DeFi Insurance: Managing Risks of Digital Assets
Understanding DeFi insurance and its importance in mitigating DeFi risks and threats.
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Learn about the different types of liquidity pool and what it means to provide underwriting capital.
One of the cardinal rules of swimming is to first make sure the water is safe before diving in. The same rule applies to liquidity pools in the blockchain space. You must be aware of the risks associated with funding an underwriting pool before taking the plunge. Here’s what you need to know.
Many liquidity providers express dissatisfaction with undefined “lock-ins” and the inability to exit insurance protocols, particularly when this comes as a surprise in what might be called “opaque” liquidity pools.
The goal of underwriting is to earn a return on capital through its use as a guarantee payment, which obviously is required in the event that the underwritten risk occurs and generates a call on the underwriting capital. Liquidity providers who are considering investing in insurance protocols must accept the financial risk resulting from the liability arising from such a guarantee. This is generally well understood, however there are other constraints, such as lock-in, that are often far less transparent.
In this blog, we highlight some of the questions you should ask as a liquidity provider so that you don’t end up jumping into opaque, unsafe waters.
With the resurgence of risk averse behaviours in the crypto bear market, insurance protocols are gradually gaining more traction; currently there is over 600m USD in TVL. Much of this TVL locks-in liquidity providers in a way that is unexpected and unwelcome for many.
At Neptune Mutual, we believe that knowledge is key in encouraging people to pool their capital in a cooperative environment. We also believe that insurance protocols will benefit from transparency, communication and a more widespread understanding across the blockchain community of the benefits and risks of both purchasing cover and providing liquidity to underwrite that cover.
With that in mind, it’s important to understand the risks associated with Neptune Mutual and other DeFi platforms before making any decisions.
As a liquidity provider, or co-underwriter, you join other LPs to provide a financial guarantee, and in so doing, you share the earning incentives as well as the risk exposure—no different from traditional insurers. Although there are inherent risks in underwriting, exposure to the risk of being locked-in for an indefinite period is unnecessary. You should have a clear way out.
Underwriters must evaluate a number of risks before investing, and indefinite lock-ins should not be one of them: before you get into a pool, make sure you can get out!
Insurance or cover pools are generally constrained by a minimum ratio in relation to the amount of underwriting capital compared to the amount of payout risks that have been underwritten through policy sales. This often means that if there is ongoing policy sales activity, and a relative shortage of underwriting capital, then liquidity providers will not be able to withdraw their funds.
This effect can clearly be seen where insurance protocols try to resolve this lock-in problem by creating a wrapped token of the original project token. In so doing, projects create a secondary market for the wrapped token to allow LPs to exit their position by selling a wrapped token instead of the original token. To get an idea of whether LPs are satisfied with their investment as an LP, one just needs to look at the value of the wrapped token in comparison to the project token to see what level of discount LPs are prepared to accept in order to exit their original investment; in some cases, the market price of wrapped insurance protocol tokens represents a >75% price discount in comparison to the project token, and this demonstrates in monetary terms the extent that LPs are willing to go to in order to exit their position. In these cases the wrapped token price is probably a far better guide to the actual value of the insurance protocol than the project token itself.
In many insurance protocols, underwriting liquidity is “pooled”, often to the extent where one pool underwrites all of the different risks covered by the protocol. This means that, as a liquidity provider, you have limited, and usually no power, to decide what type of risks your capital underwrites.
You may find that the insurance protocol has covered risks that you consider excessive (e.g. financial risks of algorithmic stablecoin de-peg), but even if it hasn't, there is often little you can do if, after providing your underwriting liquidity, the protocol decides to start underwriting progressively greater and more probable risks.
One has to recognise that there is a temptation on the part of insurance protocols to increase the number of new projects covered in order to increase adoption and cover policy sales, even when projects have a high-level of risk, such as bridge protocols or financial risk. The consequence of onboarding high risk projects is likely to be felt first and foremost by those who have provided token-based underwriting liquidity.
It also means that any incident that arises impacts the return on the liquidity you provided.
Where insurance protocols are using tokens as the reward for providing underwriting liquidity, then the APY returns that you make in tokens can be significantly outweighed by the price movement of the value of the token itself.
This is very different from the low risk approach adopted by Neptune Mutual, discussed in our blog “Be Aware of the Bear” - read the paragraph entitled “ Minimise Risk” to see how the design of Neptune Mutual cover pools de-couple token price volatility from liquidity provider returns, making returns to LPs far more transparent.
