AMA June 2022: Nexo Fundamentals

June has been a rollercoaster ride of a month, but we haven’t left out our regular AMA session with Nexo Co-founder and Managing Partner Antoni Trenchev. With the recent market downturns, we go back to the basics with Kalin Metodiev, CFA, Co-founder and Managing partner at Nexo to talk about all-important business fundamentals that allow us to grow sustainably.

Dive in to understand how Nexo functions with prudent risk management, overcollateralization, licensing, security measures and sound business management.

Question 1 (2:02): After unforeseen events, the Celsius network and other competitors halted some, or all transactions on their platforms. What measures are enforced to prevent such a scenario at Nexo?

Antoni: It is about the fundamental way we went about when structuring the business of Nexo. This is not something you can do in days, weeks or months – it is how you build out the business from day one, all the processes that we have and safeguards we’ve put in place over the last close to 5 years. At the core of our business is always the security of client funds. We know how hard you worked to get those – you deserve to be protected. We have designed the platform with that in mind.

In the early days we started with our bread-and-butter product, the Instant Crypto-Backed Loans. And these were always on an overcollateralization-basis, because markets are volatile. As long as we know who you are, you come and deal with us – you have the collateral and we don’t need to conduct credit checks. In that sense, it is a much more inclusive product. This is an example of some of the safeguards we have in place – like the overcollateralization. Kalin can perhaps briefly touch up on risk management and how we go about our business and counterparty selection, and managing that risk.

Kalin: Risk management has always been probably the centerpiece of our business model deployment. There are other competencies that complement the entire picture and our operating approach, but risk management is essentially the harness that has allowed us to grow as quickly and as ambitiously as possible, but within the framework of it, of the constraints that it gives us.

For example, one of the things Antoni has always mentioned on these AMA sessions is that we are very dependent and heavily involved in the building of our automation since day one. Every single aspect of our business is automated, so that it allows us to objectively and without any further human involvement execute certain algorithms that protect the principle of the Nexo’s balance sheet and our customers’ money.

Sometimes we’ve been accused by competition and by unfortunate members of our community that this particular aspect works in a very unforgiving way – our margin calls and ultimately, during times of excessive volatility, unfortunately liquidations on the collateral.

That is part of over-extended loans that have quite high LTVs. In sum, I’d like to add that we always work on the deployment of our business model in the most professional way with uncompromising risk management. Adding team members that have specific qualifications so that they always provide a synergistic effect to the efforts of the overall team.

Antoni: This is what sets us apart from almost everybody – the automation part. That’s why when you issue time-based versus price-based margin calls you can get in trouble. That’s how, at least partially, the currency mess in the space came about.

Question 2 (7:05): Did you get a response from the Celsius team? If you get a positive response, does that mean Celsius is now under Nexo control and management?

Kalin: First of all, we as a company would like to express our empathy to our community, to the entire blockchain space about the wealth destruction that we have seen here over the last few weeks. The macroeconomic factors have changed, the overall optimism and inclination to direct money to our space and in general to capital markets, to assets around the world, has turned 180 degrees.

From an overly optimistic state the market has gone into a state of fear. Some people might say that the pendulum has swung too much in the opposite direction, that the correction has been too much. We believe that there is some visible volatility on the horizon and nobody can say whether this is the bottom and whether we will see smaller market valuations, so definitely buckle-up.

We have always been very open about our commitment to the healthy growth of the ecosystem. We’re always interested in supporting companies, partnering in projects and strong teams that have a clear vision of how they can create an innovative product that will be demanded by the blockchain community or users of financial services around the world on a sustainable basis.

They would have the correct pricing model for the provision of their services and the project or company will have the ability to break even eventually and deliver returns to its investors. We have supported such teams and initiatives, but at the same time we have kept our eye on companies that have built momentum in the space, but are struggling with the proper execution of their business model or with the financial metrics that can underline its success. In the recent developments that we have seen over the last weeks, some companies have gone into trouble for various reasons.

