Adventurers in what is perhaps the most lucrative and risky corner of the cryptocurrency world are starting to see a bit of a safety net.
In the past year, scores of investors big and small have poured billions into decentralized-finance applications that allow users to lend, borrow and trade crypto without intermediaries like banks. While the DeFi sector is booming, it has also been plagued by hacks, fraud and a copy-and-paste coding culture where a modified app can siphon away users from an established rival.
Now software developers are launching products that claim to reduce the risks by selling something akin to insurance coverage. But here’s the catch: They’re also DeFi apps.
Unlike insurance offered through the likes of Lloyd’s to custodians and large crypto exchanges, these apps — which run on digital ledgers called blockchains — let any investor buy coverage. They also allow anyone to form investment pools to provide coverage — often promising annual returns of at least 50%.
Here’s how it works. Investors typically decide to offer coverage for a specific DeFi app, or vote on which DeFi apps everyone’s money should go into covering. That means a chance to get rich, or to lose everything by making the wrong bet.
“Definitely do your own research and buyer beware,” said Mike Miglio, chief executive officer at Bridge Mutual, which is planning to launch a DeFi insurance app. “That is the true nature of what DeFi is supposed to be.”
But this dis-intermediation of insurance companies could also potentially undermine the very promise of insurance.
“The main missing ingredient is risk reduction,” said Aaron Brown, a crypto investor and writer for Bloomberg Opinion. “A pure financial contract doesn’t do that, and I don’t see how a decentralized entity can underwrite.”
Typically, the DeFi insurance apps are highly automated: All transactions happen via self-executing software programs known as smart contracts. And like most DeFi apps, the new insurance ones are also at the risk of being hacked.
What’s more, the investors in the insurance pools find that profits are heavily dependent on the price appreciation of digital tokens used to execute the applications. With Nexus Mutual, the largest provider of such DeFi policies, investors receive a certain number of NXP tokens in exchange for Ether cryptocurrency, and they can cash out by selling the tokens. At Bridge, users are primarily paid with the app’s own BMI tokens, as well as in a so-called stablecoin DAI whenever a premium on a policy is paid.
“If the price of the token goes up or down, the APY goes with it, but we are aiming for a base of 50% assuming the price is stagnant,” Miglio said. The market value of BMI’s tokens have more than doubled since the coin’s debut in February, according to data tracker CoinMarketCap.com. But there are no guarantees the rally will continue.
“The fundamental purpose here is for sharing risk together rather than for gains,” said Hugh Karp, founder of London-based Nexus, who lost NXM tokens in a phishing attack last year before the company offered that type of coverage.
Now Nexus offers coverage for 70 different smart contracts and has issued about 4,000 policies. So far it has had to pay out twice for a total of $2.5 million, which includes when Yearn.Finance got hacked earlier this year. Meanwhile, it’s taken in $20 million in policy premiums.
Whether the good times will last is unclear.
“The insurance protocols are being thoughtful and careful to the extent possible, but much of this is still unknown unknowns,” said Lex Sokolin, global fintech co-head at ConsenSys.