Investing the Capital Pool in stETH

Governance Discussions Nexus Mutual Protocol Improvement Proposals
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Introduction

The following is a proposal to invest a portion of Nexus Mutual’s capital pool into stETH.

stETH is an inflationary token representing the ETH locked in Lido, a pooled staking service for ETH2 with a focus on liquidity and community governance.

Feedback in the form of comments, suggestions, concerns/red flags and areas for further due diligence are welcome.

If this proposal is successful, we expect that Nexus Mutual’s community, with guidance from the Investment Committee (more info to come soon), will actively keep the investment under review and propose additional/alternative options for deploying the capital pool on an ongoing basis.

The numbers in the proposal were last updated on the 4th of May, so may be out of date by the time of posting.

Rationale

Why Invest?

The main purpose of investing assets into stETH is to provide an additional driver for growing the size of the capital pool, thus:

  • enhancing the profitability of the mutual as a whole, and
  • enabling it to further protect the members against risks by creating capital, which can be used for writing additional covers

The reasons why the mutual should invest a portion of the capital pool into yield-bearing assets, how investment fits into the overall objectives of the mutual and the universe of available assets have been well discussed previously in the whitepaper and various forum threads.

In the medium/long term, investing in yield-bearing assets makes us competitive with traditional insurance companies. Insurance companies typically invest their entire pool of assets and measure the yield obtained, treating it as one of the major drivers of profitability and competitive advantage.

From Swiss Re’s 2018 Sigma 4 Report, for non-life insurers the weighted 10-year average (2008-2017):

  • Net investment result as a % of net premiums was 9.8%
  • The investment yield on the assets held was 3.6%

If Nexus Mutual wants to disrupt these embedded models of insurance, we need to be able to compete with the asset returns obtained by the legacy insurance system. Thankfully, with the proliferation of DeFi yield-bearing opportunities and the emergence of ETH2 staking, such options are quickly becoming available. Investing a portion of the capital pool in stETH would be the first step taken by Nexus Mutual towards out-competing the incumbent players.

In the short term, there are a wide array of protocols within the Ethereum & DeFi ecosystems for depositing ETH/tokens to obtain a yield, be it in the form of direct ETH2 staking, yield farming opportunities, other risk management protocols or even buying NFTs in the hope that they appreciate in value. Deploying a portion of the capital pool in a yield-bearing asset like stETH will provide NXM holders with another source of value appreciation and increase our competitiveness versus existing and emerging uses for ETH.

Why stETH?

Of the available universe of returns for the mutual to obtain, ETH2 staking rewards are appealing for a number of reasons.

  • The yields are relatively high and reasonably predictable (see Rewards section)

  • Members typically value that their participation in the mutual allows them to remain long ETH, which this type of investment would maintain

  • A secondary benefit arises from becoming a participant in securing the ETH2 Beacon chain and adding another layer of contribution by Nexus Mutual to the overall success of the Ethereum ecosystem

Of the available options for Nexus to participate in ETH2 staking, stETH has the following benefits:

  • Provides exposure to ETH2 rewards without having to set up our own staking infrastructure

  • stETH can be traded for ETH on-chain on Automated Market Makers, so the investment remains liquid, even while ETH2 deposits themselves are irredeemable

  • Lido itself uses a number of validators rather than its own infrastructure, thus further spreading the risk of slashing

Of the available options for tokenised, liquid ETH2 staking assets stETH provides a good balance of:

  • liquidity,
  • low technical requirements for implementation,
  • competitive fee structure,
  • community governance, and
  • increasingly, proven stability.

Other options for ETH2 yield are available now and in future. The community is encouraged to provide feedback and to research and propose alternatives and additions to this initial allocation.

Proposal

Amount and Duration of Investment

The proposal is for Nexus Mutual to invest 15,000 ETH from the Capital Pool into stETH.

This represents investing 9.2% of the mutual’s current assets.

At the present time, this seems like an appropriate level where the risks to the overall soundness of the Mutual are limited (see Risks section), while obtaining a meaningful reward for our investment (see Rewards section).

There is no set duration for the investment, with the caveat that the appropriateness of holding stETH in the Capital Pool and the size of the holding be reviewed on a regular basis.

