Key Takeaways:
- DeFi platforms offer NFT loans that allow NFT owners to collateralize their NFT collections in exchange for cryptocurrencies.
- NFT staking, and collateral lending gives collectors new ways to leverage their NFTs.
- NFT loans are available on platforms to allow users to borrow funds without an intermediary up to 50%.
The past year has been a rollercoaster for Non-fungible tokens (NFTs) as they attracted investors and curious minds worldwide. Artists were the first to join the bandwagon, such as Beeple, who made an auction in March 2021 that sold a mosaic of his images at $69 million.
Since then, the industry has gone wild, attracting huge financial institutions such as TikTok, Christie’s, and Visa.
However, most NFTs are highly illiquid. The only option they present after buying is selling it later.
Such reasons have prompted DeFi developers to dive into the NFT niche to try and generate more use cases for these lucrative digital assets. With DeFi, NFT enthusiasts can borrow, trade, and lend crypto assets without centralized approval.
Platforms are merging DeFi with NFTs to solve the illiquidity issue. The integration has birthed NFT lending and borrowing opportunities. This article will dive into the world of NFT lending and borrowing, what it is and how it works.
The Rise of NFT Lending
Non-fungible tokens are digital assets that people can use to represent ownership of various real-world items and digital assets. Their main selling point is non-fungibility, whereby they cannot be replicated or split because they have a unique digital identifier.
On the other hand, cryptocurrencies allow users to purchase fractions of the token at a time.
NFTs are great for recognizing the unique characteristics of digital assets due to their lack of fungibility. You can compare them to traditional fine art and rare physical collectible items such as Pokémon cards.
Unfortunately, non-fungibility doesn’t come around without its flaws. For investors, acquiring NFTs can be very illiquid since it limits their options for selling them.
DeFi platforms offer NFT loans that allow NFT owners to collateralize their NFT collections in exchange for cryptocurrencies. These solutions could be the ultimate solution to the NFT illiquidity problem.
DeFi and NFTs
DeFi has made primary entries into crypto markets with decentralized apps offering services such as lending, staking, renting, and even margin trading. Margin trading involves borrowing money from a brokerage firm for trading.
Fractionalized assets, NFT staking, and collateral lending gives collectors new ways to leverage their NFTs. This way, the potential goes beyond passive buy-and-hold strategies of earning.
Smart contracts are the foundation of DeFi’s decentralized loan solutions. They allow users to perform predefined tasks without requiring supervision. Unfortunately, smart contracts are not always secure.
For instance, flash loan attacks are common on DeFi platforms. They can drive the value of a borrowed token underwater and pocket the difference.
Despite these obstacles, NFT loans slowly make their way into the mainstream crypto market. Due to their growing use cases, folks expect that the NFT ecosystem will continue developing.
How NFT Loans Work; Borrowing and Lending
NFT loans are available on platforms to allow users to borrow funds without an intermediary. They can expect to get a loan amount of up to 50% of the NFT’s value, with interest rates varying from 20% to 80%.
DeFi’s transparent and straightforward protocols make them an ideal alternative to traditional lenders. They do not require users to provide their credit scores or other personal details.
Meanwhile, DeFi platforms use smart contracts to provide users with complete control over their funds. These contracts act as an automated third party that can help with the lending and borrowing process.
How the Value for NFTs for Loans Is Determined
Users must first connect their crypto wallet to the loan app to secure a loan. Thereafter, the website displays the NFTs they own and asks them to choose their preferred ones as collateral.
Before applying, the borrowers must enter their loan details, such as the duration and the amount they’re willing to pay.
After this, the next step starts, valuation. NFT valuation is a complicated aspect as it involves trying to find a reasonable price for the loan. Both the parties, the lender and borrower, would need to have a dialogue to reach a reasonable conclusion.
In addition, it takes a while for the lender to develop the absolute value of the NFT, as it requires in-depth digging. Notably, NFTs could also increase in value, hence a consideration factor.
The lender decides the fair value of the NFT based on the asset’s past performance, prior transactions, or the lowest offer price for the NFT that a particular series can currently offer, the floor price.
Note that a loan only originates when a lender accepts the terms offered by a borrower. The NFT is then digitally locked and is only unlocked once the borrower has paid the total amount of the loan.
If the borrower can’t make the required payments by the end of the loan period, the lender is entitled to the NFT. The lenders cannot accept new NFT collateral as there is a risk of volatility.
Hence, it could lead to losses on the lender’s side if they do not spot market demand for the defaulted NFT.
The NFT Lending Rates
NFT loans are typically short-term, ranging from a week to three months. Depending on the terms and conditions of the loan, the NFT lending rate can vary. For instance, NFTfi doesn’t charge the borrower. It also cuts 5% of the interest earned by the lender.
NFTfi has facilitated over $12 million in loans. Its average loan size is $26,000, and its default rate is 20%. Some NFTs, such as CryptoPunks, have an annual percentage rate (APR) of around 18%.
BAYC, on the other hand, may fetch an APY of 40%–60%. In addition, some loans may attract interest rates of up to 150% and beyond.
