision to create a smarter, better risk marketplace for DeFi.
Liquidity is essential for DeFi insurance since high liquidity means lots of coverage — without adequate liquidity, policyholders can’t be paid when a claim gets approved. However, unjustifiably high APYs can cause token hyperinflation, making it vital for DeFi protocols to develop balanced, thoughtful emissions schedules and use-cases. Steady State harnesses a layered reward system with up to four different types of yield: premium payouts, STDY mining, shield mining (earning the native token of the insured party), and asset management rewards (coverage providers will be able to choose if they’d like to stake their collateral on another protocol for additional APY). Multi-yield rewards have the critical responsibility of encouraging liquidity to stay in and around the platform.
We can measure the health of a DeFi protocol with one metric: liquidity. High liquidity is a hallmark of a thriving protocol, whereas low liquidity causes friction and instability. As lone players in a no-holds-barred free-market ecosystem, DeFi protocols must compete with each other for liquidity if they want to last. This typically means dishing out the best rewards possible, most commonly in the form of a protocol-native governance token first popularized by Compound.
A dynamic, well-designed token brings in new users and more capital to the ecosystem. It should have strong ties to governance functions and have more than monetary value for the owner, who will be inclined to hold it long-term if there’s a good reason.
Governance is crucial to the security, democratization, and network growth of a DeFi insurance protocol. Governance allows token holders to have a say in how the protocol operates and its future mission. Decentralized autonomous organizations (DAOs) have become one of the most recognizable forms of DeFi governance, and it’s probably fair to assume that they haven’t reached their maximum potential or the full scope of abilities quite yet. Projects such as Yearn Finance (YFI) show that DeFi governance works when participants can make meaningful decisions.
As the number of DeFi platforms and protocols grows and disperses across more blockchains, comprehensive cross-chain coverage will become paramount to DeFi’s overall health. We’ve already seen DeFi move from Ethereum to layer-2 solutions like Polygon, and other blockchains using EVMs (Ethereum Virtual Machines) such as Binance Smart Chain (BSC), Solana and Fantom. This diaspora will likely hasten over time, making it crucial for DeFi insurance platforms to follow suit and offer cross-chain coverage. In the future, users will want to know they have protection across all four corners of the DeFi world, and cross-chain coverage will likely become an insurance standard.