Nexus Mutual
Evaluating NXM and decentralized insurance
As more and more blockchain companies continue to leverage autonomous technology through the advent of smart contracts, insurance will play a crucial role in the long-term stability and growth of the industry as a whole. In particular, companies such as MakerDAO and Compound Finance currently have over $400M of digital assets being stored in their smart contracts to date.
While communal trust remains a large proponent of the digital asset ecosystem at large, insurance solutions will be fundamentally necessary for investors and institutions to feel confident that there is some remedy in the event of a hack, bug or exit from the issuing entity.
For this week’s Token Tuesday, we’ll be taking a look at Nexus Mutual, an Ethereum-based protocol providing decentralized insurance through the use of their native token, NXM.
Here at Fitzner Blockchain, we believe that as smart contracts continue to accrue and store value (DeFi applications and DAOs being two primary examples), the need for capital to be insured will increase in parallel. With this being said, Nexus’ use of a bonding curve (described below) provides a strong incentive for early adopters engaging with popular smart contract systems today.
Background
Nexus Mutual is set up as a company limited by guarantee in the United Kingdom and will operate under a discretionary mutual structure. For those unfamiliar, a discretionary mutual structure means that all insurance claims are paid at the discretion of the Board (i.e. Nexus Mutual members). With this, NXM holders have the right to decide on whether or not they should pay out certain claims.
Currently, the team is around 8 members large led by Hugh Karp. Karp has over 15 years of experience in the insurance industry, including the role as CFO of UK Life Operations. Other notable team members include Board Member, Graeme Thurgood, who has 17 years of extensive experience launching mutuals in the UK as well as prominent Ethereum community member, Evan Van Ness.
The company has raised an undisclosed amount from blockchain-based venture capital firms such as Kenetic, KR1, MilliWatt and 1kx.
Token Overview
NXM tokens represent membership rights as well as a claim to the mutual’s capital. With this, NXM tokens can be used to purchase smart contract covers as well as participating in the ecosystem through claims assessment, risk assessment, and governance.
Unlike most ERC tokens where the price is determined by the open market, Nexus Mutual leverages a continuous token model (also known as a bonding curve) to determine the price of the token. In essence, the token price is driven by two main factors:
The amount of capital required to support the covers written (MCR)
The funding level of the mutual with respect to the minimum capital requirement (MCR%)
The minimum capital requirement (MCR) represents the minimum amount of funds required to pay all claims with 99.5% confidence. The MCR was set at launch for 7,000 ETH and increases gradually when more covers are purchased. As long as the MCR is above the minimum level, the token price will increase as new covers are purchased and decrease when covers expire.
The other price driver is MCR% which can be thought of as the overcollateralization ratio of the mutual. This is determined by the total amount of funds in the capital pool relative to the MCR. In the token model, MCR% is one of the short term price drivers whereas MCR is an indicator of long-term growth and tangible usage of the platform.
The token price can be calculated as follows:
Price= Token Price in Ether
MCRETH= The minimum amount of capital required to support existing covers in Ether. The minimum capital requirement (MCR) is calibrated to a 99.5% solvency level
MCR%= Ratio of capital pool funds to the MCR
A = Fixed constant, to be calibrated based on the prevailing Ether price at launch
C = Fixed constant to be calibrated based on the prevailing Ether price at launch
The NXM token has multiple use cases within the Nexus Mutual ecosystem. For the most part, it can be used for the following actions:
Purchasing a cover: Mutual members can purchase covers with NXM where 90% of the NXM is burned with the remaining 10% locked for the cover period plus an extended 35 days.
Stake for claims assessment: Members can participate in claims assessment by staking NXM tokens to earn an income.
Stake for Risk Assessment: Participating in assessing risk by staking NXM tokens to earn a commission
Redemption: If the capital pool has sufficient funds (above the MCR), members can redeem Ether in exchange for NXM and vice versa.
Token Supply
Given that Nexus Mutual uses a bonding curve, new token issuance occurs when capital is contributed to the mutual or through rewards for participating in the ecosystem. As such, the NXM token supply issuance can be broken down into these main areas:
Initial tokens = NXM set aside for founders and early contributors when the contract was deployed.
Purchased via Token price model = NXM created when purchased via the bonding curve.
Claims assessment rewards = NXM allocated as an incentive to perform claims assessment.
