Still largely in the midst of a crypto winter, it has me thinking. After having laid witness to so many projects collapsing and token values dropping off cliffs, wouldn’t it have been great to have profited as the market unwound? I’m not talking about on larger assets like Bitcoin for which there are numerous ways to take bearish positions, but instead on the myriad of altcoins and certain NFT projects which (in hindsight) were so overvalued. I’m bullish to a fault so shorting is against my nature, but it’s a thought.

Remembering the Limits of DeFi

The answer, in short, is that it’s not easy. Not because traditional finance (TradFi) or regulation is necessarily standing in the way, but more because of the structure behind shorting assets that even DeFi struggles to enable. Remember, DeFi isn’t a magical answer to all of our needs and wants. Although it allows for some significant alternatives to TradFi such as permissionless loans and payments, real assets are still involved.

So, for example, if you’re taking out a leveraged short position on a token, someone needs to be on the other side of that trade in some capacity (e.g., by providing liquidity to a related lending pool). Return doesn’t come out of nowhere, and for a lot of random altcoins for example, liquidity pools just don’t exist for purposes of borrowing and conducting the trade. The point being that like TradFi, DeFi protocols also need to be well-structured in their own respective ways in order to work, limiting the scope of certain trades in the process.

Introducing NFT-Fi

This idea of structure leads us to the burgeoning NFT-Fi ecosystem which is the primary focus of this article. At its simplest, NFT-Fi is DeFi and its various possibilities as applied to NFTs, opening up a range of new opportunities in the process. If you’re reading this article in April 2023 when first published, you’re still very early and the landscape is far from settled — embrace the chaos and learn along the way.

To date, DeFi’s applications have not been widely extended to the world of NFTs for certain obvious reasons. For example, much like artwork, the valuation of NFTs is extremely subjective, and the market as a whole is also volatile. Whether value is sustainable in the long run is also unclear, even for the blue chips. As a result, you can probably see the problems that emerge here when, for example, using an NFT as collateral for a loan.

However, it all comes down to structure to work, and the NFT market is just now starting to mature enough to permit sustainable lending, borrowing and other applications in the NFT context. Just like in the shorting example above though, these applications and possibilities will not apply to everyone in the NFT ecosystem — the laws of reason and structure prevent someone from borrowing $10,000 against a worthless bag, but opportunity is there elsewhere.

NFT-Fi — Lending/Borrowing

Now for an introduction to NFT-Fi’s possibilities, which for our purposes will focus on borrowing and lending. Although risky, permitting NFT holders to borrow against the value of their NFTs is providing new forms of utility for holders while simultaneously opening up profitable lines of business for astute lenders on the other side.

Introduction

Setting the stage, imagine you just bought a BAYC for $100k+. You believe in the Yuga ecosystem and the future of the brand with the emerging Otherside metaverse, and as a result want to hold on to the asset for a couple of years to see how things play out. Six months from now, for whatever reason (short-term investment opportunity, real-life needs, a degen gamble, etc.) you need some additional liquidity, but don’t want to realize a massive sale on your BAYC. Are there other options?

Nothing is without risk, but there are protocols currently out there that afford some liquidity in instances like this to the extent borrowers put up their NFTs as collateral.

NFTfi is one of the largest players right now, which serves as a peer-to-peer platform for NFT holders and lenders to negotiate loans amongst themselves. ‘Peer-to-peer’ meaning that all terms (loan duration, amount, interest, etc.) are agreed upon exclusively and directly between lenders and borrowers, with smart contracts handling the rest in terms of execution. Below is a high-level outline of NFTfi’s borrowing/lending process, providing a good overall introduction to the topic.

Peer-to-Peer Versus Peer-to-Pool Structures

NFTfi is not the only player out there however. When thinking about the landscape, I like to break it down between peer-to-peer and peer-to-pool protocols. Both forms are decentralized in that no intermediaries broker the loans (smart contracts are used instead), but each presents different risks inherent to the structure.

Peer-to-peer protocols include NFTfi (as mentioned above) as well as platforms like Arcade. Here, loans are negotiated directly between borrowers and lenders, with distinct parties on either side of the table. Since terms are actually agreed upon between borrowers and lenders, the process is not automatic — i.e., a negotiation and/or lender review of each loan occurs.

With peer-to-pool, borrowers like me or you are on one side, but a liquidity pool (i.e., the protocol) is on the other. The pool is made up of numerous individuals contributing ETH or other crypto for purposes of lending out, similar to how Aave and other DeFi lending pools you might be familiar with work. These individuals are later rewarded for providing liquidity by receiving a portion of protocol fees earned from interest, liquidations and/or other revenue streams. In contrast to the peer-to-peer set up, this allows for automatic lending to occur. For example, to the extent I put up my BAYC as collateral, I can immediately receive X dollars back on loan from the protocol’s liquidity pool. Terms like interest and even which NFTs are supported are thus largely standardized to allow for this. At the same time, however, liquidity pools present other risks not found with peer-to-peer lending. See the recent BendDAO liquidity crisis for an example — to the extent controls aren’t put in place to properly manage liquidations and ensure liquidity providers a degree of safety on their capital, the entire protocol becomes at risk if everyone exits en masse (i.e., bank run risk). Once again, proper structure is imperative, which leads to auto-liquidation controls (see below Default section for more detail) and other mechanisms not usually found within peer-to-peer lending.

Prominent players in the peer-to-pool lending space include BendDAO and JPEG’d, while ParaSpace also provides an interesting wrinkle and allows for borrowing/lending against NFTs and fungible tokens on a combined basis, meaning borrowers can package their NFTs alongside other tokens for purposes of providing collateral for a loan.

