Financialization of NFTs: How can holders maximize their benefits?

Original author: Nichanan Kesonpat, 1kxnetwork

Compilation of the original text: Bai Ze Research Institute

While  NFTs  have been around since 2017, they were originally used for a fringe use case (collecting CryptoKitties) within the crypto community. Yet four years later, we’ve seen artists, designers, game developers , musicians, and writers adopt the technology.

Before the  advent of DeFi  , the only way for users to acquire cryptocurrencies was through ICOs, over-the-counter transactions, or centralized exchanges with strict listing requirements . For most of the fungible tokens (ERC-20) launched in the 1C0 craze, the market is illiquid. DeFi protocols followed and reduced the time for these tokens to gain liquidity, which led to the vibrant trading, lending and leverage activity we see in crypto markets today.

Just like fungible tokens in the past, we can expect DeFi protocols to unlock liquidity for NFTs as well. We previously wrote about why  the financialization of NFTs is important and outlined early protocols that intersected NFTs with DeFi. Less than a year later, a suite of financialization protocols is already available in the NFT market. More importantly, we can now also develop a framework for evaluating each liquidity mechanism for different “types” of NFTs.

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Each liquidity mechanism requires trade-offs that make it more suitable for NFTs with certain properties. The unique and diverse nature of NFTs brings new challenges to finding liquidity. Some have practical uses, some are just “status symbols”. Some are “rare” items, some are completely unique. When evaluating how best to find liquidity for a particular NFT, it is worth defining attributes under which different NFTs are categorized and matching those attributes to the liquidity methods that make the most sense.

The pricing properties of an NFT and its price tier provide more insight into the appropriate liquidity approach than the NFT “category” to which it belongs. A common way of classifying NFTs, such as virtual land, PFP, game assets, domain names, music, and artwork. However, when assessing liquidity methods, categories can be relatively single.

In this article, I will:

  • Mapping the current NFT financialization landscape
  • Discuss the strengths and limitations of existing NFT liquidity approaches
  • Define NFT price tiers, and typical characteristics of these tiers
  • How can users maximize the benefits of the NFT they hold?

Existing approaches to NFT liquidity and their tradeoffs

  • market

NFT marketplaces allow users to find buyers and sellers through order books and a simple sale or auction mechanism. They can be generalized (Opensea, Rarible) or specialized (eg  SuperRare  for art, Catalog for music, Pracel for virtual land). The NFT market has a large number of buy and sell lists and bid orders, which is the most intuitive way for users to trade NFTs. However, without active participants, the market will eventually become illiquid.

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At the same time, the sales mechanism is also a relatively capital-inefficient method for valuing NFTs. Users must spend 100% of the value to achieve price discovery, and holders must sell the corresponding NFT.

  • auction

Auctions are lucrative for creators and are a great way to gain liquidity for assets such as art or rare items in collectibles. While high-profile auctions have played no small role in pushing NFTs into the mainstream, auctions as a means of price discovery are even less capital efficient than market sales, as they require bidders to lock up funds. The capital lockup between multiple bidders always exceeds or equals the price at which the asset is ultimately sold.

From the seller’s side, auctions often require pre-negotiations with potential buyers or extensive marketing efforts. If there are no potential buyers vying for that NFT, the time to acquire liquidity could end up taking a long time.

  • Aggregator

Aggregators such as Genie and Gem draw liquidity from different NFT markets and have larger order books, thus potentially providing better liquidity than a single siloed market. Users can also trade across markets in bulk.

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Image: Cross-market listing on Genie

Aggregators are most useful for NFT projects whose liquidity is dispersed across different markets. For example, crypto artists often have their artworks listed on multiple art markets. In fact, artwork has the highest user cross- wallet activity compared to other NFT categories, suggesting that despite the NFT market, users still follow artists (platform agnostic). Aggregators, on the other hand, allow users to browse works by artists across different art markets.

  • Loan/CDP

There are two main flavors of NFT mortgage protocols with complementary tradeoffs.

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In   P2P lending marketplaces such as NFTfi and Arcade, lenders and borrowers agree on loan terms (term, loan-to-value ratio, and APR) in a peer-to-peer fashion. Since the matching process is manual (all parties need to agree on terms and borrowers need to approve loan proposals), the time to obtain liquidity can be slow. The advantage of this type of agreement is that loan terms can be tailored to each user without relying on price oracles. This is useful for items that do not have reliable price feeds and require expertise to value.

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Image: Applying for a loan on NFTfi

There are also loan terms that bring in underwriters or  DAOs with valuation capabilities to provide information. Gringotts is a community of NFT collectors, traders and analysts who pool funds and issue loans through NFTfi. MetaStreet is building infrastructure on top of lending protocols for more efficient capital pooling and risk framing, taking inspiration from traditional securitization markets.

In P2P lending protocol solutions such as JPEG’d and DeFrag, lenders can provide liquidity directly to the protocol, which then automatically distributes funds to borrowers who stake NFTs.

