Safeguarding DeFi with FairSide Network
Like it or not, most of DeFi is still a financial Wild West built on the blockchain.
The one BIG difference between DeFi in 2019 and today, however, is that your average yield farmer has become painfully aware of the inherent dangers behind most crypto-native financial tools.
Rug pulls, smart contract exploits, rogue devs. Billions of dollars in losses to date. Billions more to come.
So even as the decentralized market side-turns from rugged to refined and the institutional interest grows, more and more settlers are now looking to protect their digital homesteads.
The problem is that most insurance options available in crypto - much like some of the protocols they try to cover - are poorly designed.
From cover to cover
Talking specifics, existing insurance protocols carry two built-in flaws that (despite some early wins) make their long term success unlikely.
As some of you may have already experienced yourself, these are:
Limited cover types
Permanent staking loss
The insurance protocols of today are not built to protect the user from the many-headed hydra that is interacting with DeFi or, more broadly, the wholesale crypto market.
In reality, they are designed to insulate members from a very narrow set of project-specific risks, typically limited to smart contract failures or exchange hacks.
This is achieved by staking specific projects and - in turn - offering cover on a case-by-case basis.
Want to buy cover for Uniswap on Nexus Mutual? You are protected by the staked funds of those that bet on Uniswap’s security alone. If Uniswap gets hacked, their bet has failed, and you get to claim a portion of their (staked) funds.
This type of pooled, project-specific staking is antithetical to what made the traditional insurance sector viable in the first place - diversification of risk. In the event of a hack, insurance protocols using the above model can essentially put the entire stake on the line. That means the possibility of a complete, permanent loss for stakers in favor of the network’s claimants.
Furthermore, project-specific staking means that active DeFi users have to purchase multiple insurance ‘policies’ to stay protected.
Want to buy cover for Uniswap, Thorchain and Harvest Finance? That will be three different policies, available at wildly different premiums.
No staked pool available for the cool new yield aggregator you’ve just put money into? Sorry, you’re on your own.
Thesis: project-specific staking puts a great amount of risk on the protocol’s stakers and makes comprehensive insurance borderline impossible.
The biggest names in decentralized insurance all operate in this manner, giving room for more capital-efficient models to seize market share - and in a portion of the time that it took the incumbents.
Picking a Side
At Daedalus, we strongly believe that FairSide network introduces precisely such a model, leading us to invest in the project.
The FairSide network was designed around the core principle of diversification and risk management and wants to offer the broadest possible coverage, including claims from any blockchain, any project and all approved cover types - all in a single membership.
Above all, FairSide looks to capture market share by taking the best practices that have made traditional insurance into a sustainable, trillion dollar industry, and adapting it to a decentralized setting.
Instead of project-specific staking adopted by most insurance protocols, FairSide introduces Network Staking, where contributors stake the entire network rather than a specific project or a specific type of risk.
Network Staking means that FairSide members are not only protected against a predefined list of events for a predefined list of projects. Instead, members can issue claims for any number of ‘unfair loss’ events, even for projects that have not even existed when you purchased a FairSide membership.
In FairSide, Assessors are tasked with deciding whether any event represents unfair loss that may be the subject of member claims. In other words, there is no need to purchase a dozen policies at different markups to protect yourself against any and all risk in DeFi. One membership to rule them all.
On the flip side, Network Staking is an all-embracing approach that allows contributors (stakers) to the Fairside Network to receive staking rewards from every insurer’s membership. This not only increases the contributors’ potential rewards but also reduces their risk, as their stake is no longer tied to any specific project or particular unfair loss event.
Let’s compare the above claim process to that of the current industry leader, Nexus Mutual.
Nexus Mutual uses a Continuous Token Model to distribute NXM tokens, which are then used to buy cover or participate in claims assessment, risk assessment or governance. Contributors can deposit NXM to stake a number of projects (that they believe are secure) in exchange for staking rewards.
Nexus Mutual utilizes a standard bonding curve where the token price is a function of the ratio of total asset value in the capital pool and the minimum capital requirement.
A well-designed bonding curve is critical to balance the capital required for paying out claims with the potential cost sharing events by automating/self-regulating solvency.
In the FairSide network, users can deposit ETH or ERC-20 tokens in exchange for FSD, the network’s native token, with contributions bonded to the protocol’s Augmented Bonding Curve.
Once a user has exchanged crypto for FSD, they have essentially staked the entire FairSide network, instead of any specific project or loss event.
In Nexus Mutual’s system, contributors deposit NXM to stake a particular project they believe is secure, in exchange for staking rewards. Once an ‘unfair loss’ event affects such project, the NXM funds in the project’s pool are liquidated to pay out claimants, leading to permanent staking loss for the pool’s contributors.
In FairSide, the Capital Pool is funded in ETH with contributors receiving a certain amount of FSD in return (alongside its bonding curve), that they can burn to withdraw ETH from the curve. Once an ‘unfair loss’ event occurs within the FairSide network, the funds in the universal Capital Pool are used to pay out claimants, leading to a temporary loss in the price of FSD.
