DeFi Explained: Nexus Mutual
Nexus Mutual is a digital cooperative that operates as a discretionary mutual in the UK, offering an “alternative to insurance” for Ethereum users. Those who join the mutual become members, unlocking the ability to buy covers or protection against hacking attempts in smart contract code from popular Ethereum applications.
Note how Nexus Mutual is presented as an “alternative to insurance”. The cooperative is technically distributed smart contract insurance; for legal and regulatory reasons, the team cannot precisely use the term “insurance”.
Members can hold tokens (NXM) that represent their membership rights. NXM can only be bought and sold using the Nexus Mutual application. Only KYCed members of Nexus Mutual can hold NXM tokens. Consequently, this means that by joining the mutual, one becomes a legal member of a UK company.
The NXM token enables members of the mutual to contribute in different ways: buying smart contract cover, providing capital, governing the protocol, and assessing risks and claims.
Smart Contract Cover
Members can protect themselves against failure from major DeFi smart contracts by purchasing smart contract cover. Nexus Mutual’s smart contract cover is a product designed to pay out claims if there is an unintended code usage resulting in a material financial loss.
Members first buy the cover by selecting a smart contract application from the list of supported projects that are currently being staked against. Depending on how much stake the application has it will determine the amount of coverage available to purchase and the price of coverage.
Currently Compound has a yearly cost of 5.20% compared to 34.83% on bZx which has a similar use case but has already suffered 3 hacks in the project’s existence.
High-risk projects have fewer members staking on them and more people trying to buy coverage which drives the price up.
This scenario can also make some projects reach the capacity of coverage that becomes available for purchase until more members provide additional NXM stake towards them.
Capital Provision
There are two ways for members to provide capital:
- Pay a nominal membership fee and contribute to the pool by purchasing smart contract cover.
- Purchase NXM tokens to contribute directly to the pool.
Governance
Nexus Mutual Governance’s slogan is “Deploy. Learn. Iterate.” This motto reflects the Nexus team’s mindset — they are aware of how implemented changes work in the real world and understand they must eventually amend their approach in response to new evidence.
Members have voting rights based on their NXM stake (max. capped at 5%) and are also rewarded in NXM for participating in governance voting.
The actual governance process takes place over five steps:
- Raise: The first step is for a member to raise a proposal via the Governance Portal powered by GovBlocks.
- White-List (sic): The proposal will then be sent to the Advisory Board, made up of five mutual-containing members of the founding team and other experts. The Advisory Board then whitelists the proposal by categorizing it and providing the previously-mentioned NXM token rewards for member participation.
- Advisory Board Vote: The Advisory Board votes on the proposal, working to provide a technical and informed view of the proposal to all members. For regular proposals, the results of this vote will determine the default outcome should the quorum of 15% not be reached.
- Member Vote: Members will submit a final, binding vote on the proposal. Member’s voting rights are based on their NXM stake, but will not exceed 5%. Staked NXM will then be locked for a period of time after the voting process to ensure that voting members have a vested interest in the vote’s outcome.
- Implementation: The final step involves the implementation of the proposal. In instances where new code is developed, there may be further proposals to decide whether or not the upgrade will take place.
Risk Assessment
Risk assessment describes the process of a member staking NXM tokens against particular risks for smart contracts that they evaluate as being secure.
In order to stake against risks, members must first deposit NXM tokens. Members can stake up to ten times the provided deposit amount.
When the un-staking request is submitted, NXM tokens are locked for a period of 90 days.
A minimum staking threshold must be reached before members can purchase cover on that particular smart contract.
Rewards are distributed to risk assessors when any member purchases cover on the staked smart contract.
For clarification, rewards are not generated by staking itself; a cover purchase is also required.
In the event of a successfully-paid claim, risk assessors on that particular risk will have their stake burned on a proportional basis up to the claim amount.
Recently, on September 29, Nexus Mutual introduced “Shield Mining”. Now, risk assessors will additionally be rewarded in the native token of partnered projects.
Claims Assessment
Claims will be evaluated by members of the mutual.
After a member has submitted a claim (which will lock 10% of the NXM used to purchase cover), the claims assessment voting process begins.
Claims assessors must stake NXM in order to participate in claims assessment voting.
Unlike the risk assessment process, the tokens staked by claims assessors against the consensus outcome do not get burned; instead, they are staked for a longer period of time.
By assessing claims in line with the consensus outcome, claims assessors earn additional NXM.
