Protocol Deep Dive: Nexus Mutual

Nexus Mutual: Same Same, but Different.

One of the biggest struggles for DeFi investors is token valuations. In rare cases, protocols have analogs in traditional finance and also produce cash flows accruing to tokenholders. Nexus Mutual is the DeFi equivalent of the age-old traditional discretionary cover mutual. Its governance token, NXM, is used to incentivize Members to fund the Mutual's balance sheet with Ether (ETH) and thus its capacity for underwriting risk.

Between its rapid growth trajectory, large Immediately Addressable Market, and potential for expansion, the market is undervaluing NXM’s core insurance business, in our opinion. In this Flash Note, we arrive at this conclusion through a bottom-up DCF analysis, public market comparables, and bonding curve analysis.

Key Insights

• ‍Problem: We believe there is substantial embedded demand for insurance coverage for institutional investors looking to participate in DeFi. Additionally, the audit system is structurally broken, in our opinion, with insurance currently providing the only way to truly manage smart contract risk.
• ‍Solution: Nexus Mutual is an insurance mutual with membership represented through its token, NXM. The mutual offers insurance products to its members to protect against smart contract hacks in the decentralized finance space. Nexus Mutual launched in May of 2019 and has since grown to 3,829 members with $557mn in its Capital Pool issuing $430mn in active cover.
• Opportunity: wNXM, a wrapped version of membership in the Mutual, provides a compelling, asymmetric investment. We peg potential upside at 200%+ relative to ETH, with a low downside profile and optionality for even greater returns.

Insurance 101

Insurance is a way for people and businesses to protect themselves financially from potential losses. Customers, or policyholders, pay regular payments called premiums to an insurance company. In exchange, the insurance company agrees to pay for certain losses or damages that the policyholder may experience in the future. For example, if a policyholder has car insurance and gets into a car accident, the insurance company will pay for the damages to the policyholder's car and possibly for any medical expenses. The insurance company makes money by collecting more in premiums than it pays out in claims, as well as investing the "float" according to the duration of its risk exposures. Notice that in this model, the amount of risk being covered is significantly larger than the size of the balance sheet or the equity reserves in the company. This is common with granular, predictable insurance models with low probability and severity of loss.

Nexus Mutual, despite being a decentralized protocol, has the same basic business model. It currently holds $400 million in ETH, which is used to insure $400 million in risk. It collects approximately $10.4 million in revenue through premiums and has paid $6.5 million in claims. Additionally, it has invested approximately 20% of its balance sheet, generating another $4 million in interest income. This represents a $10.5 million / $400 million = ~2.5% Return on Assets. With more data and an appropriate level of financial leverage and scale, we believe the Mutual could generate a high return on invested capital (read: Return on Equity).

Protocol Architecture and Mechanics

In order to purchase insurance from the Mutual, users must KYC and become approved members. Once approved, users can exchange Ether for NXM tokens. We will touch on how this is priced shortly. By owning NXM, users own an interest in the mutual’s financial success and are able to vote on its future and claims payouts. The entire governance process for managing the mutual is semi-decentralized with plans to fully decentralize in the future. NXM can also be used to purchase insurance (called cover) from the mutual, however, to avoid voting manipulation, 90% of purchased NXM is burned upon purchasing cover with 10% remaining with the member so they may vote on a claim if there is one. Although users could be tempted to vote against valid claims in order to keep the price of NXM high, to date, all claims have been voted on validly.

How does a decentralized capital structure work?

Today, every 1 ETH of risk covered is required to be backed by 1 ETH of capital. The NXM token is used to price capital flows into and out of the Capital Pool via a bonding curve model (learn more about bonding curves here) which is dictated by the amount of capital contributed to the mutual (i.e. the Capital Pool) and the amount of risk that has been written (the Minimum Capital Ratio = MCR). Fundamentally what is happening here is a market with one counterparty: the Mutual and its Capital Pool. The bonding curve system is designed to incentivize users to keep the mutual well-funded while also insuring against appropriate risks. If there is an excess amount of funds in the Capital Pool (i.e. more capital than needed for current level of risk), the price of NXM on the bonding curve will increase to deter new Capital Pool contributions or to encourage members to sell NXM for ETH, shrinking the collective balance sheet. The Mutual does not sell equity below Book Value and will not buy equity above Book Value. This *theoretically* results in a dynamically flowing capital base that never dilutes itself.

‍The Mutual Locks Redemptions

In May 2021, the Mutual was thriving amid a rush of institutional users allocating to a particularly healthy yield environment in DeFi. With the amount of capital and risk written growing materially in a short period of time, the Mutual made the decision to set an arbitrary mandate to keep the Minimum Capital Ratio at 98.5%. As a result, the bonding curve would not allow users to exit the Mutual if its risk exceeded the balance of the Capital Pool by approximately 2%. In effect, the Mutual wanted to ensure that there was a floor to their capital base so that residual risk could be covered according to appropriate risk parameters. When DeFi-related tokens sold off across the board, there was selling pressure on NXM but no ability to sell (since the sole counterparty - the Capital Pool - would not redeem members below Book Value).

