How NFT financing can reshape the lending and borrowing landscape

by James · June 1, 2023

According to A16z’s recent “State of Crypto 2023” report, NFT activity appears to be increasing as promising new uses and applications emerge. After a frenetic speculative period and subsequent cooling, NFT purchases are again showing positive growth.

As the world of finance evolves, non-fungible tokens have emerged as a player in the industry, opening the door to new opportunities such as NFT-backed finance (NFT-fi).

NFT-backed financing has the potential to reshape the financial landscape and create new investment opportunities for both traditional and crypto-based institutions. According to the “Non-fungible Token Global Market Report 2023”, this sector – which grew from USD 21.48 billion in 2022 to USD 32.89 billion in 2023 at a compound annual growth rate (CAGR) of 53.1% – stands as a evidence of significant impact of NFTs on the financial services industry. In order to exploit the full potential of NFT financing, the development of best practices and strong regulatory frameworks, as well as the integration of traditional financial principles, are essential, to ensure stability, promote trust and contribute to a sustainable future for the NFT-fi industry.

In this new landscape, crypto-native blockchain engineers, along with traditional finance veterans, are building protocols to leverage the potential capital efficiency of idle NFTs as a means to access instant liquidity and increase the utility of these digital assets.

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Demystifying NFT-backed financing

NFT-backed financing, also known as “NFT lending,” is a form of decentralized financing that allows individuals to use their non-fungible tokens (NFT) as collateral to obtain a loan or line of credit.

In this model, the borrower pledges his NFTs as collateral for the loan, and the lender assesses the value of the NFT based on the market price and other factors. If the NFT meets the lender’s requirements, the borrower can receive a loan in cryptocurrency or stablecoins. The borrower is responsible for repaying the loan with interest within a specified time frame. If they fail to repay the loan, the lender can take possession of the NFT collateral.

Unlocks the value of NFTs

Liquidity for NFTs has always been one of the biggest issues in the space, and NFT-backed funding is proving to be an innovative way for investors to access liquidity via the value of their NFT assets. With NFT lending, users who need immediate liquidity no longer need to sell their digital assets, especially if the market price is low. This approach has several advantages over traditional lending models, including lower transaction fees, faster approval times and greater flexibility.

As NFT-backed funding gains traction, it can democratize access to capital, foster innovation by supporting creators and artists, and provide a new avenue for investment opportunities in the digital realm.

What is driving the growth of NFT-backed financing?

Investors are drawn to the burgeoning market’s potential for high returns, as seen in high-profile NFTs such as Beeple’s EVERYDAYS: THE FIRST 5000 DAYS which sold for over US$69 million, former Twitter CEO Jack Dorsey’s first ever tweet which sold for US$2.9 . million, and LeBron James’ legendary dunk that sold for $208,000.

These sales back in 2021 fueled a craze for NFTs and the expansion of the market led to the growth of NFT-fi. The NFT market has since grown tenfold in the past two years and is expected to continue to grow. While they are traditionally illiquid compared to other digital assets, the growing demand for NFTs has popularized liquidity solutions, causing the NFT lending space to expand thirtyfold in the past year.

Understand the risks involved

While NFT-backed loans provide an opportunity to release additional liquidity from digital assets, they also pose significant risks due to the volatility of NFTs. An example from 2021 involves an “Elevated Deconstructions” NFT used as collateral for a US$12,000 loan. Originally valued at approximately US$39,600, the NFT’s value increased to around US$300,000 within a month following endorsements from prominent figures such as Snoop Dogg. Despite this increase in value, the borrower defaulted on the loan and eventually lost the high value NFT.

Such scenarios bring into the limelight the lend-to-own policy, a strategy some lenders embrace to acquire potentially lucrative NFTs if the borrower fails to repay the loan. However, lenders also face downside risks – the volatile nature of the NFT market means that the value of the collateral can fluctuate significantly over the loan period due to intangible factors such as scarcity and shifts in popularity. For example, the first quarter of this year was a rollercoaster in the NFT market, with a sharp increase in trading volume peaking at 74,550 ETH on February 22 and gradually tapering off after March. This market volatility can affect even blue-chip NFTs, challenging their reliability as collateral.