Issues Associated With NFT-Collateralized Loans
NFT lending and borrowing are relatively new to the market and still under development. Therefore, there are a few issues that platforms need to address.
In most cases, platforms use a pledge of equipment to secure a loan with insurance coverage. It ensures that the owner of the pledged equipment retains its ownership. Even if something destroys the equipment, the insurance proceeds still replace the pledged equipment.
However, in the NFT world, this requirement might not be appropriate since lenders would place their NFTs in an escrow account instead of being owned by the borrower. Hence, giving rise to many questions without answers.
Can the loan provider request additional security from the borrower if anyone steals the NFT without insurance coverage?
Since platforms automate most loan transactions through DeFi, would insurance coverage be considered an adequate risk allocation mechanism between the loan provider and the borrower?
Another issue to look out for is the fluctuation of securing a loan. Usually, lenders determine the value of the secured asset by reference to various factors. However, in the NFT world, the value is primarily determined by subjective assessments.
Although NFTs are not entirely risk-free, they can still be very risky for banks. When borrowers default on their loans, the lender will receive the NFT as collateral.
Most lenders will only accept NFTs related to a noteworthy project, such as CryptoPunks. This type of project is too volatile for them to accept.
On the other hand, a less well-known NFT can still receive a lower LTV ratio than a well-known one. Hence, NFT lending can only work through the local project’s implementation.
NFT Lending as an Investment Opportunity
The first step to investing in NFT lending is to choose an NFT lending platform that is suitable for you. It would help if you went through the loan’s terms and conditions to determine if they are suited to your capabilities.
Other important factors to look out for are legitimacy and safety, interest rates, and reviews from those who have already invested. For a start, below are some of the NFT lending and borrowing projects currently in operation.
Arcade
In 2020, Arcade launched as an NFT lending marketplace that supports Ethereum-based NFTs. Through its platform, investors can borrow loans through their bluechip NFTs.
Arcade secured a $15 million Series A funding last year to fund the transition from its private beta to a public launch later this year. In addition, the funds will provide the capital to expand its services.
Currently, the platform supports over 50 NFT collections. It also features a unique feature called the Wrapped NFT technology, which bundles multiple NFT assets into one loan collateral asset. Hence, it enhances NFT liquidity.
NFTfi
Borrowers can use any ERC-721 token as collateral using NFTfi. NFTfi offers users a loan that when they accept the proposal, they lock the NFT until payment. Its primary advantage is that lenders can earn interest while users make their NFT more liquid.
Nexo
Nexo offers centralized NFT lending and borrowing services. Currently, the only NFT collections that Nexo can accept are those with a value of $500,000 or more. They will then contact the account manager of your choice to prepare the loan agreement.
Drops
Drops is also a DeFi lending platform. NFT holders can convert their assets into collateral in exchange for an instant loan without going through an intermediary. They can borrow up to 80% of their asset’s value and receive their instant loan from the platform’s lending pools.
A Closer Look into NFT Loans as an Investment
The NFT loans market has grown significantly over the past couple of years and reached $40 billion in 2021. Due to the emergence of decentralized NFT platforms, such as NFTfi and Arcade, the industry is starting to gain mainstream appeal.
NFT loans are helping digital collectible investors solve their liquidity problems. They enable them to put their assets to work instead of engaging in traditional buy-and-hold strategies.
Even though it’s still in its early stages, the NFT loans industry attracts institutional investors’ interest.
Among the lending platforms that have attracted such interest is Arcade. The platform secured $15 million in Series A funding from investors such as Pantera Capital.
Although the community widely consider NFTs a positive development, many issues still need to be worked out before users can use them. One of these is the high gas fees.
For miners to validate the transaction, network users must pay the fees required for minting NFTs on the Ethereum blockchain. The issue with this is the fluctuation often associated with gas fees due to congestion.
NFT Loans vs. NFT Flash Loans
Another latest development in the NFT industry is NFT flash loans. These loans are different from the usual NFT loans in that they can instantly and easily borrow funds without a collateral need. In addition, they are aimed and developed for developers.
However, developers must return liquidity to the pool within a single trading block.
Developers need to create a contract that requests a flash loan to receive one. This contract will need to be executed, paid back the loan, fees, and interests in the same transaction.
If the developers do not restore liquidity within one transaction, the whole transaction and all actions taken up to that point get undone. Notably, Hashmasks was the first-ever NFT flash loan.
The Future of NFT Loans
In the future, many banks and financial institutions will start accepting NFTs as security. Hence, analysts expect the NFTs loan market to grow due to the technological advances that it has to offer. However, before you take on a loan, you must know the fair value of your asset.
Meanwhile, the crypto community often refers to NFT lending as the gateway to NFT DeFi. It allows users to earn money from their NFTs by taking out loans. NFT DeFi is focused on making NFTs more liquid and allowing users to spend more on blockchain-related services.
As much as many people expect NFT loans to have a bright future, it would be best to be careful not to get into a loan without fully understanding the value of your assets.
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