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DeFi or decentralized finance refers to financial services using smart contracts, which are automated enforceable agreements written in computer code that do not need an intermediary like a bank or broker. They run on an immutable public online blockchain like the technology bitcoin uses. With any new technology comes new risk. But the right DeFi Insurance can keep you whole.
In a new report, noncustodial crypto exchange ShapeShift explains four main risks facing DeFi investors and how the emerging field of decentralized insurance is innovating ways to avoid “landmines” in a world of opportunity.
The report released earlier this year, titled “Spreading the Risk: Decentralized Insurance,” explains the importance of insurance to bring institutional investors into the DeFi space. While the average ‘degen’ from Crypto Twitter – and now TikTok – is willing to ‘ape’ into every new meme coin, the large funds are hardly willing to risk millions of dollars of investor money without insurance.
“DeFi is gaining momentum, and we think that is an extremely positive trend,” said Kent Barton, head of research and development of ShapeShift and author of a new report on DeFi insurance. “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.”
Chart by DeFi Pulse
“The amount of money locked in decentralized finance platforms has increased at a staggering rate since last summer. This type of hockey-stick growth suggests that an enduring inflection point has been reached. Now that a product/ market fit appears to be established, users and their digital wealth are rushing into the ecosystem. It’s exciting!”
Barton separates DeFi risk into the following categories: custodial risk, smart contract risk, protocol risk and oracle risk.
Not your keys, not your coins – some exchanges like Binance aim to manage risk through insurance pools while others like Coinbase use external insurers. Then there’s the infamous “rugpull” where bad actors are innovating new ways to rob investors of their coins. Join any new project’s Telegram channel and you will see the common question – Is the team anonymous?
Smart contract bugs or exploits lead to lost funds, and with teams releasing several new DeFi DApps every day, there’s no shortage of potential problems. The good news here is that smart contract risks are a good fit for decentralized insurance. Since everything happens transparently, it’s not difficult to determine what happened. Again, join Telegram and you will see another common question – Is there an audit?
Barton describes protocol risk as an entire blockchain having a show stopping fault. This is much less likely than a rugpull or a contract exploit; however, that could change as we see new blockchains emerging.
Oracles like Chainlink connect DApps to real word data by feeding them information from external off-chain sources or from the off-chain world. We’ve had multiple cases where flash loans were used to manipulate those price feeds, leading to losses. These are more difficult to quantify, and less likely to be covered by decentralized insurers.
Barton identified Nexus Mutual and Cover Protocol as early innovators. Ironically, they have both been the target of hackers as well. Nexus Mutual founder Hugh Karp lost $8 million when someone installed a spoofed version of MetaMask on his mobile device. Cover Protocol suffered an infinite mining attack in the same month, resulting in a 97% drop in it’s token price.
Certik is a respected auditor in the DeFi space – combining audit services, insurance, and their innovative Skynet service that monitors smart contracts on-chain.
DeFi has many hallmarks of previous crypto bull markets, and the draw of huge gains often outweigh the risks for many retail investors and traders. It’s been a boon for early adopters and it’s far from over. As we see more insurance solutions and custody options, we’ll see more adoption and even more value pouring into the space.
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