Options Protocol Brings ‘Insurance’ to DeFi Deposits on Compound

The decentralized web may have reduced the need to trust intermediaries, but that doesn’t mean there isn’t risk. As the broader DeFi market grows past $1 billion in committed crypto, users need ways to manage that risk just as in the old market. 

Trustless insurance has arrived on decentralized finance (DeFi). At least on the Compound protocol, the collateralized lending platform that runs on ethereum.

The new product, from a company called Opyn, allows people to take out options on stablecoin deposits, allowing users to hedge against the risk of a catastrophic event wiping out Compound’s books.

«You can make a claim at any time. You don’t have to prove anything to anyone,» Zubin Koticha, one of the three co-founders behind the new product, told CoinDesk.

To that end, Opyn is the beginning of a blockchain-style solution analogous to those found in traditional financial markets. As it happens, derivatives are so big in those markets that it’s somewhat ridiculous even to repeat their estimated market size.

Meanwhile, Compound is the third-largest DeFi app on ethereum, as measured by DeFi Pulse. Users can earn interest on funds they deposit into the protocol, and they can also borrow against their deposits.

Compound has been stable since launching in late 2018, but no one disagrees that this world of DeFi is still tiny and hasn’t really been tested in the fires of true panic. If more serious investors are to start using Compound, they will want a way to hedge.

Multicoin Capital’s Kyle Samani told CoinDesk one of the perks of DeFi is the ability to make applications work together without having to ask permission (also known as composability). But this feature might yield surprises.

«We don’t yet have enough evidence to know that they work as intended 100 percent of the time. And so, the more that users layer these protocols together, the more systemic risk grows,» Samani said.

«There is certainly a non-trivial amount of risk in the ecosystem, as a lot of smart contracts present substantial surface area for bugs or attacks to occur,» Autonomous crypto fund founder Arianna Simpson told CoinDesk. She said the industry is working on this challenge, citing Nexus Mutual as a company that already provides insurance services for smart contracts.

On risk, Koticha says he’s talked to a lot of people in the space about their fears of depositing on Compound.

The computer types fear a bug or a hack, knowing that smart-contract languages can be very touchy. Financial types fear a liquidity event. For example, what if everyone just decided to close their deposits all at once?

Opyn’s first product will offer a hedge, what financial types call a «put option,» which will guarantee that users can recover most of their lost capital if Compound has a disaster.

«Options are great oracles of volatility and risk in traditional markets,» Koticha said.

Koticha declined to name the project’s investors.

How it works

Opyn isn’t offering insurance in the traditional sense. There will be no credit check or claims process or even proof the person owns the asset being insured (more on that below).

In fact, starting out, Opyn isn’t even going to ask users to submit know-your-customer (KYC) forms.

The team’s ethereum-based Convexity protocol can make all kinds of options, Koticha said. For now, it’s simply making put options to protect Compound users.

To explain that first product, we need to back up and talk about how Compound works. If someone makes a deposit onto Compound of, say, 100 DAI, he gets cDAI tokens back. cDAI tokens appreciate in the user’s wallet at whatever rate the underlying asset is appreciating. This makes deposits on Compound tradeable.

For simplicity’s sake, let’s say 1 DAI equaled 1 cDAI (it doesn’t, but let’s say it does). With Opyn, someone pays a small fee to buy an oToken. That oToken would be good for a year (for now). At any time, any holder of an oToken could turn in their cToken and their oToken and get back (for example) .95 DAI (there will always be a little bit of a haircut).

The advantage for insuring these deposits is guaranteed free money in exchange for staking ETH as collateral. How much the user earns will be determined by the market. New oTokens will be sold via Uniswap and the price will be determined algorithmically.

So, for a borrower, if someone put 1,000 DAI into Compound, he could go out and buy 1,000 DAI worth of oTokens for what should be a modest fee in normal times. He’ll then feel safe for the next year knowing he can get most of his deposit back if something terrible happened to Compound.

Note: You don’t actually have to hold cTokens to buy oTokens, which has interesting implications for the market. Imagine a trader who foresaw a liquidity run on Compound. He might buy up a bunch of oTokens (a so-called «naked put») knowing people will sell their cTokens for pennies on the dollar if Compound got wiped.

Of course, if they do that, the price of oTokens would start rising and other people would see that and wonder why.

«It’s an early warning signal for the community that something is not necessarily right,» Koticha said.

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