The Protection for Smart Contract Hacks, Exploits, and other DeFi Event Risks.
TDLR: UNION introduces the crypto equivalent of TradFi’s Credit Default Swaps for Smart Contract Protection: Crypto Default Swaps.
Swap premiums are paid upfront in return for 100% payout coverage should a covered event occur.
Crypto’s unique risk profile is a consequence of its multi-faceted array of threats and dynamic attack surface. Open-source code securing billions of dollars in value on permissionless blockchains presents a spectrum of vulnerabilities. These include layer one risks (e.g., node failure, MEV, etc.), layer two settlement assurances, smart contract bugs, and economic exploits that are all characteristics of an emerging ecosystem of open-source finance distinct from TradFi.
However, that does not mean instruments for risk mitigation in TradFi do not apply to crypto. In particular, credit default swaps (CDS), a derivative instrument for offsetting both common and asymmetric event risk, can play an integral role in defending against the sharp downside risks native to DeFi across variable cases.
In crypto, the covered event risks via existing insurance pools and derivatives primarily only focus on price risk. Premium pricing of covered events like smart contract bug exploits is mostly dependent on third-party audit assessments, partial payouts subject to governance votes, and liquidity providers’ explicit risk/reward trade-off for passive yield vs. claims payout probabilities.
While helpful and part of an emerging asset protection environment, current solutions are deficient in protecting against a range of unforeseen, asymmetric event risks. Coverage needs to include 100% payouts and needs to be sourced from liquidity pools backstopped by stringent solvency standards.
UNION is pleased to present crypto’s CDS analog — Crypto Default Swaps.
What Are Credit Default Swaps?
Credit default swaps (CDS) are used for any type of event risk that is hard to predict given limited observable data and imperfect correlation. For example, CDS can offset risk for rare events, such as an unexpected default of a sovereign nation’s debt triggering mass liquidations of funds leveraged long in associated bond markets. Or when formerly hidden, rampant fraud hits the mainstream headlines.
In most cases, however, CDS are primarily deployed for modeling the chance of a corporation filing bankruptcy or similar corporate default event. This is accomplished by using a Poisson process to predict the probability of scenarios based on counting the occurrences of specific event types that occur at a measurable rate but happen erratically over time.
More succinctly, this means modeling outcomes that incorporate both high occurrence events (such as people taking elevators) and low occurrence events — like the outbreak of wars.
Applied to a corporation, this could mean examining the probability of its cashflow from a specific product nosediving significantly below a commonly accepted deviation in a given year, quantifying it, and issuing an instrument (i.e., CDS) to offset that event’s risk of triggering bankruptcy.
A CDS is issued over a term period (e.g., 5 years) where the buyer pays a premium to the seller. Premiums are a function of risk, so the higher the chance of the exogenous downside event happening (e.g., some factor that leads to bankruptcy) paired with the lower the recovery amount of capital after the event’s occurrence — the higher the premium.
CDS models equate the value of two cashflows given the probability of default over the life of protection:
- The cashflow of premiums paid over the life (until maturity or event) of protection (called premium leg).
- The value of the amount of protection bought should an event occur (called protection leg).
In other words, the probability adjusted value of the premium leg and the protection leg at any point in time during the lifetime of the contract is equal.
Applying CDS to Crypto — UNION’s Crypto Default Swaps
Applied to crypto, CDS modeling is excellent for configuring the event risk of exploits of smart contract bugs, oracle manipulation, rug pulls, and more. Crypto default swaps (CDS) are paramount because of two constraints within crypto:
- Despite an abundance of economic/financial data afforded by public blockchains, observing the rates of occurrence — for example, the frequency of oracle-manipulation exploits that led to draining liquidity pools over a given time — is limited by DeFi’s very brief history. Even if there were 200 exploits observed, that number is still statistically insignificant.
- We can’t observe other forecasting indicators — a problem compounded by the tendency of new attack vectors to persistently arise in a highly complex design space.
A CDS, however, would enable us to adjust the risk probability of projects up or down based on macro-entangled probability. For example, smart contracts relying on oracles not resistant to flash-loan exploits would have a higher probability of exploitation — an ingredient of risk analysis eschewed with most current iterations of smart contract insurance pool coverage.
UNION’s CDS approach implements a model where the buyer premium is paid 100% upfront and payout is always 100% of cover bought, should an event be triggered.
Premium paid Upfront
The protection premium is paid 100% upfront to the seller, not periodically over the contract’s term. The reasoning behind this is two-fold:
- crypto’s significantly higher risk profile (volatility, novelty, etc.) compared to TradFi,
- shorter terms of protection are clearly favored in DeFi, such as 3-months or less.
As markets mature, we can build out a crypto default curve, offering longer maturities to market participants just like what exists within the CDS of Tradfi today. For example, 5-year protection premiums that are usually higher than 4-year protection contracts.
100% Payout of Coverage
Payout coverage in the case of an event trigger is also 100%. Partial payouts of claims, as seen on platforms like Nexus Mutual, are not part of UNION’s CDS model because it affords buyers the most peace of mind and avoids cumbersome governance coordination. The trade-off is that CDS premiums without partial payouts will be slightly higher — an exchange that we believe is a net positive for appealing to a broader user set. CDS buyers also do not need to be directly exposed to the project they’re underwriting, meaning professionals can arbitrage pricing disparities based on examined risk and contribute to a more efficient market.
Finally, similar to C-OP, liquidity for CDS are sourced from UNION protection pools circumscribed by our MCR/SCR thresholds that adapt to current market conditions. Moreover, once capital inflows of derivatives like CDS increase, we can more safely calibrate the Poisson hazard rate up/down to reflect dynamic views of the event’s occurrence.
The crypto default swap is a compelling derivative. In an industry mired in unique asymmetric risks that arise out of rapid prototyping and the decentralized environment of public blockchains, offering DeFi users the ability to hedge downside event exposure with a derivative highly popular in TradFi is another major step forward for DeFi’s protection market.
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- UNION is not an insurance company and UNION does not sell policies of insurance.
- UNION is not an issuer of CDOs.
- We are in rapid development phase, and the screens may or may not look like these in final product. Some of the numbers shown are placeholders.