NFTs as Collateral in DeFi (Part I)

Feb 4, 2022

Overview

Non-fungible tokens or NFTs are cryptographic assets with unique identification codes and metadata that distinguish them from each other. They enable the tokenization of a unique or rare digital item such as art or collectibles, or a real-world one like art, real estate, or an invoice, through a securitization process. That process happens on the blockchain in the case of digital items, while for real-world objects – it usually follows the provisions of a legal act (for example, the Blockchain Act in Liechtenstein).

Unlike cryptocurrencies which are identical to each other and can be used as a medium for commercial transactions, NFTs represent unique and irreplaceable tokens. It is impossible for one non-fungible token to be identical to another. This ensures a highly transparent and flexible record of ownership, managed through the unique ID and metadata that no other token can replicate. NFTs are minted through smart contracts which assign ownership and manage the transferability of the NFT itself. The most common standard that most of the popular NFTs currently use is the ERC-721 (on Ethereum). Just like any other cryptographic token on a blockchain platform – these tokens are fully owned by the user.

As a consequence of the uniqueness and non-fungibility, scarcity plays an important role in the determination of the price of NFTs. If the NFT represents digital content or art, the scope of the scarcity feature is up to the creator: a creator may intend to make each NFT completely unique to establish scarcity or have reasons to produce several replicas. However, if the NFT is a digital representation of a real-world asset, it is unique by default.

Much of the current market for NFTs is centered around collectibles, such as digital artwork, sports cards, and rarities. Gaming is also a quickly growing niche for NFTs since they enable users to claim full control of the in-game items they purchase/discover/earn, and to eventually monetize them on marketplaces external to the game itself. Other use cases revolve around domain names, physical items, investments, and collateral. The latter will be the focus of this piece – the use of NFTs as collateral for decentralized yield farming, lending, and borrowing.

NFTs as Collateral in DeFi

The NFT sector has grown significantly in 2021 in both market capitalization and popularity, thus new use cases are emerging constantly. Although digital art and gaming-related NFTs are still leading the space, there are plenty of projects currently exploring the tokenization of real estate, one-of-a-kind fashion items, and other real-world items. With valuable assets like cars and real estate represented on a blockchain network, it is only natural that NFTs will start being used as collateral in DeFi, especially for decentralized borrowing. This can be particularly helpful for users who are not cash or crypto-rich but own physical items of value.

Within the decentralized lending and borrowing ecosystems, protocols accepting fungible tokens as collateral (such as Aave and Compound) are currently most prominent. They offer liquidity providers the ability to deposit a wide range of fungible tokens (including stablecoins) in exchange for interest payment or loans. In comparison, the NFT-based lending/borrowing ecosystem is severely underdeveloped, but at the same time, it is quickly expanding.

There are, however, a number of issues that need to be addressed first so the NFT space can catch up. They are mostly related to the liquidity NFT markets hold and the mechanism for evaluation of each NFT. Here are the main differences between fungible and non-fungible tokens used as collateral in more detail:

• Liquidity – Due to their fungibility (every ETH is as valuable as any other ETH) popular crypto assets are much more liquid. They are usually tradable on numerous centralized or decentralized exchanges. In comparison, NFTs have a wide variety of features that make them unique. Furthermore, since NFTs are relatively rarely traded, their liquidity is hard to determine. Only the top 1% of non-fungible assets may potentially be considered liquid enough for borrowing or lending purposes.
• Valuation – With fungible token lending, valuation is automatically done by oracles with great precision and the price is objectively determined by the market. In the NFT space, valuation poses a big challenge because with most of the projects, the price is not driven by volume but by scarcity and hence the actual valuation is mostly subjective. Wash trading is currently also a significant issue (the practice of trading an asset for the express purpose of feeding misleading information to the market).
• Liquidation – With fungible lending, liquidations are initiated automatically when the borrowed amount breaches the borrowing limit (according to the collateral factor). The fungible assets that are used as collateral are sold on the open market to make sure lenders don’t go underwater. NFT markets are driven by scarcity and trading volumes for particular NFT tokens are low. So once the liquidation is initiated, it could take weeks or months for the NFT collateral to be sold and the lenders’ losses covered.

Taking these factors into consideration, we can see that NFT lending poses some unique challenges compared to traditional crypto lending. The lack of a sufficiently liquid market for NFTs and the absence of adequate price valuation models for such assets result in the limited offer of options for NFT collateralizations. Due to these unique market characteristics, NFT lending and borrowing is often extremely capital inefficient – collateral factors are usually as low as 90%, meaning that if the market price of an NFT is $100, all that the owner could borrow is $10.

Though, a few price-discovery mechanisms are already being explored. Some projects use auction and sale models, whereas others employ NFT fractionalization i.e. creating fungible ERC-20 fractions of ERC-721 NFTs. Let’s explore them further below.

