Capital Scaling Next Steps

Governance Discussions Nexus Mutual Protocol Improvement Proposals
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This is a copy of a reply in the following thread to ensure it gets enough visibility.

At present the MCR Floor value is increasing by 1% every 4 hours. If enough capital keeps flowing in to keep the MCR% above 130% then the MCR Floor will reach 100,000 ETH in August sometime. At this point the MCR Floor Value will revert back to increasing once-per-day as decided in the previous governance action. This post is to start the discussion on what we should do next.

Stepping back for a moment on the MCR mechanics. The MCR is actually the larger of two values:

MCR = max [ MCR Floor, f(cover amount) ]

At the moment the MCR Floor value is dominating and the more complex risk capital calculation, f(cover amount), is not being used. Without diving into the details of the risk capital calculation it can be approximated as 1/6 x Active Cover Amount, or a gearing factor of 6x.

Longer term the goal is for the risk capital calculation to drive the MCR, the MCR Floor is really just a short term measure to scale capital up to a critical mass so we can meet demand for cover. At scale we want the capital requirements of the mutual to be specifically driven by cover outstanding.

So we have a balance to strike, we want enough capital for a critical mass to meet demand, but we don’t want excess capital, as this is inefficient and could lead to issues maintaining existing capital. Discouraging excess capital also allows greater opportunity for the token price to move into the exponential section of the token price curve.

On a closely related topic, I strongly believe we should replace the complex risk calculation (currently performed off-chain once per day) with a simple factor of Active Cover Amount. This will allow the calculation to be fully on-chain and decentralised as well as being much more robust.

A more complex risk capital calculation can then be run off-chain at any point (by anyone) and parameters can be updated via governance as and when required. NB: any parameter changes would be done in a gradual fashion over time to prevent any shocks to the token price.

In general the gearing factor should increase as the mutual grows and sells more diverse range of covers. As a reference point, at massive scale AIG has a factor of around 60x and I believe we should be aiming for a factor of around 10x once we have $150m of capital and multiple products, quite a bit of judgement/art involved here though.

Taking all this into consideration I believe once we hit 100,000 ETH we should move to a more capital efficient approach and look to have cover amount drive MCR sooner rather than later. Ideally within 6 months of reaching 100,000 ETH.

So my starting point for discussion is as follows:

  • Once MCR hits 100,000 ETH revert to 1 increment every 24 hours (no change from current)
  • Develop smart contract changes to replace the complex risk capital calculation with a simple factor approach
  • Start with a gearing factor of 4x to begin with, so 25% of active cover.

This means at an ETH price of $400 the mutual could sell $160m of cover before the MCR starts increasing again, with a maximum amount on any one system of $8m = 20% of MCR.

This implies to achieve faster growth (than 1% per day) the mutual must start diversifying and selling cover on a wider range of protocols. Which is fundamentally how insurance works best. The initial factor needs to be:

  • High enough so that it doesn’t drive the MCR calculation when first implemented (ie Cover Amount x factor is still below MCR Floor);
  • Low enough that it gives confidence claims can be paid (anything 6 or below should be fine for now); and
  • Low enough that within a reasonable time it does start driving the MCR calculation so the mutual starts growing. At 4x, $8m of cover on at least 20 different risks is required.

I’m most certainly open to debate on factors and approach, I thought it valuable to propose something tangible to initiate the discussion.

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I agree with the overall plan laid out by Hugh.

One thing that I want to emphasise is that higher gearing and being more capital efficiency means that the mutual makes more money.

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Thanks @Hugh for tabling this discussion. I think this the area where having your expertise and background (coupled with some from the advisory board) is incredibly valuable. Specifically about this 10x leverage at $150m of capital, appreciate it’s a bit more art than science, but I think it would be very helpful if you could share some of the thinking around it. My perspective is that we should also take the market size as an soft input here (and I am sensing that’s what you’ve done behind the scenes): given the capacity limits, what quatum of demand across multiple systems will the market support?

A more general point though, what kinds of new risks moving MCR to a f(cover) introduces, if any? Would volatility in active cover also translate in volatility in MCR?

As always, I think backing this up with some charts and scenarios would be super helfpul if you could.

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I’ll put together some charts soon.

what kinds of new risks moving MCR to a f(cover) introduces, if any? Would volatility in active cover also translate in volatility in MCR?

Movement in cover amounts would translate into movement in MCR (which is the main point) but it’s also one reason why we don’t want cover amounts driving MCR until we get more scale and numbers become less volatile.

Closely related is a wider point that correlations between risks should be a key input into the f(cover), the higher the correlation the less gearing the mutual can tolerate. Conversely, the higher the diversification the higher the gearing.

So coming back to your 10x question, this really comes down to how much diversification we think we can get to at a certain size. Which is hard to determine right now, hence the educated guesswork.

