Bybit Introduced Mutual Insurance: What is It and Why is It Important?

For many years, cryptocurrency has been referred to as the “wild west” of the finance world. In part, this moniker is due to crypto’s unregulated status, but it’s not only that. Bitcoin’s famous volatility, the pioneering nature of the cyberpunk movement, and the high-stakes game of trading and investing in digital currencies are all somehow reminiscent of the American frontier.

The risk of losses through volatility is one thing, but there are other significant risks involved in crypto’s wild west. Hackers and malicious actors hover around exchanges and smart contracts, looking for vulnerabilities. This year, the nascent decentralized finance space has been hit several times. Most recently, a hacker lifted over $450,000 from token pools on automated market-making protocol, Balancer.

Just as the wild west was eventually tamed, there are signs that the crypto sector is starting to advance in terms of offsetting some of these risks. One such area is mutual insurance. Over the last year or so, a few different types of mutual insurance have popped up in the crypto space, offering loss protection in various scenarios.

Mutual Insurance as a Hedge Against Price Volatility

With the notorious volatility of crypto, trading the spot markets can be risky enough. However, the last few years have seen an explosion in cryptocurrency derivatives, with open interest exceeding $5 billion in February this year, according to data aggregator Skew. Cryptocurrency futures exchanges typically offer the opportunity to trade at high leverage, usually around 100x. This magnifies the potential for gains, but the same applies to losses.

This year, Bybit launched its mutual insurance facility as a way for its users to hedge against the risk of losses in the event that the market moves against a trader’s position.

Insurance protection can be taken out against long or short positions, for periods ranging from 2 to 48 hours. Traders pay a premium to have their position covered by the insurance, with all premiums pooled into Bybit’s Mutual Insurance fund, which the company itself kickstarted with an initial payment of 200 BTC.

Premiums are priced in the same way as an options product, using the Black-Scholes model. The higher the leverage on the trade, the closer the liquidation price to the value of the entry point, and so the higher the insurance premium.

If a trader incurs losses on an insured position, the Mutual Insurance fund will pay out the value of their claim.

A partial or full liquidation will trigger an automatic payoff, or the trader can also choose to manually settle their insurance. The expiry of the cover duration also triggers a payoff.

Bybit’s Mutual Insurance feature functions in a very similar way to how traders use options to hedge against losses when trading futures with leverage. However, unlike options, which require more advanced knowledge and experience of how to trade derivatives products, Bybit’s mutual insurance is easy to use and understand.

Mutual Insurance Against Smart Contract Failure

Smart contracts are still a relatively new feature and are prone to vulnerabilities. Because Ethereum’s Solidity programming language is general-purpose and Turing-complete, it can be programmed for any eventuality. However, this flexibility also means that some eventualities can be unpredictable, and this feature is often exploited by malicious actors.

The most famous incident is the 2016 DAO hack, but the growth of the decentralized finance space is also attracting hackers eager to exploit code vulnerabilities and other attack vectors.

Nexus Mutual is a community-operated insurance fund that aims to provide protection to its users. The first product on the platform is smart contract cover, for any smart contract verified on Etherscan.

Users can obtain a quote for premiums based on the amount of cover they wish to purchase. In the event that there’s an unintended use of the code underlying an application in which they’ve invested, they can apply for a payout. Payouts are determined by the Nexus Mutual community.

Premiums and claims are denominated in the platform’s NXM tokens, which is also the governance token of the platform. Members stake NXM to support claims, or to show confidence in a particular smart contract’s security. If a claim is shown the be fraudulent, or a smart contract insecure, then the stakes are slashed, providing an incentive to ensure that risks and claims are assessed honestly.

Mutual insurance is still a relatively new field in the cryptocurrency space, and Bybit’s program and Nexus Mutual are still fledgling products. However, it seems likely that as digital assets move beyond the frontiers of their wild west beginnings, we will see other use cases start to emerge, providing better risk assurance for users.