Delphi Daily

Full Disclosure: Delphi Ventures holds NXM.

For today’s Delphi Daily, we’re releasing a Research Note we sent to our Institutional clients on NXM yesterday. We hope you enjoy this preview – and please don’t hesitate to reach out if you have any questions about our premium subscriptions.

This is part of a series of posts we’ll be releasing dissecting Nexus Mutual further for our members in the coming months. If you haven’t already, be sure to check out our full report on Nexus Mutual here.

For convenience, we’ve also included a video walkthrough of this post. Enjoy!

The pace of innovation + funding status of many projects in DeFi makes fully auditing every line of code prior to deployment often unfeasible. At the same time, token-supplemented lending yields drive up the opportunity cost of idle capital. Reducing the dependency on thorough audits before comfortably deploying capital is what makes Insurance a highly symbiotic pillar of DeFi. When you’re able to hedge that risk for a negligible portion of the yield you’re going to receive, it’s a home run.

Projects will often use their supply side to incentivize behaviours that support an environment where demand for their product can grow. Nexus is dealing with the opposite. It has immediate product market fit, evidenced by growth in coverage and how quickly excess capacity for cover is usually purchased.

Even with all the recent growth in cover, the target market is still largely unaddressed.

As a result, there is currently a focus on growing capacity. That’s not to say there aren’t initiatives in place to improve demand, but we’ll touch on those in a bit. Max capacity for a single contract is the lower of 20% of MCR or the total NXM staked to that contract. This is why MCR expansion was accelerated to get to 100k Eth.

I’ll describe two of the implementations the team is working on to help scale capacity for insurance cover.

The shorter-term solution is shield mining. This will enable a project to reward NXM holders with their token for staking (adding capacity) to their contract. It’s a very low cost, value accretive proposition for projects to help grow their TVL by increasing the capacity for their users to hedge out smart contract risk.

This is a huge boon for NXM as it can materially increase yields for stakers at no extra cost to the mutual or insurance purchasers. This will likely lead to higher engagement from existing holders and an inflow of capital from new users looking to take advantage of these incentives. Nexus is currently working with five yet to be announced projects to implement it, and I imagine others will follow suit as it’s a highly replicable/turnkey model.

The slightly longer term solution is a transition from an MCR that’s programmatically grown to one that’s a function of cover. This will be massive going forward because it allows the project to scale with demand for cover.

To understand why this is significant, it’s important to keep in mind how Nexus really begins to take off, and the road that’s necessary to get to that point. As a mutual, its long term source of growth is fees. 90% of every cover goes into the mutual, with 50% of the value of the cover resulting in NXM being issued to reward stakers. The objective is to grow those fees with a focus on efficiency and maximizing reward/risk. A key ingredient here is scale.

The current Capital Pool/MCR dynamic can be thought of as the capacity bootstrapping phase. The structured increase in MCR (which dictates capacity) and the resulting formulaic pricing mechanism helps drive a combination of speculative and functional capital into the pool.

With some capital in the pool, the recent adjustment to enable pooled staking was a strong step towards increased capital efficiency. This allowed users to stake the same NXM to 10 different contracts simultaneously, while still adhering to existing capacity rules that protect the network from concentrated exposures that invite solvency risk. What this adjustment really took advantage of was the idiosyncrasies of smart contract risk. Smart contract bugs are typically smart contract specific, meaning a bug in the smart contract of one project doesn’t really increase the probability of there being a bug in the smart contract of another. They’re more or less independent.

It would be naive to think these smart contracts operate in silos, particularly with the growth of composability, but the knock-on effects are often in the form of economic risk rather than smart contract risk. The Nexus team are actually addressing these types of scenarios through the creation of Stacked Risk Cover, as seen in the road map below. It allows a user to have coverage beyond just smart contract risk, with the inclusion of factors like economic incentive or governance failure. It would be contained by the need for proof of losses.

