MakerDAO Protocol Cover using Nexus Mutual

Overview

MakerDAO, as a protocol, could benefit from transferring some of its risk off-balance sheet using a tailored policy with Nexus Mutual. This would have the following key benefits:

  1. Create a buffer that reduces the level of MKR minting should the system accrue debt.
  2. Allow more collateral types to be on-boarded, as downside risk of collateral failure is dampened.
  3. Provide buffer funds in an Emergency Shutdown situation giving greater confidence that DAI holders can be made whole.

An outline of the proposal is as follows:

Fundamentals

  • Who does the cover protect?
    • The protocol itself, rather than individual vault owners
    • MKR holders
    • DAI users indirectly, by making the overall protocol more resilient.
  • What are the main underlying risks?
    • Collateral Failure
    • Oracle Failure
    • Liquidations being sold below market value
    • Risk management processes failing
  • How do the risks manifest themselves?
    • DAI debt leading to minting and auctioning MKR
    • Implementation of Emergency Shutdown
    • DAI dropping below the peg
  • Goals:
    • Simple claim payout trigger
    • Covers all the main risks
    • keeps interests aligned with MKR holders
    • pricing is reasonable

Suggested Product

The following product assumes that nearly all material risks manifest themselves through either MakerDAO accruing debt or the Emergency Shutdown being implemented.

  • Cover is only valid if purchased by MakerDAO (not regular crypto users)
  • Cover is bought in lots (lot size TBA but might be 3,000,000 DAI)
  • Cover is paid for in DAI and claim payments are made in DAI
  • Nexus Mutual can currently offer a maximum of 32,485 ETH worth of cover in total, roughly $12m at an ETH price of $370. This will expand as Nexus Mutual grows and further cover can be bought in the future if desired.

Claims Triggers

A) If DAI debt goes above a threshold, eg 5,000,000 DAI, then a claim from one lot will be paid, eg 3,000,000. This continues for each 5m tranche, for example if DAI debt goes above 10,000,000 DAI then 2 lots will be paid, 6,000,000 DAI in total.

Note: Claims are only paid for each threshold being breached once within any monthly(?) period. This gives time so that MKR auctions get cleared and bring the debt position back to zero.

I believe the right metric to track is “Debt Available to Heal” here https://daistats.com/#/

B) If Emergency Shutdown is enacted claims on all lots will be paid. Any planned Emergency Shutdowns for the purposes of upgrading the Maker Protocol are specifically excluded.

Payments could be sent to the DAI debt pool (where auctions are conducted from), on the assumption that the DAI would directly reduces the need to hold some MKR auctions. Would need to be confirmed if this makes sense technically.

Pricing

Pricing needs to be determined by Nexus Mutual stakers after the product has been finalised.

Disclosures: I’m the Founder of Nexus Mutual and hold NXM tokens.

15 Likes

Wow, that would be a great idea.

MKR marketcap is currently $0.5B, if nexus offer at most $12m coverage, does it worth paying the insurance premium?
The the expected profit from insurance is always negative, and $12m hit is something a $0.5B token suppose to be able to handle without an insurance.

5 Likes

This isn’t necessarily true. The last time there was bad debt in the system, it was just over 5M Dai. In that instance, this cover would have prevented a Flop Auction (if I’m understanding Hugh’s proposal correctly). Personally I think this is a really interesting concept.

5 Likes

Basically if my understanding is correct they would cover up to 60%

Feels like whether this is worthwhile or not this would depend heavily on the cost to Maker. Interesting idea though, would love to hear estimates as to the pricing.

I feel like this is true, and probably a key point. Unless the insurance can cover an event that would otherwise lead to the collapse of the protocol, I’m not sure whether it would be worthwhile. Assuming that we’re pricing risk correctly, we should have positive EV.

I’m also not sure if this is good for the protocol itself. Part of the game theory supporting the protocol is that if MKR holders make bad decisions, new MKR is printed which leads to a wider distribution of the token, bringing in new token holders to govern the protocol (hopefully more effectively). If insurance prevents bad decisions resulting in MKR mints, the same people will be making (bad?) decisions in the future.

5 Likes

I can’t see this happening more than once. If we make crap decisions then Nexus will crank up the premium to compensate.

I’m not saying that I think re-insurance is a good idea; I’m really not sure.

1 Like

I actually think it’s a great idea. It shifts a lot of the “overhead” to Nexus, so that the Maker Holders are forced to actually work harder if their premiums go up due to previous mistakes. I imagine a world where MKR holders are constantly choosing to “self insure” or “outsource.”

