Explained: NFT Loans and How They Work
They’ve become a controversial topic, thanks to recent headlines about NFT projects selling for staggering amounts of money.
DeFi, or decentralized finance, refers to blockchain platforms that offer crypto investors financial products and services without the oversight of banks or financial institutions. These platforms enable anyone with an internet connection to borrow, lend or trade crypto assets in minutes without requiring approval from a centralized authority.
DeFi applications are easy to understand in the context of cryptocurrencies like Bitcoin or Ether. But how do NFTs — which aren’t divisible, and therefore can’t be easily traded — fit in the picture? The answer is NFT loans. Valuable NFTs can be used as collateral for acquiring loans, just as with a house, car, boat or stocks.
Merging DeFi with NFTs is opening up a whole new economy for this emerging class of crypto assets. In this guide, we’re going to explore how NFT loans work, and take a look at some existing platforms that have made strides in the NFT/DeFi space.
What Are 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.NFT art by Beeple broke records after it sold for $69,346,250 in March 2021. Image source: Christie’s
In many cases, NFTs simply point to the location of a digital file, whether it be an audio clip, work of art, GIF or video. The most prominent example of a sale which made headlines last year was NFT artwork Everydays: The First 5000 Days by digital artist Beeple. The work went for $69 million at Christie’s auction house, kicking off the NFT craze back in March 2021.
Other examples include Twitter co-founder Jack Dorsey’s first-ever tweet, or even NBA Top Shot, an official marketplace for NBA-licensed digital trading cards that features some of the NBA’s biggest stars. Fans can enjoy unique ownership of the licensed trading sports cards or flip them for a profit.The first edition of an NFT clip of Kevin Durant dunking a basketball sold for almost $20,000. Image source: NBA Top Shot
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.Sales of NFT art surpassed $2.1 billion in 2021. Image source: NonFungible
DeFi has made great strides in crypto markets with a host of applications that include apps for lending, renting, staking and margin trading, without involving a bank or centralized authority. DeFi mechanisms such as fractionalized assets, collateralized lending, NFT staking, and others are giving collectors new ways to leverage their NFTs beyond passive buy-and-hold investment strategies.
DeFi lending in particular is powered by smart contracts, which serve as the foundation for transparent, open and self-executing loan solutions which don’t require supervision. They execute predetermined tasks, with users able to access them through simple interfaces, just as with any regular application.
However, the smart contracts used by DeFi platforms aren’t flawless. For example, flash loan attacks are a common concern for these platforms. Attackers can exploit the market as they take out a loan, driving the value of the borrowed token underwater. They then buy back the token at a deflated price, repay the loan — and pocket the difference.
Regardless of these hurdles, NFT loans are slowly gaining exposure to the mainstream crypto market. The NFT ecosystem is currently underdeveloped, likely due to its age and the size of the market, but expanding use cases in borrowing, staking and fractionalized ownership are pumping growth into the industry.
How Do NFT Loans Work?
Platforms that support NFT loans allow holders to borrow funds and set terms without an intermediary. Borrowers can expect to get a loan amount of approximately 50% of the value of the NFT, with interest rates ranging from 20% to 80%, depending on the popularity of the NFT.
The beauty of DeFi protocols is how simple, transparent and fast they are compared to traditional lending institutions. There is no centralized authority that needs to check your credit score, verify your real identity and spend days or weeks deliberating your application.
DeFi platforms use smart contracts to give users complete control over their funds. Assets that function as collateral are sent to a secure smart contract, which acts as an impartial, automated third party programmed to facilitate the lending and borrowing process.
Lenders decide what they think is the fair value of the collateral, usually by looking at the asset’s past performance, sales history or the floor price of similar NFTs. The floor price refers to the lowest offer price for an NFT from a particular series. Once both parties agree on the terms, the NFT is transferred from the borrower’s wallet into an escrow account, and a smart contract facilitates the loan.
It sounds simple and clean in theory, but the market isn’t entirely risk-free. If the borrower can’t repay the loan and interest by the end of the loan period, then the lender is entitled to the underlying NFT. Lenders may also not accept new NFT projects as collateral because of price volatility, since they could end up losing if there isn’t any market demand for the defaulted NFT.
What Is NFT Fractionalization?
One of the core features of NFTs is that they’re completely unique, indivisible and verifiable, guaranteeing absolute ownership. That means only one owner can fully possess one NFT. Fractionalized ownership of NFTs is a method which allows multiple individuals or parties to own “shares” of a single NFT.
NFT owners can use fractionalization to mint tokenized fractional NFTs. Some NFTs are extremely high-priced, and fractionalization is a convenient way for several parties to each invest a smaller sum of money to gain fractional ownership of the asset. An NFT that’s an ERC-721 token can be fractionalized into multiple ERC20 tokens, with each one sold individually at a much more affordable price.
Fractionalization has opened up new horizons for the NFT market and brings numerous benefits, including:
- Enhanced liquidity: The non-fungibility of NFTs makes them illiquid. For example, an investor selling a high-priced NFT may have to wait a long time to attract a crypto whale who can afford to buy the asset. Fractionalizing an ERC-721 token into multiple ERC20 tokens enhances the asset’s liquidity, and makes it easier to find interested investors.
