A brief study on the solution to the NFT liquidity, Chapter II The Forethought — NFT DeFinancialisation
1 Learn from the current NFT liquidity solutions
The previous study shows various NFT liquidity solutions with strengths and restrictions. However, the NFT liquidity issue remains and the corresponding market making is fairly risky. In order to solve the problems, we can review the aforementioned solutions and explore a comprehensive solution to further increase NFT liquidity.
1.1 NFT securitisation
After reviewing the bank run on BendDAO, we understand that a more adequate liquidation mechanism with precautionary measures to control the non-performing asset ratio and interest rate is critical. Besides, as can be seen from the TVL of NFT derivative protocols, it is tremendously difficult to develop such tradings for a non-standard asset with the limitations of the price precision, price discovery mechanism, and the number of audiences. To increase NFT liquidity, securitisation seems to be a low-risk solution compared to loans and other financial derivatives.
Therefore, NFT securitisation, or more commonly known as fractionalisation, could be one of the best solutions to the NFT liquidity issue. NFT holders can turn their NFTs into fractions, a number of fungible tokens, and realise them conveniently, as the price of a fraction would be much lower than the original NFT. On the one hand, NFT fractionalisation lowers the risk and cost of holding NFTs for original holders and, on the other hand, minimises the entry price for retail traders. Moreover, it potentially reduces the risks and costs for market makers and gives them more arbitrage opportunities. Apart from that, NFT lending protocols can fractionalise non-performing assets as an alternative liquidation measure to reduce bad debts, and the fractions, as fungible tokens, will create a better environment for the development of NFT derivatives.
Another major shortcoming of NFT lending protocols and put options is the risk of losing original NFTs. Meanwhile, existing NFT fractionalisation tools either have strict redemption conditions or can hardly redeem back the exact original ones. Thus, to encourage NFT holders to realise or hedge when using NFT fractionalisation tools without concerns, the mechanism of redemption becomes vital. In addition to collecting all fractions or staking ETH tokens equivalent to the market value of a fractionalised NFT, there should be more options to redeem. NFT original holders would be willing to pay an extra fee to get their fractionalised NFTs back, which is similar to JPEG’d insurance module. Besides, an NFT collector would love to offer other fraction holders a price to purchase and then redeem a desired NFT after collecting a certain number of its fractions.
With all these measures, NFT fractionalisation can bring more trading activities and liquidity to the market and become more friendly to NFT holders, collectors, and traders. But, the profits and rights generated by fractionalised NFTs need to be allocated to complete this NFT securitisation process.
1.2 Trading model
There is no doubt that trading against liquidity pools is efficient in DEX as no direct counterparty is needed to execute trades. This concept was brought to the NFT market by several lending and AMM protocols to increase the utilisation of funds and lower the transaction fees. However, due to the contradiction between the character of NFTs and the peer-to-pool trading mechanism, those protocols choose to apply a floor price to each NFT collection pool. This trading model certainly increases the trading efficiency, especially for longtail NFTs, but sacrifices their uniqueness by eliminating price segmentation.
In this case, with NFT fractions, liquidity pools can be formed individually for each NFT. People can still collect or invest in specific fraction pools based on the value of uniqueness and enjoy the effective and efficient peer-to-pool trading experience. Moreover, concentrated liquidity should be applied to further improve the utilisation of funds for liquidity providers as the TVL for an NFT fraction pool would be relatively small in general. Even if it is a BAYC fraction pool with 100% fractions, its TVL would be about $100k (BAYC floor price @ 75 ETH and ETH price @ $1300). So, the automatic market-making with dynamic peg created by Curve should be adopted to attract more unsophisticated liquidity providers, which is friendly to NFT players and will result in sustainable liquidity.
Additionally, in order to provide a user experience similar to the existing NFT markets, the order book trading model should be integrated as well. As a consequence, when trading with limit orders, there would be no slippage caused by the relatively small TVL for each fraction pool. The entire trading system can increase the NFT liquidity by introducing advanced DEX trading models to the NFT market, and lower the costs of trading and market making for retail traders and professional market makers, respectively. It is worth mentioning that a robust oracle should be applied to avoid price manipulation as far as possible.
1.3 Tokenomics
Apart from improving the current solutions and introducing market makers into the NFT market, attracting more people to participate in the trades would be a sustainable method to increase liquidity. Thus, adopting the veToken model, a commonly tested token economy pioneered by Curve, can get a large number of DeFi players engaged in the NFT market. Basically, this model can benefit the veToken holders and direct the liquidity, which is designed to align the long-term interests of the whole community, including retail traders, liquidity providers, NFT projects, etc. In fact, the abovementioned process of forming liquidity pools after fractionalising NFTs is very similar to launching new crypto projects, which are keen to maintain sufficient liquidity with relatively low costs. So, obviously, the veToken model fits into the NFT definancialisation well as it can bring more sustainable liquidity and direct to various fraction pools by providing incentives. With the veToken model, the foundation of NFT definancialisation is being built, and more corresponding dApps will be developed on top of it.
2 Future development
Based on the brief study, forming liquidity pools with fractionalised NFTs under veToken governance could be a comprehensive way to solve the NFT liquidity issue. In accordance with these measures, developing NFT derivatives, including perpetual futures, options, and insurance, becomes more feasible, and more institutions, like professional market makers, will get involved in the NFT market and make the trading experience even smoother. Once the liquidity issue is solved and the trading volume is raised, the price discovery mechanism will be improved and can benefit the pricing on ordinary NFT markets. Moreover, NFT fraction is similar to a wrapped asset, which provides another feasibility of NFT cross-chain.
However, the measures mentioned above will also cause some issues and potential risks that need to be addressed. First of all, the distribution of profits and rights generated by fractionalised NFTs needs to be determined, which brings more value and utilities to the NFT fractions. Next, forming the fraction pools may require both internal and external oracles, which may become a SPOF for the whole system. Lastly, the veToken model is vulnerable to governance attacks, in which NFT project teams may use it as a cash runway to rug pull. It is crucial to avoid such governance attacks. It is clear that developing more NFT utilities to expand the customer base is the ultimate solution to solve the liquidity issue, but Rome wasn’t built in a day, and let’s keep laying bricks to build the NFT market.
By Jason Liu & Lizzie Lu
About ZMQ
ZMQ is a Leading Global Quantitative Market Maker and liquidity provider in Digital Assets. Since jumping into the crypto market in 2018, ZMQ has been focusing on providing liquidity globally for token projects and exchanges, institutional crypto investments and consulting services to bring better price discovery, trading executions, transparency to investors and efficient pricing to the market.
If you have any new ideas about NFT liquidity, please reach out to us at liz@zmquant.com!
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