Why the 'Pass-Through' Insurance Model for Stablecoins is a Mirage

The combined market cap of major stablecoins exceeds $150B. No on-chain insurance protocol holds even 1% of that in liquid reserves. This creates a systemic liquidity mirage where advertised coverage is mathematically impossible to honor during a black swan event.

• Capital Inefficiency: Locking $1 to insure $1 defeats the purpose of fractional reserve banking, the core innovation of finance.
• Adverse Selection: Only the riskiest, most volatile assets would seek coverage, guaranteeing pool insolvency.

Successful models like Nexus Mutual avoid the pass-through trap by insuring smart contract failure, not asset price. They use staking-based capital pools and risk assessment to set premiums, creating a sustainable market.

• Capital Efficiency: A $1 capital stake can back $10+ in coverage based on risk parameters.
• Clear Scope: Limits liability to a verifiable, binary event (code bug), not an infinite price oracle failure.

The true 'insurance' for stablecoins is the liquidity and composability of DeFi itself. Protocols like MakerDAO, Aave, and Compound create resilience through over-collateralization and liquidations.

• Dynamic Safety: $20B+ in excess collateral backs the DAI ecosystem, a buffer no insurance pool can match.
• Market Resolution: Price de-pegs are arbitraged away by Curve/Uniswap LPs, not claim adjusters.

Issuers claim assets are held in a bankruptcy-remote Special Purpose Vehicle (SPV). In practice, courts often consolidate SPV assets with the bankrupt estate, as seen in Celsius and FTX. The legal distinction is a pleading, not a guarantee.

• Key Risk: SPV status is a legal argument, not a physical firewall.
• Key Precedent: Celsius's 'Earn' accounts were ruled to be unsecured loans, not custodial assets.

So-called 'pass-through' insurance does not make the holder the policy beneficiary. The policy is an asset of the bankrupt custodian. Payouts go to the estate, not directly to users, defeating the entire purpose.

• Key Risk: Insurance is a corporate asset, not a user asset.
• Key Reality: In bankruptcy, all corporate assets are frozen for equitable distribution to creditors.

Custody agreements often grant the custodian broad re-lending rights. This transforms 'custodied' assets into the custodian's general unsecured claims, vaporizing any pass-through protection. This was central to the BlockFi and Voyager collapses.

• Key Risk: Your 'custodied' stablecoin is likely a loan on a balance sheet.
• Key Consequence: In default, you become an unsecured creditor in line behind secured lenders.

Stablecoin issuers operate in a regulatory gray zone, avoiding bank charters to escape stringent capital and custody rules. This creates a systemic fragility where no federal deposit insurance (FDIC) applies, and state money transmitter laws offer minimal asset protection.

• Key Risk: You are trading bank-level security for fintech promises.
• Key Gap: Absence of Regulation EE or SEC 15c3-3 protections standard in traditional finance.

Even with 'qualified custodians', the issuer retains control over movement instructions. A single compromised admin key or fraudulent transaction can drain the omnibus account, as nearly happened with Maple Finance's custodian. Insurance responds to proven theft, not operational failure.

• Key Risk: Custody is only as strong as the issuer's operational controls.
• Key Failure Mode: 'Pass-through' does not mean 'user-controlled'.

The only credible model is on-chain, verifiable 1:1 backing with assets held in a transparent, permissionless smart contract. This removes the custodian intermediary entirely. MakerDAO's PSM and fully collateralized decentralized stablecoins demonstrate this.

• Key Benefit: Assets are user-controlled or algorithmically locked.
• Key Proof: Real-time attestations and chain-resident proof-of-reserves.

Insured reserves are held with a single, centralized custodian like a bank. This creates a single point of failure and counterparty risk that is antithetical to crypto's ethos.\n- No On-Chain Proof: Insurance status is an opaque, off-chain promise.\n- Bank Run Vulnerability: In a crisis, the custodian's liquidity and the insurer's capacity become the bottleneck.

Insurance policies have strict limits, exclusions, and deductibles that render them useless during a systemic collapse—the exact scenario where they're needed.\n- Aggregate Caps: Policies often cap total coverage far below the stablecoin's market cap (e.g., $250M policy for a $10B+ token).\n- Exclusion Clauses: Insurers can deny claims for 'fraud' or 'market disruption', precisely the triggers for a de-peg.

Marketing a token as 'insured' invites heightened regulatory scrutiny from bodies like the SEC and FDIC. It frames the stablecoin as a securities offering or an unauthorized deposit-taking entity.\n- Misleading Marketing: Promises of insurance can be deemed deceptive under consumer protection laws.\n- Liability Amplification: In a failure, issuers face lawsuits not just for the loss, but for misrepresentation.

The crypto-native answer is verifiable, excessive collateralization on-chain, as pioneered by MakerDAO's DAI and Liquity's LUSD.\n- Transparent Reserves: Collateral ratios and assets are publicly auditable on-chain.\n- No Counterparty: Safety is derived from math and economic incentives, not a fallible third-party promise.

Users lulled into a false sense of security underestimate protocol risk, leading to capital concentration in inherently fragile systems. This creates systemic risk for the entire DeFi ecosystem built atop these stablecoins.\n- Complacency: Holders don't demand on-chain proof of reserves.\n- Contagion Vector: A failure of a 'insured' large-cap stablecoin would cascade through Aave, Compound, and Uniswap pools.

Future stability requires moving beyond the bank-IOU model. This means hybrid algorithmic designs (like Frax Finance) and diversified, verifiable reserve baskets that aren't reliant on a single insurer's balance sheet.\n- Dynamic Response: Algorithms adjust supply/demand in real-time to maintain peg.\n- Resilience Through Diversity: Backing with a mix of on-chain assets, treasuries, and strategic liquidity pools.

Pass-through models create a legal chasm between the on-chain token holder and the off-chain insurance policy. The token is not a direct claim; it's a promise from an intermediary.

• Enforceability is murky: Legal recourse requires suing the issuer, not the insurer.
• Jurisdictional nightmare: Which court governs a global, pseudonymous holder's claim?
• Speed kills: Traditional claims processes operate on a ~90-day cycle, incompatible with blockchain's 24/7 finality.

Proponents claim 1:1 backing with insurance is capital efficient. This ignores the fundamental risk mismatch and cost structure of traditional insurance.

• Premiums are prohibitive: Insuring against smart contract risk or custody failure costs 5-15% annually, destroying yield.
• Coverage caps apply: A $1B fund might only have $100M in aggregate coverage, making 1:1 backing for all holders impossible.
• Exclusions render it useless: Standard policies exclude 'protocol design flaws' and 'governance attacks'—the primary risks in DeFi.

The model centralizes critical failure points in the issuing entity, creating massive counterparty risk that insurance cannot solve.

• Issuer is the gatekeeper: All claims flow through them. If they are insolvent or malicious, the policy is worthless.
• Incentives misaligned: The issuer's goal is to minimize payouts; the holder's goal is to maximize recovery.
• See: Real-World Assets (RWA): This is not a new problem. Maple Finance and Centrifuge structures show that legal entity risk dominates, not asset risk.

The solution isn't gluing broken traditional finance to crypto. It's building native, capital-efficient risk markets.

• Over-collateralization: MakerDAO's DAI and Liquity's LUSD prove this works, with ~150% and 110% minimum collateral ratios, respectively.
• DeFi-native insurance: Nexus Mutual and Uno Re pool risk on-chain, with payouts in days, not months.
• Algorithmic stability: Models like Frax Finance's hybrid or Ethena's delta-neutral synthetics use crypto-native derivatives, not legal promises.