Risk assessment rewards = NXM allocated as an incentive for participating in risk assessment
Governance = NXM allocated as an incentive for participating in governance
Valuation*
Assumption 1: MCR
In 2019, we’ve seen the DeFi ecosystem explode. As of writing today, DeFi is reaching all-time highs of 3M ETH in total value locked (TVL). At current Ether prices, this is upwards of $500M in total value currently held in smart contracts. While we’ve seen large amounts of retail capital beginning to be locked in DeFi, most of the underlying smart contracts have only been live on main-net for less than a year.
Unfortunately, for the DeFi space to mature and realize the importance of smart contract insurance, we’ll likely need to see a large-scale hack where millions of investor funds are compromised. It’s likely inevitable. This event could happen tomorrow or in two years but until it occurs, we’ll likely see low insurance rates across the board. Despite over $500 million in total value locked, active cover amount in the Mutual is $680,000. This translates to 0.13% of TVL currently being insured. In other words, 99.87% of existing capital in DeFi is vulnerable in the instance of a smart contract hack.
Over the next few years, we’ll likely see gradual increases in insured capital throughout the DeFi ecosystem. With this, we’ve modeled potential growth rates for DeFi TVL and insurance capture rates (i.e. the percentage of TVL capital insured) through 2023.
Assumption 2: MCR%
The MCR% is a bit tougher to estimate as it essentially represents a degree of the FOMO factor in NXM. In other words, MCR% increases largely when users purchase NXM tokens without actually purchasing a cover for it. At minimum MCR% must be above 100% in order for investors to withdraw their funds. In the few short months that Nexus Mutual has been live, we’ve seen MCR% ranging anywhere from 100% - 150%.
With both the expected total value locked in DeFi and the potential insurance capture rate, we can model the price of NXM across a matrix of possible MCR% rates. Below is the price of NXM (in ETH) given the above capture rates and minimum capital requirements.
The NXM token is currently trading at 0.015/ETH and assuming that decentralized insurance becomes rather popular in the coming years, there’s a massive amount of upside for prospective investors looking to get into Nexus Mutual.
To view our model. feel free to visit this link below:
https://docs.google.com/spreadsheets/d/1Cda7eS680rjS6QXn997ajVSoqCNXfOIlg_mFQEOHsio/edit?usp=sharing
Drawbacks/Concerns
As it currently stands, Nexus Mutual only covers smart contracts based on Ethereum. While is definitely a strong starting point, the protocol will likely need to develop other policies to garner wider attention. With the current framework in mind, potential buyers are largely limited to sophisticated traders either (i) supplying large sums of capital or (ii) very technically familiar with DeFi and actively participating in a number of different services including margin trading or lending. As such, it remains unclear whether or not Nexus Mutual would be a preferred insurance solution for anything outside of niche digital asset uses.
Furthermore, the mutual cannot cover its own smart contract in the instance of a hack. This makes sense however, it would require separate insurance funds to cover the mutual and the team must be highly cautious in assuring that their smart contract(s) are audited and secure. With this, the mutual currently has some emergency features (i.e. centralization features) to protect users during the early stages. The list of emergency controls can be seen here. While these controls do provide a certain degree of peace of mind, they also strongly challenge the notion of “decentralization” posed by the project from a high level. However, this is fairly common practice in DeFi today and the team does plan on removing these features once the Mutual has been tested and battle-hardened.
Summary
As mentioned in our introduction, the gradual increase in value storing smart contracts combined with an increased number of policies bodes very well for NXM token holders. It’s our belief that DeFi services and DAOs will continue to lock capital into their systems, thus further increasing the demand for insurance from parties with a vested interest in their long-term success.
Moving forward, it’s exciting to consider the idea that protocols such as MakerDAO or Compound may bake insurance options directly into the CDP creation process, thus providing smaller barriers to entry and greater use of Nexus (or a similar product) at large.
We at Fitzner Blockchain are bullish on continuous token models and believe that Nexus Mutual is one of the few projects to have successfully deployed a token model that has seen a moderate amount of traction so far to date. In the future, we will be keeping an eye on other bonding-curve models along with decentralized insurance competitors looking to capture market share alongside Nexus Mutual.
*DISCLOSURE: The managing partners do not endorse or recommend any investment action in NXM. This document should not be regarded as investment advice, offering document, or as a recommendation regarding a course of action. The managing partners of Fitzner Blockchain own NXM. These views are those solely of the managing partners of Fitzner Blockchain Consulting and do not represent the views of the Nexus Mutual team.
Resources
https://medium.com/nexus-mutual/nexus-mutual-nxm-token-explainer-b468bc537543