Decoupling from the risk of DeFi insurance

In our last article we touched on the problems in DeFi insurance and our solution to fix it — Network Staking and a Cost Sharing Model. To summarise,

Network Staking is a broad based staking approach that uses one capital pool to cover all projects, instead of one capital pool per project. Cost sharing is how our network supports itself, by sharing the costs associated with paying claims and the fees the network generates from memberships among our stakers — the costs and benefits of the network are shared alike.

These two concepts work hand in hand and are important to reiterate because it’s what makes us so distinct from existing options that require a 1 to 1 model of a capital pool per project. That existing model has four distinct flaws:

1. Since each project requires their own pool, you can only insure against one project at a time
2. As a result costs and benefits can’t be shared across all stakeholders
3. Even worse, stakers experience permanent loss (liquidation) when coverage is paid out to members
4. Cover types, like what is actually covered by the platform and paid out — are notoriously strict

In our opinion that’s pretty brutal, and why we designed FairSide with those inefficiencies in mind — so our network wouldn’t have them. With our Network Staking and Cost Sharing model, FairSide is able to:

1. Use one capital pool, so all qualified projects are covered by one membership
2. Share costs and benefits across all stakeholders
3. Offer non-permanent loss to stakers when cost share requests are paid out (remember on other platforms stakers experience permanent loss)
4. Offer more cover types

Insurance is one of the most profitable traditional sectors, yet it hasn’t been successfully adapted for the blockchain space in an impactful and highly usable way. Insurance products and their usage remain niche. To understand why you need to first focus on the stakers — who supply the capital needed for these protocols to offer coverage. We’re going to break down the cause and effect of the current insurance model used in defi, focusing on the staking risks and rewards (or lack thereof). It should help put into perspective how much of an improvement our model is.

Permanent loss (liquidation) and a lack of diversification

To put it simply, permanent loss is the liquidation of a user’s staked assets and is the intended result when staking in today’s defi insurance protocols. Most, if not all insurance protocols are project-specific staking pools. When a loss is paid, the staked position is liquidated in order to provide the payouts of the insured. This creates a permanent loss of the cover provider’s staked assets. Given that APYs are not necessarily that high for the current platforms that exist — it’s hard to believe stakers who seed these insurance pools are interested in such a model that is not built to protect their interest equally, in comparison to those they are protecting.

Project-specific pools create an unhealthy correlation between staked assets and the risk (the project they are insuring). As you know, diversification in our portfolios is important. We’ve all heard the saying “don’t put all of your eggs in one basket.” — diversification is how we create financial health and sustainability. So, with this in mind, why do users stake insurance protocols this way?

Making the bet

Some defi insurance protocols pitch staking as “betting” that the protocol or project won’t have a failure or exploit. To put it simply, this is not insurance, it’s gambling and I can assure you that traditional insurance companies are not making bets. The insurance industry is one of the most profitable in the financial sector, and for good reason. Well-formed risk models are anchored in the principle of diversification of risk. Diversification has been the backbone of insurance for hundreds of years and has made the insurance industry the powerhouse it is today.

The Solution — Non-Permanent Staking Loss

To solve this dilemma, we must decouple the assets from any specific project risk and provide compensation from the protocol’s entire premium pool. You got it, diversify it! — the risk and the rewards. This can be achieved by way of network staking. Designed correctly, network staking produces a unique effect called non-permanent staking loss.

Non-Permanent Staking Loss defines a temporary decrease in token value vs. a permanent loss (liquidation) of the number of tokens you hold. Liquidation and permanent staking loss is the consequence that occurs today when staking in defi insurance protocols as losses are paid. When a non-permanent loss protocol pays out claims, you will experience a temporary decrease in price of the tokens you hold, due to the protocol’s decrease in capital, but the tokens you hold are not liquidated in order to pay claims.

At FairSide, it works in this way. When a contributor has staked ETH in exchange for FSD, they have staked the entire network, not a specific project, type of loss or exchange. The FSD is held in the contributor’s wallet and the number of FSD held does not change. The ETH is bonded to the Capital Pool and used for Cost Share Benefits. The FSD has multiple utility functions, but also acts as a sort of synthetic of the Capital Pool. As payouts arise, the value in the Capital Pool will marginally decrease, lowering the token price of FSD. Thus, a temporary, non-permanent loss has occurred. As the price of FSD is lowered, it will incentivize recapitalisation of the Capital Pool by attracting more staking.

The key advantage of non-permanent staking loss is the effect it has on contributors (stakers). After a loss is paid, FairSide contributors will still hold the same amount of FSD as they did prior to the loss being paid. But, temporarily, it is valued less. This allows the contributor’s position to recover, while continuing to earn rewards the entire time. In contrast, with project-specific staking, the stakeholders lose their position and rewards permanently when a loss is paid.

Since FairSide contributors are not staking specific projects and will not experience a permanent loss, there is no need for a lock up period.

Network staking is a broad-based staking approach that allows contributors to spread out their risk, while receiving staking rewards from every membership fee paid. Network staking embodies all the principles of diversification. It provides a strong incentive to stake and creates a sustainable cost sharing network.

In the end, the fundamentals never needed to change to bring insurance to DeFi. We just need it to be a fair decentralized distribution of products and compensation.

Stay up to date and follow us! Twitter | Telegram Announcements | Telegram English Chat | LinkedIn