Who Insures the Insurer? Cowl Protocol Assault Exposes DeFi’s Promise and Peril

Monday’s $four million assault on the Cowl Protocol, a decentralized insurance coverage service, despatched my thoughts to that traditional nursery rhyme, There Was an Outdated Girl Who Swallowed a Fly.

You already know, the one the place an unlucky girl retains consuming ever bigger animals to catch the beforehand swallowed animal. 

Decentralized finance faces an analogous downside with decentralized insurance coverage. Decentralized insurance coverage exists to guard individuals from losses if a DeFi protocol’s coding flaws permits somebody to assault it. However what occurs when there’s a vulnerability within the insurance coverage protocol? What do you swallow to repair that?

Now, I don’t assume DeFi finally ends up just like the previous woman – “useless, in fact” – from finally having to swallow the blockchain equal of a horse. These sorts of dwell, totally public conditions, with real-world losses, are what drive open-source developer communities to construct higher stronger methods. That prospect is strengthened by the truth that this assault got here from a “white hat” hacker reasonably than a bona fide criminal.

However the Cowl story gives a sobering coda to a yr of startling innovation that stirred the creativeness for a brand new monetary system unencumbered by centralized gatekeepers. It reveals how far that system nonetheless must develop. 

This yr, the DeFi “DeGens” confirmed us how you can create an entire decentralized stack of nearly all the things from the previous, centralized system, with open protocols for exchanges, lending, borrowing, collateral administration, credit score default swaps and even digital {dollars}. 

That is thrilling, not solely as a result of eradicating Wall Road intermediaries might scale back prices, or a minimum of extra equitably disburse them, however as a result of it guarantees an finish to counterparty danger, a core downside with the incumbent system’s closed, centralized structure. 

Within the credit score default swap disaster of 2008, market individuals had no visibility into their counterparties’ a number of, hidden monetary exposures, which is a recipe for distrust. CDS and different contract-based devices designed to assist traders hedge their dangers have been depending on the contracted events’ capability to make good on their guarantees. So when individuals not believed in these guarantees, the frenzy for the exits meant these hedges weren’t solely nugatory however made issues worse. They supplied nothing however systemic danger.

DeFi guarantees to keep away from this. If a contract to ship collateral within the occasion of a worth discount is executed by a protocol that attracts on funds locked in decentralized escrow, with no single occasion in command of them, in concept counterparty danger is gone. The identical concept applies to decentralized exchanges (no extra Mt. Gox or QuadrigaCX), decentralized CDS, and different elements of the DeFi ecosystem. 

The issue is we’ve traded counterparty danger for software program danger. And one might argue that’s even riskier. The caveat emptor ethos of DeFi is nice for daring-do innovation and speculative buzz, however when there’s no centralized service supplier to carry accountable and when hackers utilizing untraceable pseudonyms can simply escape regulation enforcement, there’s little to no authorized recourse after an assault. 

For the majority of humanity, particularly the large establishments that handle our fiat financial savings, that situation is untenable. 

It doesn’t matter that every one these establishments face their very own software program vulnerabilities. (A latest report by the Heart for Heart for Strategic and Worldwide Research and laptop safety firm McAfee estimated that the full value of cybercrime, together with each losses and safety bills, will exceed $1 trillion in 2020.)  It’s that, if these “too large to fail” establishments’ losses get too large, whether or not from crime or monetary panic, the federal government and central financial institution will finally discover methods to socialize these losses. They simply want an identifiable perp on which to stage blame. 

A decentralized system doesn’t enable for that, which is why it wants a brand new mannequin of insurance coverage towards losses. The issue with that’s, effectively, what occurred to Cowl.

For now, the answer might lie with centralized insurance coverage methods, in order that there’s somebody holding the bag who will be recognized and sued. These companies exist and, with an insistence on thorough, ongoing and top-level code audits, some will attain sufficient of a consolation stage to bear the danger – at a worth. 

However not solely will that add prices, it brings us again to the identical counterparty danger downside. What occurs if there’s a 2008-level system-wide disaster in DeFi?  What occurs when everybody fears a breakdown and nobody trusts that the overexposed insurers – or their reinsurer underwriters – have the wherewithal to cowl the fallout? 

For this reason, to realize the best, decentralized insurance coverage is required. It’s simply that its growth must happen dwell, in real-time, examined in the true world in order that bugs will be uncovered and patched. 

And that’s why at present’s assault is definitely excellent news. An unidentified particular person seemingly concerned…