In order to avoid the compounding of risk within the mutual, Nexus should not be providing Protocol Cover for Lido, or at the very least minimising exposure so that total risk is capped to 20% of the mutual’s assets.

Parameters

  • Minimum amount of asset: 15,000 ETH
  • Maximum amount of asset: 20,000 ETH
  • Oracle: fixed at 1:1 against ETH, pending Chainlink integration.

Technical

As an inflationary token, the balance of stETH held increases regularly in the holder’s account. The same would be true of the stETH held within Nexus Mutual’s Capital Pool contract.

One of the technical developments being implemented by Nexus Mutual’s core team is the ability to use Curve to swap the mutual’s assets in addition to the current Uniswap v2 implementation. Curve is required because there is insufficient liquidity for stETH on Uniswap v2.

However this will be implemented in stages:

  1. As part of a planned upgrade of the MCR, we can generate new stETH by directly interacting with the LIDO contracts. At this point it is not possible to sell stETH.

  2. Integrate Curve which enables the sell side if/when it is required.

To begin with the oracle will be fixed at 1, meaning 1 stETH will equal 1 ETH when calculating the total capital held in the Nexus Mutual pool. This could potentially create a situation where stETH de-pegs from ETH and the mutual is holding the assets above market value. There is some risk here which is considered acceptable for the following reasons:

  • Chainlink are looking to add an oracle once stETH becomes more widely accessible on different exchanges (not just Curve). So this issue is not expected to be ongoing for long periods of time.
  • The total stETH is capped at 20,000 ETH maximum and stETH is very unlikely to de-peg more than 5% for sustained periods. At 5% the MCR% would be overstated by 0.62%, which is much lower than the 2.5% sell spread.
  • Under a severe and sustained de-peg the oracle can be updated to more accurately reflect the price.

Implementation

The proposal will be put forward through the Nexus Mutual governance process after a period of review and feedback by the community.

If the governance process approves this investment, the implementation steps as outlined in the Technical section above will be put in place by the Nexus Mutual team.

Rewards

The rewards obtained are dependent on two variables:

The current APR after Lido’s fees in stETH is 7.1%, with ETH2 validator rewards currently sitting at 7.7%.

There are two drivers for the gap between the return in stETH obtained on holding stETH assets and the ETH2 validator rewards:

  1. 10% profit fee (used to reward validators, LDO governance token holders and an “insurance” fund).
  2. The lag involved in launching validators to obtain ETH2 rewards vs. ETH locked up for stETH in Lido.

The existing validator rewards go to all stETH holders, thus if a proportionally large amount of ETH has flowed into Lido recently, the returns are temporarily reduced.

Between these, the range of penalty has fluctuated roughly between 10% and 15%, so for the sake of illustration, the examples below assume a 12.5% multiplicative reduction compared to ETH2 staking APR.

The outcomes below also assume a 99% own validator uptime and a 99% average validator uptime.

Source ETH staking calculator

Scenario for ETH staking ETH Staked as % of total supply 1 year from now ETH 2 staking return 1 year from now stETH rewards in the first year (assuming linear increase from today) stETH reward per day in the first year
Low 4% 7.5% 1,017 2.78
Medium 7% 5.7% 896 2.45
High 10% 4.75% 835 2.29

Assuming the current stETH return of 7.1% APR, The investment would yield approximately 2.9 stETH per day starting from Day 1.

Risks

Lido’s Own Risk identification

This section discusses the risks identified by the Lido team, with some commentary as applies to Nexus Mutual’s potential investment.

From the Lido.fi FAQ:

  • Smart contract security

There is an inherent risk that Lido could contain a smart contract vulnerability or bug. The Lido code is open-sourced, audited and covered by an extensive bug bounty program to minimise this risk.

Two audits of the code were conducted by Quantstamp and Sigma Prime in December 2020 and no high risk or critical issues were found. However, this remains an active risk of investing in stETH.

  • ETH 2.0 - Technical risk

Lido is built atop experimental technology under active development, and there is no guarantee that ETH 2.0 has been developed error-free. Any vulnerabilities inherent to ETH 2.0 brings with it slashing risk, as well as stETH fluctuation risk.

