Spool DeFi Insights: NFT Loans, A House Of Cards?
Imagine owning a valuable asset, something more valuable than you’ve ever owned before. You don’t want to sell it, as there are benefits to owning it, and it could go up in value. But, you want a way to unlock the value and find a way to leverage it. That’s the position many blue-chip NFT holders have found themselves in over the last 12 months. In a short space of time, the price of many blue-chip collections jumped up considerably.
In June 2021, Bored Ape Yacht club, for example, was trading for a daily average of around 1 ETH, or approximately $1700. By April 2022, that average daily selling price was up to 140 ETH, which, combined with the increase in ETH prices, meant the average sale was around $400,000-$500,000, and in some cases much higher. Without a doubt, for many holders, that was a major asset to hold, and a story that was repeated, though not to that extreme level, across the NFT space.
In many cases, despite this value, there were plenty of reasons not to sell. As well as the right to use the IP of a high-profile brand such as Bored Ape Yacht Club, they also received multiple “drops” of free assets, plus early and discounted access to others. The value of these items, issued just for holding a BAYC, has been worth over 6 figures for many holders, and it’s likely the financial benefits of holding will continue.
That raises the question of how users can leverage their assets more effectively financially and is where NFTs cross into DeFi solutions, in particular in terms of loans secured against the asset.
DeFi loan protocols.
In theory, DeFi asset-backed loans are a simple model. Using smart contracts, the holder of the NFT locks their NFT in exchange for a fixed amount of ETH (or other cryptocurrencies) loaned by an individual wallet. Provided they repay the loan back within the conditions set by the contract, there are no issues. If they default and fail to repay the loan according to the conditions, the new loan issuer gains ownership of the NFT and then can sell or hold it as they wish.
On a small scale, this works fine. These transactions were arranged by platforms that took a fee as part of creating and managing the smart contracts, and the process was fairly common. In particular, this model was often used to generate “flash loans”, namely those that were designed to be taken and repaid in the same set of smart contract orders.
The challenge came as these loans increased in popularity and faced an issue that all new financial models come across, namely liquidity. In short, there were plenty of people wanting loans against their assets, but very few individuals who had the financial reserves to do such a loan and the willingness to risk their ETH in exchange for an NFT.
As a result, more decentralised loan models started to develop, in particular BendDAO. In the BendDAO model, rather than loaning from an individual who can resell or trade the asset individually, the loaning parties pool their funds together.
In order to protect their investors, they ran automated contracts that included a model and process for automatically selling the NFTs, should the holder fail to make repayments. This calculation was based on “(floor price X liquidation threshold) / outstanding debt amount”. When that figure drops below 1, then the next stage in their process begins. Once a particular NFT hit that threshold, a 48-hour locked auction would then begin, with anyone being able to bid up to 5% below the floor price by locking their ETH for that time.
Potentially, this meant someone could then buy an NFT that had hit these criteria for 5% below the floor price, and considerably lower than its potential value. In addition, during that window, the original holder could still pay their outstanding debt, plus a 5% penalty to the first bidder.
In a bull market, such as when the protocol launched, this is ideal. As floor prices continue to rise, the calculation moves further away from the forced-sell threshold, or even with large interest rates against the loan, the movement is much slower. Even if some of the assets hit the threshold, in theory there would have been plenty of demand to buy, particularly for NFTs which were valued above the floor price.
Unfortunately, bull markets don’t last forever, and it appears the protocol was never tested against bear market models. In particular, the extreme bear market that has hit the entire cryptocurrency, DeFi, and web3 ecosystems over the last several months, had a major impact. With prices decreasing across the board on high-value NFTs from all-time highs of anywhere from 75–90%, the formula rapidly started causing forced liquidation sales.
However, due to uncertainty and risk-aversion in the space for potential buyers, there was an unforeseen issue. With markets dropping, even though prices were slightly below the floor price, there were few if any bids on those NFTs. The requirements were that bidders locked the ETH for their bid for 48 hours, which meant that if prices dipped further, the 5% they stood to gain could be lost before the auction was even completed.
This meant that, as the loaned NFTs weren’t selling, potentially BendDao could have been unable to repay its lenders their assets. As it was a pooled model, there was no way to allocate the NFTs to individual lenders as an alternative solution. As a result, the BendDAO treasury saw a “bank run” with the 18,000 ETH it was holding being reduced down to just 15 ETH.
If prices had continued to drop, the space faced a real risk of multiple high-value assets listing and potentially increasing the bull market further. In turn, this could have created a wider cascade effect through the crypto and DeFi ecosystem, in a time of uncertainty due to the upcoming Ethereum Merge.
The house of cards still stands?
As it stands currently, it appears the worst has potentially been avoided. Prices have crept back up in a number of key blue chip NFT collections, in turn pushing the auto-sale cutoff further away, and the BendDAO treasury has started to recover. While there is still some risk as prices remain uncertain, what can we learn from this model and the wider implications for DeFi and the complex models that can emerge from the ecosystem?
The first seems the most obvious. It’s hard to not make money in a bull market, but protocols need effective testing, and models built that are sustainable, in bear markets as well. With DeFi being fully automated and designed to operate without human interference, any external effects have to be accounted for within the code. This requires more detailed testing than we are seeing in many projects. Developers not only need to check that the code does what is expected during code audits, but that the models being created are stable across a range of market conditions.
The second is that there will continue to be a market for asset-backed loans and DeFi protocols enabling the monetisation of web3 assets. Currently, we are seeing basic models of loans managed by smart contracts emerging. As these continue to be tested and refined, newer models will also appear, allowing more leverage of digital assets through DeFi.
As with all emerging decentralised technologies, there will continue to be teething pains as new models are developed and launched into the ecosystem. While these are a requirement for the space to grow, with such an interlaced and co-dependant ecosystem they can also create wider market risks, should they fail.
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