Bootstrapping Decentralized Cover Pool Liquidity

8 min read
Bootstrapping Cover Pool Liquidity

Learn about how to bootstrap the liquidity on cover pools, the risk, and the rewards.

Incidents in the DeFi space happen, and when they do, they can cause serious financial damage. Neptune Mutual’s marketplace allows DeFi, CeFi and metaverse projects to create cover pools with parametric cover policies that protect digital assets and are designed to meet the needs of their own project and community.

The crisis in crypto markets has many DeFi projects asking themselves, how can we help protect our community, and how can we bootstrap the liquidity to do this? To answer this question, it is helpful to understand the perspective of those who can provide liquidity who may ask: Why should I invest my liquidity in your cover pool?

In our blog Don’t Be a Salmon in a Bear Market, we covered the importance of risk and return, and how investors need to understand both the risks they are taking as well as how their returns are generated. Investors should ask, “What are the risks (probability and impact) that my liquidity will be underwriting in this cover pool?” And of course, investors will want to know about the returns they might expect for providing this liquidity. The final question investors need to answer is, how well does the risk/return opportunity of providing liquidity compare with other investment options?

Understanding Risks#

Information and data analysis plays an integral part in understanding and predicting risks and returns. In the traditional world of insurance and banking this is so true that they created a specific term for it, actuarial science:

Actuarial science is the discipline that applies mathematical and statistical methods to assess risk in insurance, finance, and other industries.

In the case of the blockchain industry, it is still so young that there isn’t enough historical data to develop statistically reliable blockchain risk pricing models.

Fortunately, there are “reference points” that can be used to benchmark project risks. What’s clear though is that there is an information asymmetry between those that create and manage blockchain projects and those that provide liquidity for underwriting blockchain project risks.

The role of cover creators, and Neptune Mutual which provides the marketplace infrastructure, is to help all stakeholders develop their understanding of hack and exploit risks, and above all to provide an effective and reliable means of mitigating these risks. This leads to the first and probably most important aspect of bootstrapping liquidity: effective communication that builds trust in a community’s security measures.

When it comes to blockchain projects and smart contracts, one of the most fundamental attributes of these systems is that they do away with the need for trust: “trustless” is no doubt a term that you have seen regularly in relation to blockchain projects. It is therefore ironic that trust plays such an important role in convincing liquidity providers that your project security is resilient to cyber threats, and that providing liquidity to your cover pool is a good opportunity. The key to bootstrapping liquidity is to build trust in the security of your project. If you are leading a CeFi, DeFi, or metaverse project then the process of creating a cover pool for your community provides an ideal forum to create a connection with your community in relation to security, protection of digital assets, and responsible investment. This should help drive engagement, attract new members and grow your community.

Transparency Promotes Trustworthiness#

One of the most obvious ways to make a project more trustworthy is by being transparent. Projects in the DeFi space often tend towards anonymity and secrecy; there may, of course, be good reasons for this, but it does make it more difficult to develop a relationship of trust if the community has no visibility of who they are trusting.

Transparency in relation to the project team means the community can more easily identify with, and above all hold accountable, the individuals of the team. Nonetheless, for DeFi teams that wish to remain anonymous Neptune Mutual can go some way to helping build trust by KYCing the cover creator team; this way the Neptunite and project community can be sure that the cover creator/project team can be held individually responsible (as their identity is known by the Neptune Mutual leadership team), despite remaining anonymous to the wider community.

At Neptune Mutual, we try to live by our recommendations, and so our team is clearly identified on our project website’s front page, making it easy for everyone to know who we are, and to hold us responsible for our actions.

Transparency also carries over into code. How secure a project is depends, in large part, on the quality of the code. While it is true that many liquidity providers are not typically well versed in assessing solidity code, front-end code, or other attack vectors, it seems a reasonable assumption that those projects with an open-source code repository will be more open, transparent, and confident in the robustness of their code in protecting against technical risks. In other words, the more open a project is, the better chance it has of being secure. This point deserves emphasis since cover creators are asking liquidity providers to underwrite security vulnerabilities, and liquidity providers can legitimately ask how they can assess this risk if the code is hidden behind a virtual wall.

