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

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Monday’s $4 million assault on the Cowl Protocol, a decentralized insurance coverage service, despatched my thoughts to that basic nursery rhyme, There Was an Old Lady Who Swallowed a Fly.

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

Decentralized finance faces the same drawback with decentralized insurance coverage. Decentralized insurance coverage exists to guard folks 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Now, I don’t suppose DeFi finally ends up just like the outdated woman – “lifeless, in fact” – from ultimately having to swallow the blockchain equal of a horse. These sorts of reside, totally public conditions, with real-world losses, are what drive open-source developer communities to construct higher stronger programs. That prospect is strengthened by the truth that this assault got here from a “white hat” hacker moderately than a bona fide criminal.

However the Cowl story supplies a sobering coda to a 12 months 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. 

Promise

This 12 months, the DeFi “DeGens” confirmed us how you can create an entire decentralized stack of nearly every thing from the outdated, centralized system, with open protocols for exchanges, lending, borrowing, collateral administration, credit score default swaps and even digital {dollars}.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 not less than extra equitably disburse them, however as a result of it guarantees an finish to counterparty threat, a core drawback with the incumbent system’s closed, centralized structure. 

Within the credit score default swap disaster of 2008, market members 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 buyers hedge their dangers had been depending on the contracted events’ means to make good on their guarantees. So when folks 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 risk.

DeFi guarantees to keep away from this. If a contract to ship collateral within the occasion of a value discount is executed by a protocol that pulls on funds locked in decentralized escrow, with no single social gathering accountable for them, in idea counterparty threat is gone. The identical idea applies to decentralized exchanges (no extra Mt. Gox or QuadrigaCX), decentralized CDS, and different components of the DeFi ecosystem. 

Peril

The issue is we’ve traded counterparty threat for software program threat. 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 massive establishments that handle our fiat financial savings, that state of affairs is untenable. 

It doesn’t matter that each one these establishments face their very own software program vulnerabilities. (A recent report by the Heart for Heart for Strategic and Worldwide Research and pc safety firm McAfee estimated that the entire 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 in the end discover methods to socialize these losses. They simply want an identifiable perp on which to degree blame. 

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

A Manner Ahead

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

However not solely will that add prices, it brings us again to the identical counterparty threat drawback. 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 improvement must happen reside, in real-time, examined in the true world in order that bugs could be uncovered and patched. 

And that’s why at present’s assault is definitely excellent news. An unidentified individual seemingly concerned with Grap Finance finds a bug in a protocol, makes use of it to empty lots of COVER tokens, giving everybody concerned a brief interval of panic. Then in a basic white hat transfer, he/she/they return the funds to the Cowl Protocol and publicly announce, by way of Twitter, that they’ve performed so. 

Since then, folks like Band Protocol CTO Sorawit Suriyakarn have labored to elucidate, in a similarly public way, how the hack occurred. Whereas some may see that as an invite for different hackers, it’s most significantly an alert to others inside DeFi to patch comparable bugs. Already, Cowl has pivoted to develop a brand new token.

What doesn’t kill you’ll make you stronger. That’s the notion that can in the end drive the DeFi ecosystem to create a scalable new mannequin for international finance. 

It’s simply not going to occur tomorrow.



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