- Price discovery: With enhanced liquidity comes better price discovery. One of the biggest benefits of fractionalization is that it helps investors more quickly assess the market value of an asset.
- Easy monetization: It’s easier to find a market for NFTs which are fractionalized. Instead of paying hundreds of thousands of dollars for one CryptoPunk or Bored Ape, investors are more likely to pay thousands of dollars for a fraction of one.
Fractionalized NFTs have the potential to disrupt the NFT market for digital art, collectibles, in-game items, domain names, music and real estate. In all of these areas, NFT creators, artists, and property owners can use fractionalization to quickly sell their assets to a wider market that includes small-to-medium investors.
Best Platforms for NFT Loans
The market for NFT loans is still in its infancy, but there are already a handful of DeFi platforms offering opportunities to mortgage NFTs for permissionless loans. There are also several upcoming projects, such as those using the lending protocol Aave (AAVE), looking to accept NFTs as collateral for loans. Currently, the best platforms for NFT loans are as follows.
NFTfiImage source: NFTfi
NFTfi is basically a digital pawnshop that offers loans using ERC-721 tokens as collateral. It allows users to mortgage NFTs in exchange for various cryptocurrencies, which can then be sold for cash. Lenders offer borrowers loan proposals based on the value of the NFT that’s been put up as collateral. If the borrower accepts the proposal, then the NFT is locked in a smart contract until the terms of the loan are fulfilled.
The platform has reportedly done over $12 million in volume since its launch in June 2020. The average loan size is $26,000 for one month, but the platform has purportedly facilitated loans as high as $200,000. Default rates hover just below 20%, and vary depending on the NFT.
ArcadeImage source: Arcade
Arcade is an NFT lending platform geared mainly toward retail investors with a high net worth and institutional lenders. It’s built on the Pawn Protocol, a noncustodial liquidity infrastructure designed specifically for loans backed by NFTs.
NFT holders can request loans using one or more of their assets as collateral via the Arcade app. Users must first connect the app with their MetaMask wallet, select which assets (from the list of supported collections) to use as collateral, and then request a loan with specified terms.
The platform uses a smart contract to create a wrapped NFT (or wNFT) which represents the borrower’s loan collateral and is used when requesting a loan. The wNFT is time-locked in an escrow smart contract that notes when the funding principal is both sent to the borrower and repaid to the lender. Arcade earns a percentage of every transaction completed on the platform.
DropsImage source: Drops
Drops is a DeFi lending platform where NFT holders can put down their collection as collateral in exchange for instant access to a trustless loan without having to talk to an intermediary. Users can borrow up to 80% of the value of the asset (as determined by the floor price) and receive an instant permissionless loan from the lending pools.
NexoImage source: Nexo
Nexo is a centralized NFT loan platform that only accepts blue-chip NFT collections valued at over $500,000. These include valuable NFT collections such as CryptoPunks, Bored Ape Yacht Club, and others. Crypto whales who hold these blue-chip NFTs can acquire instant liquidity without having to part with their assets.
Nexo assigns a dedicated account manager to loan applicants. Once an application is approved, applicants can receive a loan without a hard credit inquiry or credit history review. The NFTs held as collateral won’t be liquidated, even if the value of the NFT fluctuates during the course of the loan.
Are NFT Loans a Good Investment?
Recently, the market for NFTs has grown exponentially, becoming an estimated $40 billion market in 2021. Decentralized NFT loans are opening up new opportunities for growth in this nascent industry and are slowly gaining mainstream appeal, thanks to platforms like Arcade, NFTfi and Nexo.
NFT loans are solving the illiquidity problem facing most digital collectibles. At the same time, they enable NFT holders to put their assets to work, instead of engaging in simple buy-and-hold strategies.
Even institutional investors seem to be taking interest in this new market. In December 2021, Arcade announced that it had received $15 million in Series A funding from investors including Pantera Capital to further develop its platform.
That being said, the adoption of NFTs isn’t completely rosy, with many issues that still need to be worked out. Other than the impact NFT minting has on the environment, one of the other major problems is high gas fees.
Minting an NFT on Ethereum’s blockchain requires fees which users pay to miners to validate the transaction, thereby adding it to the blockchain. This sounds straightforward, but the issue with gas fees is that they fluctuate. When the network is congested, fees go up, which is unfair to the consumer.
The good news is that Ethereum is actively working to fix this problem by switching to a proof of stake model in 2022. This change will not only solve Ethereum’s energy consumption and carbon footprint problem, but also expand the network and improve its transaction-processing capability. This should ease congestion and reduce gas fees.
While no one knows for sure where the NFT market will trend next, it’s safe to say NFT loans will continue to offer good investment opportunities in 2022 and beyond.
The Bottom Line on NFT Loans
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.
To learn more about lending protocols and how blockchain technology is continuing to develop, check out our guide on DeFi Lending.