NFTs (non-fungible tokens) have been a buzzword in the past two years. Regardless of personal views, it has grown near impossible not to take notice of them. Even with recent slowdowns, total NFT sales volume could top $90 billion by the end of this year (after seeing a record $40 billion in 2021). That success has brought a new type of interest from a new group of participants in the NFT ecosystem — lenders. And with a new participant in the NFT space comes a new label for NFTs — collateral.
In this article, we will discuss how lending works in the decentralized space, why NFT can be a great collateral, and how it works in the DeFi sector.
Defining NFT Loans
NFT loans are offered by DeFi platforms. They allow NFT owners to mortgage their NFT pieces or collections in exchange for cryptocurrencies or fiat currency. Many NFTs on the market are highly illiquid, and several DeFi projects have identified the growing need to improve NFT liquidity using solutions such as lending.
Non-fungible tokens (NFTs) can represent ownership of a wide variety of real world items and digital assets, ranging from virtual real estate and collectible cards, to digital artwork and avatars. The biggest selling point for NFTs is their non-fungibility, which basically means they aren’t divisible and can’t be replicated.
By contrast, cryptocurrencies are divisible — which means that investors don’t have to buy one Bitcoin in its entirety, but can instead buy fractions at a time. In comparison, all NFTs have a unique digital identifier that ensures they can’t be copied or subdivided. An original NFT can easily be verified on the blockchain.
NFTs’ lack of fungibility is great for establishing the uniqueness of assets. It’s created a distinct class of assets for digital items which shares parallels with traditional fine art collecting and other rare physical collectibles, like baseball or Pokémon cards.
However, non-fungibility isn’t without its flaws. The most prominent one is that it limits what investors can do with their NFTs, which makes NFTs highly illiquid. Once an investor obtains an NFT, the standard option to turn a profit is to sell once its value increases.
That’s where NFT loans come in, a mechanism made possible thanks to DeFi. NFT-backed loans and fractionalized NFT ownership through DeFi protocols are becoming a way to solve the NFT illiquidity problem. These innovations create a market where NFT owners can mortgage their NFT(s) in exchange for cryptocurrencies or fiat.
Once you purchase an NFT, it’s generally challenging to use it productively. Unlike fungible cryptocurrencies, NFTs can’t be staked or otherwise put to work to generate yield. However, NFT-backed loans enable holders to acquire funds using their digital assets as collateral. The loan can then be used to buy more NFTs, purchase tokens that can be converted into fiat, or acquire other tokens that can be deployed into DeFi protocols for yields to generate income.
How it works
Let’s take a look at real-world examples to demonstrate how NFTs can be a valuable asset to collateral loans.
Whether it is an NFT-secured loan, a used car loan or a multimillion-dollar leveraged finance of an entire company, the motivations of lenders and borrowers are consistent. The lender is incentivized to give temporary funds to the borrower in exchange for an interest rate charged on top of the principal loan amount. The borrower is willing to pay the interest rate because they need an immediate source of liquid funds without selling the asset.
What does change in each asset class is how the lender is protected from a borrower’s non-payment of the loan, or “default.” In a used-car marketplace, the lender receives ownership of the car if the borrower defaults. A deep foundation of secured lending regulations gives lenders the necessary confidence that this car ownership transfer will occur with or without the defaulting borrower’s cooperation.
NFTs that are listed as collateral for a loan gets transferred into a double-audited escrow smart contract for the loan duration. Borrowers must repay the loan before the due date so they can receive back their NFTs. If the borrower defaults the payment, the existing smart contracts on the loan automatically executes, which means the NFT is transferred from the borrower’s wallet to the lender’s wallet.
Is it safe to use NFTs as collateral for loans?
In the lending and borrowing protocols, we have seen protocols that use cryptocurrencies as collateral. One of the best-known examples of such platforms is AAVE. AAVE operates on different blockchains and allows one to supply assets and earn interest on them.
While recently, centralized borrowing and lending protocols, namely Celsius, is in bankruptcy proceedings, decentralized ones, like AAVE, performed very well in turbulent markets and proved that decentralized market players are here to stay. We are now starting to see protocols launching that use NFTs as collateral, however, this method has not yet been widely utilized. One of the main reasons is that NFTs are usually illiquid assets. Using them as collateral can be difficult, because if there is no buyer for that NFT then the value of this collateral cannot be estimated.
One of the out-of-the-box ideas came in peer-to-pool NFT lending platforms, like Fluid Tokens. In these platforms, borrowers stake their NFTs in a smart contract and receive the required loan amount from the liquidity pool comprising assets deposited by lenders. Furthermore, since the lender and borrower can decide when the loan must be repaid in full, the borrower can, at any time, pay back the loan before expiry. Still, the loan can be repaid even after expiry, provided the lender hasn’t claimed the collateral NFT.
Final Thoughts on NFT Loans
NFTs have come quite a long way since the beginning as basic collectibles, and now expanding in form and function with many future use possibilities. Integration of NFTs with the DeFi world and the potential use of NFTs as collateral is a novel and exciting concept, and one that many NFT fans and owners will be interested to keep an eye on.
NFT loans are a gateway into the NFT/DeFi sphere. They could potentially create exciting revenue streams for previously illiquid assets like NFTs. The core goal of NFT loans is to increase the liquidity of NFTs, providing users access to capital to spend on other projects and services.
Though using NFTs as collateral does pose some challenges, we are now starting to see the ways that developers can tackle the issues and provide workable solutions that keep pushing the space forward.
