The cryptocurrency industry is growing at a rapid pace, with the market capitalization of crypto assets reaching $3 trillion in November this year. With new investors entering into the crypto space, it is essential to have robust insurance solutions in place to manage and hedge risks in the crypto sphere.
However, even as the crypto industry continues to gain traction, 96% of it remains uninsured as of early 2021. The insurers have been slow to enter the crypto market due to the real and perceived risks attached to crypto exacerbated by insufficient knowledge about the crypto industry and lack of access to tools giving access to historical data. Read about the challenges faced by insurers looking to underwrite crypto risks here.
Why does the crypto sphere need insurance?
Attracting Clients from Traditional Financial Institutions: If the crypto industry wants to attract clients from the traditional financial institution sphere, they will have to ensure that they have robust insurance solutions in place. Since traditional financial institutions such as banks are bound by strict regulatory requirements, strict compliance standards must be in place such as having mechanisms for ensuring safe custody of assets and risk management arrangements. For instance, BitGo, which was the first qualified custodian for storing digital assets and has since expanded into other institutional digital asset financial services, was one of the first service providers to build a robust insurance program — thus helping it attract traditional finance clients and gain a dominant position in this segment.
Hacks and Scams: The surge in the crypto industry’s growth has also garnered the interest of bad actors leading to a risk of attacks in the crypto space. According to industry reports, as of November 2021, a total of 169 blockchain hacking incidents have taken place, with close to $7 billion in funds lost. These attacks are adding to the reputational damage suffered by the crypto industry, highlighting the crypto industry’s inability to store and protect the digital assets of the users. Therefore, it is imperative to have a robust insurance framework in place in case of fraud, scams, and exploits surrounding crypto and provides coverage that protects insureds against losses sustained from these attacks.
Black Swan Events: The need for insurance in the crypto industry is not just limited to protection from hackers. For instance, risk transfer solutions provided by traditional insurance can protect users from market gyrations and black swan events. A black swan risk refers to the possibility of the occurrence of an unexpected event. In the crypto industry, a black swan event can take multiple forms like a governmental clampdown on crypto trading, an example of such a government clampdown would be South Korea shutting down all its crypto exchanges. In such situations, the prices of crypto assets may plummet and users may find their positions liquidated and be susceptible to penalty fees due to lack of collateral. To ensure the safe and healthy growth of the crypto sector, it is essential to users’ funds by having insurance mechanisms in place
The crypto industry is proactively creating innovative insurance solutions
To fulfill the gap created by the lack of commercial insurance products, the crypto industry has been proactively creating innovative solutions to manage risks in crypto such as self-insurance, DeFi insurance, and partnering with traditional insurance companies.
Self Insurance - Self-insurance is a risk management technique wherein an entity, either by choice or due to lack of options, does not use third-party insurance firms. To this end, the entity sets aside a certain amount — a pool of funds — that would be used in case of emergency to pay back the users.
Crypto businesses like Binance, Equilibrium, and Crypto.com are implementing self-capitalized fund protection schemes for their users. Back in 2018, Binance announced that it would allocate 10% of all trading fees it received into a Safe Asset Fund for Users (SAFU). This fund is stored in a separate cold wallet and is used to protect users and their funds in “extreme cases.” In May 2019, when attackers stole 7000 Bitcoins, Binance used funds in SAFU to cover the loss. Further, Gemini, another prominent crypto exchange, has gone one step further and created its own insurance company, Nakamoto Ltd to protect its clients against the potential loss of coins from its cold wallets.
Industry-driven insurance products - Decentralized Finance (DeFi) which is pegged to be the next frontier of fintech innovation has grown exponentially over the past year. Unfortunately, parallel to the growth in DeFi, hacks, and attacks are also increasing. DeFi hacks have cost the crypto community over a billion dollars in 2021. With cases of DeFi hacks becoming increasingly common, a growing number of DeFi insurance protocols such as Nexus Mutual, Cover Protocol, Unslashed Finance, and Insurance.io, are helping their users gain coverage against wallet hacks, smart contract exploits, rug pulls, and so on.
Nexus Mutual has emerged as one of the early innovators and biggest players in the decentralized insurance space it provides coverage to its users by creating a risk-sharing pool of funds that can be used to handle claims on smart contract bugs and exploits.
Further, insurance companies such as Evertas, which solely focus on the crypto industry, are slowly emerging. Instead of just providing coverage to crypto assets in cold or hot storage, Evertas provides coverage to crypto businesses themselves. Therefore, not only can it provide coverage for online hacks but crypto businesses can also insure loss of private keys, loss due to technology omissions and failures such as smart contract failures, exchange outages, and hardware malfunctions.
Partnering with traditional insurance providers -Some crypto exchanges are partnering with traditional insurance providers to protect their digital assets and underwrite losses by working closely with traditional insurance providers. For example, in April 2021, Coinbase partnered with Lloyd’s of London-registered broker Aon to provide $255 million limit insurance coverage for its hot wallet crypto holdings. Further, in September 2021, Crypto.com — a leading digital currency exchange—expanded its total insurance policy coverage to $750 million including both direct and indirect coverage. This new policy is backed by Arch Underwriting, a division of Lloyd’s Syndicate 2012. This policy secures cold storage assets on Ledger Vault (Crypto.com’s custodial partner) from physical damage or destruction and third-party theft.
While there are some traditional insurance companies offering products in the crypto space, the solutions provided by them are very limited. These insurance companies do not provide coverage for a range of situations such as the loss of private keys due to users’ fault, smart contract failures, and cost-effective protection of crypto held in hot wallets. Some companies such as Lloyd’s of London are providing insurance policies targeted towards protecting crypto held in hot wallets against theft or other malicious hacks; however, providing coverage for the hot wallets, in general, is significantly more difficult and expensive.
How can Merkle Science Help?
In order to create effective insurance policies, insurance companies need to understand the level of risk exposures of their customers. Merkle Science provides a predictive crypto risk and intelligence platform, setting the standard for the next generation of crypto threat detection, risk management, and compliance solutions. We are creating the infrastructure necessary so that a full range of entities including crypto businesses, insurers, and banks may transact safely with crypto.
Merkle Science’s highly customizable platform and proprietary Behavioral Rule Engine is easy-to-use, allowing institutions to detect illicit activity beyond the blacklists so that FIs may catch undetected suspicious activity that legacy providers might miss and better meet AML and KYC obligations as per guidance from jurisdictions around the world.
To find out how Merkle Science works for your business, please contact us via our website.