Wash trading in the NFT market further complicates this landscape. Data aggregator CryptoSlam detected over USD 577 million of wash-traded NFTs related to NFT marketplace Blur.io since February 2023 and over USD 635 million in NFT wash trades on Ethereum in April alone. (CryptoSlam and Discard are both part of Forkast Labs.) This malpractice, which would be illegal in US securities markets, involves an investor acting as both a buyer and a seller to generate more trading volume and pump up prices, and it extends beyond Ethereum to destroy other blockchains such as Solana, Binance, Polygon, Cardano, Flow and Arbitrum. These distortions require a standardized valuation method, leveraging technological innovations such as big data analytics, machine learning algorithms and AI tools to provide reliable and accurate NFT valuation, essential for good NFT-backed financing.

Borrowers must also tread carefully, especially given the high interest rates associated with these loans. In 2022, annual percentage rates (APRs) reached as high as 302% for seven days on NFT-fi, and loan terms went up to 90 days. Furthermore, just like traditional finance, borrowers also risk damaging their credit scores with loan defaults, potentially making it more difficult for them to secure future loans.

Best practices for lenders and borrowers

Indeed, NFT-fi adoption requires education and awareness to create confidence in NFT-backed financing among potential borrowers and lenders. While regulatory frameworks and robust technological infrastructure will ensure the stability of NFT-fi, there is also a need for a set of best practices to ensure the safety of NFT-backed loans.

To proactively manage risk, here are four best practices for lenders:

Carefully consider the value and liquidity of the NFT security, taking into account factors such as rarity, demand and market trends.
Evaluate the borrower’s creditworthiness to minimize risk through credit scores and credit history in the chain.
Manage risk by diversifying loan portfolios to minimize the impact of market fluctuations.
Monitor market behavior closely and adjust lending criteria accordingly to reduce exposure to high-risk assets.

To ensure safety, here are four best practices for borrowers:

Provide data on past sales, market trends and potential future demand to provide assurance to lenders about the value and stability of their NFT assets.
Diversify their NFT collateral mix to reduce reliance on the performance of a single asset, providing a buffer against market volatility and, very importantly, offering a more attractive risk profile to lenders.
Present a clear plan for the loan including future income generation to demonstrate repayment ability.
Maintain a healthy debt ratio and prioritize repaying loans on time.

Well-defined responsible practices can contribute to a thriving NFT-backed financing ecosystem.

The role of traditional finance in NFT-fi

As NFTs and the emerging field of NFT-fi continue to grow, traditional financial principles will play a critical role in shaping a sustainable future for this market and driving it forward.

As with all financial products, NFT-fi must be designed and managed in a way that minimizes risk to investors. This may involve the use of hedging strategies, diversification and other risk management techniques.

Transparency will be crucial to building trust in the NFT financing market. Investors will want to have a clear understanding of the underlying assets backing NFT-fi products. Pricing, valuation and liquidity will also be relevant for NFT-fi.

These principles will help ensure that NFT-fi products are fairly priced, accurately valued and have sufficient liquidity to meet investors’ needs.

Democratization of the finance of the future

As we navigate the landscape of NFT-backed financing, we must recognize the transformative potential this Web3 innovation holds for the future of finance.

NFT-backed financing promotes the utility of NFTs by unlocking liquidity, lowering barriers to entry and improving market efficiency. As a result, it is expected to play a significant role in the ongoing development and adoption of NFTs in the coming years.

While NFT financing is a relatively new concept in the financial world, the emergence of NFT-based lending and borrowing platforms, which allow individuals to lend or borrow money using NFTs as collateral, provides a new avenue for financing, especially for those who may do not have traditional forms of security.

NFT financing shows promising potential to democratize financing and make it accessible to all, underpinned by the traditional financial principles of risk management, transparency and regulation.