Tidal Tech Series #1: Capital Leverage and Efficiency

Published in

Tidal Finance

4 min readApr 27, 2021

Background

With the release of Tidal approaching, the Tidal team has received many warm messages of support, as well as questions, from our early adopters. The community is eagerly awaiting release of our protocol on testnet.

To build a strong decentralized community, we believe a deeper insight into the platform should be developed. We have created a series of technical articles that is designed to help our community learn more about the inner workings of Tidal. Each article will focus on an important component of the platform, with examples, to educate our users, promote discussion and evolve from feedback.

Without further ado, let’s dive into the first article — one of the core principles behind Tidal’s design -capital leverage and efficiency .

Capital Leverage in Traditional Insurance

The way that traditional insurance companies utilize their capital reserve is through a high leverage approach. For example, Company A wants to sell health insurance to 100 people, and the maximum coverage for each person is $3,000, in case of sickness. The aggregate maximum coverage amount in this case would be $3,000 x 100 = $300,000. But does Company A need $300,000 in its reserve to backup the sold insurance? The answer is no, only a fraction of the total amount is required. This concept is also known as fractional reserves.

But what’s the actual required reserve capital for Company A? It is a relatively small fraction of the $300,000. In the real world this number depends on the regulatory policies guided by historical data and probabilistic calculations (done by insurance actuaries).For the sake of simplicity, let’s assume the 100 years of data shows us on average, 3 out of 100 people get sick during the covered period, Company A only needs $9,000 capital reserve, which is just enough to cover 3 people’s sickness event. And from $9,000 to $300,000, that’s a 33x leverage.

Why not use the same amount of reserve $300,000, to backup $300,000 amount of insurance? Well, it’s all about how to maximize capital efficiency, thus increasing profits as well as lowering the costs of insurance. Let’s say an affordable insurance cost is normally a small percentage of the maximum coverage. For example, let’s assume it costs $100 for a person to get $3,000 coverage in this case (~3%), the total revenue would be $100 x 100 = $10,000. Minus the potential loss of 3 people getting sick (payout $9,000), leaves $1,000 as profit to Company A. With the amount of capital it would have to have without leverage, $300,000, the return is pretty low at roughly ~ 0.3%. In the previous case, if Company A only holds $9,000 reserve, the return on capital becomes much more reasonable at ~11%.

DeFi Insurance Capital Efficiency

The same principle applies to DeFi insurance products. As of right now, the most popular use case is to cover smart contract vulnerabilities and hacks, due to the fact that over 100 million USD were lost in 2020 among various protocols out of 10 billion USD TVL.

Looking back, if 100 million USD could be used to protect all 10 billion USD, that’s a leverage of 100x. And even if the 10 billion covered amount pays a 2% insurance premium to get covered, that’s 200 million revenue, taking out the 100 million losses, still leaves a 100% return on the reserve capital. Of course such an example is over simplified based on one year’s historical data, but the concept of leverage is very much applicable here.

How to achieve such leverage to efficiently utilize reserve capital for insurance is at the core of Tidal’s design. The reserve capital should be used to cover multiple protocols simultaneously, to implement the concepts of leveraging up and diversifying risks.

On the other side, they don’t have to cover all protocols in the pool they select. They can decide what protocols and how many they would like to cover. Reserve providers can be conservative and select fewer protocols, by doing so they will reduce the risk they are taking but also will reduce the leverage and returns they can generate on their capital.

Reserve Providers can see the premium prices, utilization rate, and other relevant statistics to make all these decisions. It’s our goal to make the design of Tidal to be as transparent, and decentralized as possible, to act as an infrastructure level component for the growing DeFi landscape.

The next article in the series will be discussing how and why tidal balances reserve and purchase on a weekly basis, stay tuned!