DeFi Insurance Design: Always Start from General Equilibrium to Reduce Systematic Arbitrage
On March 1, 2020, Odaily, a professional media platform for blockchain, and nestfans, an enthusiast of NEST (NEST is a distributed oracle machine), had a deep dialogue on the development trend of the DeFi insurance industry. What are the design ideas and development trends of DeFi insurance products? Here is the content of the dialogue on these hot issues.
Odaily: What do you think is the significance and role of the DeFi insurance for the entire DeFi ecosystem?
NEST fan: DeFi insurance is a kind of security protection for some of the DeFi products, which is mainly a kind of compensation for the development risk of DeFi and the fluctuation risk of DeFi assets. These two kinds of risks are not the same. In terms of development risks (code bugs, back doors, arbitrage algorithms, etc.), the value of DeFi insurance is higher, which is also the core direction of the industry development. As for the insurance of asset fluctuation, it is essentially a kind of swap or option, which reflects the derivative structure of asset price more, and can not be called insurance completely. This kind of product will be more included in the list of derivatives in the future. It is not an insurance product in strict sense, but its value is also great.
Odaily: In your opinion, where is the ceiling of DeFi insurance? Does DeFi lockup have value?
NEST fan: The ceiling of DeFi products is ultimately the market value of ETH, because all the risks on chain can be offset by insurance. But the code risk of ETH cannot be offset by insurance, because your insurance is also developed on chain. If we say that the market value of ETH measures the code risk and consensus risk of ETH, then the ceiling of insurance is the market value of ETH without changing the current structure (anti-attack) of ETH. But if we look at the relationship between supply and demand, it may be far lower than this standard. It has a certain relationship with the lockup of DeFi, but not entirely. For example, if the asset fluctuation insurance in question 1 is included, it is larger than the lockup. It is difficult to estimate the above two types of demand. If we do not consider the two types of demand, it is really limited by the scale of the insured DeFi lockup.
Odaily: due to the high interoperability and composability of DeFi products, the capital loss incident on DeFi is often not an independent probability event. When a product’s capital is damaged, it is often associated with other products. In view of this problem, do the current insurance products have better strategies?
NEST fan: That’s a good thing, not a bad thing. This reflects the effectiveness of the financial market. The solution is not to provide more insurance. Even if more insurance is provided, it will also be incorporated into the whole arbitrage system by arbitrageurs. The core is to improve the overall view of DeFi product developers. Do not develop financial products with wishful mindset or partial equilibrium mindset, but to start from the perspective of general equilibrium. That is, all variables in the whole market should be considered on your product, and your products should be constantly attacked and arbitraged! Only based on such a starting point of development, can it be correct.
The problem with traditional Internet development is that demand is used as the starting point, such as user experience, user feeling, efficiency, etc.. But in the financial field, especially in the field of contract products, there is only one demand: arbitrage (or making money). The demand of all participants is homogeneous. Therefore, we should consider the whole market behavior, and whether your product can help reduce the market arbitrage or increase its arbitrage? If it lowers arbitrage, your product will have a market. But if it increases arbitrage, you’ll be arbitraged, and the product won’t make sense. So, it’s not a matter of insurance, it’s a matter of mindset change for all the DeFi developers.
NEST system is based on this assumption to build a modern DeFi system. From the oracle machine to the trading market, interest rate market, derivatives market and insurance market. All of them are based on the starting point of development to reduce the arbitrage opportunities in the whole market . We should know that as long as arbitrage is increased, it means that there is a group of people with advantage strategys, which will lead to the disappearance of the whole market! The design and development of DeFi is a big deal, and there will be a lot of issues for experimenters to go through, such as centralized risk or contract code security.
Odaily: A few days ago, Nexus Mutual was exposed to governance vulnerabilities, which raised a question for the DeFi insurance platform. Who can underwrite the insurance acceptor of DeFi? From this point of view, does it mean that the completely decentralized DeFi insurance platform can not guarantee the safety of DeFi?
