The Complexity of NFT Loans
For several NFT enthusiasts and jpeg lovers, NFTs present a difficult trade-off between
(1) the signalling effects and utility of NFT ownership (status, clout, hype etc.), and
(2) the opportunity cost of earning yield on the underlying cryptocurrency on a DeFi platform
The greater the financial value of an NFT, the greater the opportunity cost. With DeFi platforms boasting yields of >10% p.a., and the additional yield that can be derived from yield farming, there is a considerable opportunity cost to NFT holders.
In hopes of alleviating this second issue so that people can stay squarely focused on the first, a number of platforms have sought to unlock NFT liquidity by empowering NFT-collateralised loans.
A basic loan may look something like: X lends 1 ETH to Y on agreed terms (e.g. 15% interest, repayable in 60 days). Upon acceptance, Y’s NFT is locked up and held by a smart contract. After 60 days, if Y repays the 1 ETH + accrued interest, the smart contract returns the NFT to Y’s wallet. If Y defaults, Y retains the funds (whatever is left of the 1 ETH), and the NFT is transferred to X’s wallet.
The underlying technology is permissionless and trustless. Nothing too complicated.
The state of permissionless lending in DeFi
When you buy a house, you typically put down 20% of the value as a deposit, and the bank loans you the remaining 80%. This represents a 4x loan-to-value ratio. For most TradFi loans, you would expect a loan-to-value ratio greater than one because it doesn’t seem to make much sense borrowing less money than you already have.
But that’s the only way to do it in crypto.
Currently, crypto loans are widely available (on DeFi platforms, and centralised exchanges alike), but must be overcollateralised. Binance, for example, offers an initial loan-to-value ratio of 65%, which requires you to put up $1000 in collateral for a $650 loan. This collateral can be in the same, or a different, cryptocurrency.
This approach is lender friendly. It ensures that the lender doesn’t risk their capital. On the Binance platform, if the value of the underlying currency changes such that the LTV moves from 65% to 83%, the platform liquidates the position, takes your collateral and laughs. Ok maybe they don’t laugh, but they’re definitely grinning.
Fine, some people may say that this approach is alright. We don’t want to promote reckless borrowing in the crypto ecosystem, especially before any meaningful regulation is implemented to govern DeFi lending. If too many people are looking to borrow cryptocurrency at an LTV greater than 100%, we’ve probably got bigger issues to be concerned with.
I believe low/zero collateral crypto loans are going to be developed over the coming years. As regulation enters the space, and certain cryptocurrencies’ volatility decreases, this form of lending will become increasingly mainstream.
Using NFTs as collateral
So we know that people want liquidity for their NFTs, and we know that most permissionless lending in DeFi is currently facilitated at LTVs below 100%.
Rather than use cryptocurrencies for collateral, NFTs could be used instead! Not the most revolutionary idea. It’s being done on NFTfi, Drops, Arcade, and Nexo, just to name a few.
Often, these platforms match lenders with borrowers directly. A borrower lists their NFT on a platform, and lenders make bids on key terms:
(1) the amount of capital they’d be willing to lend (usually ~50% of the NFT’s floor price)
(2) an appropriate interest rate (usually from 20–80% APY), and
(3) a loan term (usually 15–90 days)
Once they agree, the NFT is transferred from the borrower’s wallet into the platform’s smart contract, and the funds are transferred from the lender to the borrower.
The risks and rewards of this form of lending are quite straightforward. The lender is paid interest, and receives the NFT if the borrower defaults. The lender risks ending up with an NFT that can’t be sold (or if it can, at a substantially lower price than the original loan was based upon). The borrower receives capital to spend / yield farm on another platform and loses their NFT if they are unable to repay the loan.
The incentive structure of NFT loans is particularly interesting.
NFT loans are inherently lender friendly and geared towards blue chip NFT projects which retain their value over time (at least in the currency which they are denominated). This is because lenders are more likely to make loan offers on NFTs with stable floor prices so that they are more likely to be repaid. Even if these loans default, blue-chip NFT projects still hold reverence in the crypto space, so it’s a fantastic opportunity for lenders to pick up a blue chip NFT at a cheap price (remember that most loans are only 50% of the NFT’s floor, so the lender is essentially paying half price for a blue chip NFT).
This provides lenders with the ability to ‘shop’ for blue chip NFTs. Worst case, the borrower repays the loan with 20–80% interest. Best case, the lender walks away with a blue-chip NFT that otherwise may never have been listed for sale. In this model, lenders may actually want their counterparty to default.
Think of it like this: I may be living in my dream house and vow to never sell. At some point, I may need some additional ‘life working capital’, so I take out a loan of 50% of the house’s value. If, for whatever reason, I am unable to repay in the pre-agreed period, I lose the house. That sucks.
Now you may say, that’s exactly what the banks do, so why can’t it be the same for NFTs? Not wrong… but at least the space has more borrower (home owner) protections!
In a smart-contract driven world, there is no negotiation, no extension or adjustment of the loan repayment terms, nothing. There are simply very few avenues to negotiate. While the trustless and permissionless nature of this arrangement may have benefits, it also has some drawbacks.
Furthermore, there are definitely issues with this direct borrower-lender matching approach. Given how early we are in the cryptocurrency lifecycle, and the fact that some very young people minted these ridiculously valuable NFTs in their bedrooms for pennies, it’s hard to believe that borrowers have sufficient protections.
Yes, borrower-beware, but I personally believe that we need protections to prevent opportunistic and malicious lenders. The incentives are definitely skewed to the lender!
A basic model for an automated NFT loan market would look something like:
(1) liquidity providers contribute to a pool, and receive some baseline level of interest for doing so (possibly a percentage of the interest paid by borrowers)
(2) borrowers lock up their NFTs and receive a loan at, e.g. 50% LTV based on the current floor price, with an interest rate governed by some combination of (a) the collection’s floor price volatility and (b) the underlying cryptocurrency’s volatility (unless you do all the loans in USDC or another stablecoin)
(3) Interest and the principal are repaid by the borrower, their NFT is returned to them, and some percentage of the interest is paid to liquidity providers to compensate them for funding the pool.
To me, this model is more scalable because (1) borrowers can set their own terms rather than wait for a lender to make an offer, and (2) it substantially speeds up the approval process and expands access to loans.
It’s likely that the existing protocols used a direct matching approach because it’s difficult to find the balance between incentivising liquidity providers, selling the NFTs received from defaulting borrowers (which would now be the protocol’s responsibility), and determining an optimal LTV ratio and interest rate which is catered to the risk of the NFT collection. These are all difficult problems.
Nevertheless, somebody’s probably going to do it. A number of DAOs already invest in different NFT collections, and it is highly attractive for them to put their treasury assets to work by providing NFT loans and receiving blue-chip NFTs in the case of default. There is high demand to fund these loans, and plenty of borrower demand.
It’s highly possible that the best model for this market requires some degree of active participation and decision-making by the loan protocol; just like the curation of an art collection. In fact, auctioning the liquidated NFTs could be a very very interesting model (similar to what the DeGods team are doing with their $DUST token).
We’ll save that for another day…
Originally published at https://www.xanderhoskinson.me on March 14, 2022.