We have initiated conversations in a professional manner – this isn’t some sort of a stronger-competitor feeling satisfied or being overly-confident, because we are seeing some of the other players in our niche are struggling. It is exactly the opposite – we believe the ecosystem needs help. Everybody is aware that, contrary to established capital markets, there isn’t somebody out there at the end of the line to save everybody when we get in trouble – there isn’t a lender of last resort. More or less, we self-regulate ourselves to this day – we are very diligent thanks to Antoni and his team with all the regulatory steps we’re taking. In other parts of the industry everybody relies on themselves.

This is where we come in to provide possibly a helping hand and find ways to help – whether it is advice or the provision of liquidity, or on the basis of the acquisition of certain parts of the business, or the entire business. We’re currently looking at about 7-8 companies in the space, where Nexo can be instrumental with turning things around and optimizing the pursuit of shareholder returns. I cannot speak in detail about ongoing processes, but I can assure our viewers and our community that we are very active on this front and I only hope that when we extend our help, it will be received.

Antoni: Just to sum up the overall situation and something that I brought up in my last interview. This is reminiscent of the 1907 Banks Panic, there are a great many parallels to that time and to the current state and development of the blockchain. The point is that, early days in crypto look like early days in traditional finance.

The panic that came out from the railroad sector in the US, JP Morgan and his bankers, that were solvent, prudent and liquid came about and self-regulated, cleaned up and consolidated the space out of which grew the next wave of the dominant players and household names that still ring bells.

This is what we’re seeing in crypto play out – there will be consolidations, there will be different fractions coming together, hopefully for the betterment of the state. This is how we’re approaching this. I have refused to engage in any sort of trash-talking of competitors.

Question 3 (14:55): How are you guys doing so well when others are almost liquidated? What’s your secret to success?

Kalin: I will say there isn’t some sort of a unique secret. Early on when we devised our whitepaper, the operations and the goals we have pursued in these almost 5 years are not different. Contrary to some of the players in space and not only the lending space, but the blockchain industry as whole, many companies have gone through one or even more pivots before they’ve figured out what their true calling is.

For us, we have had a very well-defined set of goals and a very well-structured business plan on how to pursue these goals. All the pillars of the execution of our business plan have been incorporated since day one. We pursued operations that were a part of our professional track record until then – we brought our experience, know-how, systems, and experienced team-members to the building of Nexo. We incorporated technology and automation since day one.

I believe this strong discipline and reliance on our expertise has been probably one of the core secrets to our success. We have stayed true to our calling and our procedures and I believe this discipline has been one the most important factors for our success.

Antoni: Another thing that contributed to our successful mitigation of risk is this refusal to yield to the temptation to do something just because everybody is doing it. I remember this prominent hedge fund that was in the media last week. They came to Kalin at the institutional lending desk and asked for an uncollateralized loan. Kalin was adamant about our inability to lend to them, given their risk profile, given their strategies, given precisely what they had in mind to do.

He was almost laughed at by them and similar market participants – it appears Nexo is the only one who doesn’t understand the interbank market of crypto. Fast-forward two years later and it’s a totally different story. We have held ourselves together and in-check the way the enterprise has been built between different departments, checks and balances, so we don’t get caught in this cycle of financing long-term debt with short-term depositors.

This is something that always goes sour whether it’s long-term capital management in ‘98, whether it is the subprime mortgage crisis of the late ‘00s. It always ends up in tears and us being good students and some of us being slightly older than others, we remember that well and have been good at learning the lessons of history and translating them to reality. There is this saying by Lloyd Blankfein: “Be an excellent interpreter of the present.” You don’t need to see what the future holds, because managing the present properly is sufficient for you to be successful in life.

Question 4 (20:45): Could you give us a sense as to the amount by which assets exceed liabilities?

Antoni: Just to give context, the question is referring to our real-time attestation that we pioneered with Armanino and to this day I think we are the only crypto-lender to have real-time attestation of assets. Everybody should do it and I’ve challenged the industry to be better than the individual and bring up to speed on that front. We have this audit which is in real-time by Armanino and it shows on-chain, cryptographically-provable that our assets exceed our liabilities by more than 100% and the question is by how much.