  • ETH 2.0 - Adoption risk

The value of stETH is built around the staking rewards associated with the Ethereum beacon chain. If ETH 2.0 fails to reach required levels of adoption significant fluctuations in the value of ETH and stETH could occur

There remains a risk that ETH2 is not successful in its launch, significantly delayed or is not adopted by users. This is a systemic risk for the whole Ethereum ecosystem, including Nexus Mutual. Ethereum scaling and adoption is already seen as crucial for the success of the mutual, so the additional technical and adoption risk of ETH2 is not considered to be significant.

  • DAO key management risk

Ether staked via the Lido DAO is held across multiple accounts backed by a multi-signature threshold scheme to minimise custody risk. If signatories across a certain threshold lose their key shares, get hacked or go rogue, funds risk becoming locked.

This remains an active risk. However, the signatories are well respected across the DeFi ecosystem. More info: Withdrawal key generation event

  • Slashing risk

ETH 2.0 validators risk staking penalties, with up to 100% of staked funds at risk if validators fail to validate transactions. To minimise this risk, Lido stakes across multiple professional and reputable node operators with heterogeneous setups, with additional mitigation in the form of insurance that is paid from Lido fees.

Lido’s set-up is protected against significant slashing events via using a set of elected node operators. Currently there are five running operators, so the risk of all five getting significantly slashed at the same time is reduced.

  • stETH price risk

Users risk an exchange price of stETH, which may be lower than its inherent value due to withdrawal restrictions on Lido, making arbitrage and risk-free market-making impossible.

This represents the risk that stETH becomes significantly de-pegged from ETH before it is possible to redeem it 1-to-1 on Lido’s platform following the launch of withdrawals from the Beacon Chain.

In addition to the risks discussed above (all of which may lead to a reduction in the value of stETH), there may be further unexpected events leading to stETH becoming worth less than ETH, including but not limited to:

  • Lido team/keyholder reputational risks
  • Unexpected decisions made by Lido team/governance mechanisms
  • Large fluctuations in the supply or demand of stETH on the open market
  • Curve liquidity pool (>70% of stETH) gets hacked

The main mitigation of the risks above is the alignment of incentives of the Lido stakeholders with maintaining the expected operation of the system and, therefore, keeping the value of stETH pegged to ETH.

Additional Risks and Considerations for Nexus Mutual

This section discusses the additional risks for Nexus Mutual as a 3rd-party investor in stETH.

  • Curve liquidity insufficient at point of buying and at point of selling portions of the stETH investment.

Currently the stETH/ETH Curve pool has 186,456 stETH and 179,179 ETH, which is sufficient to obtain the required volume over a short period of time.

There is uncertainty over the available liquidity at the time of redemption, but this is mitigated by

  1. the continued growth of the Lido protocol,
  2. the ability of the Nexus Mutual team to create technical solutions to access alternative markets, and
  3. the eventual expected launch of ETH2 whereby it should be possible to redeem directly with Lido’s smart contracts.
  • Liquidity of stETH in extreme cases where the mutual has to sell the stETH to pay claims

This is a risk to the mutual, but mitigated by only investing 9.2% of the capital pool.

  • Opportunity cost for not investing in other opportunities as and when they come up

Again, mitigated by only investing a relatively small portion of the capital pool.

The stETH can be re-allocated to other investments, or other investments can be selected on an ongoing basis using the remainder of the capital pool.

  • Front-running of purchasing transactions

Mitigated by not choreographing/announcing the exact times of purchase, as well as spreading the buying transactions over smaller amounts and over a period of time.

  • The investment represents ~6% of the ETH locked in Lido

While this is a reasonably sized portion, we do not expect that the Nexus Mutual community as a whole would like to devote significant time to participating in the governance processes of Lido.

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I agree 100% - appreciate the very detailed and thorough analysis. I think we should proceed in getting this implemented as soon as possible.

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Thanks Rei - Loving the extensive work here :fire:

Fully supportive.

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This is awesome. Let’sssssss do it!

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Hey! Would love to have Nexus on board. Having an option to cover slashing risks in Nexus would be great too, so if possible, would prefer that this option would be open to us.

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Great, thorough proposal! It makes sense to put a portion of Nexus’s capital to use with staking ETH. It’s important to assess how this fits in with the overall strategic allocation framework for Nexus’s capital pool. Look forward to contribute on this.

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I agree with investing in stETH, sooner rather than later.

How did you decide on proposing to invest 9.2% of assets in this way? Why not lower? Why not higher?

