Cover Protocol is a nascent project that provides what the cryptocurrency industry needs urgently: insurance. Given the recent rise of exploits, and Nexus’s attitude that they do not cover oracle manipulations, Cover Protocol has been a much in-demand product, a peer-to-peer insurance on defi platforms. https://www.coverprotocol.com/
Insurance is provided for leading and trendy yield-farming projects, which are often the targets of hackers, given the amount of tokens these platforms are handling and relatively shorter histories of these platforms. In particular, Cover Protocol made a bold but justified move to compensate Pickle, following its recent exploit. Whilst the Pickle compensation is a collective decision by the governance (a voted results of the COVER token holders), it’s nonetheless clearly spelt out in the terms of Cover Protocol. This makes Cover Protocol the ONLY product that insures oracle manipulation at this moment. (For details, please refer to https://docs.coverprotocol.com/product/claims-guidelines.)
Cover Protocol’s peer-to-peer insurance is achieved by an innovative mechism:
- User A deposits a mount of DAI for a protocol. Let’s say User A deposits 10,000 DAI for AAVE. By depositing 10,000 DAI with Cover Protocol, he mints two tokens of 10,000 each. He can redeem the pair of tokens for DAI at any time to rescind this action.
- Claim: in the event that a claim is made (see step 2 and 3), the Claim tokens are entitled to redeem 1 DAI each (and noClaim tokens receives none);
- NoClaim: in the event that no claim is made, at the expiry of the insurance period (usually a few months), the NoClaim tokens are entitled to redeem 1 DAI each (and Claim tokens receives none);
- A claim is a binary situation during the insured period, so the User A either uses Claim tokens to get back the 10,000 DAI, or uses NoClaim tokens, depending on whether a claim is made. A claim is not specific to the User — he does not need to prove that he has a loss of funds from AAVE of any amount to make a claim. Instead, a claim can be made as long as an exploit happens in AAVE and anyone files a claim for the governance to vote and verify. Think it in the traditional finance terms: it’s like a class litigation. This is the basic mechanism of Cover Protocol that’s disruptively different from Nexus and any traditional insurance firms.
- The community votes on a claim and if voted pass, a professional committee comprised of blockchain audit firms further verifies the nature of the claim. If passed, the status of the Claim and NoClaim will be updated to reflect that Claim tokens can claim 1 DAI each. If not passed, nothing changes.
From the above process, we note that User A does not benefit from his actions of holdings the Claim and NoClaims tokens at the same time, as he get his DAI back in any case. Neither does he earn anything from them (in the absence of Mining Rewards). But User A has a few choices:
A) He only wants insurance cover: he will sell NoClaim tokens and hold Claim tokens. For instance, if the market price of AAVE’s Claim is 0.14 DAI each and NoClaim is 0.86 DAI (they always add to approximately 1 DAI as User A can redeem any time for 1 DAI), then by selling AAVE’s NoClaim tokens, User A is effectively paying 0.14 DAI for 1 DAI in the event of an exploit on AAVE happens. Then his cost of BUYing this insurance is 14%.
B) He only wants to write an insurance: similarly, User A can sell Claim tokens and hold NoClaim tokens only. In this sense, he is taking risks with his 10,000 DAI on AAVE being exploited, for the insured period. But if nothing happens, he can redeem 1 DAI for each NoClaims token, and this gives him a return of (0.14 DAI + 1 DAI)/(1 DAI) -1 = 14% for the period. You may argue his starting cost is 0.86 DAI but disregard this, his return on UNDERWRITing an insurance is 14%.
Now the Cover Protopol has effectively established a mechanism for underwriting and buying insurances on a peer-to-peer basis. To facilitate the trading of Claim and NoClaim tokens, Cover Protocol creates a Balancer Pool for each of the tokens (and each insured platform has its own two pools of Claim and NoClaim tokens on Balancer).
For now, all Claim token pools have a ratio of 80%:20% and No-Claim pools have a ratio of 98%:2%. To be a liquidity provider for Claim and NoClaims tokens, additional 525.51 DAI is required (based on the current prices):
As a liquidity provider, one earns the Mining Rewards (currently 654 COVERs per week for all pools) and the trading fees in each pool. Liquidity providers are exposed to impermanent loss, and in this case, it’s almost expected as the perceived values of Claim and NoClaim tokens will certainly change in response to the exploit events, as time approaches expiry. The Cover Protocol team is researching on how to minimise such impermanent loss or price it. For instance, higher trading fees in Balancer pools can be set to compensate liquidity providers. Fair-priced liquidity is the key to long-term viability of Cover Protocol.
For now, COVER is trading at close to $900 and the Mining Rewards outweigh the impermanent loss (even in the event of an exploit) significantly. If one mints both Claim and NoClaim tokens and provide liquidity for both on Balancer pools, the expected APY is over 100% for now. (If you are concerned about an exploit still, try provide liquidity for the Claim/NoClaim tokens for safer projects like AAVE or Yearn or Balancer). The APY will reduce as total value locked (currently 22 million DAI or equivalent) increases or COVER price decreases, but still it’s a relatively good strategy given the yield now. Whilst the project has a legacy from being SAFE, it’s recent collaboration with Yearn Finance gave the investors and liquidity providers a strong boost. And more disruptive innovations may come from here.
(Serenity Team, 7 Dec 2020, Twitter @SerenityFund)