The inherent risk in the decentralized finance (DeFi) market has been one of the most discussed topics in the last few months in the crypto market. It feels that not a week goes by in which investors are not suffering severe losses in DeFi via technical exploits or disproportional economic vulnerabilities. Robust risk management is paramount to catalyze the adoption of DeFi, particularly from an institutional standpoint.

Jesus Rodriguez is the CEO of IntoTheBlock, a blockchain analytics provider.

Insurance models are one of the most important elements required to build a strong foundation for the mainstream adoption of DeFi. While conceptually trivial, the mechanics of building insurance mechanisms for the DeFi space are incredibly challenging and don’t quite align with what we see in traditional capital markets.

DeFi uses smart contracts to automate financial services. The initial wave of DeFi protocols focused on two fundamental primitives: lending and market making. These two areas account for the vast majority of the value locked in DeFi protocols, although there have been relevant progress in derivatives and insurance. With the latter, protocols such as Nexus Mutual or InsurAce have taken an innovative approach to address this problem (see below) in the first wave of DeFi protocols. But it’s pretty clear the problem is significantly more complex and the solutions require more development.

Insurance can be considered the missing link in DeFi. Every financial market in history has had insurance mechanisms. Granted, in traditional finance most insurance models are targeted to protect intermediaries that are absorbing the bulk of the risk in transactions. Insurance models for DeFi could be drastically different, and that’s what makes this a fascinating topic.

Technical versus economic insurance in DeFi

Establishing insurance-efficient models in DeFi starts by understanding the fundamental types of risks in the space. While there are many forms of risks in DeFi, from an insurance perspective they can be classified in two main groups: technical and economical.

Technical insurance directly targets the potential of smart contract failures or attacks. Smart contract exploits are the best known form of technical risk in DeFi protocols. Nomad, Wormhole, Cream, Ronin, Badger DAO, Horizon bridge and Beanstalk have been some of the notable DeFi exploits of the last few months. These types of exploit are obviously unexpected and regularly result in irreversible losses in DeFi protocols. They are a natural candidate for insurance models.

Economic risk represents one of the major barriers to entry for investors in DeFi protocols. Every day there are millions lost to economic inefficiencies in DeFi protocols, and this remains a largely unaddressed problem.

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A classic example in DeFi occurred when long-term ether (ETH) holders were earning yields in ETH-stETH pools in protocols like Curve or Balancer. The objective of many of those investors was to earn additional yield on ETH. But the recent events leading to the staked ether (stETH) de-pegging caused imbalances in those pools, leaving investors with significant holdings on stETH relative to their original ETH positions. A similar but more drastic example is when large holders participating in an automated market maker (AMM) pool withdraw their entire position in a single transaction, causing massive slippage to the remaining investors in the pool. From an insurance perspective, addressing both economic and technical risk is extremely relevant.

Insuring technical risk seems more important today given the nascent nature of DeFi where positions can be lost in a blink of an eye. A typical technical insurance model would guarantee the return of an investor position in case of an exploit against a given protocol or other technical infrastructure components like bridges. As DeFi matures and protocols become more robust, technical risk should become less relevant which, from an insurance perspective, translates into cheaper policies.

Insurance against economic risk in DeFi is trickier to achieve and needs to depart from the traditional models. The decentralized nature of DeFi means that economic risk can’t be absorbed by trusted intermediaries. Therefore insurance policies in DeFi should focus on enabling protection against impermanent loss or slippage in AMMs, liquidations in lending protocols or even de-pegging scenarios that are conducive to economic losses in DeFi positions. The economic risk present in those scenarios is likely to increase as DeFi evolves, making economic insurance policies in protocols even more precious to participating investors.

DeFi insurance with programmability

Adapt traditional financial insurance structures to DeFi protocols means relying on static analyses of DeFi risks and intermediaries that evaluate claims associated with DeFi protocols. The benefits of this model are that it can leverage on the insurance infrastructure used by traditional financial markets and would have an easy path from an institutional adoption and regulatory standpoint. The drawbacks are that it doesn’t quite fit the principles of DeFi.

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The programmable and decentralized nature of DeFi infrastructures continuously challenges established concepts in traditional finance. And just as DeFi brought us unique concepts such as flash loans in the lending space, there is an opportunity to reimagine traditional insurance models. Think about a universe in which economic and technical insurance policies for DeFi protocols are built in the form of smart contracts. That mechanism enables dynamics that are unimaginable in traditional insurance models.

For instance, an investor deploying capital in an AMM like Curve or Balancer could programmatically request an insurance policy that protects him against whale manipulation attack in a specific pool and a potential hack on the underlying AMM. The policy could be automatically paid and terminated after he exits the position. If a large token holder exits the pool causing our investor to suffer slippage beyond the risk thresholds, he can automatically file a claim and get immediately paid by the insurance smart contract. Additional claims that can’t be processed immediately can be evaluated via governance votes. All these interactions are completely programmable and don’t require trusted intermediaries.

DeFi desperately needs efficient insurance

The DeFi market has suffered massive shocks in the last few months, leading to a lack of trust in its value proposition. Insurance is required now to manage risk and restore the trust in DeFi among institutional and retail investors. Designing insurance policies that target both economic and technical risk is challenging but certainly doable. Even more exciting is that DeFi offers a blank canvas to reimagine insurance with programmability and decentralization as core constructs.