There are multiple iterations and escalation steps described in the flowchart above. For further details, refer to the Nexus Mutual Governance Gitbook.
The process aims to be completed within a maximum of 48 hours.
Value Proposition
The industry lacks the insurance infrastructure needed to diversify risks for entities or DAOs, let alone for crypto-native risks like smart contracts.
In the short term, even in the abstract of smart contracts, insurance is essentially unavailable for any business in the blockchain space. The terms “crypto” or “blockchain” immediately raise a red flag with almost every insurance company.
Ultimately, the value proposition of Nexus Mutual lies in the fact that they offer an “alternative to insurance” for a niche product (blockchain products).
The basic concept of insurance is to pool individual risks together with significant scaling effects. This institutional model has historically provided benefits to customers via reduced premiums.
While this trusted process seems appealing, there is evidence against its cost-effectiveness. According to a study by McKinsey in 2015, the overhead for insurance companies in the financial sector is still about 35%.
In other words, more than a third of the funds pooled from customers for risk protection is not redistributed to the community (customer base); instead, the funds are sunk into the insurance company’s operating costs and profits.
Nexus Mutual’s approach is to remove administrative inefficiencies and reduce the governance and regulatory costs by moving trust from a black box (institutions and regulations) to a “transparent code”.
By aligning incentives and lowering governance and regulatory costs, Nexus Mutual estimates that their overhead cost will be reduced by c. 50%.
Use Cases
To reiterate, Nexus Mutual offers smart contract cover against potential bugs or hacks. The demand for Nexus Mutual’s smart contract cover is directly tied to the growth of DeFi.
In the past, we have seen hack and bugs that result in multi-million dollar losses for protocol users. Let’s quickly revisit some of the most known incidences in the history of smart contracts.
Hacks
The infamous DAO Attack on June 17, 2016, made it possible for a hacker to drain 3.6 million ETH (the equivalent of $70M at the time) from the DAO by exploiting a recursive call bug.
Lending protocol bZx has also been exploited in back-to-back “flash loan” attacks on February 14th and 18th, 2020.
The first attack was a single transaction, borrowing millions of dollars in a flash loan. These funds were then threaded through different DeFi protocols to manipulate and exploit bZx’s collateral pool. The hacker was able to drain 1,271 ETH (the equivalent of $355k at the time) from the protocol.
Though similar to the first, the second attack on bZx was more akin to an oracle attack. In this instance, while bZx was tapping into Uniswap as an oracle, the flash loan manipulated the spot price of ETH-sUSD on Uniswap. The hacker was able to drain 3,378 ETH (the equivalent of $630k at the time) from the protocol.
In the bZx incident, Nexus Mutual paid out claims worth $87k to members staking against this smart contract.
It’s also important to note that not all incidents are caused by malicious actors. Like every line of code, smart contracts can also simply have bugs that negatively impact members.
Bugs
On November 6th, 2017 GitHub user devops199 created issue #6995 in the OpenEthereum repo stating they “accidentally killed it”.
The user accidentally exploited a vulnerability within the Parity smart contract library code. This blocked the funds of 587 wallets, holding a total of 513,774.16 ETH (the equivalent of $153M at the time) as well as various other tokens (around the same figure of $120M-$150M).
On August 20th, 2020 a bug was discovered in the YAM rebasing contract. This bug initiated the minting of far more governance tokens than intended. These tokens were owned and locked by the governance contract itself, preventing participation in governance voting and making it impossible to meet the minimum voter participation.
The market capitalization of YAM crashed from a theoretical value of more than $500M to $30M with almost no liquidity the same day; this effectively cost token holders half a billion USD.
Shortly after YAM Finance went live, members of the mutual put up a stake for the contract, but “nobody bought coverage”.
These devastating bug-related incidents demonstrate the growing need for smart contract covers.
Today
DeFi applications have seen exponential growth in recent months due to the emergence and increasing prevalence of yield farming. The total value locked (TVL) in DeFi applications reached its ATH on September 23, 2020, with close to $12B locked.
In comparison, the NXM market cap reached its ATH on August 31st, peaking at $417M with $87M TVL — a fraction of the TVL in DeFi.
Though smart contract covers are a very niche product as of today, there is clear hope in this alternate insurance. Nexus Mutual has a market leader position, and the numbers above indicate the extensive growth opportunities that are present.
Tokenomics
In order to understand Nexus Mutual, one can make a very basic, high-level comparison to the concept of Uniswap.
