NFT Valuation, Lending & Borrowing: Putting Non-Fungible Assets to Work
DeFi Applications in the Traditional Crypto Ecosystem
DeFi (Decentralized finance) has made immense strides in “traditional” crypto markets (I can’t believe I’m writing “traditional” crypto markets) in just a few years. A host of applications have been built and are widely used in the space. MakerDAO allows the creation of loans without a bank and provides DAI, a decentralized cryptoasset that is pegged to the US dollar. dYdX created an innovative and effective method of lending, borrowing, and margin trading cryptoassets. Decentralized exchanges, like Uniswap, have burst onto the DeFi scene to allow users to safely and seamlessly trade ERC20 based cryptoassets. Within the borrowing and lending ecosystem, Dharma and Compound are both popular DeFi protocols. These applications allow you to send specific cryptoassets to their smart contracts and earn returns based on the market rate. With all of these incredible decentralized financial products, it is no surprise the traditional cryptoasset market is huge: the current market cap is ~$250 billion (August 2019).
DeFi Applications in the NFT Ecosystem
Compared to the traditional cryptoasset market, the non-fungible token (NFT) ecosystem is severely underdeveloped in both applications and market cap. This is due to a multitude of reasons, but market size and age likely play a dominant factor.
Luckily, the NFT space is making swift progress and can advance upon what the traditional cryptoasset ecosystem has built. Wrapped CryptoKitties are a great example of this. CryptoKitties are sent to the “wrapped kitties” smart contract and can be exchanged for a WCK token on the decentralized exchange, Uniswap. WCK tokens can be redeemed for any CryptoKitty within the wrapped kitties pool, be bundled with other kitties, or be exchanged for a rare CryptoKitty. Interestingly, entirely different NFTs are also being exchanged for WCK. Below is a CheezeWizard on sale for 55 WCK tokens. This example shows one small way NFT users use existing crypto assets to create new assets.
Why We Need NFT Debt Markets
Debt markets are a major missing piece in the NFT ecosystem. I propose the need for a marketplace to allow people to both obtain loans from their NFTs and to lease their NFTs. Many NFT users have assets in their wallets that are not used unless they are playing a specific game or interacting within a specific platform. When not in use, they sit idle in a wallet, figuratively collecting dust. It would be incredible if there was a marketplace to allow users to put their assets to work through use as loan collateral or leasing them so other users can use them within their platform.
How Would NFT Collateralized Loans Work?
I imagine a marketplace where users send their NFTs to a smart contract escrow system that displays the NFT with the previous sale price and other information. Let’s use OpenSea as an example, specifically the CryptoKitty “Purrity #1 (Lowest Gen).”
NFT Valuation Questions
So now comes the interesting part: how do we value this NFT? This CryptoKitty previously sold for 20 ETH, but is the current value 20 ETH? Note that we are not shown the price of ETH when it was last sold. Etherscan shows us that the last sale was on August 23rd, 2018, when ETH was roughly $275/ETH. This means the buyer paid an estimated $5,500 for this specific CryptoKitty. But are we valuing this asset in USD or ETH? Valuing an NFT at its last purchase price is straightforward, but not all that accurate. The market is constantly changing, so to get an accurate valuation we need to perform a comparable analysis on this CryptoKitty’s species and its properties. We also need to know general market trends for CryptoKitties as a whole.
Our example CryptoKitty has three properties; “Fancy,” “Purrity,” and “Virgin.”
My CryptoKitties knowledge is limited, but we can see that the “Purrity” property is extremely rare: only 0.36% of CryptoKitties have this property. In order to accurately value this CryptoKitty and its properties, you need either intimate knowledge of CryptoKitties and the wider community or access to a leading community member to ask for input. Perhaps the most cost-effective price discovery method is leaving it up to the markets.
A Solution to NFT Valuation: NFT Collateralized Loan Marketplace
An NFT collateralized loan marketplace would be an extremely effective method of determining the fair value of NFTs. The marketplace could allow users to post the NFTs they want to use as collateral and others could place bids on how much they are willing to lend against it. The marketplace could also have options for loan term length and whether or not the lender is offering ETH or DAI. Such a marketplace would eventually produce a fair valuation of NFTs.
For example, if our example CryptoKitty from above was asking for loan offers in this marketplace, I would come up with an offer by researching the general CryptoKitty market, the last sale price (20 ETH or $5,500 USD), comparable CryptoKitties, and lastly its specific properties. After my research, maybe I am willing to lend 5 ETH with a loan term of 3 months. But perhaps a CryptoKitty expert knows it is extremely rare and offers 10 ETH for a 3-month term. Multiple offers and valuations will help produce a more fair appraisement. This process will be inefficient at first, but will eventually lead to more solidified valuations on NFT assets.
Leasing NFTs
This marketplace could also have an NFT Leasing section in which users can view different NFTs that are available for others to lease. The leasee could input the amount of time they want their assets to be leased for, and the leaser could input the amount of time they’d like to have the asset. Keeping the marketplace open to customization from both parties would be an effective way to see what users actually want. Once user behavior is determined, the market can focus on popular lending categories such as “lend asset for 1 week” or “lend asset for 1 month.” Having narrow and predefined categories is easy for new users to understand and will help the leasing market grow from its original user base. If such a marketplace was to launch today, NFT leasing would be an extremely small category since the NFT ecosystem is still in its infancy, however, it would provide another avenue for NFT owners to earn income. Once NFTs go mainstream, the size of the NFT leasing market will be massive. Not only because people enjoy playing new games and trying new items, but also because people will have many assets and will want to put them to efficient use via lending or leasing them out.
How To Value NFTs for Lease
An NFT leasing market would help discover the fair value of NFTs in a similar way an NFT loan marketplace would: the market would eventually settle on a fair value for leasing. The leasing market may be even more dependant on the asset type due to the nature of the assets themselves. For example, if you need to urgently mine resources in CryptoSpaceCommanders, you would lease a spaceship specifically meant for mining and then return the ship once the resources have been obtained. That type of need might be rare, so in theory, the market would price that type of asset cheaply for leasing. On the other hand, if you are breeding assets like CryptoKitties or Axie’s, there are a limited number of times they can breed efficiently before the process slows down significantly. The leasing market value for an activity like breeding could be much higher if the CryptoKitties and Axie assets have sought after breeding properties. There are countless factors when considering the leasing market value of NFTs, but the marketplace will help discover the fair value for such activities.
Conclusion
We will see a massive increase in market activity and useability by unleashing the power of DeFi applications in the NFT space. NFT loan and leasing marketplaces will allow users to earn passive income and, more importantly, will lead to more accurate valuations of these assets. We are currently in the Friendster-era of NFTs, but we can get closer to the MySpace-era by taking traditional crypto market builds and modifying them for NFTs. Once NFTs have millions of users, a robust and highly liquid marketplace, we can finally enter the Facebook-era where the user-experience is seamless. The first step is to continue building and adopt traditional crypto ecosystem use-cases for the NFT ecosystem.
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