Decentralized insurance could save DeFi from contagion, according to ShapeShift report

Decentralized finance has many of the hallmarks of previous cryptocurrency bull markets: incredible gains, extreme volatility and massive risks. In a new report, leading noncustodial cryptocurrency exchange ShapeShift explains the four biggest risks facing DeFi investors and why the emerging field of decentralized insurance could offer a solution.

The report, titled "Spreading the Risk: Decentralized Insurance," categorizes DeFi risk into the following “landmines”: custodial risk, smart contract risk, protocol risk and oracle risk.

The history of crypto is filled with examples of centralized exchanges “losing or absconding with users’ funds,” argues report author Kent Barton. For smart contract risk, one needs only to consider “the DAO incident” in 2016 in which 3.6 million Ether (ETH) was drained.

Major protocol-level risks haven’t been spotted just yet, but that could quickly change as the market continues to evolve. Oracle risk is in the same category, but one that is much harder to quantify or predict. Still, Barton reminds readers that the so-called DeFi Summer of 2020 was replete with cases where “flash loans were used to artificially manipulate” the price feeds of oracles.

The report says that decentralized insurance protocols, which offer crypto users a way to limit downside exposure, are stepping up in a big way to solve these challenges. Barton explains:

“The decentralized, community aspect of DeFi has meant that it lacks many of the risk reduction features of traditional financial avenues. However, the DeFi community itself is coming to the rescue by creating a decentralized solution. It’s an emerging field that is worth continuing to watch.”

The author identified two protocols, Nexus Mutual and Cover Protocol, as early innovators in the field of decentralized insurance. Neither company is affiliated with ShapeShift.

Nexus Mutual has emerged as the biggest player in the decentralized insurance space, with its total value locked rising nineteenfold to $200 million in the past year alone. The Nexus model revolves around creating a pool of funds that can be used to handle claims on smart contract bugs and exploits. The Nexus ecosystem consists of three players: risk assessors, claim assessors and policymakers, with the native NXM token being the common thread among 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 buy coverage on practically anything, but its governance token — in this case, COVER — is not used for underwriting risk. Unlike Nexus, Cover issues separate ERC-20 CLAIM tokens for each application and coverage expiry date. As Barton notes, it’s possible for a decentralized exchange to facilitate the trading of these ERC-20 tokens against other insurance projects.

Perhaps ironically, both protocols have been the target of hackers in the recent past. Cover Protocol suffered an infinite mining attack in December 2020, resulting in a 97% decline in the price of its token. The 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’ve entered the market over the past 12 months. The DeFi sector has been one of crypto’s biggest success stories in terms of adoption, return on investment and total value locked into various ecosystems. The top projects are collectively worth $100 billion, which is roughly 20% below last week’s high. The total value locked peaked above $123 billion on April 16, according to industry data.

As for ShapeShift, the organization has expanded its research scope in recent months, having only recently launched a report on staking derivatives. The exchange also made headlines last week after integrating cross-chain swaps via ThorCHAIN. Mobile users are now able to directly trade Bitcoin (BTC) with Ether and Litecoin (LTC) without the use of a custodian, counterparty or intermediary.