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Great point. For me just below 10% seems like an appropriate mix between reasonably meaningful rewards and a portion of the capital pool that wouldn’t expose us to excessive risk (and therefore not being able to pay claims in a black swan event).

If the early allocation works out well, there is scope for increasing it, or indeed diversifying into other forms of tokenised staked ETH.

Any less and it seems trivial.

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Love this! 100% in support.

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Thank you for the time and effort you put into this analysis. Top notch :v: :turtle:

stETH is a great start to investing a portion of the mutual’s assets. The rewards outweigh the risks here. Generating yield will help us solve the MCR% issue, and this is a solid strategy. I’m on board with this.

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Thanks @Rei, excellent write up and exciting proposal. Cannot think of a better suited asset to start deploying the capital pool in. Support!

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You did a great job on this. Let’s do this. We have underleveraged assets.

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Another thought I had this morning - to cut down on potential liquidity issues, we can make the Mutual’s investable ETH assets a function equal to {MCR Floor(ETH) * [X]%}. As a pro, as long as X is chosen correctly, the mutual will always have enough immediately liquid assets to pay regular claim amounts. The only real drawback I could see is if the size of the capital pool grows sufficiently far away from the MCR Floor, the mutual could be sitting on excess liquidity - though by then, we can evaluate raising the floor again.

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Thank you, Rei for this great proposal. The risks and advantages are all laid out very clearly.

While I am skeptical of the prioritization of investing the mutual assets now vs. focusing on growth, growth, growth, I do believe that ETH 2.0 staking is likely the lowest risk available for ETH.

Our suboptimal prioritization seems particularly obvious in this section:

The current APR after Lido’s fees in stETH is 7.1%, with ETH2 validator rewards currently sitting at 7.7%.

There are two drivers for the gap between the return in stETH obtained on holding stETH assets and the ETH2 validator rewards:

  1. 10% profit fee (used to reward validators, LDO governance token holders and an “insurance” fund).
  2. The lag involved in launching validators to obtain ETH2 rewards vs. ETH locked up for stETH in Lido.

Lido has its own insurance fund, for which they likely pay much more than they would if they’d use Nexus (please correct me if I am wrong).
I personally think we should focus on these opportunities to establish Nexus as a general risk backstop versus wanting to go for 0.6% overall return (7.7% x 9.1%) on the assets of the mutual.
These things are not necessarily mutually exclusive, but I see very little competitive advantage from investing the mutuals assets at this point. I’d also question whether it is worth the engineering resources unless of course, they serve as a base for major future upgrades.

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Hey Christopher (pun intended) - I tend to disagree with the assertion that this is a suboptimal prioritization of resources purely because of a corollary to the end of your statement - in order to invest any of the mutual’s assets (which truly is a core need in growing a lasting insurance vehicle) we need to start somewhere.

While I agree a 0.6% annual return doesn’t seem like much of an opportunity cost to prioritize other growth initiatives, I think you need to evaluate that number in the context of the size of the mutual’s asset pool. At the current value of ~$575mm, the paltry 0.6% return would yield nearly $3.8mm in earnings; not an insignificant sum in absolute terms. Additionally, there are multiple levers which help to grow investment earnings - (1) as we continue to allocate additional portions of the asset pool (continuing out from this initial investment), the yield earned by the mutual on its assets should increase (assuming at least linearly to stETH depending on risk profile), and (2) as the asset pool continues to grow through natural demand (which we obviously want to continue to push in perpetuity), the amount available for investment will increase, which will increase absolute unit return.

Assuming a more normalized investment ratio of 50%, earning a yield similar to stETH (7.7%), the mutual would earn nearly $22mm. If the asset pool were to then double (~$1.15b), this would be nearly $45mm per year.

I appreciate not wanting to distract from demand and protocol growth and development, but think the opportunity here is too large to ignore, and serves to help the mutual over the short, medium, and long-term.

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You make a valid point, @HeyChristopher. I believer you’re saying that investing the mutual’s assets isn’t the top priority now: it’s growing membership, which in turn grows the amount of cover buys.

I tend to agree with you here; however, I think we do need to start exploring investment options to grow the capital pool while we work to grow our membership. With the wNXM-NXM parity issue ongoing, it’s harder to grow membership when potential members realize the continuous token model locks them out of taking profit through the bonding curve. That is the biggest point of contention with members on Discord, Twitter, Reddit, etc.

