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The numbers in the proposal were last updated on the 4th of May, so may be out of date by the time of posting.
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.
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:
- 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.
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.
- Minimum amount of asset: 15,000 ETH
- Maximum amount of asset: 20,000 ETH
- Oracle: fixed at 1:1 against ETH, pending Chainlink integration.
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:
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.
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.
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.
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:
- 10% profit fee (used to reward validators, LDO governance token holders and an “insurance” fund).
- 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.
|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|
Assuming the current stETH return of 7.1% APR, The investment would yield approximately 2.9 stETH per day starting from Day 1.
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
- the continued growth of the Lido protocol,
- the ability of the Nexus Mutual team to create technical solutions to access alternative markets, and
- 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.