NFTs are no longer just cute JPEGs to use for a Twitter avatar — they’re big business. The latest proof: NFT lending, which lets people lend out their NFTs as collateral to borrow crypto, is booming.
Even as prices have taken a tumble along with the broader crypto market, NFTs are growing in use for everything from fantasy sports to social clubs. That has made NFT lending profitable and popular. It’s also an example of the way that crypto can turn almost anything into a complex financial instrument. That’s adding more and more risk along the way, with major implications for the future of Web3.
NFTs are often thought of as one-off artworks. But non-fungible tokens are still tokens, which means they can be traded on blockchains and used in smart contracts. That’s how crypto turns them into financial assets that can be loaned out and borrowed against.
The NFT trade
Larger financial institutions are getting involved, which is tying the NFT trade to the broader financial system. Prime crypto brokerage Genesis Trading and crypto exchange Nexo are two of the institutions that are lending against NFTs on Arcade, one such service.
These structures also bring increasing risk. The steep drop in NFT prices, with some top-tier NFTs dropping 50% in the past month alone, shows how fast things can change in this market. And the more NFTs are collateralized, traded and held by larger institutions, the more risk they bring to the wider market, some investors say.
Why do NFT holders want to borrow against them? Many individuals or funds are sitting on large gains in value of NFTs. They often don’t want to sell their NFTs because they believe in the long-term value or don’t want to pay taxes on the gains.
Some borrowers want to maximize how many new NFTs they can buy, while others want the cash to opportunistically buy new investments, said Stephen Young, CEO of NFTfi. Others want to generate returns through play-to-earn games or yield farming. One person even took out a loan on a Doodles NFT to buy a truck to donate to Ukraine, NFTfi reported on Twitter recently.
Another strategy is hedging. In case an NFT drops in price below the amount borrowed, a borrower can default on the loan and walk away with more value in cash, Young said: “You can almost think of it as a put option in that scenario.”
Still, this form of lending is extremely risky, some investors say. “This is the peak of overcollateralizing and overleveraging,” said Adam Jackson, the CEO of Freelance Lab and an angel investor.
While this is more risky than NFT trading already is, these loans are self-contained and lenders can’t go after a borrowers’ other assets, Young said. That’s because the loans are all on the blockchain — those are the only assets lenders can access. But there’s still a lot of risk involved.
“Obviously, if you go super-leveraged on all of your assets, there's still ways for people to get into trouble, right?” he said. His company tells people in presentations: “[B]e careful — your leverage allows you to increase your upside, but it also allows you to increase your downside. So you need to make sure that you know what you're doing and make sure that you limit the risk to assets you're willing to put at risk.”
Borrowing on the blockchain
NFT lending is typically done on-chain via smart contracts. Both NFTfi and Arcade offer fixed-period, fixed-rate loans. Both do not have access to the NFTs or capital involved, and their systems will not liquidate an NFT holder’s loan if the NFT’s price drops. That differs from some offerings such as decentralized protocol JPEG’d, which will liquidate an NFT if the loan-to-value ratio hits 33% or higher.
On NFTfi and Arcade, lenders compete on terms such as loan-to-value ratio or interest rate. Depending on the type of asset, the loan-to-value ratio may be higher or lower, and the interest rate may also vary.
NFTfi, one of the larger services, had its public beta launch in June 2020. It did $300,000 in loans in its first year, $14 million in 2021 and $150 million so far in 2022, with $37 million in loans outstanding. Its loans range from 30 to 180 days in duration. The loans are paid back all at once, like a traditional bullet loan. Typical loan-to-value ratio is about 50%, and NFTfi charges lenders 5% of the interest earned only on loans that don’t default. The largest loan NFTfi has done was an $8.3 million loan for 104 CryptoPunks at a 30% loan-to-value ratio and 10% APR.
NFTfi allows NFT owners to borrow against their assets.Image: NFTFi
The sharp crypto downturn this month has had a sizable effect on this market. That has “absolutely” caused more NFT holders to be liquidated recently, said Frank Chien, an NFT collector.
Meanwhile, the downturn has caused these loans’ interest rates to jump: Last month, the average APR was 50%. After falling, it’s now up to 60%. “So that's the lenders telling you that they're taking on more risk by doing loans, so that tells you that they think the markets are still gonna be choppy going forward, and there's risk in that,” Young said.
NFTfi’s average loan size was around $20,000 prior to May, but now has dropped to about $16,800. However, the total number of loans has increased recently.
Defaults are also up. But Young said this isn't necessarily because the borrower couldn’t repay the loan. “The main driver of defaults is when the market conditions completely change. And it just doesn't actually make financial sense to repay the assets because it's cheaper to just default it and then go buy another asset from the same project for cheaper,” he said.
Arcade, which launched in late January, focuses on higher-end NFTs like Bored Apes and CryptoPunks. The rates typically range from 10% APR to 40% APR, with an average of 18%, said Gabe Frank, its CEO. Arcade takes a 0.5% origination fee from the borrower.
Right now it focuses on 90-day loans with capital paid back in a lump sum. So far, it has not had any defaults. NFT holders have the option to extend the term. Arcade plans to add one-year installment loans that can be paid in 12 monthly installments.
Those with higher liquidity and demand, such as CryptoPunks, can get higher loan-to-value ratios of 60% to 70% from lenders, while on lower ones it can be 20% to 50%, Frank said.
Arcade provides valuations and appraisals on assets and uses machine learning to help appraise NFTs.
While this type of loan is clearly risky, most of the NFT holders borrowing on Arcade are crypto experts. “Most are sophisticated players in DeFi,” said Frank, who himself has taken a loan on Arcade against a Bored Ape that he owns. He plans to keep the loan recycling over time.
Securitization takes coordination
Meanwhile, these assets are becoming more complex, securitized and potentially more risky. Goblin Sax is building pooled liquidity on top of NFTfi through instant loan products, Young noted. Meanwhile, MetaStreet buys the NFTfi loans as promissory notes and packages them up in tranches to be sold, similar to the way mortgages are packaged in collateralized debt obligations.
There are also derivative products being built on top of MetaStreet that are similar to interest rate swaps, Young said. He also believes NFTfi itself can build products on top of those derivatives.
Meanwhile, there’s been consolidation among lenders. These more sophisticated lenders have set up APIs, AI and bots to automate their lending strategies. “Typically for an Ape or a CryptoPunk, you'll get five or six offers within two or three minutes on listing that asset,” Young said.
This complex financialization of NFTs is making what started as a set of online art projects into a more tradable asset. Proponents compare it to the mortgage market. Critics who remember the 2007-2008 crisis might make the same analogy.