It is also important to understand what influences the price of the tokens of different insurance protocols. In most cases, where tokens have been bought and invested as underwriting capital (and possibly converted into Ethereum or another crypto currency), then in the event of an incident causing a major payout of underwriting capital, this will create downward pressure on the token price, because of the lower returns that will be generated by token holders. In these cases, incidents punish loyal token holders.
When an incident occurs in some cover protocols, token holders sell their tokens. Some protocols penalise their loyal community for holding onto their tokens by reducing their balances because of the incident. This causes friction within the community because users are often unfamiliar with how DeFi insurance underwriting works. As a result, it is critical to categorise activities into different features and make it simple for users to understand.
The blockchain community is not very loyal to projects that do not provide them with compelling reasons to stay. Every few years, the top 100 projects change. It’s crucial to first establish trust before creating a loyal following around a DeFi project. This becomes challenging when projects do not communicate effectively about the risks they are exposing their communities to.
Many DeFi cover users have witnessed a sudden reduction in their staked token balance in a staking pool. This curious event occurs when tokens are distributed to claimants as payouts. But many don’t fully comprehend what they’re agreeing to until it’s too late.
Loyal holders lose out because they receive less than expected — this arises because those that have lost funds, and make a claim, recover their position by receiving and selling project tokens which puts downward pressure on the value of the token.
The NPM tokens in Neptune Mutual’s staking pools are immune to underwriting risks. We do not distribute NPM tokens as compensation to claimants.
Insurance companies are in the business of predicting risks. As mentioned, insurance companies deploy their capital as a guarantee payment in case of loss, and they use extensive data analysis to ensure that the revenues they earn are sufficient to provide a return when taking into account an expected number of losses arising from a certain number of incidents that may arise as part of their underwriting activity.
To do this, they need a lot of timely, reliable data and analytic skills, in order to forecast the probability of insured events arising, and how much it will cost them when it does.
People who want to cover a specific risk, such as asset loss, theft or damage to property, health, or death pay insurance companies fees in regular instalments. Insurance companies profit from the income generated by the sale of these policies minus the operational expenses.
profit = policy fees - (claims payout + operating expenses)
Insurance companies use data and data analysis to ensure, as far as possible, that underwriting capital is handsomely rewarded despite the expected level of payouts that the insurance activity is likely to incur.
The nature of the risks that traditional insurance companies cover means that they rarely have to make large numbers of payouts simultaneously, and they can therefore use this diversification of the timing of incidents to spread out the cash outflow of losses and offset them against policy revenues. This is very different from the context of cover in DeFi where risks can affect thousands of policyholders all at once: one single trigger event, such as a hack, can affect thousands of users in an instant.
Neptune Mutual is a parametric cover marketplace developed by a technology company and operated by an Association. Neptune Mutual is not an insurance company. You can draw a closer comparison between traditional insurance providers and the individual cover pools offered within the Neptune Mutual marketplace. In contrast to typical insurers, Neptune Mutual does not earn a commission on policy premiums; this is the principal source of revenue for liquidity providers.
Similarly, liquidity providers own the liquidity pools, not Neptune Mutual. In other words, Neptune Mutual provides the DeFi community a conduit to crowdsource the capital required for projects to create parametric cover policies that offer protection to their respective communities.
Not all DeFi protocols can be covered successfully and this is why the cover creation feature is on an invitation-only basis. In addition, Neptune Mutual conducts a thorough due diligence of the protocols before allowing them to create cover pools in the marketplace; this includes a comprehensive security review.
Neptune Mutual even provides a process by which cover creators can request liquidity assistance for their pools from a strategic liquidity provider partner. In addition, Neptune Mutual can provide technical assistance to programmatically and gradually bootstrap cover liquidity via smart contract and SDK integrations . To secure this assistance cover creators must demonstrate a high-level of commitment to cybersecurity.
Unlike the majority of DeFi cover protocols, Neptune Mutual does not cover financial risks, such as margin calls or liquidations, stablecoin pegs, or private key exploits. We believe we are still early and that these risks are currently not coverable due to the lack of maturity of these products. Neptune Mutual is not interested in taking unreasonable risks to accelerate short term growth at the expense of liquidating LP hard-earned capital. Our primary design goal is to protect liquidity providers from unnecessary risks and to allow them to exit if necessary for whatever reasons they may have.
You can select which cover pool to underwrite as a liquidity provider. Your risk exposure will only apply for that specific pool, rather than everything in the Neptune Mutual marketplace.