Unlike P2P lending markets, P2P lending protocols can provide instant liquidity as the protocol takes care of the matching process. However, this means they have to rely on price oracles to automate loan terms. Therefore, eligible NFT collateral will be limited to those with reliable price feeds (those that are already liquid) or with quantifiable properties that can be valued algorithmically.

Taker takes a hybrid approach and incorporates peer review into their protocols. Liquidity providers can form or join a “Curator DAO” on Taker to collectively evaluate an NFT. This is a pricing mechanism that can be used in lending activities to provide immediate liquidity to borrowers with the highest asset valuations.

The benefit of loans with NFTs as collateral is that debt positions can also be represented as NFTs, which can then be plugged into other financialization protocols again. For example, NFTfi promissory notes can be further utilized in hedging strategies.

But it is important to consider that the loan-to-value ratio is always below 100% (usually 50%), and the APR can be very high, depending on the risk profile of the collateral as determined by the lender or the agreement (high risk assets have an interest rate of 60-80%), while NFTfi blue chips have 18-25% risk assets).

  • Liquidity Pool

The liquidity pool allows users to deposit similar NFTs into the pool, mint a derivative token, and redeem the assets in the pool at any time. NFT-LP protocols like NFTX and NFT20 effectively become markets built on top of liquidity pools of “similar” asset groups.

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Floor items are candidates for such protocols, which could theoretically create liquidity pools based on certain characteristics of the set, where non-floor NFTs could be grouped into the same class. As long as there is sufficient supply, NFT projects in a category are considered fungible with each other. Buyers can offer to buy any asset with that particular characteristic. Any non-floor or overpriced asset will be arbitraged out of the pool, enabling price discovery.

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Image: Azuki Vault on NFTX. All items have the same Buy Now price

Instead of finding buyers for a specific NFT, liquidity protocols open up a buyer pool to users who want to buy any NFT of the same kind, providing better liquidity than the general market. In addition, although representative ERC-20 derivative tokens (such as NFTX’s vTokens) can be traded in any number, a single NFT is not actually divided, and one NFT can be redeemed from the pool as long as one has a full vToken .

As with lending protocols, there is room to build services on NFT-AMMs. FloorDAO is a decentralized market maker on top of NFTX. It “swept up” community-voted blue-chip projects, creating deep liquidity for many collectibles. This liquidity allows traders to instantly buy, sell, and exchange assets, while  DEX  transaction fees and NFTX vault fees flow back into the DAO treasury.

  • fragmentization

Fragmentation involves “splitting” an NFT into parts that can then be traded as fungible tokens (eg, 1 NFT becomes 10,000 tokens). By buying NFT “shards”, more buyers can gain exposure to the asset and its upside without having to buy the full one. Shards can be combined with other DeFi protocols and can receive premiums above fair market value through buyout clauses.

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The limitation of this approach is the need to create new markets and provide liquidity for each NFT. This adds to the complexity of ownership and governance. This approach is more suitable for high value NFTs and less useful for low value/underlying assets.

Composability again allows applications to be built on top of NFTs. PartyBid – built using Fractional.Art  smart contracts – is a crowdfunding platform that enables users to pool funds and collectively bid on NFTs. If the auction is won, the contributors will receive decentralization tokens in proportion to their investment.

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Image: On PartyBid, a group of people won a Zombiepunk auction for 1202  ETH  , with each contributor getting a proportional Fractional NFT decentralization token

Szns takes a different approach, enabling the community to create lightweight managed DAOs that collectively govern decentralized NFTs. Album DAO starts with similar parameters for each community, and can define its own flow of buyout, NFT management, token distribution and arbitrary operations.

  • Leasing/Lending

The leasing/lending protocol allows users to rent out their NFTs in exchange for a stability fee (Twitter PFP leasing) or future income (YGG lends AXIE Token to new players in exchange for future SLP earned in  Axie Infinity  ). While reNFT and RenTable are more general, there are also dedicated rental platforms for specific classes of NFTs (e.g. Double for gaming assets, Landworks for virtual land) to support specific classes of use cases that enable tenants to put their funds Group together to rent adjacent virtual lots for large events.

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While NFT holders typically only get a fraction of the value of their assets, it’s a good option for collectors who don’t want to give up their assets in order to make money from idle NFTs. For both low-value and high-value NFTs, leasing is a valuable source of additional demand and liquidity.

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Image: Virtual land in Decentraland available for rent at Landworks

Other price discovery solutions

Before we bring NFTs into the liquidity methods that belong to them, it is necessary to discuss 2 emerging solutions for price discovery and map them to NFT price properties.

  • algorithm

While NFTs are often considered unique, collectibles markets are often priced in quantifiable attributes such as idiosyncratic rarity (Alien Punks). In these cases, we can simply calculate pricing based on historical sales data. NFTbank uses algorithms to predict the price of an asset based on past pricing of similar assets.