I am in a position to say that these are triple-digit millions. Due to the volatility of the market and some constraints we have on confidentiality and the legal side, I cannot disclose more. There is a big cushion which provides us the comfort to operate within these volatile markets.

Question 5 (22:39): You increased the insurance on Nexo, but I still want to know how you manage risk and why you put so much emphasis on overcollateralization?

Kalin: This is a question we’ve been asked many times and we have never gotten tired of explaining it. The most important thing I touched on is that collateralization for us is one of the most important aspects of our risk management. When we lend to hundreds of thousands of people around the world, the reason why we’ve chosen to do this since day 1 is because we have the ability to geographically spread our risk, but also across various user groups and user segments.

There isn’t an over-reliance on the consumer dynamics and behavior in a particular US state or a particular south-east asian country or any country around the world. For us, this was one of the most important considerations since day one – we want to make sure that the total resource that we have on our balance sheet can be spread as thinly as possible and we’re not going to be subjected to specific macroeconomic events that affect a particular user group or geography.

From that point on, the collateralization on the loan that we extend is one of the more straightforward ways, an aspect that we can assess every split-second. Antoni has mentioned on a number of his sessions, that we have this automated system connected to over 20 exchanges and liquidity pools, which pings every split-second every single one of these values, it incorporates specific statistical aspects of liquidity, the depth of the order book on various exchanges and it gives us a slightly adjusted, but I believe a crystal-clear view of the market value of every single collateral that we hold for every single loan exposure to every single client of ours around the world.

This is the direct answer to this questions – when we have this overcollateralization and we know exactly what the LTV is, we have the ability in a fully-automated manner to issue these margin-calls to warn our customers: “It’s time for action, because the market can move against you.” We make these margin calls extremely visible – those of you who have received these margin calls can attest to it, email and text messages.

We don’t want our customers to get liquidated, rather we want them to take action by either repaying part of the loan or adding additional collateral to bring it to a manageable and healthy LTV level, so we can avoid this ultimate threat, which is our system to automatically liquidate collateral.

If I can use this session today, it would be to deliver this message to our clientele and say: “Please, regardless of the margin call level, make sure that in these volatile times, during this market uncertainty, that you keep your LTV at healthier and relatively lower levels than your normal preference to make sure that you don't get subjected to sudden volatility, congested networks and people are trying to take action but unfortunately they don't have the time to do it.”

Antoni: Our systems have been stress-tested like no others. In 2018 bitcoin lost 86% over the course of the year so gradual decline. In 2020 amidst Covid, Bitcoin lost 47% intraday so a sharp decline. The same thing happened last year 2021 around another China-related Bitcoin ban and we as an entity did not lose a dollar, because we have this fiduciary obligation. We have people who are earning and we have people who are borrowing. When times get ugly and markets get volatile we have this fiduciary obligation to balance out the interests of those two groups and we have done one of the finer jobs of doing that.

Question 6 (28:31): Why did you say you are the only lending platform not to have been hacked when a director of a competitor has told me this to be specifically untrue?

Antoni: I challenge anyone who claims that we’ve been hacked in any way to show proof of that because this is quite blatantly gossip and we don't engage in gossip. Nexo has never been hacked and given the amounts of both in-crypto and in-dollar value that we hold within our wallets, believe me people have tried and they have failed. I don't want this to challenge all the ill actors of the world to be on alert, but believe me if there were exploits to be exploited, they would have been exploited.

Kalin: When we try to assess market conditions, when we try to make our investment decisions, when we try to form an opinion about something that happens in the market, I urge you to always double check your information and try to verify it from numerous sources. “A director of a competitor” probably is not the most objective voice of opinion out there. We receive a ton of information every day from the community, from our users and believe me, we never take anything for granted and 100% face value.

We always put it through numerous other ways to cross-check it and make sure that we find as much objective truth as possible. But the more important aspect here goes back to our business model. A number of our competitors have openly declared cases where they have been hacked, because they had the need, they were urged to go and deploy assets on other platforms, especially in the DeFi space without having the ability to verify the security of these platforms.

