Aug 11, 2020 | Fred Ehrsam
Crypto-native insurance - on-chain insurance covering protocols and DAOs - has the potential to be the next big financial primitive in DeFi. The market size could be enormous and the initial wedge is credible.
Design challenges abound. Whoever solves them can create one of the fundamental building blocks of DeFi, supporting billions in value today, and unlock broader use by increasing the amount of capital users, investors, and traders are willing to commit to the system. As crypto expands into all financial and internet applications, crypto-native insurance has the opportunity to provide a critical service which backs the broader digital economy, supporting trillions tomorrow.
Why crypto-native insurance?
DeFi has rapidly grown 10x over the last year from $500m in user funds to $5bn today. Money-losing bugs have occurred amidst this growth and the stakes are increasing. By enhancing trust, insurance can simultaneously enable DeFi to continue its rapid pace of iteration and grow its potential market size.
Offering centralized insurance to enhance user trust was an important step we took early in building Coinbase. In 2014 I personally secured the first ever crypto insurance (I believe) from Lloyds of London. The impact was material but not critical for early crypto adopters with high risk tolerance, increasingly important for mainstream users, and a requirement for institutions when they eventually onboarded. Absent speculation, crypto-native insurance is likely to follow a similar adoption arc as centralized crypto insurance.
Insurance also creates a prediction market on the likelihood a protocol or DAO will fail. I suspect many crypto traders will love to play in this market, and, like most modern financial markets, speculators will be key in bootstrapping the market and constitute the majority of the volume (for example, in modern foreign exchange markets 95% of volume is speculation, 5% "real flows"). Speculation is societally positive here: it helps bootstrap liquid markets for those seeking "real" coverage and provides a barometer for how safe different DeFi elements are.
Through this lens, "insurance" can be thought of as closer to modern credit derivatives products like credit default swaps (CDS).
The combination of users/investors looking for insurance, traders looking to speculate, and longer term investors seeking yield-producing products produces a credible wedge today. With $4.5bn locked in DeFi and insurance covers 5% of the market (the rough ratio in traditional credit markets of insurance total market size), a successful system could see $225m demand today.
Market size: Potentially very large
The market size for crypto-native insurance is hard to estimate as it 1) barely exists today and 2) will probably look very different than traditional insurance products and markets. With that said:
Sustained growth in DeFi would produce a large opportunity alone. If and as crypto expands to become the digital financial system of the world, the opportunity becomes enormous and difficult to estimate.
The insurance market is $5tn globally today. However, that's inclusive of all types of insurance which are unlikely to be relevant to crypto anytime soon. Credit derivatives are a better comparison. Much like some investors need protection against companies failing, some crypto users will need protection against the on-chain entities they rely on (protocols, DAOs, or otherwise) failing. The credit derivatives market globally is $4.2tn, of which $3.7tn are credit default swaps - the product that may look most similar to a successful insurance offering in DeFi.
There are 2 empirical data points in crypto today. First, insurance for centralized crypto companies is in the high hundreds of millions to low billions. Second, one crypto-native insurance mutual with manual governance, Nexus Mutual, has grown from $0.5m in coverage a year ago to ~$15m today.
Hard problems There are a lot of hard design problems to tackle in building crypto-native insurance, including:
A perpetual swap for CDS may be a winning approach across a number of these dimensions, as it could be on-chain, programmatic, able to bootstrap and maintain liquidity, and capital efficient.
Crypto-insurance ends up not materializing. Why?
Net: Crypto-native insurance is hard to build but high potential
Crypto-native insurance can produce a valuable service to the community and feels ripe to build today. The problem space is extremely challenging to navigate, but if navigated, has the opportunity to support billions in DeFi today and trillions in global commerce as crypto expands over the coming decades.
Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors and is not made on behalf of Paradigm or its affiliates and does not necessarily reflect the opinions of Paradigm, its affiliates or individuals associated with Paradigm. The opinions reflected herein are subject to change without being updated.