Before the NFT Summer of 2021 — a time where the global market for NFTs ballooned to over USD$2.5B — the cryptosphere bore witness to a similarly exuberant period, which has since come to be known as the DeFi Summer of 2020.
In large part fueled by the phenomenon of yield-farming, the events of DeFi Summer drove the total value locked (TVL) in DeFi protocols to roughly USD$10B by late-September. With the recent explosions that both the NFT and DeFi markets have undergone, it was only a matter of time before the two technologies would inevitably cross paths.
NFTFi is using NFTs to finance transactions through accessing more liquid assets.
This collision of DeFi and NFTs has opened up a variety of possibilities for NFT holders by making their NFTs a much more liquid asset.
There are a variety of sectors within NFTFi, and this article will go through what they are, their respective pros and cons, and the largest platforms in these sectors.
The sectors within NFTFi include:
Currently DeFi protocols are designed around mimicking traditional finance. However, with the introduction of NFTs, there’s potential for a whole new range of financial products. For example, some lending protocols now allow for NFTs to be pledged as loan collateral, granting both borrowers and lenders an alternative to the more traditional stablecoin or cryptocurrency-backed loans in DeFi. In either case, NFT/-DeFi projects exploit the strengths of each technology to offer a product that is patently more valuable than the sum of its parts.
In practice, the marriage between DeFi and NFTs is an area that has been accumulating increasingly more interest and development activity. Overall, it would appear that some projects are generally more geared towards augmenting NFTs to suit DeFi methods. For instance, the existence of liquidity pools and fractionalization protocols allow NFT holders to realize liquidity on their holdings while granting investors who are not as well-capitalized the opportunity to gain exposure to high-value tokens. In contrast, other projects seem to place greater emphasis on enhancing DeFi primitives through the use of NFT-based assets. As an example, some lending protocols now allow for NFTs to be pledged as loan collateral, granting both borrowers and lenders an alternative to the more traditional stablecoin or cryptocurrency-backed loans in DeFi. In either case, NFT/DeFi projects exploit the strengths of each technology to offer a product that is patently more valuable than the sum of its parts. Let’s look at some examples.
NFT fractionalization is the process of sharing ownership of an NFT through a set of fungible tokens tied to the original NFT.
To fractionalize an NFT, the NFT is placed in a vault. ERC-20 tokens representing ownership of the NFT are then minted, each of which represents a share of ownership in the original NFT.
NFT fractionalization allows investors that are less well-capitalized to gain exposure to expensive NFT collections. This enables more liquidity to enter the market, since an expensive NFT can be divided into shares of its worth using fungible tokens.
A difficulty that arises from NFT fractionalization is the process of “putting it back together.” For the whole NFT to be removed from the vault, all of the holders must sell their shares, meaning all of the fractions have to be put back together.
Blue-chip NFT projects such as the BAYC or the Cryptopunks are not affordable for the majority of people. At the time of writing, the collections have floor prices of 84 ETH ($142,200) and 74 ETH ($125,300) respectively. Like fractionalization, NFT Renting has been established as a solution to this problem, just in a different, more familiar form.
Like renting a flat or a car, renting NFTs provides an individual with access to an NFT for a limited time.
NFT renting comes in two forms:
1. collateralized renting
2. collateral-less renting.
For collateralized renting, an NFT owner lists their asset on a rental marketplace. The renter can then initiate the renting process.
The NFT is placed in a smart contract with the terms and conditions of the borrower and the lender. These conditions include the rental fee and collateral, which has a higher price than the NFT to protect the lender. After the contract expires, the NFT and the collateral will return to their original owners.
The process of overcollateralized renting isn’t dissimilar to the method adopted by borrowing and lending protocols in DeFi. A prospective renter can gain access to the NFT they’d like to borrow by posting collateral valued at a higher price than the NFT they’d like. Borrowers can then access the NFT for a period of time specified by the NFT holder and encoded smart contract to which the NFT is tied.
The key difference between the two is that the renter, in collateral-less renting, will never receive the original NFT.
Platforms that offer Collateral-less renting allow lenders to deposit their NFT and make a wrapped version of it. Once a user rents the NFT and pays the rental fee the renter will receive the wrapped NFT enjoying the same utility as the original one. After the contract expires, the wrapped NFT is burned and the rental fee will be sent to the lender. Collateral-less renting minimizes risk for both parties since the renter doesn’t need to put up collateral, and the lender doesn’t need to rent out their original asset.
