The Viability of FDIC and SIPC in DeFi

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In the US, gov­ern­ment-sup­port­ed orga­ni­za­tions pro­tect most tra­di­tion­al finance users by pro­vid­ing a sort of insur­ance on their deposits.

Among oth­er things, these orga­ni­za­tions pro­tect funds in reg­is­tered Insti­tu­tions from being lost through insol­ven­cy or due to bank failures.

Would a sim­i­lar orga­ni­za­tion work in DeFi?

What are the FDIC and SIPC?

The FDIC

The FDIC pro­tects deposits in banks up to cer­tain lim­its. If a bank becomes insol­vent, the FDIC will pre­serve or liq­ui­date its assets and begin to pay back customers.

The FDIC spends much of its bud­get on its Super­vi­sion and Con­sumer Pro­tec­tion pro­gram.

The pro­gram is con­cerned with the exam­i­na­tion of banks to assess their oper­at­ing con­di­tions, man­age­ment prac­tices and poli­cies, and com­pli­ance with applic­a­ble laws and regulations.

It also makes sure par­tic­i­pat­ing Amer­i­can com­mer­cial and sav­ings banks com­ply with con­sumer pro­tec­tion laws. About $1.1 bil­lion was spent on that pro­gram – thus, mak­ing up 58% of its spend­ing in 2021.

It spent $227 mil­lion on bank fail­ure res­o­lu­tion and receiver­ship man­age­ment of these resolved funds. Fur­ther, It spent $316 mil­lion to man­age its deposit insur­ance fund, and last­ly, $303 mil­lion was for so-called ‘cor­po­rate gen­er­al and admin­is­tra­tive expenditures.’

That makes a total of $1.9 bil­lion in FDIC oper­at­ing expen­di­tures. A more detailed view of their expen­di­tures in 2021 can be found on their annu­al report here.

The SIPC

The SIPC pro­tects user hold­ings in bro­ker-deal­ers. If a bro­ker-deal­er los­es your secu­ri­ties through insol­ven­cy, the SIPC will step in to liq­ui­date their assets and bring legal action against any­one nec­es­sary to return as many funds as possible.

Both of these orga­ni­za­tions func­tion well to pro­tect con­sumers against loss in tra­di­tion­al finance – but they’re tai­lored for that purpose.

Apart from being able to raise funds through charg­ing an assess­ment rate, which acts like a mem­ber­ship fee or insur­ance cost for insti­tu­tions, the major­i­ty of their func­tion­al­i­ty comes from the abil­i­ty to liq­ui­date assets and take legal action against respon­si­ble parties.

This may not be like­ly or even pos­si­ble with DeFi.

Could this mod­el work in DeFi

DeFi hacks – espe­cial­ly since last year – are not only more preva­lent and more cost­ly – in terms of per­cent­age of the indus­try. They are also less like­ly to result in a return of stolen funds.

The most effec­tive method to make up for lost funds from users in DeFi is not lit­i­ga­tion. It’s repay­ing users with funds from the organization.

While the SIPC does this at times, it is often not need­ed since most of the funds are recovered.

The SIPC’s Board of Direc­tors decid­ed that 2022’s assess­ment rate will be 0.0015% of the gross rev­enue of the mem­ber invest­ment firms.

Sim­i­lar­ly, small num­bers apply to the FDIC, where estab­lished insti­tu­tions with more than five years of insur­ance under their belt pay between 0.015% to 0.4% of revenue.

DeFi hacks ver­sus mem­ber­ship fees

Hack­ers got hold of about 0.25% of DeFi TVL – not rev­enue – in rel­a­tive­ly safe pro­to­cols last year.

Because we can­not rely on recov­er­ing any of these funds, we must assume that the mem­ber­ship fee would need to be big enough to pay out these loss­es directly.

Fur­ther­more, lim­it­ing these loss­es to a max­i­mum dol­lar amount can­not be trust­ed to low­er pay­out require­ments because it’s triv­ial to split invest­ments between addresses.

This means, for exam­ple, that a pro­to­col like Mak­er with a TVL of $7.9 bil­lion would need to pay about $20 mil­lion per year for its mem­ber­ship fee.

That is if we assume that 0.25% will stay a con­stant risk per­cent­age for rel­a­tive­ly safe pro­to­cols, exclud­ing oper­a­tional costs.

