Modern crypto exchanges often have audited financials, chief compliance officers, and seek out regulators without hesitation. Will insurance be the next step?
If the crypto sector is to attract more institutional investors, it will need to provide more insurance solutions. This point was driven home anew with the recent news that the Gemini crypto exchange has launched a captive insurance company, Nakamoto Ltd., to insure its Gemini Custody business for up to $200 million — reportedly the largest amount for any crypto custody service in the world.
This new insurer will help Gemini’s institutional clients to meet their regulatory requirements, Gemini’s head of risk, Yusuf Hussain, explained to Cointelegraph in a Jan. 16 story, and this “is consistent with Gemini’s approach of being a security-first, compliance-first, and regulatory friendly exchange and custodian.”
Black swan events
The crypto sector badly needs risk transfer solutions, including traditional insurance, and this goes beyond protection from hackers and thieves. It is no secret that the crypto world suffers from continued price volatility and that users could benefit from some protection against market gyrations — whether through traditional insurance carriers or by other means.
Equilibrium, a multichain framework for DeFi products, explained in a white paper: “The crypto community needs a reliable insurance mechanism to ensure users of DeFi projects will get their funds back in case of a black swan event.”
A black swan event needn’t be catastrophic. It could be South Korea deciding to shut down all its cryptocurrency exchanges, for instance, or United States regulators suddenly lowering the hammer on Bitcoin (BTC).
Along these lines, Equilibrium has recently created a “stability fund” to protect the users of its stablecoin, EOSDT, against “extraordinary market events,” which is self-capitalized with 6.5 million EOS tokens, worth about $17.5 million at the time of the fund’s announcement in mid-December.
As Equilibrium CEO Alex Melikhov explained to Cointelegraph, users expect that the price of EOSDT remains stable, saying: “But in an extraordinary market event, the price of all cryptos, including EOS, could plummet.” ESODT users could suddenly find their positions liquidated and liable for a 20% penalty fee due to insufficient collateral. According to Melikhov:
“Should something unusual happen, like a market shock to cause the value of EOS to plummet and the overall system collateral value to drop below the total dollar value of EOSDT supply, our smart contract-based fund can step in and algorithmically ensure that EOSDT users are able to maintain their value.”
Equilibrium isn’t the only crypto firm to implement a self-capitalized fund for the protection of its users. In July 2018, leading crypto exchange Binance announced that it would allocate 10% of all trading fees it received into a Safe Asset Fund for Users (SAFU), which are stored in a separate cold wallet, to protect users and their funds in “extreme cases.”
An extreme case occurred 10 months later, in May 2019, when hackers stole 7,000 Bitcoins — worth about $41 million at the time. Binance used its SAFU as a kind of emergency insurance to cover the incident as Cointelegraph reported.
Proceed with caution
Meanwhile, traditional insurance companies are beginning to dip their toes into the crypto waters. “Over the last two years, insurance carriers have cautiously expanded underwriting appetites to provide coverage for crypto exposures,” according to broker Willis Towers Watson. “But so-called crypto coverage isn’t cheap, and underwriting remains hamstrung by the unsettled and even precarious state of cryptocurrencies as well as the lack of historical loss data.” The broker’s message comes down to: proceed with caution.
More crypto exchanges and custodians are turning to traditional insurers and brokers to secure protection against hackers and thieves. In April, Coinbase revealed details of its $255 million limit insurance coverage for its hot wallet crypto holdings — purchased through a Lloyd’s of London-registered broker, Cointelegraph reported. Gemini, for its part, was assisted by major brokers Aon and Marsh in its recent Nakamoto Ltd. launch.
In the wake of last year’s Quadriga scandal, crypto security firm Bitgo announced a $100-million Lloyd’s underwritten policy to cover the digital assets of its custodial clients “where the offline private keys are held 100% by BitGo, Inc.,” per a press release.
“Some insurance companies are further along than others” when it comes to working with the crypto community, Jacob Decker, vice president and director of financial institutions with insurance broker Woodruff Sawyer, told Cointelegraph.
He went on to add that most still have to educate their management teams about cryptocurrencies and that it’s not an overnight process. It can take two to three years. That said, more carriers are beginning to write policies today, said Decker, who helped BitGo secure its Lloyd’s policy.
Best use of capital?
Often, exchanges have elected to self-insure by setting aside capital to cover potential losses. There are problems with this approach, however. Setting aside coins that could have been potentially invested is often not the best use of capital, said Lei Wang, head of Huobi’s Global Institutional Center, and risk remains fairly concentrated within the exchange — without access to the reinsurance market. Coverage terms and claiming procedures are often ambiguous, too, due to lack of expertise. Wang told Cointelegraph:
“We have currently put aside 20,000 Bitcoin, which could have been put to better use in the ‘Huobi security reserve’ as a fallback protection mechanism in the event of security breach. The funding cost is significant.”
Huobi is interested in exploring other insurance options, Wang explained, including forming a captive insurance entity, in which segregated funds are held in regulated and audited vehicles that could potentially help the exchange get more coverage from the reinsurance market. Wang added that he is “optimistic about the captive insurance option.” Details like standardization and pricing would still have to be figured out, and even here he had a few caveats:
“Every exchange has different security mechanisms and potential exposure to attacks. It would be difficult to come up with a standard industry pricing model without completely understanding each exchange’s security methods, assuming they are willing to share with competitors. Furthermore, owning insurance may encourage exchanges to reduce investment in security to compensate for the cost of the insurance.”
Insurance has its limits
Not everything can be easily insured, however. Crypto assets held in hot wallets are difficult — and expensive — to insure, and “We can’t insure against Bitcoin going to zero,” added Decker. For a user who is worried about losing their private key, “the best thing may be to go to a specialty vendor who will protect you, a firm that will make you whole.” The retail investor will want to research the reputation of that vendor and its balance sheet before entrusting crypto assets to them.
Insurers need a framework by which to assess and price risk, according to Decker, something the crypto community doesn’t always understand. Who, in the case of exchanges, is the insured’s regulator? Does the firm have a relationship with that regulator? What’s the financial condition of the company? Are there minimal capital buffers? Audited financials? Who is on the management team? Are they experienced? And so on. Decker summarized:
“The evolution of companies dealing in crypto has been extremely rapid. A crypto exchange trading today looks very different from one trading several years ago.”
According to Decker, they often have audited financials, a chief compliance officer, and seek out regulators when issues arise. When regulatory compliance is a priority, businesses are easier to underwrite. Overall, “I feel very positive,” Decker said.