Our take on using NFTs as collateral
My colleague — Jamie — asked me the question: “Can you lend me 10K? I’m good for it because I’ve got a bored ape which is at least 50K worth”. If the last part bewilders you, you’re not alone.
Jamie was referring to ownership of a digital art item — a bored ape — represented by an NFT. Non-fungible tokens (NFTs) are cryptographically unique tokens that are linked to digital (and sometimes physical) content, providing proof of ownership. They are used for art, collectibles, music, and land in the metaverse.
TBH, we have difficulty why anyone (like Enzo Knol, Dutch influencer) would pay 111,111 ETH for this specific bored ape.
Putting our own difficulty aside, the NFT market cap is forecasted to reach USD 35B for 2022 and to grow to over USD 80B in 2025. More and more people have considerable assets in NFT’s and have a need for real or virtual world liquidity based on these assets. They’re happy to even pay a premium for it! On the financial services provider side, there is an interesting first-mover opportunity to provide loans with NFT-based collateral. Reason enough to explore NFTs from a lender point of view.
Note that there are some DeFi lenders — for example Drop.co and NFTfi — who provide lending services for NFT asset holders. However, the more general case where a client wants to take out a loan using (partly) his NFT portfolio as collateral is not covered.
In this article, we’ll take a look at two aspects for using NFTs as collateral:
- How would it work? What are the mechanics of it?
- How would you assess the fair market value of an NFT?
When applicable, we’ll take Fyndoo as a reference platform for determining the impact. Note that you may experience a different impact when using another lending platform.
How would collateralizing NFTs work?
An NFT that is collateral for a loan is transferred to an escrow smart contract. When the loan is repaid, the NFT is transferred back to the borrower. If the borrower defaults, the lender can foreclose and receive the NFT. So, besides the escrow smart contract, an NFT is the same as any other asset-based collateral. The smart contract for the escrow is not trivial: as the payments are not made on the blockchain, an so-called oracle pattern is required to relay the payment data to the smart contract.
How can Fyndoo accommodate NFTs?
We’ll introduce a new collateral type for NFTs. An important configuration is the collateralization ratio. In DeFi, it is presently common practice to collateralize at least 150% of the loan value and often much more. This provides the necessary padding for lenders for volatility (see also below).
Second, we’ll extend the collateral component in the platform to connect to the escrow smart contract.
Third, the workflow engine will be integrated with the escrow smart contract to — for example — trigger the disbursement when the NFT is transferred to the escrow smart contract.
Finally, our collection component needs to expose an interface so that incoming payments are relayed to the escrow blockchain.
In summary, some configuration and some engineering.
How to assess the fair market value of an NFT?
There are three basic approaches to determine the value of an NFT:
- Income approach: what is the earning capacity of the asset? This assessment depends on the type of asset: for example, the earning capacity of a plot in Decentraland is nil; the earning capacity of music or art may be valued using a relief-of-royalty method.
- Asset approach: what is the value of comparable NFTs? There are a number of collections that contain comparable NFTs. Think BAYC (Bored Ape Yacht Club), CryptoPunks, Doodles, and land in Decentraland. Neural networks can be used to identify visually similar NFTs when dealing with art. When it is land, comparable plots can be found by location, adjacency, and size.
- Sales history approach: What is the sales history of the NFT? Although susceptible to fraud, the sales history is a good predictor of its price.
For lenders, having a good valuation of an NFT’s fair market value is crucial. It seems logical to limit NFTs to specific collections, marketplaces and types so that a comparison can be made. It seems that there is ample data available to construct predictive ML models for the various asset classes that are included (like land, art, collectibles).
Another issue specific for NFTs is the fluctuation of asset value. Both the underlying currency and the NFT value are highly volatile. This compounded volatility requires a lender to be either very conservative with LTV ratios and/or require a borrower to provide additional collateral when the NFT’s value drops below a certain threshold.
How can Fyndoo accommodate value assessment of NFTs?
In the case of Fyndoo, assessing the value of collateral is outside the scope of the system; a collateral assessment is triggered by the workflow engine. This mechanism also works for NFTs so that an outside party or system is used for assessing the value.
Fyndoo’s monitoring processes can be configured to monitor for example currency fluctuations and to trigger a business process that requires the borrower to provide additional collaterals.
There is an interesting opportunity for financiers to lend in the real world with NFTs as collateral. The technical impact on our SaaS end-to-end lending platform is limited — opening up this opportunity for all our clients when needed (any takers?). It is advised to limit the collateralisation of NFTs to specific classes and collections to reduce risk and to allow for a proper assessment of fair market value.
To circle back to Jamie’s question about lending him 10K. I trust he’s good for it — with or without bored ape. If only I had 10K to spare!
There’s much more to explore than we did in this article. Are you interested? Contact us.