Uniswap, which makes no rev­enue from trades, would need to pay about $15 mil­lion per year, accord­ing to the same estimation.

While these are very rough esti­mates, it’s clear that these mem­ber­ship fees are not sus­tain­able for many DeFi protocols.

Why DeFi is attrac­tive to hackers

Accord­ing to Token Ter­mi­nal, DeFi pro­to­cols and their blockchains gen­er­at­ed over $19 bil­lion in rev­enue in the last 365 days as of August 31, 2022.

Some of these prof­its go to the founders and devel­op­ers. Some get redis­trib­uted to the users through rev­enue-shar­ing tokens. Often, smart con­tracts make rev­enue accu­mu­late in treasuries.

There are many ways lots of val­ue can flow with­in and between those trans­par­ent blockchains and smart contracts.

So, it is no sur­prise that mali­cious actors like hack­ers or scam­mers are look­ing for ways to get their hands on some of those inter­net tokens.

DeFi ver­sus TradFi

Why is there no such sys­tem in DeFi already? Let’s recap.

• Hacked assets are hard to recu­per­ate in DeFi.
• Hacked amounts in DeFi are so big that even tak­ing a per­cent­age of TVL instead of rev­enue wouldn’t be sus­tain­able to cov­er lost amounts.

It points out that a sys­tem that would try to cov­er the entire­ty of DeFi pro­to­cols the same way the FDIC and SIPC do wouldn’t be sus­tain­able. We can­not rely on or be fund­ed by DeFi’s TVL – not to men­tion their revenue.

We saw that DeFi pro­to­cols’ rev­enues aren’t able to counter loss­es such as those from May 2021 to May 2022 (2.56%).

Even their TVL wouldn’t be suf­fi­cient to sus­tain­ably bear the cost of insur­ance with giv­en hacked amounts, espe­cial­ly in cur­rent mar­ket conditions.

Why may that be?

Audit­ed code ver­sus exploits

One prob­lem our research uncov­ered was that over 70% of the hacked pro­to­cols we exam­ined had no audits that incor­po­rat­ed the exploit­ed part of the code.

Besides, all oth­er pro­to­cols were audit­ed by only a small num­ber of audit­ing firms or even only inter­nal­ly by the DeFi pro­to­col itself.

How­ev­er, we can­not con­clude that these well-known audit­ing firms are incom­pe­tent or unreliable.

They typ­i­cal­ly also audit­ed most of the unhacked part of the DeFi ecosys­tem, which could explain their over­rep­re­sen­ta­tion in our data.

But ulti­mate­ly, we can still say that there is a need for over­sight of how audit­ing firms oper­ate. This is to ensure thor­ough audits of the code of DeFi’s crit­i­cal infrastructure.

Audits do miss exploits fair­ly often or just do not audit for all pre­vi­ous­ly used attack vectors.

A poten­tial solution

A poten­tial solu­tion would be the cre­ation of a DIPS (DeFi investors pro­tec­tion sys­tem). This sys­tem should ensure investors and their deposits from loss­es of fail­ing pro­to­cols and hacks.

It should do so by assist­ing in the super­vi­sion and review­ing the rig­or­ous­ness of par­tic­i­pat­ing pro­to­cols’ audits. It can also poten­tial­ly help with asset recov­ery efforts and poten­tial­ly much more.

DeFi pro­to­cols should only be able to join the DIPS if they con­tin­u­ous­ly go through the over­sight of trust­ed, bat­tle-test­ed and – sta­tis­ti­cal­ly speak­ing – most suc­cess­ful auditors.

By doing so, the DIPS could give seals of approval to DeFi pro­to­cols. Those sig­nal users that their invest­ments are with DeFi pro­to­cols that have been rig­or­ous­ly test­ed and audited.

Con­clu­sion

Look­ing back at our num­bers, this has the poten­tial to decrease the cur­rent­ly mas­sive amounts hacked drastically.

The idea of a DIPS that relies on DeFi’s TVL – or even its rev­enues to cov­er hacks under its umbrel­la –wouldn’t seem far-fetched anymore.

Let’s cov­er every dol­lar in DeFi with native blockchain solu­tions – not repur­posed Trad­Fi solutions.

Dominik Predi­ger is a Web 3.0 devel­op­er at Ease.org. He’s a busi­ness infor­mat­ics stu­dent with a focus on explor­ing the blockchain and learn­ing about smart con­tract security.

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