Nexus Mutual members contribute liquidity (in ETH) into a shared pool of funds and receive NXM tokens in return. The surplus from smart contract cover purchases remains in the Nexus Mutual capital pool and is jointly owned by all NXM holders.
Fundraising
The company raised approximately $256k from April 2018 to October 2019 and never had an ICO.
The protocol token (NXM) is not available to be traded on exchanges (we’ll visit wNXM later in this article); additionally, only members of the mutual can buy and sell NXM into the bonding curve. To become a member, one must pay a nominal membership fee of 0.002 ETH and successfully pass a KYC check.
Bonding Curve & Token Price
As mentioned earlier, the NXM token price (in ETH) is based on a bonding curve: a mathematical curve that defines the relationship between price and token supply.
TP= A + (MCR / C) × MCR%⁴
- TP = Token Price in Ether
- A and C are constant values that were calibrated at launch:
- A = 0.01028
- C = 5,800,000
- MCR = The value of the Minimum Capital Requirement in ETH, which grows as the number of covers grows. In other words, this is the capital required for Nexus Mutual to maintain operations.
- MCR% = The ratio of the Capital Pool to the Minimum Capital Requirement.
Three key metrics are essential to understanding the NXM token price:
- The MCR never decreases. It increases at a pre-programmed pace and continues to increase as long as the MCR is above 130%.
- MCR% is an exponential short-term function. The NXM token price skyrockets when funds exceed those required to back the covers written to encourage redemptions.
- Nexus Mutual smart contract covers are designed for Ethereum smart contracts. Therefore, the NXM token price is designed to be calculated in ETH. An NXM token holder is entirely exposed to the price movements of ETH.
Wrapped NXM (wNXM)
As previously mentioned, NXM can only be acquired by a KYCed member of the mutual.
Community members have created the NXM token wrapper for a freely-tradable version of NXM, which can be received on AMMs and centralized exchanges (like Multi.io). Only NXM token holders (KYCed mutual members) have the ability to wrap and unwrap NXM, keeping the core token supply compliant with regulatory standards.
Key Metrics
Below, we will explain some of the key metrics found in the Nexus Mutual Tracker.
Active Cover Amount
The Active Cover Amount is the payout in case of a successful claim for all members that have purchased smart contract cover; in essence, this is the total value that is “insured”. The Active Cover Amount to Capital Pool Size Ratio describes the leverage factor between the collateral (Capital Pool Size) and covered TVL (Active Cover Amount).
Total Premiums Paid
Total Premiums Paid describes the aggregated amount of all coverage bought by members of the mutual.
Capital Pool Size
The Capital Pool Size can grow in three ways:
- Surplus of ETH generated from cover purchases
- Members add ETH into the pool by purchasing NXM
- Yields earned on investing pool assets
The Capital Pool can also decrease in three ways:
- Paid claims
- Holders redeem NXM
- Potential losses from investing pool assets
Total Amount Staked
The Total Amount Staked is the aggregated amount of NXM staked in covers of all smart contracts.
The Current State of Nexus Mutual
On July 18th, Nexus Mutual members approved a proposal to change the constant increase of MCR from 1% per day to 1% per 4 hours, as long as the mutual has excess capital to scale with the massive growth and demand of DeFi.
It’s worth noting that the token price is dependent upon MCR%⁴ (ratio of the Capital Pool to the Minimum Capital Requirement) in the short term, meaning that the community was willing to suppress the short-time price in favor of long-term growth.
This shift is a very strong and bullish indication that members of the mutual are committed to the project’s long-term success.
Nexus Mutual has found a product-market fit in today’s cryptocurrency environment which favors applications that pool users’ capital together like lending markets, liquidity pools, and yield farms.
These types of applications are the perfect honeypot for hackers to try and attack continuously which makes smart contracts risk a permanent part of the ecosystem.
It’s hard to imagine a crypto world without a service like Nexus Mutual continuing to exist and not be one of the most successful projects in the space.
Information & Data Sources
Nexus Mutual Medium Blog — Follow Nexus Mutual on Medium.
Nexus Mutual Discord Server — Join Nexus Mutual on Discord.
Nexus Tracker — Live tracker for key metrics.
Nexus Mutual Whitepaper — Whitepaper v2.3
Nexus Mutual Gitbook — In-depth descriptions and technical documentation (work in progress).
Token Wrapper by Token Faucet — Wrap and unwrap NXM.
