Introduction
The following is a proposal to increase the allocation of Nexus Mutual’s capital pool to stETH from the current 15,248 (at time of writing) stETH to 30,000 stETH, representing 18.5% of the total Capital Pool.
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. The previous successful proposal to allocate the capital pool to stETH can be found here.
Feedback in the form of comments, suggestions, 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 Hub, will continue to keep the investment under review and propose additional/alternative options for deploying the capital pool on an ongoing basis.
Rationale
The reasons for investing in ETH2 derivatives and stETH have been previously discussed in the original proposal.
Since the original allocation to stETH, Lido has emerged as a clear market leader in providing a smart-contract based ETH2 staking service with an associated liquid derivative token. At the time of writing, 1,288,781 ETH (or ~$4.5bn) is being staked via Lido.
Other options for ETH2 yield are available now and in future. The community is encouraged to provide feedback and to research and propose alternatives to this allocation.
The Investment Hub members are currently actively exploring alternative options to obtaining ETH2 staking rewards, but these are seen as additional opportunities for obtaining yield and the viability of such options is not seen as a reason to prevent Nexus from expanding the stETH allocation.
Proposal
Amount and duration of investment
The proposal is for Nexus Mutual to invest an additional 14,752 ETH from the Capital Pool into stETH.
The combined investment in Lido would represent 18.5% of the mutual’s current Capital Pool.
This continues to be 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).
As before, 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 continues to be reviewed on a regular basis.
In order to avoid the compounding of risk within the mutual, the combination of:
- total exposure to stETH within the capital pool, and
- the cover exposure to Yearn ycrvstETH v2
needs to be kept at an appropriate level.
The mutual currently provides cover of 1,238 ETH on Yearn ycrvstETH v2. Combined with the 30k ETH proposed investment, the mutual’s total exposure to Lido would be 31,238 ETH at the time of the investment, representing 19.2% of the total capital pool.
Updated parameters:
- Minimum amount of asset: 24,360 stETH (15% of Capital Pool)
- Target amount of asset: 30,000 stETH (18.5% of Capital Pool)
- Maximum amount of asset: 32,500 stETH (20% of Capital Pool)
- Oracle: fixed at 1:1 against ETH, pending Chainlink integration.
Technical
The implementation of the additional stETH investment is largely unchanged from the original implementation. One of the benefits of increasing the Lido allocation as opposed to integrating other ETH2 derivatives is the pre-existing integration and, therefore, minimal development resource required.
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.
The technical development of the ability to use Curve remains on the roadmap of Nexus Mutual’s core team. As the main focus is on the ‘v2’ upgrades to the system, this is expected to be implemented around January.
Therefore, the steps for stETH integration continue to be:
-
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. If prioritised, this can be completed in the space of 1 month.
Oracle: The oracle will continue to 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 have recently added a stETH price Oracle, which is due to be implemented over the next few months by the core development team.
- 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 current APR after Lido’s fees in stETH is 4.9%, with ETH2 validator rewards currently sitting at 5.6%.
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 25%, so for the sake of illustration, the examples below assume a 15% multiplicative reduction compared to ETH2 staking APR.
The outcomes below also assume a 99% own validator uptime and a 97.5% average validator uptime.
Note that since the original proposal, ETH locked up in the ETH2 staking contract has increased from 3.55% to 6.48% of total ETH supply, so the ‘Low’, ‘Medium’ and ‘High’ scenarios used for illustration have been revised from 4%, 7% and 10% of ETH supply locked up 1 year from now to 7%, 11% and 15% respectively.
| Scenario for ETH staking | ETH Staked as % of total supply 1 year from now | ETH 2 staking return 1 year from now | Total stETH rewards in the first year (assuming linear increase from today) | Additional stETH rewards in the first year (assuming linear increase from today) | stETH reward per day in the first year | Additional stETH reward per day in the first year |
|---|---|---|---|---|---|---|
| Low | 7% | 5.57% | 1,424 | 700 | 3.90 | 1.92 |
| Medium | 11% | 4.45% | 1,286 | 632 | 3.52 | 1.73 |
| High | 15% | 3.81% | 1,206 | 593 | 3.30 | 1.62 |
Assuming the current stETH return of 4.9% APR, the additional investment would yield approximately 2 stETH per day.
Risks
Most of these are unchanged from the original investment proposal, with some risks reduced - such as key management, available liquidity and the size of Nexus’ investment as a proportion of the total size of Lido.
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 - UNCHANGED
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 - UNCHANGED
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 - UNCHANGED
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 - IMPROVED
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. Since the original proposal, Lido have upgraded their Withdrawal Credential methodology to be controlled by LDO governance.
- Slashing risk - IMPROVED
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 thirteen running operators (8 additional operators have been onboarded since the original proposal). The risk of all thirteen getting significantly slashed at the same time is reduced.
- stETH price risk - UNCHANGED
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 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 (>55% 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 selling portions of the stETH investment - IMPROVED
Currently the stETH/ETH Curve pool has 719,874 stETH and 483,156 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 - IMPROVED
This is a risk to the mutual, but mitigated by limiting investment size to below 20% of MCR and monitoring of the investment relative to cover exposure. While the investment size is larger as a portion of Nexus’ total pool, this is more than mitigated by the growth of Lido compared to the time of the original investment.
- Opportunity cost for not investing in other opportunities as and when they come up - UNCHANGED
ETH2 staking derivatives are seen as one of the most appropriate types of investment for Nexus Mutual, and Lido is the market leader in providing liquid ETH2 staking.
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 - UNCHANGED
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. Not applicable if integrating directly via Lido’s smart contracts.
- The total investment would now represent ~2.3% of the ETH locked in Lido - IMPROVED
This is an appropriately sized position and 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.
Governance
This proposal is open to review for the next seven (7) days.
We welcome community discussion around the stETH increase proposal.
At the end of the seven (7) day period, this proposal will proceed to Member Governance vote.
