In simplistic terms, Decentralised Finance (DeFi) uses blockchain-powered platforms to, in effect, automate many aspects of the financial industry sector which historically have largely evolved from paper-based analogue processes and procedures. DeFi aims to remove many of the layers of intermediaries using embedded smart contracts and structured digital data to provide greater transparency for all parties, potentially including the regulators. This is leading to an alternative digital way in which to do business when it comes to handling insurance claims, lending, borrowing and making payments. Furthermore, DeFi is finally enabling the financial sector to reach out to the 1.7 billion unbanked by addressing financial inclusion in developing markets. After all, these 1.7 billion unbanked are often digitally savvy – according to the World Bank, 66% of them have access to a mobile phone.
The costs of regulation and compliance is a significant burden for the financial services sector and ultimately for its customers and shareholders. One of the key advantages DeFi platforms offer is to be able to monitor risk and traditional compliance functions using technology on a real time basis, as opposed to after the event. This means that compliance staff and anyone involved in managing risks within a business (e.g. treasury departments, financial controllers, board directors etc) are able to focus on managing risks as opposed to simply being engaged in manual paper based monitoring and box ticking exercises.
It is often said that nothing is new – well, it seems that DeFi has taken a leaf from the history books in following the lead of mutual insurance companies and cooperatives which had pioneered much of the insurance sector we know today. Furthermore, DeFi has embraced the mutualisation based on peer-to-peer transactions. The data held by these DeFi platforms is in a cryptographic manner and decentralised, hence not reliant on one point of failure which so many of our existing centralised services providers currently rely on. Good behaviour is incentivised and poor behaviour is easily identified and penalised. An example of such a DeFi protocol is Feed Every Gorilla (FEG), a community-driven platform which uses smart contracts to help protect investors from ‘rug pulls’ (i.e., when the developers abandon a project and take investors’ money). A market practise constantly monitored by regulators in traditional equity markets is known as ‘front running’, which is when asset managers buy stocks before they buy for a client in the belief that the price will rise once the client’s order is executed. Front running presents a challenge for DeFi exchanges since transactions are broadcast publicly. This means people can see large trades about to happen and therefore try and trade beforehand so as to take advantage of the situation. All they need to do is to work fast and bid high for gas charges so that their deals get processed more quickly. DeFi exchange, Osmosis, is working on a way in which to tackle front running. These previous examples help to give an insight into how DeFi exchanges are learning from the experiences of traditional centralised exchanges and are trying, therefore, to both build systems and use technology so as to ensure that investors can have confidence in how DeFi exchanges operate.
Meanwhile, DeFi has also created new products and services such as Yield farming which transfers cryptocurrencies 24/7/365 between different lending marketplaces, to maximize returns, with no custodians/middlemen, and available to anyone, anywhere provided they have access to the internet. Another service DeFi platforms offer is flash loans used by DeFi traders looking to profit from arbitrage opportunities when two markets price a digital asset at different prices. This means that price differentials are quickly normalised and so, in time, ought to lead to more stable pricing of digital assets. DeFi can enable the way risk is managed in a completely different manner since decentralised exchanges can automatically match buyers and sellers on a peer-to-peer basis ensuring best execution and reducing all human involvement and inherent human error that can so often take place. In effect, this means that anyone with assets is able to turn once passive assets into assets that can be borrowed and generate additional returns, not dissimilar to traditional stock lending which historically has been dominated by only institutional investors.
Whilst DeFi is attempting to reduce and manage risks using technology, there is a possibility that smart contracts could themselves create new types of risks that need insuring. In essence, the power of DeFi is really based on smart contracts, defined by International Insurance.org as : “Smart contracts are irrevocable computer programs deployed on a blockchain that execute a set of pre-DeFined instructions. They are the basis of the DeFi ecosystem as tokens are themselves a smart contract”. Smart contracts rely on data which is ideally sourced from trusted ‘oracles’ i.e. sources that are trusted and independent. This presents a challenge for insurers because if the oracles are defective who is liable in the event of a claim and how can this risk be underwritten. Moreover, who is liable in the event that a smart contact fails? In essence, despite these potential issues, what we are now seeing in the DeFi sector is regulation, legislation and smart contracts overlapping and, until we see greater clarity from regulators, it will be hard for those using DeFi exchanges to truly understand all the risks, let alone insure them.
New risks to address
Source: International Insurance
According to the legal firm Norton Rose, since DeFi is accessible to various jurisdictions a variety of legal and regulatory challenges exist, including:
• the need for analysis to confirm if the structure will fall within the scope of the insurance regulatory perimeter of relevant jurisdictions.
• risk coverage provided in relation to parametric-type insurance with index based loss payments also has the potential to push the boundaries of how an insurance contract can operate within existing regulatory frameworks – in particular, the extent to which certain products can arguably be seen to constitute derivative contracts.
• the need for analysis to confirm the status of any tokens issued by the dApp, from a regulatory and securities perspective, in relevant jurisdictions.
However, some jurisdictions (such as Germany) have legislation which enables them to regulate DeFi exchanges with Swarm Markets being the first DeFi exchange to be regulated by BaFin in Germany. Another firm in the DeFi sector worth watching is Risk Harbor which has an automated claims process, whereby protecting DeFi users’ assets. Furthermore, it runs on a blockchain-powered platform and so offers greater transparency for all parties. So, progress is being made, and as we see more regulated exchanges appear this will undoubtedly enable institutions to become more engaged with the DeFi sector.