They were in a very desperate need to find sources for yield generation. On our end, when you have a sustainable and working business model, when you have global demand for our crypto-backed loans, this gives us the ability to stay within the confines of our system, of our platform and worry about the protection on multiple levels, both software and hardware, against hacks.

But we have this confidence, because we do daily checks and rechecks to make sure that all, even theoretical holes are plugged and then we don't have to worry so much and keep our fingers crossed. If our business model didn't deliver the results and we were forced to look for opportunities elsewhere then, obviously, we will be subjected to non-market risks and I believe that this is one of the first questions that you should be asking other platforms, wallet providers and custodians when you go and do business with them.

Question 7 (32:39): Could you please explain how Nexo generates yield and distributes it to earn products? Are high yields sustainable in the bear market?

Kalin: Our signature product since day one has been the fully-collateralized crypto-backed loans. When we source liquidity from various segments in the market, whether it's our savings product called Nexo Earn, whether it's our arrangements that we have with various companies, corporate treasuries around the world and last but not least our institutional counterparties, we use this liquidity mainly to satisfy demand that comes around the world for loans extended to our customers who can back up these loans with the acceptable cryptocurrencies on our platform.

This gives us the luxury, the stability to rely on the soundness of this core business model and then we’re not tempted to look elsewhere for answers. Of course there are answers and we have the ability to explore some of these answers as the market develops and as it provides to us opportunities that may have not existed even in 2018 and 2019 when liquidity in the markets was much weaker and we didn't have the ability to take advantage of it.

For example, there are numerous market-neutral types of solutions. Some are well known like the traditional carry trade. It was obviously something that was available for everybody's use last year. There are other approaches related to our advanced trading capability – we recently announced our Prime brokerage platform.

So if you have a lot of parties trading on this platform that aggregates an order book from numerous exchanges, we have the ability to provide a market-making layer of services on it – on one hand to narrow the trading spread which is something that everybody benefits from, but on the other end to also pursue returns from these operations that are provided on a risk-free basis. Revenues from trading on this exchange, revenues from other services that we’re providing more and more on the institutional front. These represent the core of our revenue generation.

On the other hand, the strong automation and our very disciplined approach to how we expand our opaque structure, meaning that we don't expand it beyond limits that will endanger our operating and net profits, is something that is key in our operations.

Antoni: I'll take the second part of the question about the sustainability of high yields in the current environment. It's a tricky question, because I understand it pertains to the crypto space. In crypto nobody truly knows, but my personal guess would be the following: that due to some challenges that some companies will face, they will be forced to offer higher rates. Sometimes even rates that seem exorbitant, that seem irrational, that do not make sense in a rush and an effort to “keep the lights on” so to say and to avoid insolvency.

People will be forced to borrow at higher rates, so you will be bombarded with “interesting” and high-yield products. At the same time, due to less ability to generate the yields, providers like Nexo, who in order to pay you let's say 6%, we have to go out and make at least 8% to make it all work and economically sound and sustainable those platforms and service providers those type of platforms will perhaps offer lower rates over the next couple of months. But this goes back to what we talked about – the sustainability of the models, the safety, the soundness of the business. At the end of the day, it is better to have a lower-yielding, but more secure product than prospects of double digit yield that will result in a 100% loss for you.

Question 8 (38:37): How is Nexo’s financial situation? Can you bridge two years of bear market?

Kalin: I hope that the bear market lasts less than two years, because obviously it's not fun in a bear market. We are known for not gloating about our strong competitive positions in many aspects of the business. We understand that this market is devastating to a lot of companies, to a lot of young projects.

We are very well aware on the basis of our strong presence in the ecosystem through our venture capital fund. How many ambitious and skillful teams are there that are actually imagining right now and building and reading to deploy new innovative models for the provision of services, not only financial services but various new solutions in our lives, that those projects are currently endangered. It's questionable whether they will find the proper support over the necessary period of time to make sure that these products and services are finalized and they can be offered to the global community.

