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John Martin 31 Aug 2023 ◦ 7 min read

What Are NFT-Backed Loans?

What Are NFT-Backed Loans?

This summer, the Binance cryptocurrency NFT marketplace has integrated a new feature that allows users to borrow and lend cryptocurrencies using NFT tokens as collateral. With this feature, they’ve joined a number of platforms that have been providing this service. Let’s take a look at how NFT lending works, what are its pros and cons, how to benefit from this opportunity, and more.

Working Principles and Perspectives

NFT-supported financing, also known as "NFT lending," is a type of decentralized finance that enables individuals to use their non-fungible tokens (NFTs) as collateral to secure a loan or credit line.

In this model, the borrower offers their NFTs as collateral for the loan, and the lender assesses the value of the NFT based on its market price and other relevant factors. If the NFT meets the lender's requirements, the borrower can receive a loan in either cryptocurrency or stablecoins. The borrower is responsible for repaying the loan with interest within the designated time frame. If the borrower is unable to repay the loan, the lender may seize the NFT collateral.

Lending and borrowing with NFT support can unlock liquidity and expand investment opportunities.

According to a report by A16z on the State of Cryptocurrency in 2023, the activity of NFTs appears to be increasing as new and promising applications emerge. After a feverish speculative period and subsequent recovery, purchases through NFTs are once again showing positive growth.

As the financial industry advances, interchangeable tokens have emerged as a significant player, creating new opportunities such as NFT-supported funding (NFTFi).

Financing supported by NFTs has the potential to revolutionize the financial landscape and create novel investment opportunities for both traditional and crypto institutions. According to the 2023 Global Token Market Report, the sector has experienced significant growth, increasing from $21.48 billion in 2022 to $32.89 billion in 2023, with a combined annual growth rate (CAGR) of 53.1%. This growth highlights the significant impact of NFTs on the financial industry. Leveraging the full potential of NFT financing requires the development of best practices and a robust regulatory framework. Additionally, integrating traditional financing principles is crucial to ensure stability, build trust, and contribute to the sustainable future of the NFT-fi industry.

In this new landscape, blockchain engineers, in collaboration with traditional finance experts, are developing protocols to leverage the potential capital efficiency of non-performing NFTs. This will enable instant access to liquidity and enhance the utility of these digital assets.

What Is Driving The Growth Of Funding Supported By NFTs?

Investors are drawn to the potential of a rapidly expanding market that promises high returns, as demonstrated by the success of high-profile NFTs such as Beeple's EVERYDAY: THE FIRST 5000 DAYS, which sold for over $69 million, former Twitter CEO Jack Dorsey's first-ever tweet, which sold for $2.9 million, and LeBron James' iconic dunk, which sold for $208,000.

The sales in 2021 have generated widespread enthusiasm for NFTs, and the expansion of the market has contributed to the growth of NFT-based finance (NFTFi). Since then, the NFT market has grown tenfold in the past two years and is expected to continue its growth. Despite being traditionally illiquid compared to other digital assets, the increasing demand for NFTs has led to the development of liquidity solutions. As a result, the NFT lending space has expanded thirty-fold over the past year.

Risks

Although NFT-backed loans provide an opportunity to gain additional liquidity from digital assets, they also pose significant risks due to the volatility of NFTs. The following example from 2021 illustrates the use of NFTs as collateral for loans. An NFT called "Enhanced Deconstruction" was used to secure a loan of $12,000. Initially, the cost of the NFT was approximately $9,600. However, after receiving approval from well-known figures such as Snoop Dogg, the cost of the NFT rose to about $300,000 within a month. Despite receiving this appreciation, the borrower defaulted on the loan and eventually lost their expensive NFT.

Such scenarios draw attention to the "provide yourself" policy, which is a strategy used by some lenders to acquire potentially profitable NFTs in case the borrower is unable to repay the loan. However, lenders also face downside risks. The unstable nature of the NFT market means that the cost of collateral can fluctuate significantly over the credit term due to intangible factors such as shortages and changes in popularity. For example, the first quarter of this year was a roller coaster ride for the NFT market in America. The trading volume surged, reaching a peak of 74,550 ETH on February 22, but gradually declined after March. Such market volatility can even affect NFTs, raising questions about their reliability as collateral.

Borrowers should also exercise caution, particularly due to the high interest rates that are linked with these loans. In 2022, the annual percentage rates (APRs) for NFTFi loans reached a staggering 302% per annum for a seven-day period, and the lending period was extended to 90 days. In addition, similar to traditional financing, borrowers also face the risk of damaging their credit ratings if they fail to repay their loans. This could potentially make it challenging for them to secure future loans.

Best Practices for Lenders and Borrowers

Indeed, the introduction of NFT-based financing (NFTFi) requires education and awareness to instill confidence in potential borrowers and lenders regarding the use of NFTs as collateral. While a regulatory framework and a robust technology infrastructure will ensure the stability of NFTFi, a set of best practices is also necessary to secure NFT-backed loans.

To actively mitigate risks, here are four best practices for lenders:

  • Carefully assess the value and liquidity of NFT collateral, considering factors such as rarity, demand, and market trends.
  • To minimize risk, it is important to evaluate the creditworthiness of the borrower by utilizing credit ratings and examining their credit history within their network.
  • Manage risk by diversifying loan portfolios to minimize the impact of market fluctuations.
  • Carefully monitor market trends and adjust credit criteria accordingly to minimize exposure to high-risk assets.

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

  • Provide historical sales data, current market trends, and future demand projections to instill confidence in lenders regarding the value and stability of their NFT assets.
  • Diversifying the suite of collateral for NFTs can reduce reliance on the performance of a single asset, which provides protection against market volatility. This also offers lenders a more attractive risk profile.
  • Present a well-defined loan plan that outlines future revenue generation to demonstrate potential repayment opportunities.
  • Maintain a healthy debt-to-income ratio and prioritize making loan payments on time.

Well-defined and responsible practices can contribute to the prosperity of the funding ecosystem supported by NFTs.

Conclusion

Guided by the NFT-supported funding landscape, we must recognize the transformative potential that this Web3 innovation holds for the future of finance.

NFT-supported funding increases the utility of NFTs by releasing 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 implementation of non-fungible tokens (NFTs) in the coming years.

Although financing through NFTs is a relatively new concept in the world of finance, the emergence of NFT-based lending and borrowing platforms that allow individuals to use NFTs as collateral opens up new funding opportunities. This is especially beneficial for those who may lack traditional forms of collateral.

NFT financing demonstrates the promising potential of democratizing finance and making it accessible to all. It builds on traditional financial principles of risk management, transparency, and regulation, which are essential for ensuring the stability and security of financial systems.

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