NFTFi — A New Catalyst For NFTs?
NFTs have been in existence since 2018, initially utilized for a niche purpose within a niche group. However, as of 2021, we are seeing the technology being adopted by a variety of creators, including artists, game developers, writers, and musicians. One of the biggest questions surrounding NFTs is whether they should be considered an investment or a digital collectible. Some creators may argue that NFTs should not be considered an investment due to regulatory concerns and the belief that NFTs are not created with the intention of generating profit for holders. Despite this, many in the community treat NFTs as investments in practice, with discussions on social media and in financial publications about how to allocate NFTs within a portfolio and the potential benefits and drawbacks of investing in NFTs. Additionally, when the value of NFTs increase, holders tend to view it as a positive outcome and may hold the project creators accountable if the value does not increase.
As slowly but steady an actively and innovative submarket called NFTFi (Non-fungible-token Finance) is growing, this question becomes more and more irrelevant. With this article we want to guide you through the combination of NFTs and DeFi and present you interesting projects we’re excited about.
The art and collectible markets, including the NFT market, tend to have lower liquidity than other types of assets such as crypto coins or stocks. This is partly due to the fact that the NFT market is still relatively new and much of the activity in this market is based on speculation. After a period of high buying, selling, and trading of NFTs during the previous market cycle, investors are now looking for new ways to make use of their NFT assets. While new projects and platforms are being developed, the lack of liquidity in the NFT market is becoming more apparent, particularly during the current economic downturn across all industries.
NFTFi was created with the goal of addressing this issue by combining the concepts of DeFi and NFTs. NFTFi platforms provide a way for NFT owners to earn real returns on their NFT assets, rather than simply holding them in a digital wallet without generating any income. The current daily cumulative borrow volume in USD is led by BendDao and NFTfi and shows a strong increase since summer 2022 and has been growing steadily since then.
The Twitter chad 0xminion did a great job mapping out the NFTFi ecosystem. So let’s go down the rabbit hole of these different categories.
So you just spent your life savings on a nice PFP and instead of just flexing with it on Twitter you also want to access the value of it by taking out a loan using it as collateral. Protocols like NFTfi are here to help you out and this is how it works. The borrower lists an NFT and waits for an offer. In the best case scenario multiple lenders make offers and the borrower can decide, which one he wants to accept. If he accepts an offer the contract transfers principal from lender to borrower and locks the asset in an escrow. If the borrower repays the loan the contract transfers the asset back to the borrower and the principal plus an interest from the borrower to the lender. If the borrower doesn’t repay the loan, the contract transfers, the asset in this case the NFT, to the lender.
Lending NFTs poses a high risk from a protocol perspective, as the NFT market is known for its volatility and potential for rugpulls. To mitigate this risk, many lending protocols only accept blue-chip NFTs, like Bored Apes, CryptoPunks, Doodles, Azuki, etc. as collateral. However, the drawback of using a peer-to-peer model for NFT lending is that it is capital-inefficient, as it relies on matching borrowers and lenders with a double coincidence of wants. To overcome this, projects like BendDAO and JPEG’d have introduced a more efficient “peer-to-pool” model, which connects demand and supply in a customizable liquidity pool, eliminating the need for individual bids.
Imagine you own an NFT that possesses utility, particularly in the context of a game. Now you have the option to utilize the utility yourself or to lease the NFT to another person for a cost. If you choose to rent it, you can put it up for rent on a marketplace. Projects that offer such services are Vera or reNFT. On these marketplaces people can rent your NFT, which is then put into a smart contract. This contract includes important details such as the cost of the rent and a collateral, which is worth more than the NFT to protect the lender. Once the rental period is over or the renter no longer wants to use it, the NFT and the collateral go back to their original owners.
Currently there are two different options of renting, over- and under-collateralized renting. If you choose to use an over-collateralized renting, you put up a collateral, that is worth more than the NFT you want to borrow. This way, the NFT owner can lend the NFT for a certain period of time. If you want an under-collateralized renting, you pay a rental fee and receive a wrapped version of the original NFT with the same utility. After the rental period is over, the copy NFT is burned and the rental fee is sent to the original NFT owner. This type of renting reduces the risks for both parties, as the renter doesn’t need to put up a collateral and the lender is never in risk of losing his NFT.
NFT renting is often use when it comes to games, but can also be used in other cases such as access to real-world events or if people want to have access to a certain Metaverse.
Trading derivatives is a well-established practice in the world of traditional digital assets that are listed on exchanges. This concept also applies to NFTs where platforms are made available for regular users and traders to either buy or sell NFTs based on their future value. This allows for more advanced trading strategies that can help users increase their profits while managing risk and exposure.