I’ll provide some graphs which translate diversification of risk among systems at various cover amounts with appropriate gearing factors, this should make it easier to gauge what factor is appropriate.

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Thanks @Hugh, that’s super helpful. It does feel like starting from a low gearing (like you suggested 4x maybe) would make a lot of sense. My feeling is that with the current state of DeFi, correlation would be very high.

In that respect, what are some tangible short/medium term plans to decrease correlation?

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In that respect, what are some tangible short/medium term plans to decrease correlation?

New products and covering a wider range of protocols via distribution. Specifically, things like:

  • oracle failure
  • partial claims, which would open up the product design space quite a lot
  • making it super easy to purchase cover on things like smart contract wallets (Argent, Gnosis Safe, Authereum etc)
  • could also start covering cross chain stuff relatively easily if we make some adjustments to product architecture

Lots of solid ideas, hardest part is prioritising!

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Hey Hugh, great post. I’d like to chuck in two cents of thinking as a consideration. It’s something that struck me as a potential balancing act between incentivising incoming capital and long term growth of the mutual to have the capacity for new products.

This feels the correct approach:

Until the six months point it would be great to encourage new capital and keep rising the MCR floor. This means the mutual continues to grow and has potential for new products.

Could the time increments be based on the amount of excessive capital. For example:
MCR% < 130%: Every 24 Hours
MCR% < 150%: Every 12 Hours
MCR% < 170%: Every 6 Hours
MCR% < 190%: Every 3 Hours etc.

If that was to be considered. The numbers and timing would need further debate.

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@Hugh, I recommend the scaling strategy reduce to the maximum extent possible the volatility (and speculative behavior) that comes with large fluctuations in MCR%. A sliding scale similar to what @charlie details should ensure smart growth. Is there a down side to this approach?
I’d like to see something that would ensure MCR% doesn’t go higher than ~160% until ~200,000 ETH is locked.
130% < MCR% < 140%: Every 4 Hours
140% < MCR% < 150%: Every 3 Hours
150% < MCR% < 160%: Every 2 Hours

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Thanks @charlie @Jeffshaw !!

If we accept that the MCR floor scaling is a temporary measure to get us to 100k ETH then I feel like this is over-engineering. Alternatively, if we want MCR floor scaling to continue for much longer then this is a reasonable approach.

My preference is to get to the goal of f(cover amount) driving the MCR, rather than the floor value, sooner and therefore I’m on the over-engineering side of this debate. As this is more capital efficient.

To expand on this, if we go with your suggestion it means the mutual is more likely to sit on excess capital for longer, as cover purchases would need to catch up with capital. The two main downsides of this are:

  • possibility of not being able to maintain existing existing capital as it searches for higher yields elsewhere
  • much lower likelihood of the token price moving into the exponential section of the bonding curve in the short term.

The key benefits are:

  • more capital and ability to offer higher cover amounts per protocol
  • ability to access demand not previously available as cover amounts too low.

So conceptually if we describe the capital scaling phase as short term pain for long term gain, your suggestion is extending the pain phase on the assumption that the potential future gains would be greater. At some point this trade-off doesn’t work, and it’s hard to work out where that point is. 100k ETH, 200K ETH? I honestly don’t know, so I’m not outright against this, it’s a difficult judgement call.

All things considered, my view is that 100k would go a long way to meeting current demand and we should firstly consolidate demand for cover at this level and therefore this suggestion is likely over-engineering.

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Thumbs up to everything. This point summarises it well. I could see a point where Nexus expands to new products (outside of DeFi) and needs to encourage capital. The community could then take a vote in the future to do a similar process to what is currently engaged to get to 100k ETH.

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Thanks for your response @Hugh. I respectfully disagree about the downsides you identified related to sitting on excess capital for longer. I think we are clearly seeing that Mutual members are willing to continue to contribute to the capital pool for long-term incentives vs. short-term incentives of immediate high yield return. Like most startups, we should align incentives for slow and steady capital appreciation of the members. I don’t think we should take the view that we are sitting on “excess capital”, but rather we have grown the bandwidth and broad community who believe in the Mutual and are willing to accept very little short-term return for the long-term benefit of the Mutual. Plus, when the demand for cover comes, the capital will be ready and cover rates will be desirable. I also argue that at this stage of the Mutual, it is not desirable to move into the exponential section of the bonding curve because it discourages willing Mutual members from investing in the capital pool.

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[quote=“Jeffshaw, post:12, topic:121”]
Like most startups, we should align incentives for slow and steady capital appreciation of the members.
[/quote] I think this is key! We should target long term participants whose capital is for the long term and not short term speculators. Or at least have a way to reward/incentivize long term capital to stay in the mutual