I think these are definitely challenging times but at the same time we have this tool on our website which presents in real time that our assets exceed our liabilities. It's not just our opinion here, it is readily verifiable, that we have positive net assets and positive equity, which makes us one of the strangers in this industry. To this point we have not had to rely on any equity raises to support our growth and to fortify our financial position. If you look at these two aspects only, we have a very strong financial position that not only testifies to the viability and strength of our business model, but it also gives an indication about our ability right now in this market to emerge stronger, to help some of those possibly that need help in the industry, but at the same time also to use the opportunity to consolidate more of our business and to help provide services on a wider user-front, that make sense and that our customers can feel happy, but also secure with.

Antoni: The business model of Nexo works in bull markets and bear markets. Obviously we prefer a steadily rising market like every investor out there, but it has proven during the lengthier market of our first year of operation nonetheless that it is one that also works in bear markets.

Question 9 (43:02): I believe Nexo can be the Amazon of crypto lenders. Do you agree and what is needed to evolve further?

Antoni: I re-watched an old Jeff Bezos interview and he said he had a very simple vision of Amazon – he wanted to make an online bookstore and if you look at his original business plan, it’s very simple. It’s the same thing with Nexo. We wanted to devise a platform for instant crypto credit, because we as users needed it.

Our co-founder and the guy who originally came up with the idea of Nexo, Kosta needed it because he had a bunch of Bitcoin he wanted to borrow against, so he can buy more Bitcoin. These are the ways that the greatest products are built out. You have to have a very clear vision and you have to grow organically according to the needs of the space. Right now we're seeing this consolidation phase, we are seeing that sound business practices, cash flow and pedestrian things like that in the crazy phases of the bull cycle do matter at the end of the day and you have to be responsible.

You have to go back to the fundamentals, that we talked about – prudent risk management, overcollateralization, licensing, security of the ecosystem and all those things that we talked about today they matter at the end of the day because you cannot be consistently on the right side of things without them whether it's bull market whether it's a bear market whether competitors are going insolvent unless you have those. Be a good interpreter of the present so that you will be among tomorrow's victors.

Kalin: It's only natural for the blockchain space and it's been natural in the history of humanity. Societies have gone through such transformations, cultures, music, taste for fashion. There's always some sort of consolidation and people tend to very quickly direct their attention, their efforts, spend their time, spend their money on solutions in all of these areas that make the greatest sense – the most user-friendly, the most appealing, the most sustainable, the most eco-friendly.

My point is that the blockchain space is still young, but at the same time a number of years have rolled since the publishing of Satoshi's white paper. Recently especially in light of this market implosion, we're having more and more interesting conversations with customers, with traders around the world, but also with business owners and I'm talking about the big institutional owners of businesses in our lending niche. They are becoming convinced that some of the business models that are deployed by other companies just don't work. They don't have the same level of execution, they don't have the same level of readiness and know-how – for some reason the inner mechanics of the business development and deployment don't work.

And last, but not least – just some bad managerial decisions have been made. It's high time for communities to just deviate from this model of being uber-loyal to a particular company, project or token, and just start looking at the bigger picture. To start evaluating by thinking logically – if we have given this much time to a particular project and it hasn't delivered, while at the same time it's burning through some heavy cash, isn't it time that we consider that there's perhaps somebody better positioned? How to pass the baton and make sure that a more experienced, more tech-centered team can come and take over. We would like to deliver a message to you – be more vocal within your community, ask harder questions to those that are leading the companies you're invested in and basically say isn't there a better way?

Consolidation whether we like it or not is coming to the space. These market developments that we're seeing right now only accelerate these developments, so I would suggest let's work all together to figure out how there could be a quicker and more orderly procession and discussions, collaboration towards the emergence of these Amazons in various aspects of the industry. The world doesn't need 20 000 blockchain projects, there aren't going to be 20 000 successful business companies in this space.

There will be fewer, but at the same time they will have a much better alignment with the regulatory climate, they will have much better readiness to execute a sustainable business model, they will have the necessary degree of automation, they will have the experienced teams and they will have a happy and healthy community to take advantage of the products and services that they will deliver to the world.