As the price of FSD is lowered, it incentivizes the recapitalization of the Capital Pool and attracts more staking. Given the proper incentives, the price of FSD starts to recover, reducing/nullifying losses for all of Capital Pool’s contributors.
And speaking of incentives:
Smart Rewards
FairSide is a 100% fully staked network, which means anyone is free to contribute to their Capital Pool by staking ETH or ERC-20 tokens (which will be dynamically swapped for ETH) and receive FSD tokens in return.
During the ‘hatch phase’, the contributor rewards are affixed to 20% of the membership fees, which may seem low when compared to 50% rewards taunted by most insurance protocols. However, there are two major caveats to FairSide’s incentive structure that we believe make it superior to incumbent market solutions.
First - and as we already covered - FairSide’s contributors are much better insulated from unfair loss events and network payouts, which only prompt a temporary drop in the price of their FSD tokens, and not a permanent staking loss. The piece of mind alone, you’ll agree, would be worth a reasonable reduction in potential contributor rewards.
However, FairSide’s Smart Staking model also ensures that the network can in fact provide competitive incentives as the protocol-level adoption grows. To understand how, we need to introduce the concept of FSHARE% and its dynamic impact on contributor rewards.
FairSide’s Capital Pool has a floating floor known as the FSHARE, which tracks the minimum capital requirement of the pool. This level will naturally rise with FairSide’s adoption to accommodate the increase in cost sharing potential.
FSHARE%, then, is a ratio that measures the amount of ETH in the Capital Pool relative to all potential cost-sharing requests (i.e. network payouts). Simply put, FSHARE% tracks the difference between the funds in the Capital Pool and the network’s minimum capital requirement (or FSHARE).
The more ETH is staked, the further it distances FairSide’s Capital Pool from the FSHARE minimum. In return, the FSHARE% also rises, as there are now more funds in the Pool relative to potential payouts.
Here’s the kicker: as the FSHARE% grows, so too do contributor rewards. While they’re initially capped at 20%, the rewards are really on a dynamic slider between 20%-85%, all based on the Capital Pool’s current level of funding.
We see this as a massive competitive edge of the FairSide network. In other insurance protocols, additional staking actually has a negative effect, as contributor rewards get diluted among the growing staker base.
FairSide’s Smart Staking model identifies when the Capital Pool is overfunded and instead diverts excess funds to contributor rewards, boosting their potential margins up to 85%. Again, compare this to most insurance protocols which cap their rewards at 50% of their premiums/membership fees.
In short, FairSide’s project-agnostic model dilutes risk, not reward for its contributors, offering a much better end product than the incumbents.
Gearing Factor
As DeFi grows and evolves, we believe the success of decentralized insurance protocols will hinge on their ability to be - and remain - capital efficient.
In the long term, only capital efficient models will be able to offer insurance cover at reasonable prices, due to their potential to cover liabilities much larger than the collateral or the network’s Capital Pool.
This is where gearing factors come in. Put simply, gearing is the mechanism used to determine the maximum cost-sharing benefits (read: payouts) that a protocol can offer relative to its Capital Pool.
When a higher gearing factor is used, the protocol can offer more active benefits without increasing the minimum capital requirements (known as FSHARE in FairSide’s model).
As such, gearing factors are de facto influenced by the risk profile of projects being covered. For projects with a high asset-to-risk correlation, a low gearing factor needs to be used. But as the protocol diversifies its ‘risk portfolio’, it opens the door for higher gearing factors.
Given their project-specific models, most existing insurance protocols employ 1-to-1 staking or use models that demonstrate a gearing factor of 1 (very low).
Thanks to FairSide’s network-staking model, the protocol is able to use a gearing factor of 10 upon launch, meaning it allows 10 times more cost-sharing compared to the same amount of capital held by existing insurance options. This makes FairSide highly capital efficient and provides strong membership incentives compared to project-specific covers.
Eyeing up the incumbents
By introducing tangible improvements to DeFi insurance, we believe FairSide is well equipped to contend with market leaders like Nexus Mutual and Cover Protocol, and quickly capture a dominant share of the market.
Both Nexus and Cover (and dozen other cookie-cutter protocols) suffer from the same drawbacks that are still being ignored due to Hobson’s choice, but are likely to hinder their long-term sustainability and growth.
Most egregiously, these include limited cover types that are unable to protect DeFi users from the dangers of tomorrow as well as permanent staking loss that deters new contributors and reduces the protocols’ capital efficiency.
FairSide addresses both of these issues - not by reinventing the concept of insurance, but by codifying a century worth of best practices from a trillion-dollar industry into a smart contract.
DeFi is still a lawless wilderness, and people need assurance their spoils won’t vanish overnight. We believe FairSide gives them the best chance to succeed. They say money can’t buy a piece of mind, but FairSide’s membership may be the next best thing.