That's the problem. That insurance is not possible within Bitcoin. In equities markets, shorting is possible because the broker can force the borrower to cover and return the borrowed security. The broker can in turn resort to another layer of force in legal recourse if the borrower doesn't have sufficient cash deposited with the broker.
In Bitcoin, no entity can ever compel another to spend bitcoins (to the protocol, anything like asset seizure or any other method of surrendering a bitcoin is spending.) So the short-seller can walk away and never cover a short position that went badly, and the lender never receives back his bitcoins. For Bitcoin shorting to exist requires a broker with some way of enforcing non-Bitcoin power over the short-seller, perhaps a deposit in a fiat currency or some other kind of collateral. It is possible for this to exist but not at all simple.
> That's the problem. That insurance is not possible within Bitcoin.
The solution involves the insurance companies understanding the risks involved, forcing Bitcoin companies to implement specific security measures designed to mitigate risk, and accepting the fact that they will have to pay out a certain percentage of trades. The premium charged for the insurance plus the deductible cost to make a claim reflects the risk of fraud + expected profit. This is a solved problem in the insurance industry already.
The only remaining question is which insurance company will put sufficient effort into understanding the risks so that they can issue a product to meet whatever market demand exists?
Hypothetically, the legal system could enforce Bitcoin contracts in this way, with legislation that a Bitcoin wallet can be seized under the threat of other penalties such as imprisonment. But until that happens, Bitcoin insurance and shorting can only exist as far as you trust the insurer or the lender trusts the shorter, because there is no ultimate avenue of forcible recourse.
Part of me suspects it's because a lot of people intend to sell their bitcoins as soon as the market shows a significant downturn, and so they don't want to lend their bitcoins in the first place.
Although given how large the percentage swings are right now, I have no idea what such a "significant downturn" would have to look like.
From what I understand shorting is just borrowing some bitcoins from someone, selling them now, buying them back and giving them back at the date agreed when borrowing them. If bitcoins are cheaper at that date you earned a profit. If they are more expensive you suffer a loss.
The only problem I see is that I wouldn't trust my bitcoins to anyone. But if I had some sort of insurance that I'll get my bitcoins back (also the fee) then I'd gladly borrow them to someone since I don't like the risk of selling them myself because I'm afraid they might never get cheaper and I won't be able to buy them back.