As mentioned, we try to lead by example and the Neptune Mutual code can be seen in our project’s Github repository.

Bootstrapping Cover Pool Liquidity: Leading by Example and Building Resilience#

If cover creators are hoping to encourage liquidity providers (LPs) to underwrite security risks in their projects, it stands to reason that LPs expect cover creators to inject some initial liquidity into their own cover pool. This is where the idea of “walking the talk” comes in; by doing so, it will encourage LPs to do the same.

Cover creators need to be aware that protecting their project communities requires more than completing one or more smart contract audits. It’s about taking proactive measures, including providing initial liquidity and showing through different ways how committed the project is towards digital asset protection.

Reassuring Your LP Community#

One of the four design principles that we used in creating the cover pool marketplace is minimising risk for stakeholders; all four principles are discussed in our recent blog. This principle led us to the idea of the reassurance pool. The reassurance pool reduces risk to LPs by re-capitalising the liquidity pool in the event that an incident arises (assuming it is validated by the community and the cover pool pays out to policyholders). Recapitalisation of the cover pool by the reassurance pool can be made up to 25% of the loss suffered by the cover pool. Cover creators that fund a reassurance pool will lower the risk exposure of LPs and will therefore find it correspondingly easier to attract and bootstrap liquidity from their community and from the Neptunite community.

The Neptunite Community#

As a cover creator, you will need to communicate the benefits of your cover pool to your community. To help create a more accessible platform, we have designed a feature where cover creators can request assistance to bootstrap liquidity. Visit the bond section to see the details of this application process for cover creators.

The idea is to engage and empower the Neptunite community. Only projects that can demonstrate a complete commitment to existing and ongoing security excellence will receive liquidity assistance, and this is yet another way of providing confidence to the liquidity provider community that the cover pool is worth considering.

The importance of a staking pool cannot be understated for those who are serious about bootstrapping liquidity. Cover creators should carefully consider it while looking to activate the NPM community and realise the advantages of Neptune Mutual’s staking pool feature.

Returns and Protection from Crypto Price Volatility#

Stablecoins are a popular way to keep your cryptocurrency safe, but it’s important that you know the risks associated with them. In our last two articles about Capital Requirements and Widespread Adoption of Financial Protection, we discussed how APYs that incorporate tokens can be misleading because they ignore potentially large changes in the value of both the principal (the amount deposited) as well as the value of the additional tokens (irrespective of how many new tokens you actually receive): it the token value drops significantly this can lead to a situation where investors make an overall loss in dollar terms even when achieving very positive APY token returns.

In the Neptune Mutual marketplace, returns for liquidity providers are transparent, because liquidity is provided in stablecoins and returns are paid in stablecoins; in this way, LP returns are insulated from variations in token prices. In addition, the amount of liquidity in the pools is insulated from token price volatility and this is just one of the reasons that policyholders can be confident there will always be sufficient liquidity to pay all policyholders in the event of an incident.

For those readers who have used our testnet application, you’ll see that whilst policyholder fees are the most prominent source of LP returns, there are quite a number of others. Firstly, some of the pool’s excess liquidity is used to generate returns through automated investment strategies in select lending protocols like Compound and Aave. In addition, cover pool liquidity can be used for flash loan lending that generates income for the pool and hence returns for LPs.

POD Staking#

The POD staking mechanism allows projects to provide an additional return to LPs over and above that indicated in the cover pool card in the Neptune Mutual application. POD staking returns take the form of project native tokens. This additional return is not included in the standard cover pool LP APY calculation. Take a detailed look at how POD staking works and find out its importance in bootstrapping cover pool liquidity.

Bootstrapping Conclusion#

In this uncertain time, it’s more important than ever to build trust with your community. By following these liquidity bootstrapping guidelines we hope that cover creators can build resilience, improve project security and offer a reliable solution to their community to protect digital assets. We hope you’ll join us in our mission to cover, protect, and secure on-chain digital assets.