Overview of DeFi Security Incidents in 2019
Time
Incident
Type
the Attacked
Loss Amount
2019/1/30
Huobi’s stablecoin service HUSD v1.0 has arbitrage vulnerability.
design flaws
Huobi Exchange
millions of dollars
2019/2/12
Nuo Network’s trading account smart contract has security vulnerabilities.
Smart contract issue
trading account smart contract
/
2019/5/7
There is an itchy DAO vulnerability in the voting mechanism of the MakerDAO governance contract.
Smart contract issue
MakerDao governance contract
/
2019/6/25
Oracle exception on Synthetix platform leads to exchange rate error, and large amount of low-price arbitrage robots buy sETH.
Oracle offline data exception
Synthetix platform Oracle
35,759,524 sETH
2019/7/2
Edgeware’s MLC contract is vulnerable to DoS attacks.
Smart contract issue
Edgeware’s MLC contract
/
2019/7/13
Decentralized exchange protocol 0x has check order signature vulnerability.
Smart contract issue
0x Exchange v2.0 contract
/
2019/9/13
The AirSwap team announced a fatal vulnerability in the smart contract.
AirSwap decentralized exchange contract
smart contract issue
/
Table made by Odaily
Data Source: Peckshield
NEST fan: This is entirely a matter of product design. I mentioned in the article “the first principle of decentralization” that if the so-called on-chain governance contract can be broken, it is centralized in nature and will be eliminated. This kind of product and phenomenon should not be included in the scope of discussion, but should be criticized on a large scale.
Odaily: In addition to the DeFi insurance, what are the more feasible risk prevention measures in terms of technology for the risks caused by the composability of DeFi?
NEST fan: We have explained in the answer to the third question that this is a good thing. The problem is not the mindset of the combination, but the mindset of the combiner. Because they are following the wrong product development ideas and the product will be eliminated eventually. The new generation of DeFi will be created from a global perspective. This is the general equilibrium mindset that we have mentioned in question 3. The development of each product aims to reduce the market arbitrage opportunities.
Some people may say, you don’t think about demand? Obviously, if the demand is not satisfied, it indicates that there is an arbitrage opportunity (note that the demand here does not refer to the demand that is used quickly and looks good, but refers to the demand that the risk return is not reasonably allocated and priced). We should welcome the new development mindset of DeFi and enter the era of efficient finance.
Odaily: Among the existing DeFi insurance products and platforms, which are your personal favorite? (ETHerisc, CDx, Nexus Mutual, Opyn, VouchForMe, KeeperDAO, etc.)
NEST fan: As we have mentioned, I think they are all partial equilibrium products. They should be careful of arbitrage. Someone should analyze this kind of products systematically. If the mindset does not change, with the passage of time, this kind of partially balanced products are doomed to be eliminated by the market.
Odaily: Can you talk about the philosophy of the design of DeFi insurance products? Can you also put forward some improvement suggestions for the existing products?
NEST fan: Always start from the general equilibrium, reduce the arbitrage of the whole system, and always improve the pricing efficiency of the whole system. What is insurance? Insurance is negative security. Why negative securities? For the sake of market integrity. Why market integrity? Only in this way, can pricing be effective. What does effective pricing mean? The market is efficient. What does market efficiency represent? Financial resources are allocated in the most efficient and best way.
Odaily: Would you like to conclude that DeFi insurance will become a trend in the future? What do you think are the necessary conditions for decentralized insurance to become a trend?
NEST fan: I think DeFi is the general trend, and DeFi insurance is just an important part of it. As I said earlier, the oracle machine, the trading market, the interest rate market, the insurance market and the derivatives market are all very important. They have developed together. Because this is a hyper rational world on chain. Code arbitrage can only be done in a moment. It can not be completed if any step is slow. I think it is the trend of all-round development. The necessary condition is the Oracle machine. With this, the future will flourish. I hope you pay more attention to NEST distributed price Oracle network, a better Oracle solution.
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