I believe we can focus on both growing the mutual’s membership and growing the amount of funds in the capital pool through conservative investments. Investing a portion of the capital pool will put the mutual in-line with strategies used by insurance companies in traditional markets. It will also make Nexus more competitive with other protocols in the DeFi cover market.

The Nexus Hub initiative I’m championing is focused on education, awareness, and growth. I believe we can work to grow our membership, grow the number of protocols/custodians listed, and grow demand for cover buys. To do that, we need to address the MCR% issue at the same time.

The MCR% problem is a chicken-and-egg situation. Growing membership would grow the capital pool, but if the capital pool is at the MCR Floor, members will tend to go somewhere else where they can access liquidity.

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Generating investment returns benefits those NXM holders. Therefore, it incentivizes wNXM to unwrap and hold NXM. At which point, this drives the capital pool, and should increase staking, and therefore drive down the cost of the cover for customers. Likewise, it will act to attract new NXM purchasers.

Not mutually exclusive, it seems accretive. The return is small I agree, but we must make this step in the right direction and start investing. I do believe this would act as a “base for major future upgrades” in terms of enabling other investments, @Hugh can you comment?

Unless there is a very defined plan for future investment of funds, the % suggested in this proposal is low and should be increased. The sunk cost of development is there, so we should make the most of the cost and maximize the benefit. Eventually, those funds should be re-allocated to reduce the risk of concentration. But in relatively short term, I don’t believe the risk is significant.

In terms of Lido having their own insurance fund, I’m not sure that they would be open to using Nexus. If they would, that changes things.

0.6% isn’t really a fair way to look at things either. I understand that’s the return on the total assets, because the fixed cost exists regardless of if it’s 9.1% or 91% invested. But truly only that % is risked, and 7.7% is a fairly reasonable return, given the risk and long ETH benefit.

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Thanks for the comments everyone.

Two brief comments from me:

  • Cover growth (and distribution) is the number one focus and continues to be. But opening the second major revenue stream of all insurance companies is quite important, so it’s second, but not a distant second.

  • Work we’re doing on contracts to enable investment earnings gives us more flexibility, so it’s not just for stETH it’s more long term capability.

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I think the disparity in wNXM-NXM price stems from some token holders not being bullish on the future of Nexus Mutual and that is why they are still using the wNXM route to exit the system.

I doubt that 1% investment earnings will be enough to convince them to stay in this bullish market, even 5 or 10% would probably not change their mind.

Given the competition that is entering the market these days and in the coming months, I think having any other focus than growth right now is underestimating the situation we are in. Nexus is in war time and we should be much more aggressive in growth…

If members think that NXM holders are exiting the system because they earn 2-3% too little inside Nexus, then I would prefer to spend some NXM from the community fund to augment staking rewards for some time, but I doubt that will change anything in regards to the wNXM-NXM difference.

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@HeyChristopher
Insurance is essentially a commodity, so price is arguably the biggest lever that we have for driving cover growth.

How do we drive prices down? We need to increase the amount being staked in proportion to the demand for cover.

There has to be some incentive for wNXM holders to unwrap, and then stake their NXM. I don’t think that we can just grow cover through marketing or any other way, especially with all the upcoming competition that you mentioned. We should be trying to establish a brutal monopoly through pricing power, which only becomes stronger as we grow.

Those looking for yield through insurance should have no better option than Nexus, and that should mean that those looking for cover won’t find it cheaper than with Nexus.

Investing earnings helps to achieve this by encouraging unwrapped, though I agree with you that 1% earnings is marginal. Staking is not rewarding enough and the risk is too high still. Both of these issues need to be resolved to encourage long term commitment to the capital pool and consistent staking.

I could imagine a scenario whereby some investment earnings are used to augment staking rewards going forward. This achieves the goal of encouraging active ownership through staking, rather than passive NXM holders.

I don’t believe that it’s just about achieving a higher absolute return for holders. The risk is practically unknown because of limited data, so it’s hard for stakers to get comfortable with the risk and to know if they’re getting an adequate margin of safety.

Truthfully, I don’t stake. I’m very bullish on Nexus overall, but I don’t feel comfortable with the current returns from staking to risk complete or major capital loss.

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