One very interesting project is nftperp, a perpetual futures DEX for NFTs. You can either try the “Paper Trading” version, to test you degen skills, when it comes to predicting the floor price of BAYC or join their private beta, where you can trade with real assets.
Trading NFT derivatives can open up a lot of possibilities for NFT liquidity. Also the market for derivatives in traditional finance is much bigger than spot markets, which suggests that there is potential for the NFT market to grow with the introduction of NFT derivatives. However, it’s important to note that trading NFT derivatives can be risky, especially when using leverage, as it can amplify losses. Always keep in mind that with higher risk comes the potential for higher rewards and losses. Furthermore, only a few selected NFT collections are available for derivatives trading.
Everybody has done it before. You are online shopping and choose the option to buy it now and pay it later. “Buy now, pay later” (BNPL) is a popular trend among tech-savvy young people in recent years. Web3 developers are now applying this budget-friendly financing method to NFT markets.
Cyan is one of the main examples of this kind of BNPL protocol. Here’s how it works for a buyer.
Let’s assume you want to buy a Azuki. Therefore you go to Cyan and initiate a BNPL plan on Cyan for any Azuki that is currently listed on Opensea, LooksRare, Sudoswap or X2Y2. Cyan offers you an installment plan with the interest rates clearly stated, which you need to pay over a 3-month period. Regardless of any changes in NFT prices, the installment payments stay the same over the three-month period. If you agree to the plan, ETH from Cyan’s vaults are used to purchase the NFT and it is held in escrow under a Cyan-wrapped smart contract. Once you finished paying all your installments, the NFT is transferred into your wallet and you have full ownership. If the price of the NFT goes up during this time, you can also pay off the BNPL plan early and sell the NFT. If you miss a payment, it’s considered a default, and the NFT will remain in the appropriate Cyan vault to be sold.
How does Cyan make money?
Cyan also offers a “pawning” service that allows users to temporarily use their NFT as collateral in exchange for a loan. These loans are repaid with interest, which goes directly into Cyan’s vaults. To guard against defaults, Cyan uses a variety of risk management measures such as higher interest rates to regulate loans and prevent over-investment into higher-risk NFT collections.
Making a non-fungible asset kind of fungible is what fractionalization is attempting to do. Fractionalization involves breaking down an NFT into smaller units that can be bought and traded on either a public or private marketplace. This process allows for the sharing of ownership of the NFT through a collection of fungible tokens linked to the original NFT.
Tessera is one of the leading platforms for fractionalization and makes it possible for average investors to gain access to valuable NFTs that would otherwise be out of their price range. By dividing ownership and representing it with more reasonably-priced shares in the form of fungible tokens, NFT ownership becomes more attainable and can lead to a more active market for high-value NFTs. On the other hand one of the most difficult challenges in the NFT space is the process of consolidating fractionalized NFTs. In Fractional, this is done through a voting system where token holders set a reserve price, which is calculated as a weighted average of all the votes. When a sufficient majority of holders agree on a minimum price, a buyout is initiated, and all owners can exchange their tokens for ETH. The main issue with this approach is the potential for a whale, to outbid the entire community of token holders.
Determining the value of NFTs is a challenging task due to their illiquid and low-velocity nature. NFT projects try to estimate their value by adjusting various mechanisms such as borrowing rates, loan-to-value ratios, and liquidation thresholds, but these are largely experimental attempts to mitigate the volatility of the market.
An alternative approach is to remove centralized valuation processes and rely on market speculators who are incentivized by price. One example of an NFT appraisal project is Abacus.
For example, Abacus utilizes proof-of-stake technology to create a liquidity-backed valuation system. Appraisers act as validators who estimate the value of NFTs and stake their money in different levels of valuation tranches. In return, NFT owners receive liquidity that can be used to collateralize their NFTs.
The commodification of art through NFTFi has generated mixed reactions. While some argue that it perverts the essence of art and threatens Web3 culture, others see it as an opportunity for commercialization to enable art to flourish as a form of creative expression and communication for the public. The use of immutable smart contracts through NFTFi opens up a world of financing possibilities for NFT ownership, empowering individuals to take an active role in the creation of culture. NFT finance is a necessary instrument to help the NFT market reach broader capital and has the potential to be recognized as an asset class. These new financial instruments can unlock novel value flows for both existing and new market players, as the NFT space in general is still very small compared to other verticals in the blockchain industry.
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Disclaimer: None of the information contained here constitutes an offer (or solicitation of an offer) to buy or sell any currency, product or financial instrument, to make any investment, or to participate in any particular trading strategy.