July 20, 2022
The cryptocurrency market has been on a roller-coaster ride in 2022 — with the value of bitcoin falling 70 percent since its peak in November 2021. But, despite the uncertainty hitting the market, it is nonetheless growing rapidly. One recent forecast suggests the value of the market could grow from $1.78 billion in 2021 to $32.42 billion in 2027.
Also growing at a rapid pace is the metaverse — a virtual simulation of the real (or imagined) world. In the not-too-distant future, as businesses and commerce move into the metaverse, cryptocurrencies will play an essential role in the virtual marketplace.
Still, there are risks associated with cryptocurrencies, and it’s essential to address them before “working” and “living” in the metaverse becomes commonplace. As can be seen in the recent turmoil hitting the cryptocurrency markets, a variety of issues around infrastructure must be resolved, including creating insurance products for some of the risks associated with digital assets. It’s also necessary to bring together the technical talent required to effectively address those risks.
“The state of the current crypto market is in consolidation and product development,” says Benjamin Peach, director of digital asset innovation and strategy at Aon Growth Ventures. “There’s so much more that needs to be done. Technological and infrastructural developments are still a way off from where it needs to be.”
“At the same time, the metaverse is being taken more seriously,” Peach says. “If we’re all jumping into the metaverse without the necessary infrastructure layers already in place, there will be a serious risk of significant losses for individuals and businesses operating in the realm.”
Businesses in the cryptocurrency industry largely fall into one of two groups: CeFi — centralized financial institutions, or DeFi — decentralized service providers or self-proclaimed ‘crypto’ institutions. Each has their own set of risks, though CeFi risks skew nearer toward traditional banks and financial exchanges, who often have to adhere to national financial regulations.
CeFi service providers are licensed and stringently regulated, and are most often legally liable for customer assets. DeFi service providers are not, often serving only as a technology service to facilitate automated cryptocurrency transactions. They perform financial services on behalf of investors capitalizing smart contracts and protocols.
“The main risks in the DeFi arena are protocol and smart contract failure, such as hacks, breaches or faults in the open-source code that can lead to business interruption and direct financial loss,” says Peach. “We’re seeing this a lot. The amount of DeFi hacks that have occurred over the last few years has just grown exponentially each year. And at the moment, there are no regulated or rated insurers providing solutions for truly decentralized DeFi companies.”
From the insurance market’s perspective, the DeFi service providers don’t have care, custody and control over deposited assets, Peach says. “If you think about a traditional bank, it’s easier to underwrite crime coverage as you know where customer assets are being held at all times. Banks can often retrieve stolen money. But once you lose your crypto to another wallet, it’s pretty much game over in recovering your assets.”
Bridging a Skills Gap
Beyond a lack of experience with an emerging market, insurers may not currently have the technical skills necessary to provide coverage in the blockchain-based cryptocurrency environment.
“You need technical know-how to be able to audit codes and review any type of code that is launched onto the blockchain,” Peach says.
One potential knowledge gap could concern cryptocurrency smart contracts. These are like any contract in that they establish the terms of an agreement, but those conditions are stored and defined as code on a blockchain. Because of the near impossibility of amending smart contracts once issued onto the blockchain, underwriting smart contract risks will require underwriters to utilize either in-house or third party knowledge to audit the code for modelling and pricing — capabilities that are lacking in many of today’s insurance underwriters.
As a result, interest in providing capacity for the underwriting of DeFi risks is currently coming mostly from institutions like hedge funds and private equity houses. They have the technical expertise to effectively conduct due diligence on the underlying code and stability of smart contracts.
There also will likely need to be regulatory changes to enable insurers to deal in digital currencies, Peach says. “The whole payment ecosystem is changing,” he says. “Insuring these risks is merely a byproduct of the innovation that’s occurring in the global financial services sector.”
Gaining Knowledge Through Collaboration
In part to help meet that need for technical know-how, Aon recently begun a strategic alliance with Bank of New York Mellon Corporation.
The data and digital collaboration focuses on supporting investors’ environmental, social and governance (ESG) decisions, and on enhancing solutions in the areas of digital assets and data and analytics.
“The main issue we face as an insurance sector is finding enough capacity and technical underwriting capabilities,” says Peach. “BNY Mellon has a dedicated digital asset team which really understand the nuts and bolts of crypto risk. They also have innovative ideas on understanding where new capacity for risk transfer can come from.”
The collaboration also will provide opportunities for knowledge sharing and joint publications addressing cryptocurrency market risks and potential solutions.
The Metaverse Is Coming, Cryptocurrency Will Be Part of It
While there is hesitancy by governments and companies to embrace cryptocurrencies now, when the metaverse is to become a reality, mass-scale digital asset adoption will be the key in enabling individuals and organizations to transact in a new virtual economy. Understanding and addressing the emerging risks of tomorrow will allow the virtual world economy to flourish.
“We need more talent coming into this sector from ‘big tech’ and traditional financial institutions,” says Peach. “We need them to build the best risk management protocols and systems to adequately protect both consumer and corporation when playing in a decentralized world. We’re building a metaverse where we’re going to live, shop and transact. We must make sure we have the best possible foundations for it to be a success.”
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