Why Nexus Mutual poses a challenge from a risk management standpoint?

One of the greatest breakthroughs in cryptocurrency is the innovation of decentralised finance (DeFi). In short, DeFi consist of decentralised alternatives to traditional financial services and products. While many applications surrounding the DeFi ecosystem have garnered much appreciation over the past four years, the importance of decentralised insurance has gone largely unnoticed. Drawing influence from traditional markets, insurance is one of the largest segments within financial services. In crypto, decentralised insurance is still heavenly underdeveloped in terms of product market fit and market capitalisation. As such, I have developed a keen interest in applications of decentralised insurance, such as Nexus Mutual. For the purpose of this article, I will be focusing on the problems associated with nexus mutual. In particular, I will focus on a fundamental flaw within nexus mutual’s token pricing model and equally important; the serious implications this could have on the network.

Do we need insurance?

Before we begin, I think it is important to address the elephant in the room: Do we need decentralised insurance? To put it simply, yes.

Risk is all around us. From your health, to the car you drive, to the house you live in, everything has an associated level of risk. Naturally, with risk comes the need for insurance. Reason being, insurance is a way to decrease the economic cost of a liability should it occur. Within crypto, there have been numerous incidences where users have lost money due to bugs or hacks in smart contracts. The most prominent example was the DAO exploit, where $70 million worth of Ethereum (ETH) was stolen. A smart contract, for those of you who aren’t familiar, is a self-executing computer program that operates on the blockchain. In 2016, a hacker found a loophole in the smart contract code that allowed him to continuously withdraw funds from the DAO before the smart contract could update its balance to zero. Since then, re-entrancy attacks have decreased in frequency as a result of better developer education and coding practises. That being said, DeFi protocols are seeing a growing number of attacks using flash loans. Before mass adoption becomes reality, there is a pressing need for crypto native insurance protocols to effectively protect users against loss or theft of cryptocurrencies.

So, what is decentralised Insurance?

The best way to understand decentralised insurance is to consider how traditional insurance works. In short, insurance carriers receive income from premiums paid by individuals for insurance coverage. To clarify, a premium is the sum amount of money you pay, usually on a monthly basis for your insurance cover. Since insurance companies have a large number of clients, they pool their clients’ money to cover a particular risk, in which they only give money to individuals who bear a financial cost based on the particular risk.

With decentralised insurance, ‘pooled money’ for a common risk is not placed in the hands of insurance companies. Instead, decentralised insurance protocols replaces insurance companies with effective transparent computer programs, which allows for better efficiency and easier participation.

Nexus Mutual

For the uninitiated, nexus mutual is an alternative risk sharing platform that helps users cover against smart contract risk. Drawing inspiration from how insurance started thousands of years ago, nexus mutual builds upon the fundamentals of decentralised insurance by providing a way for users to come together as a community and share risk, without going through an insurance provider. By doing so, each user becomes a member of the mutual, owns the funds, in which they can decide how it is used. Memberships rights in the mutual is represented by the nexus mutual native token (NXM), which acts an “internal incentive mechanism to bind the mutual together”. Focusing on nexus mutual’s business model, it leverages a bonding curve to determine NXM’s price. In essence, the more capital locked in the mutual, the higher the price of NXM, in which members may redeem their NXM for ETH. Conversely, the less capital locked in the mutual, the lower the price of NXM.

NXM’s pricing model problem

On the surface, nexus mutual looks like the best practise standard for smart contract protection. That being said, there is a fundamental flaw within nexus mutual’s token pricing model. According to nexus mutual’s white paper, the formular for calculating the nexus mutual token price is as follows:

For clarification, MCR ETH refers to the minimum capital required to support existing covers. MCR%, on the other hand, refers to the ratio of capital pool funds to the minimum capital requirement. Lastly, ‘A’ and ‘C’ are fixed constants calibrated at launch. In essence, the price of the NXM token depends on the amount of capital inside the pool. For the purpose of understanding the issue at hand, I want to focus on the MCR and MCR%.

To be perfectly clear, the MCR ETH never decreases in value. In fact, the mutual increases by 1% per day if the mutual has excess capital. In this context, ‘excess capital’ refers to the total funds being over 130% of the MCR. At first, I thought this would mean the 130% MCR% would acts as a benchmark for the Nexus mutual token, making it a safe entry point. However, say a liquidation crunch is on the horizon, in which causes the MCR% to drop below 130%, it is plausible to believe early NXM holders, who have accumulated large amounts of profits, would exit their positions and exchange their NXM tokens for ETH. To a degree, that is what exactly happened.

Judging from the graph above, you can see a gradual but sharp decreases in the MCR%. The decrease in the MCR% can be attributed to people burning their NXM token and leaving the network. The reason why it takes several months for the MCR% to drop to around 100% is because when a member of the mutual submits an un-staking request, it takes 90 days for the locked NXM tokens to be burned.

Drawing your attention to graph below, on the 30th of August 2020, there was a spike of around ($71) 0.068 ETH.

90 days later, on the 28th of November, the price fell to ($20.59) 0.020 ETH — a 29% drop in price. This price drop can be attributed to people selling their token or un-staking at $71, in which it takes 90 days for them to exchange their NXM for ETH.

Wait, there is more

In my humble opinion, the implications NXM’s pricing model could have on the network and its community is very severe. Again, drawing attention to NXM’s whitepaper, “if the capital pool has sufficient funds, redemptions of member tokens in exchange for ETH is permitted”. This begs the question: how much money is required for the capital pool to have sufficient funds?

Well, according to the whitepaper, for the capital pool to have sufficient funds, the MCR% needs to be above 100%. However, if the MCR% falls below 100%, redemptions are capped per transactions. In other words, users cannot redeem their NXM for ETH as long as the MCR% is below 100%.

At the time of writing this, the MCR% is 100.01 and this may not have as big of a detrimental impact as I have quite imagined. Nonetheless, NXM’s price model poses a problem from a risk management standpoint. In an attempt to solve this problem, I would suggest decreasing the lock up period from 90 to 30 days. Despite this problem, I am incredibly interested in knowing of any changes and improvements the team make to the network. Overall, I strongly believe decentralised insurance will play a critical role in crypto’s narrative, and I look forward to seeing the innovation that emanates from the decentralised insurance space.