Pooled staking has some positive knock-on effects as well. There is now enough NXM staked to basically every major individual contract to allow users to typically purchase a full year’s worth of cover for 1.3% of the notional exposure. I believe that cost might be a bit too cheap, particularly when compared to the yield expectations of cover buyers, but that’s why the governance mechanism exists.This also means shield mining will be much more effective as well. If a user can participate in 10 different shield mining programs, the expenditure from each incentive provider can also be much smaller, making these programs considerably more sustainable.

The longer term adjustment to scale capacity is a bit of a reversal in structure, going from MCR dictating cover capacity to cover demand dictating MCR. This is done through a gearing factor, which can be thought of as the ratio of active cover to MCR. The difference here being that active cover in the numerator is the driving factor, and MCR just grows in proportion based on the assigned gearing factor. A side benefit of the gearing factor is that it’s a much simpler on-chain approach for calculating MCR relative to the existing off-chain calc.

The goal is to have the gearing factor naturally incorporated by having the factor based MCR catch up to the current version of MCR, while the current version continues to grow at 1% per day. The logic for selecting a factor is picking one that’s not too high since it would cause MCR to be very low, making it difficult for factor based MCR to drive the MCR calc, and one that’s not too low where it will immediately start driving MCR up. The goal is a gradual transition.

This transition also incentivizes the growth of a variety of cover types in order to grow MCR, which helps reduce mutual risk. The currently proposed idea by Nexus Founder Hugh Karp is that we start the factor at 4 and eventually make our way up to 10, but these values are yet to be set in stone. Using a factor of 4 as an example, that means active covers would have to be 4x current MCR in order for factor MCR to catch up. Since an individual contract is limited to 20% of MCR, that implies you’d need 20 contracts at the global capacity limit. Proposal 88 that was passed August 7th should make achieving this considerably easier by reducing the low risk limit (making it cheaper to get insurance) and doubling net stake for existing contracts (making capacity more readily available).

In reality, the effects of a gearing factor are more long-term in nature, and this is where I think the mutual can really thrive. Rather than assessing the factor on an absolute basis, let’s consider what happens when you increase it. When it goes up, that means total active cover is going up while MCR remains flat. Since MCR dictates the quantity that can be covered in one specific contract, it means the mutual is offering more overall cover while it’s reducing its concentration to any specific contract. Growth through diversification and horizontal scaling is a much more sustainable and efficient way to scale the mutual.

The other benefit boils down to what we discussed initially, the long term source of growth for a mutual is from the fees that flow to the capital pool. Increasing the factor means you’re able to offer more coverage for the same level of MCR, which translates to more fees for the same level of MCR. All else held constant, a higher gearing factor would lead to a higher MCR % since the mutual is able to accrue more fees and grow its capital pool faster. I present some examples of the structure of 3 hypothetical mutuals below, with gearing factors of 4, 6, and 10. Keep in mind that the gearing factor manually gradually increases as the sources of cover diversify over time.

The impact of fees on the mutual will primarily be a function of MCR% and the Gearing Factor. Increasing MCR % will reduce their impact since the Capital Pool will be larger relative to the same amount of fees. Increasing the Gearing Factor will increase the impact since you’re able to offer more cover on the same amount of MCR. Below we show a chart that shows the growth in the Capital Pool purely sourced from fees.

Assessing the impact on price is helpful when trying to understand why a gearing factor approach could keep MCR% elevated. The values below show the 1 year impact on price, holding everything else constant, from fees that grow the capital pool from cover purchases. This is the expected price growth in an environment where no new capital enters the pool. This really shows how the mutual can accelerate its growth as it scales. The introduction of new types of insurance will allow the mutual to reduce risk and make it more capital efficient over time.

On the demand side, product market fit is and always will be a primary driver, but accessibility is also important. That’s why the recent integration with Yearn will be huge. The initial process was a bit restrictive as it required purchasers of insurance to go through KYC. Now Yearn enables users to purchase Nexus Mutual underwritten insurance through their platform without having to go through a KYC process.

DeFi TVL is rapidly growing, and only about 70 bps of it is currently insured.  We’re excited to be supporting a team that is filling this void.

Watch the video walkthrough we put together for our NXM report and model here.

Yan Liberman, CFA, CAIA Calendar
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