Auction / Sale Method

Stater

Stater is a P2P lending platform that helps users leverage their NFT assets without losing ownership. By staking their NFTs as collateral, borrowers create the so-called “borrow package”. The package includes either one or more NFTs. Bundling multiple assets together increases the total value and improves the likelihood of receiving a quicker loan in the marketplace.

Borrowers on Stater determine the value of their NFT collateral and the loan duration on their own. Consequently, liquidity providers browse through the available borrow packages and choose which one they would like to lend to. Lenders are responsible for performing their own due diligence regarding the market value of the NFTs in the borrow package. In case the loan is not repaid, the lender has the option to take the assets in their custody.

NFTfi

NFTfi applies a similar model to the one of Stater. When in need of a loan, a borrower deposits any ERC-721 token as collateral and waits for the best loan offer. Crypto lenders must identify an acceptable NFT offer, and then submit a proposal featuring the loan amount, the interest rate to be paid, and the loan duration.

Genesis

Genesis is a digital asset trading company (centralized platform) that has recently announced its intentions to accept NFTs as collateral for loans and derivatives transactions. Details on price valuation mechanisms are not available yet, although Genesis confirmed it will be taking a “very conservative” approach and in order to avoid extreme volatility will only accept premium or blue-chip NFTs.

NFT Fractionalization

Auction and sale models are currently struggling due to the inefficient mechanisms available for the determination of NFT prices. Fractional Non-Fungible Tokens (F-NFTs) are created to mitigate that problem. Currently, there are several projects that help owners create tokenized fractional ownership of their NFTs, facilitating the buying and selling of fractions of the NFT in the form of fungible tokens (ERC-20 on Ethereum). Fractionalizing allows the NFT owner to generate liquidity from their asset without completely selling it. As a result, the ERC-20 tokens backed by a NFT can be used as liquidity on other platforms, including yield farming. Some of the projects exploring this model are covered below.

NFTX

NFTX allows users to make ERC-20 tokens, called “funds”, that are backed by NFT collectibles, and then trade those on DEXs such as Uniswap. There are two types of funds on NFTX – the first is D1 funds that have a 1:1 backing between a single NFT contract and an ERC-20 contract. In this case, the ERC-20 token (called Vault Token or vToken) has a 1:1 claim on a random NFT within the NFTX vault. The second type is D2 funds that represent Balancer pools including different D1 funds. This is to offer a diversified exposure without requiring users to hold multiple tokens.

By redeeming a vToken, the user can take ownership of a random NFT within the Vault. For an additional fee, usually 5% (1.05 vTokens), users are able to select a specific NFT from the vault.

NFT20

NFT20 is a permissionless P2P protocol to tokenize NFTs and make them tradable on decentralized exchanges such as Uniswap or SushiSwap. The model is similar to the one of NFTX – users deposit their NFT into pools on the NFT20 DEX and receive ERC-20 tokens in exchange. They can then trade the ERC-20 tokens on other DEXs or deposit them as liquidity to earn rewards.

If users do not wish to tokenize their NFTs, they can simply swap them for any other NFT in the same NFT20 pool. Another possible scenario is for users to use the ERC-20 tokens to bid in a Dutch auction for a higher value NFT and thus exchange their lower value NFTs for higher-value ones.

Fractional

Fractional is a decentralized protocol where NFT owners can mint tokenized fractional ownership of their NFTs in the form of standard ERC-20 tokens. Those have control over the staked NFT. By fractionalizing an NFT the owner is able to get some liquidity without selling the entire piece. Fractionalizing entire collections of NFTs under one shared ownership token is also possible.

On Fractional NFT holder can mint an “NFT Vault” directly on the Fractional platform – this vault takes custody of the NFT and in exchange generates 100% of the fractional ownership tokens. The user can use these ERC-20 tokens to provide liquidity on other DeFi platforms in exchange for rewards, while simultaneously holding full ownership of the locked-up NFT.

Meanwhile, a buyer for the staked NFT may appear. Each NFT has a reserve price associated with it – the price in ETH required for a third party willing to initiate an auction for that NFT. Each holder of fractional shares of the NFT has the right to vote on the reserve price. At completion, the auction winner will receive the NFT and token holders will be able to claim the ETH paid in accordance with their share of the NFT itself.

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The second part of this Mettalex Research piece will be dedicated to other NFT price valuation mechanisms and will feature more well-known protocols that incorporate NFT collateral.

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This article is based on research conducted for Mettalex by Felix Bucsa and Albena Kostova.

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The Mettalex Research blog post series dives deeper into the latest innovations in Decentralized Finance. Apart from Part II and Part III of the research on NFTs as collateral in DeFi, check also our analyses on DeFi 2.0 principles with focus on the MetaversePro implementation, on the novel tokenomics model Ve(3, 3), and on The 8 Hottest DeFi Trends to watch in 2022 with Part I exploring Regulations.

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