Sampling of NFT Loan Terms

Are the terms of NFT-backed loans entirely different from what we see in the real world? Yes and no. Terms offered within any secured lending market, including here, depend on the underlying collateral held. Better quality collateral presents less risk for lenders, which leads to better lending terms (interest %, LTV, etc.). The difficulty here, of course, is how to determine the value and associated risk of lending against NFTs held as collateral. To say that the market is still young and volatile is an understatement.

With this context, it’s interesting to see how loan terms have evolved just over the course of the last year. As most of us are aware, NFT volume and prices have generally declined, but the market and players within it are slowly maturing. Keeping with NFTfi, here’s some quick stats on how average terms have changed from January 2022 to March 2023 (from Dune):

Loan-to-Value (LTV) Ratios and Default

So, how much can users borrow against their NFTs (i.e., loan-to-value ratio), and are there risks of liquidation in the event of market downturns? The answer is that it depends, both on the protocol used as well as the NFT put up as collateral.

For example, with NFTfi which is peer-to-peer, there are no auto-liquidations and lenders cannot foreclose before a loan’s due date. The key for lenders in this set up is to be very careful that any loan provided does not end up being worth more than the underlying NFT held as collateral, or else it would be more profitable for borrowers to default at the end of a loan’s term. Such was the case during the last NFT crash, leaving some lenders holding near worthless NFT bags as borrowers defaulted and walked away with more value in cash from loans. To help with the analysis and managing risk, what results is LTV ratios varying depending on the particular NFTs used as collateral. For example, more stable blue-chips like BAYC or CryptoPunks might receive higher LTV ratios (60% to 70%) since it’s less likely that the prices of those NFTs will crash, whereas less liquid and volatile NFTs might come in at a 20% ratio. As a lender here, having a solid understanding of the market and each NFT project loaned against is therefore pivotal.

Peer-to-pool structures are a touch different since the protocol needs to properly manage liquidity as a whole in order to work (recall the BendDAO liquidity crisis mentioned earlier). For this reason, with peer-to-pool offerings like JPEG’d, borrowers are automatically liquidated if the LTV ratio hits 35% or higher on a borrowing. If this were to not occur, liquidity providers might lose trust and run for the hills at the first sign of danger or uncontrolled selloffs in the market. See BendDao once again for an example, whose reserves declined from over 10,000 ETH to a low of five (!) ETH over just a few days during its crisis.

NFT-Fi — Other Use Cases and Developments

Although lending/borrowing is the primary focus of this article, see below for a few other use cases that NFT-Fi is starting to unlock for those in the NFT space.

Hedging

NFT-Fi enables a few hedging strategies for owners that did not exist before. One way simply occurs through borrowing in a peer-to-peer setting, which sets a floor price on any NFTs used as collateral. Recall how default works on peer-to-peer platforms like NFTfi. If an NFT drops in price below the amount borrowed, a borrower can default on the loan and walk away with more value in cash. The dollar amount of a loan (e.g., 50% LTV ratio) therefore serves as a floor price in these instances. There is a cost as interest still needs to be paid on any loans taken out, but it’s an interesting perspective to take from a borrower’s perspective.

Another hedging strategy is by purchasing derivatives like options on NFTs. Although very much unproven in terms of demand, see Nifty Options as an example here, which allows users to create on-chain agreements that provide the right, but not the obligation, to sell NFTs at an agreed upon price and expiration date. The derivatives market in TradFi is significantly bigger than spot markets so there’s always a chance NFT derivatives similarly grow out significantly, but that just hasn’t been the case to date and I’m skeptical whether it ever will in an already niche and volatile market.

Payment and Ownership

NFT-Fi is also creating more options in terms of payment and ownership for users.

For example, protocols like Cyan seek to make blue-chip NFTs more accessible to the masses by allowing users to make installment purchases over a period of months. Buy now, pay later.

Others are making expensive blue chips more accessible through a process called ‘fractionalization’ which breaks NFTs into fungible components. Each part represents a specific, tiny percentage of the original NFT, making it much more affordable for investors to own a piece. Here’s an interesting article covering the recent fractionalization of various CryptoPunks.

Rentals

Why would anyone ever pay to rent an NFT? Although use cases are limited to date, that might change in the future. For example, someone might want to rent a cool weapon or skin in a popular Web3 game for a specific utility, but not otherwise want to pay a small fortune for the unlock. This is where rentals might become helpful. Check out reNFT for one early entrant here.

Conclusion

NFT-Fi offers some interesting benefits in the form of liquidity and trading that were not available before, so I’m rooting for the first movers innovating in the space.

However, some might still question whether the market will ever mature enough to support well-functioning protocols at scale and of relevance. I can’t answer this definitively, as there are still so many unknowns not least of which concerns regulation (see here for example for concerns around the legality of fractionalization).

What I can say though is that NFT-Fi, and in particular borrowing/lending, is currently bucking the trend of the broader market, proving demand from both sides of the camp. Whereas NFT trading volume is significantly down from its peak, NFT-Fi loan volume is up. As an example, see below for NFTfi ETH loan volume growth over the past couple years since the protocol’s first loan in May 2020. NFTfi alone has done $391.6 million in cumulative loan volume and made over 39,000 loans to date.

However, this growth is also accompanied by risk and the broader hyper-financialization of the NFT market. How far the market goes in this direction is yet to be seen, but with protocols like MetaStreet starting to purchase loans and package them up in tranches to be sold, similar to how mortgages are packaged in collateralized debt obligations, the direction is clear as the market only continues to get more sophisticated.

References

Read more: https://medium.com/blockchain-biz/keeping-an-eye-on-nft-fi-c16cfbe3696c