Renting affords NFT holders the opportunity to earn passive income from their NFT collections on their own terms, without having to concern themselves with fractionalization.
The use cases for renting are continuously expanding. As the space develops, renting NFTs will increasingly have use cases in NFT galleries and museums, with platforms like Musee Dezentral already offering this experience. Holders of NFTs that provide access rights can rent out their NFTs to those that wish to attend NFT-gated events of communities for a period of time, if they’re not using them for that purpose themselves, but wish to retain exposure to the NFT.
NFT renting is still new as a business model in the world of NFTs, and therefore is still prone to exploits. One exploit that recently happened was during the Ape Coin airdrop for BAYC holders. An unknown user took a flash loan and rented out 5 BAYC NFTs before the airdrop to make his/her wallet eligible for the Ape Coin airdrop. They were airdropped Ape Coin, and the unknown user managed to make $800,000 because of a NFT renting exploit.
NFT derivatives are one of the newer developments in the NFTFi world. Derivatives within the realms of NFTs, are similar to non-NFT derivatives;
they represent tradable contracts which let people bet on the future prices of NFT collections.
NFT derivatives help a lot in terms of NFT liquidity. It opens a lot of possibilities, such as access to trading high value NFTs, and even access to using leverage to trade NFTs. Users can also trade in either direction of the price of the NFT either up (long) or down (short).
The derivatives market in TradFi is significantly bigger than spot markets, with the notional value of derivatives estimated to be worth hundreds of trillions of dollars. This shows the market growth potential of NFT derivatives, especially when using the 11 billion dollar market for NFTs as the equivalent to the spot market.
Just like other derivatives trading, NFT derivatives are highly risky, especially when using leverage, as it can magnify losses. Moreover, NFT derivatives trading is in its nascency, therefore few NFT collections are currently available for derivatives trading.
There are three emerging types of lending in the NFTFi world:
NFT lending is a growing sector within the NFT industry. Like DeFi lending, NFT lending is usually facilitated on-chain via a smart contract. The smart contract contains the assets, the liquidity (loan), and the terms and conditions of the loan. P2P NFT lending platforms connect prospective borrowers with lenders on a peer-to-peer basis, setting up a trustless loan between the two parties, using NFTs as collateral.
A collateral debt position for NFTs is created by locking collateral in a smart contract to generate a stablecoin. The collateral in this case would be an NFT, and the CDP is created by finding a floor price for the NFT collection, which is used to determine the size of the loan.
Lending pools in NFT money markets operate much like they do in DeFi, where they’ve become popularized by platforms like Aave and Compound. Lending pools use an over-collateralization approach. Borrowers post NFTs as collateral. This enables them to borrow funds for a fee for lending, with a market value which is less than the total value of the collateral. This fee is distributed to lenders to incentivise them to provide liquidity.
NFT lending provides additional liquidity support to the whole NFT ecosystem. This new industry allows NFT lenders to leverage their collections to earn yield, which is paid by the borrower, in the form of a borrowing fee. Borrowers also have the potential to finance new NFT purchases through loans, as they can access more liquid capital without having to sell their NFT.
A con of all of these lending options is the difficulty of pricing an NFT. As seen below, platforms have different mechanisms, such as simply using the price floor, or using their own pricing oracle. Using a price floor can severely undervalue the NFT though, as the price floor is that of the least valuable NFT in a collection. The oracle pricing mechanisms are also problematic, as they are shrouded with uncertainty over their methods or their accuracy.
To mitigate this issue, currently, most platforms only allow certain NFT collections to be used as collateral, guaranteeing some form of stability in the price of collateral for those who provide loans.
In contrast to UnUniFi, all debt positions on JPEG’d have a LTV ratio of 32%. There is some maneuverability, as special requests can be put into the DAO to allow for a higher or lower ratio. As well as having a set debt position, there is a set interest of 2% on all loans at launch. JPEG’d also allows for borrowers to buy insurance on their CDPs.
NFTFi is emerging as one of the most exciting newer innovations within Web3. This industry solves the liquidity problem that NFTs face by opening up them to a wide variety of new financial use cases which are currently enjoyed by other asset classes.