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Image: Algorithmic valuation of NFTBank

This is a more capital-efficient pricing method, as the fixed costs of developing a pricing model are amortized over time among users’ trading assets. However, given the relatively small amount of data available for top-level projects, this approach is likely to be most useful for the valuation of low- and mid-level projects for the foreseeable future. Data-driven approaches are also less useful for subjectively priced items, such as 1/1 art NFTs, for which cryptoeconomically incentivized evaluation protocols may be better suited.

  • peer forecast

Peer forecasts incentivize participants to answer questions about asset valuations honestly. Upshot incentivizes users to use crowdsourcing methods to value NFTs. Abacus offers sellers another way to discover the spot price of their NFTs, and it creates a liquid market for traders to speculate on the value of NFT pools.

As with the algorithmic approach, valuation costs predicted by peers are amortized across a large number of asset transactions.

Considering these tradeoffs, we can derive a simple mental model for price discovery methods for NFTs with certain price properties.

Define price tiers

A rough framework for thinking about NFT prices is the price “tier” they belong to. By setting the price range, we can plot the price distribution:

Low-level: Mostly homogenous performance, making it especially suitable for liquidity pools, which effectively act as “on-exchange AMMs” where users can earn income from trading activities of exchange-traded assets and enjoy the deepest compared to other levels Liquidity. We define the low-level price item here as a price between the floor price and the floor price * 1.4

Intermediate: Intermediate NFTs may have properties that make them more valuable than other levels, but are not the most valuable items. We define this group as a price between the reserve price * 1.4 and the reserve price * 2.5.

Top tier: Top tier projects can include general blue-chip collectibles (e.g. Fidenzas, Autoglyphs, CryptoPunks), or works by well-known crypto artists (e.g. XCOPY, Beeple, Hackatao). But for our purposes, they are the rarest and often most sought-after items in any collectible. For example, Alien Punks, Black Suit Board Apes, and Matrix CrypToadz. We define top here as priced at reserve * 2.5 and above.

The following is based on NFTbank’s data on December 15, 2021 and January 15, 2022: the former contains 279 projects, totaling about 2.4 million NFTs, with an estimated market capitalization of 3.7 million ETH. The latter contains 540 projects totaling about 14.2 million NFTs, estimated at 8.9 million ETH.

Throughout the series, we can see that the low-level (blue) make up most of the items.

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Image: Share of NFT projects divided into bottom layer (blue), middle layer (orange), top layer (green)

When we look at the market share of each price group, we can see that the top projects are often 10 to 1000 times higher than the low-level projects, cannibalizing the NFT market cap.

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Image: Market share of NFT projects divided into bottom layer (blue), middle layer (orange), top layer (green)

At first glance, financialization protocols for low-level projects appear to have the largest share of the market, but there is a lot of untapped value in finding liquidity solutions for mid-level and top-level projects.

  • Mapping NFT price tiers to liquidity methods

To sum up, we have come up with a matrix that provides a rough mental model where users can choose different liquidity options based on the price class, supply, and utility of NFTs to maximize the benefits of holding NFTs.

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https://hx24.huoxing24.cn/image/crawler/2022/02/25/1645799233920276.jpg

 

Image: Availability: Blue (Low Level), Orange (Intermediate), Green (Top Level)

future

In addition to the development and adoption of NFT financialization projects covered in this article, I would like to note the following:

  • specialization.  Just as there are general-purpose and specialty markets today, it wouldn’t be surprising to see other financialized products for specific NFT categories emerge – for example, we’re starting to see virtual land leasing platforms. The rapid growth of NFT projects across categories will soon make it futile to think of “NFTs” as a single ecosystem. On the contrary, NFTs and financialized products for virtual land, artwork, game assets, etc. will be independent ecosystems, and each vertical will have specialized protocols as its infrastructure.
  • Composability. Protocols can leverage each other to further leverage idle assets. For example, NFT liquidity pools can reuse assets within AMMs, rent them out or use them as loan collateral. Alternatively, NFTs used as loan collateral can also be leased for the same term. Locked NFTs can be used to leverage liquidity or offset loan repayments.
  • Service DAO. A community of analysts, appraisers, underwriters, and liquidity providers will continue to emerge to drive demand for financialized protocols. These can be formed within the community of the protocol itself, or within the community of NFT collectors. Service DAOs will play a key role in helping the protocol lead adoption, improve valuation capabilities, and rapidly increase NFT liquidity.
  • New NFT derivatives. For example, Putty is a put options market that allows users to trade put contracts on any basket of NFTs or ERC-20 tokens. NFT holders can hedge their downside risk by buying put contracts.

In this article, we define the price tier and provide some data on its market share so that users can apply NFTs to the most suitable liquidity method.

Although the NFT market transaction volume has declined somewhat in the past month, the potential of NFTs has not yet been fully realized. Many still view NFTs as an illiquid asset class. But as we’ve seen in previous waves of innovation, as applications proliferate, there will soon be a “wave of infrastructure building” that can enhance those applications and unlock more complex use cases for NFTs .

If 2020-2021 is a boom time for NFTs, we will now ride the coming wave of infrastructure by addressing liquidity issues – which will greatly enhance the capabilities of NFTs.

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