There exists a fundamental mismatch in the way the Mutual accumulates capital and the demand for its product: most of members of the Mutual were speculating on the token and now wanted to sell their position, and allowing them to do that would put the Mutual's solvency into question. This is a key dynamic to the backdrop of this investment.

‍What is wNXM Token?

Simply put, wNXM creates liquidity. Since the Capital Pool has converged with the lower bound set by the Minimum Capital Ratio (i.e. MCR% is 100%), members of the Mutual are unable to swap their NXM for ETH through the bonding curve. As a result, the Nexus community created wNXM, a freely tradable “wrapped” NXM token that can be traded on popular DEX and CEX markets. This allows members to sell their NXM exposure without withdrawing ETH from the Capital Pool, a win-win for both the protocol and its users. Another benefit of wNXM is that anyone in the digital asset space can purchase the asset without having to KYC. As a result, the creation of wNXM has created a crucial building block for members of the Mutual to participate in DeFi. wNXM enables holders to borrow, lend, exchange, and more.

Unsurprisingly, this security has traded at a discount to native NXM since arbitrage loops cannot be closed out and the price of liquidity is non-zero.

‍Nexus Mutual's Market Positioning

Diversifying Risk

‍Nexus Mutual provides smart contract cover on a growing list of protocols on the Ethereum blockchain (currently 103 in total). Although the primary distribution channel is directly through Nexus’ website, the Mutual has successfully managed to grow its integrations with the most popular DeFi protocols so that users can append smart contract cover through the given DeFi protocols’ native interface.

Competition is Scarce but Growing

‍With tremendous potential of blockchain-native insurance as well as the natural subset of smart contract cover, new players have emerged in the space offering different value propositions. Some have substituted the bonding curve model with a market-based pricing model, some allow for more financial leverage, some are focusing on other product verticals (i.e. slashing), and some are exploring new ways to distribute their product (e.g. FDIC-style protocol-level insurance). Thus far, the Mutual has solidified as the only source of ETH for insurance purposes, with other protocols opting to use its capital pool rather than bootstrapping their own.

‍wNXM Offers Asymmetric Upside Potential

We begin by valuing Nexus Mutual, the business, using a Discounted Cash Flow analysis. We maintain models for a range of potential outcomes and probabilistically weight their outputs to arrive at a Fair Value. In our base case scenario, we assume the Mutual grows with the broader DeFi ecosystem and gradually puts more capital to work into revenue-generating investments. We do not assume a wholesale change in how they do business. According to our models, NXM (without taking into account the discount) presents a compelling case for investment.

Given our bullish outlook on the Mutual’s potential for growth, the ability to purchase the asset at a 33% discount offers an attractive risk-reward profile, in our opinon. Not only are we able to enter at a substantially lower valuation to book value (0.66x P/B), but also we are able to retain the optionality that NXM and wNXM begin to trade in sympathy as they have historically. Notably, collapsing the discount is driven by guagable fundamentals (i.e. the size of the capital pool and whether it ultimately eclipses the MCR).

‍wNXM offers a unique hedgable opportunity, with multiple ways to win.

The Mutual created wNXM to give NXM holders liquidity despite currently shutting off withdrawal from the Capital Pool. As the price of liquidity has grown, wNXM is trading at its widest discount to the bonding curve to date: over 60%. If the Mutual liquidates as a going-concern, investors in wNXM can expect to be taken out at par, based on our analysis, which would offer high returns. Additionally, since the wNXM trades on a P/BV multiple denominated in ETH, the trade could offer a uniquely hedgable opportunity in DeFi. An outcome where the DeFi insurance sector grows and the Mutual returns to well-capitalized status would be a home run.

If the Mutual finds itself in an excess capital position, holders of wNXM can unwrap their asset back to NXM and redeem ETH collateral from the Mutual at a formulaic price.

In the matrix below, we use the Mutual's Bonding Curve pricing formula to construct the "bonding surface" and thus estimate and contextualize the return to wNXM holders given a range of outcomes. Of note, this model assumes the price of ETH does not increase over the next 36 months.

NXM is highly levered to ETH’s upside.

The Mutual’s Book Value is primarily composed of Ethereum, a logical decision given the nature of risk they are insuring (also denominated in ETH). Applying the discounts we are able to pay today via wNXM, the idea of owning a materially undervalued business at a discount to its ETH-holdings offers a high degree of upside optionality. In the context of a deep discount to ETH-denominated liquidation value, the downside profile seems roughly equal to ETH, with the upside offering many avenues to outperform materially. Historically, wNXM has traded at a 1.15x downside beta to ETH, substantiating its similar risk profile. In our next post, we will discuss some of the exciting developments coming to light that put a further floor to wNXM's valuation.