2 Likes

This hits really close to home for me, as solvency risk was one of the first things I engaged with at MakerDAO <3

Completely agree with @LongForWisdom that ultimately, whether this is a good idea for MKR holders depends on the cost of capital/coverage. But, I think it could be worth pursuing on a small scale even if the cost isn’t great initially - MakerDAO could potentially help nexus reach economies of scale with specialized risk transfer products.

4 Likes

We can help each other :wink:

How is the claim enforced? In other words how are we assured that if it complies with the requirements the claim is paid?

1 Like

Nexus is a discretionary mutual. Members are KYCd, so there are real people and a legal entity to fall back on. But ultimately it is up to NXM holders to decide to pay claims. There is non-negligible tail risk, if the entire mutual would go BK rational holders might vote against paying claims.

1 Like

The idea is that usually one buys insurance for event that he cannot handle/survive. MKR handled the $5m print, and the max cover op suggest is $13m, which is something one would expect $0.5B token to survive.

That said, it could be interesting experiment, and how they price it is interesting.

So basically we should factor in the possibility that they may chose not to pay as there is no enforcing mechanism

I see it as similar to how people consider insurance co credit ratings when purchasing annuities or life insurance. We’d want to keep an eye on Nexus capital levels and exposures - not making a 100% assumption that they would have the money to pay claims.

That being said, I think it’s unlikely that NXM holders would vote against valid claims - the value of the project ultimately rests on reputation.

3 Likes

Yes agreed, although taking into account the magnitude of outstanding dai there is a likelyhood of concentration risks, also we should factor in composability risk.

5m on black friday…we are 9x today, at the end of the day it depends on pricing and $ covered but although i did not look into NXM I presume we may be taking a big piece of the pie that’s why I wanted to know if there was enforceability.

Lastly I would not compare this to real world insurances, that’s a very regulated sector and you cannot simply chose not to pay.

1 Like

Since the NXM holders are all real people and it’s a mutual insurance company, shouldn’t there be legal enforceability? Maybe you can help on this one @Hugh_Karp

Maybe that’s why individuals buy insurance, but in this case I think the calculus should be if the premiums over the lifetime of the policy are less than the cost of the probable consequence of self-insuring. For example, if Nexus was willing to charge us $1M for a $5M policy, that covered an event that we assume has an 80% chance of happening over the same timeframe, we should obviously buy that policy. My point is that the calculus should be “self insurance vs external insurance”, on a mathematical basis. At that point, it’s our actuarial skills versus theirs, and in theory everyone wins.

2 Likes

Well if it’s a specific insurance one of the parties is mispricing the risk or in the best case scenario we are loosing from the premium paid.

We do win by outsourcing the risk analysis and focusing on the revenue side if it can be enforced. We also win on maker having discounted the potential loss of mkr printing since it would be “insured”, of course as long as we have guarantees that it effectively can be enforced. This can also be looked as a downside since mkr holders and the risk team should specialize on this issues, having a key component outsourced is a dependency risk on itself.

But it’s not like NXM can have independent parties subject to the same risk (car insurance) , there is only one maker for the time being.

I’m not discounting the option, it has upsides & downsides, another option within maker could be to have mkr stalked as insurance and pay them the fee.

Thank you for offering to quote policy covers for potential bad debt accrued to MakerDAO, Hugh.

I think Nexus Mutual will sell tailored policies with MakerDAO as beneficiary, and the buyer won’t be MakerDAO.

Most likely, Nexus Mutual would offer a price MakerDAO would not choose to pay. The exception would be if both sides had wildly divergent risk assessments. MakerDAO already has insurance against bad debt, so only a positive expected value would make buying a cover policy potentially worthwhile (a large one to be worth the bother).

A more likely customer for this policy is a collateral on-boarding applicant.
The applicant’s goal is to get on-boarded, and under optimal terms.
An applicant may want to improve its chance of getting on-boarded by including a Nexus Mutual policy cover benefiting MakerDAO (even if they agree that the policy itself has a negative expected value).

I suggest contacting the interested parties of collateral applications. An applicant could place the policy fee in escrow, so that the policy is purchased (with MakerDAO as beneficiary) upon successful on-boarding, otherwise returned after some period of time. Then, the applicant can update the application to reflect their improved risk profile.

This could potentially make some applications so much more attractive to MakerDAO that including a policy cover becomes the standard. A loose analogy might be including a major appliance home warranty policy with the sale of a house.

3 Likes

How in theory everyone win? This is zero sum game (beside publicity maybe).

Agree that if they sell it for cheap it could be worth while, but then they lose (on average).

3 Likes