For a long time now, users have asked about the ability to stake on other user’s models. Such an idea at face value sounds reasonable to an outsider, but from Numerai’s perspective, this is not ideal.
How does Numerai benefit from such a system? Without more detail, and assuming this naïve case, they do not benefit.
What if a user could solicit backers? Here’s a thought experiment.
I am willing to accept a backer as long as they agree to a payout ratio of my choosing (where I keep X % of profit) and a sufficient lockup period to prevent backers from chasing short-term gains.
The backer is going to want some assurances of model stability; this would come from some type of vetting process between the user and the backer. Numerai would have nothing to do with this part of the process, but benefits directly, because backers would only select users who could sufficiently satisfy them that the user won’t be swapping submission files and other risky behaviors. Backers therefore would select the users with the best disclosure and communication, which should also translate to the most performant models gaining representation in the stake weighted meta model.
Why have a lockup? First, the user doesn’t want to lose backers after only a few rounds. For such a system to work, the backer has to stick around for a while. The backer benefits from a lockup as well. If the user and the backer share in gains, then they should share in losses, too. Murphy’s Law suggests that most backers would start their lockup at the beginning of a burn sequence, so a long window helps to smooth out the return series in the case of entering during a burn. A claw-back provision could exist, or even a high-water mark. A user could signal their confidence (and justify a high profit sharing ratio) by offering a claw-back or high-water mark just as hedge funds do. This also benefits Numerai because, again, the highest-quality users would offer such terms, and therefore attract larger backers, thus weighing more heavily in the stake-weighted meta model. Again, Numerai benefits in this scenario.
This system requires a few features:
1 – a payout ratio
2 – a lockup period
3 – burn reserve or mechanism for shared burn expensing
4 – a UX for the user to establish the terms of the agreement
Users should offer terms and not the other way around. Users can establish unit sizes for backers so that custom amounts are not required. For instance, every agreement is for a fixed amount of NMR, and the backer can choose how many units to fund. They should be sufficiently large to avoid high ETH gas cost but also small enough to allow for backers to diversify their stakes across a number of models.
I believe the third option is the most difficult only because I haven’t thought about it as much as the other components. Some analysis should be done to ensure that a claw-back or high-water-mark is fair for the model owner but not at the expense of signal value to Numerai.
Here’s a full example.
I offer a 50% profit share with a 4-month lockup. I will only accept units of 100NMR. Stakes compound for 3 months, with a 1-month wind-down to withdraw the NMR to pay the backer and the user. If the net return was 40 NMR, then 20 NMR goes to the user, and 120 NMR goes to the backer. Now the backer can choose to fund another agreement.
What happens if there’s a burn? Here’s where I am unsure of how this would work mechanically.
Same deal terms, but now there’s a burn. If I offer a 50% profit share, then I must be willing to also take part in the burns. This could be funded by the modeler’s personal stake. Surely a backer would not stake on a model that has no stake of their own? If the net burn was 20 NMR, then I would owe the backer 10 NMR. Either a reserve could be established at the start, such that the backer’s stake plus some amount of NMR from the modeler gets locked up together, or upon the initiation of the wind-down process, an amount is withdrawn against the user’s stake to fund the burn share.
Since profit is shared alongside burns, users are limited to the amount of NMR that can be staked against them. This is also good for Numerai, since a single user would be unlikely to attract all of the available NMR for outside staking. A limit exists where the user’s own NMR must be sufficient to fund their agreements with backers in the case of burns.
What about cheap payout ratios? This is sub-optimal for all parties. If I offer a 10% profit share, then the backer is taking 90% of the risk. If I offer a 90% profit share, then the backer may not receive enough return to justify the agreement. At 90%, I’d need to have 90 NMR available on a 100 NMR backer agreement in the event of a full burn, if the agreement called for a full reserve. Leverage, therefore, is controlled by the amount required in reserve. In the vetting process, a user and backer can determine a sufficient reserve requirement. Smaller reserves allow for higher leverage, but more risk for the backer. Again, the vetting and due diligence process benefits all parties; users unwilling to communicate will not receive lower reserve requirements.
Spence (1973) theorized that the greater the cost of a market signal, the greater the trust (creatively summarized). Anonymity is free. Therefore, anonymous users are not likely to attract capital, whereas users who provide a vast amount of data and communication for backers to digest will receive the highest allocations. This, again, is beneficial to all parties, and especially Numerai.
This is simply a thought experiment resulting from discussions that I’ve had over time, and is not a full proposal. I welcome your comments and discourse to improve upon these ideas. Remember, anything that you suggest MUST be additive to the performance of the meta model. Anything that does not benefit Numerai will NOT be accepted. Makes sense, right? They’ve got to do the work to design such a system, after all…