Decentralized finance (DeFi) and non-fungible tokens (NFTs) are two of the hottest segments going in the blockchain space. DeFi has paved the way for activities like staking, yield farming, lending, and borrowing on the blockchain, while NFTs have transformed how collectors invest their money from the real world to the metaverse.
DeFi and NFTs are said to represent the future of finance, the credit markets included. These innovations give cryptocurrency users something to focus on while the bitcoin price, which tends to influence the direction of the broader market, continues to hunt for a bottom.
The numbers don't lie. According to DeFi Llama, the DeFi market currently boasts $194.8 billion in total value locked (TVL), reflecting the size of cryptocurrency assets that users have poured onto protocols with names like Curve, MakerDAO, and AAVE. Meanwhile, the NFT market is in a league of its own, with total sales in the past week alone topping $322 million, according to Nonfungible.com.
Collateralized loans are nothing new and have been used for ages in the credit markets. Therefore, it was only a matter of time before developers discovered a way to harness the power of DeFi for NFT-backed loans on the blockchain. After all, with digital avatars like CryptoPunks selling for millions of dollars, digital art more than passes the sniff test as a collateralized asset.
Punks & Apes
It is not uncommon for NFT owners to have a big chunk of their net worth tied up in their digital collectible portfolio. For example, the floor price for a CryptoPunks NFT currently hovers at 65 Ethereum (ETH), which at last check translates to $168,675. The rock-bottom price dropped 1.5% in the previous 24 hours amid the downdraft in the broader cryptocurrency market.
If the owner of a CryptoPunks finds themself in a cash pinch, what if they can't find a buyer willing to meet their price? Despite the $40 billion in sales that NFTs raked in last year, the market has not escaped the negative sentiment entirely. Sotheby's was poised to launch an auction for a collection of 104 CryptoPunks NFTs on Feb. 23, just as the seller decided to withdraw the lot at the last second. While the reason for the cancellation wasn't immediately apparent, market participants surmised on social media that it's just not a seller's market right now. That's where loans backed by pricey NFTs come into play.
‘Advantageous to Lend'
Twitter account @BoredElonMusk, which boasts 1.7 million followers, has some experience with NFT loans. He discussed his experience in a recent Twitter Spaces hosted by NFT-focused DeFi lending platform Arcade. @BoredElonMusk has a handful of Bored Apes in his collection, an NFT set that jockeys for position with CryptoPunks as the leading project. He explained how he had a craving for yet another Bored Ape and decided to put up a couple of NFTs he already owned as collateral in exchange for a loan on Arcade, the proceeds from which he used to purchase yet another Ape. Rumors suggest that the Bored Ape Yacht Club project to which the NFT collection belongs could soon be launching its own token, which seems to have served as a catalyst for @BoredElonMusk to keep buying. He said on the call,
“I thought it was advantageous to take the risk…to lend out two of mine and acquire a third.”
— BORED (@BoredElonMusk) January 4, 2022
So is it advantageous for others to do the same? Arrington Capital, a hedge fund created by TechCrunch founder Michael Arrington that invests in digital assets and Web 3.0, calls NFT lending “the birth of a new institutional capital market,” one that has been “instantiated by the team at Pawn.fi.” The Pawn Protocol makes NFT loans possible on the Arcade platform to provide liquidity to NFT owners. Institutional adoption in the cryptocurrency markets is looked to as a Holy Grail because of the sheer size of this market, which as FTX CEO Sam predicts, could be “really enormous.”
NFT-Backed Loan Mechanics
You may be wondering what kind of terms accompany an NFT-backed loan. The answer is that it is mainly up to the users. However, it does appear that the durations on NFT-backed loans are short-term in nature. On Arcade and the Pawn Protocol, they set their own terms, including:
- Principal amount
- Loan duration
- Interest rate
Here is a sampling from September 2021, as per Twitter account gmoney.eth:
Chinks in the Armor
To be clear, putting up NFTs as collateral to secure loans is not something you can do at your local bank, at least not yet. DeFi has made it possible to sidestep the banks for access to products that until now were reserved for those with access to traditional financial services. It is a double-edged sword for investors, who put it all on the line in a market where regulation is still finding its sea legs. While DeFi and NFTs might be the future of finance, there are still some chinks in the armor for investors, chief among which are fees.
For example, the Tubbycats collection is a recent NFT drop. According to social media accounts, a crypto whale doled out 200 ETH, worth the equivalent of $492,400, to mint 950 of these NFTs during the project's public sale. The Tubbycats team warned, “If you cannot afford to lose the gas (fees), please do not mint.” While the Tubbycat drop was sold out, the NFTs are available on the OpenSea secondary marketplace.
NFT-backed loans provide a way for market participants to access liquidity when they need it, collateral that probably would never pass the muster on a traditional loan application. The blockchain space has created a virtuous cycle of innovation and surging purchases, a trend that seems determined to persist.
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