Last week, founders from leading DeFi insurance companies, Nexus Mutual, InsurAce, Bright Union, and Cover Protocol, came together to address the UST de-pegging event.
The Twitter Spaces event, which lasted about an hour, is available in full via the sound clip below.
— Akiba | Liam Designer 🥷₿ (@akibablade) May 23, 2022
The space was moderated by Prince Barksfield, Lead Developer for Cover Protocol. The conversation began with a discussion about the UST de-pegging event and whether it was avoidable. Hugh Karp, the founder of Nexus Mutual, began,
"If you're experimenting with a large number of users who don't fully understand the mechanics, you can end up with significant problems. I believe that’s what happened here... Things got out of control very quickly."
Building on this, Robert Forster, CTO of Assist, continued, "I think the team could have easily capped their assets and not gone all-in. Essentially, every DeFi protocol should focus on slow, sustainable growth... we need more time to figure things out." Forster’s insight suggests that Terra’s rapid growth was a primary failure, and that its team missed an opportunity to manage that expansion.
To resolve systemic issues, it can be necessary to artificially restrain growth to allow for a proper assessment of a project's risks. Terra failed to do this, and Forster suggests this was their critical mistake.
Kiril Nikolov, the co-founder of Bright Union, then commented on the silver lining of the event, notably, "DeFi insurance worked as intended... which is great because it was a real-world test." Several DeFi insurance protocols have already begun processing payouts for users who held de-peg protection policies.
InsurAce was represented by CMO Dan Thompson, who added, "it became progressively more likely until the de-peg was inevitable."
Prince directed the conversation to Karp from Nexus Mutual, who clarified that his protocol did not offer protection against the UST de-peg.
"Yes, we specifically analyzed all algorithmic stablecoins a while ago, about a year past, and made a deliberate decision not to cover any of them. We believed the risk was too high.
So, that decision looks wise in hindsight... I’m not claiming we had a crystal ball, but we intentionally avoided providing coverage because we assessed the risk as excessive at the time."
Forster also added that broader issues were happening concurrently with the UST event that have been overshadowed in other news.
"Last week, there were at least three other major hacks on Aave, Anchor, and the Uranium protocol. This suggests there was significant correlated risk within the system, where the failure of one token could have triggered a contagion effect.
Fortunately, none of us were heavily exposed, but it’s concerning in terms of how we can accurately assess the security and diversity of risk for something as fundamental as stablecoins."
Forster continued, stating that the event has made him more cautious about adding new stablecoin offerings to his customers and "has motivated me to find more solutions to this problem." Barksfield then continued,
"In my view, the outcome will be a massive payout required from protocols like Unslashed and InsurAce, which will significantly impact their treasuries. This, in turn, will affect staking yields across all other DeFi protocols as well."
DeFi insurance pioneer Nikolov then discussed the differences between traditional and DeFi insurance.
"Compared to traditional insurance, what we have here is instability. The risk that capital providers bear is incredibly high. In a traditional setup, their exposure would typically be covered by reinsurance capital, which virtually no one in DeFi currently has.
So, capital and risk are the core issues. That's why we launched our Bright Risk Index, a single-tranche model that allocates capital efficiently. Essentially, the money is diversified to achieve maximum diversification and a reasonable return.
We often talk about how composable DeFi is—everything is interconnected. And you can see the downside of this structure with the UST collapse. But imagine for a moment what would happen if a stablecoin like DAI lost its peg? DAI is the backbone of hundreds of protocols.
Another point is cross-protocol breaches. How massive would the contagion effect be? We are offering diversification for risk management, but we still have a very long way to go."
The conversation then moved on to the need for an independent body to help set and regulate risk within the DeFi insurance sector. Thompson from InsurAce started the conversation,
"Having a trusted, independent body to arbitrate these disputes would be incredibly helpful. There are two sides to this coin: you have the policyholders who are claiming and want to be paid. Their bias is that this was a clear-cut de-pegging event.
Then on the other hand, you have the stakers who are at risk of losing their capital, and they're not happy about it. Some of our stakers are unhappy that they have to pay out for this. Their bias is to argue that this wasn't a de-pegging event but rather market volatility or another factor that would invalidate the claim.
There's also the issue of potential compensation plans for small holders, or a fork of the Terra blockchain. These could result in our policyholders receiving a double payback.
So, should we delay the process to wait for this? It gives us more time to assess, but it also ties up user funds."
The conversation moves on to address regulation within the DeFi insurance space, with debate among the group on how far this should go. Some advocated for an impartial committee to evaluate protocols and establish fair pricing. In contrast, others believe that risk assessment is a competitive advantage for their business.
Some protocols, namely Assist, do not offer collateral-backed underwriting but instead distribute risk among users, adding another layer to this conversation. Dan from InsurAce also suggested creating a bug bounty program to identify fraudulent claims for policy redemptions. His theory is that community governance through post-mortems of major events within a bug bounty system could reduce the need for a central authority.
The public conversation concluded with final thoughts on how to improve DeFi and the direct effects of the massive de-pegging event. Thompson stated,
"We want to be better, we want to make things faster and more efficient, we want greater transparency, and we ideally want everything handled directly on-chain. We need that proof of incident to enable automatic payouts.
At the same time, this is the first major de-peg event to trigger payouts, so we're all going to learn a lot from this."
He also highlights an often-overlooked aspect: "There are other sides to this; you have the stakers who are also hurting, and they risk being slightly forgotten." Nikolov added that "I believe we are in a strong position... this event proves that what we offer is necessary because the risks are unknown, and people need to acquire protection."
Forster reiterated that protocols should focus on slow growth, saying, "There's no reason for us to aim for a billion dollars in TVL... It may take time for people to understand that this is truly about risk distribution, not just insurance." Thompson then closed out the conversation by stating his hope that all the protocols can "survive this market cycle."
