NFT and DeFi – why is this such a big deal

Two aspects of the crypto world are gaining popularity – NFTs and DeFi. Non-fungible tokens and decentralized finance are not an either-or, zero-sum pairing, but an evolution. But how did we get from the virtual cats of NFTs to the financial models of DeFi? How will NFTs of athletes, rappers, and artists work in DeFi? In this post, we break down how DeFi can accelerate the progress of NFTs to more than just an asset class.

From NFT to DeFi

An NFT is simply a form of value storage. Like a dollar bill, gold, or Bitcoin, an NFT has value locked into an asset. However, this value’s measurement is far more different at an individual and market level. This is the “non-fungible” part of “non-fungible tokens.” Non-fungible refers to something that cannot be easily replaced or replicated. This is why no two NFTs are the same, but two $100 bills can get you the same amount of groceries. You can learn more about NFTs and how they work here.

Now coming to DeFi. DeFi or decentralized finance is a financial system created using blockchain technology. Several public blockchains are building the DeFi system. The most popular one is on the Ethereum blockchain. Through various in-built tools like oracles, smart contracts, and cryptocurrencies, DeFi allows decentralized financial management. Everything from loans to invoicing can be done on DeFi.

Reading the two there is a connection that can be made. The assets of NFTs to the infrastructure of DeFi. You’re on the right track, let’s explore this further.

NFT – assets and value

What kind of assets are tokenized?

Let’s start with tokens with a realistic value proposition, like land. Real estate was one of the first real-world assets to be tokenized. This was because real estate investments are illiquid and require endless documentation. Putting these assets on the blockchain, represented by virtual tokens signifies ownership and transfer. Tokenization of these assets not only creates a database of information but eases verification. Real estate tokens come under the security token category. To learn more about tokenization of real estate, watch our video here.

NFTs unlock and mobilize value where there previously was value, but you couldn’t mobilize it. For instance, a rapper’s fan base. A popular rapper has millions of fans all over the world, but could he provide any value for them directly apart from the tracks he produces? With NFTs fans purchase tokens to take part in special engagement sessions with rappers. Of course, this comes at a cost. But some fans are happy to pay the price.

On the other hand, a fledgling rapper can leverage her audience with NFTs. She can sell NFTs to the audience, generate funds for marketing and production and hopefully make it big. If she does, the audience can prove they were early-believers through the NFTs and receive an income for their investment. We’ve written more about it here. 

Both security tokens and non-fungible tokens offer a value proposition. This value proposition is priced. As a piece of real estate can have a dollar value on it, so can digital real estate, digital art, or a rapper’s future cash flows. In fact, Crypto Kitties, the most popular NFT platform, sells virtual cats, that can be groomed, for as much as 600 ETH or $900,000. 

Here are the main characteristics of NFTs:

Limited supply 

You can’t have a stream of NFTs offering the same value proposition. From fan engagement to sports’ highlights reel to a virtual cat, they should have a cap on it

Verifiable scarcity

Whatever the cap, it should be verifiable. At any point, you should know how many NFTs are left and who holds them. This can be done on the blockchain.

Unique

Unlike Bitcoin, NFTs are unique. No two tokens are the same. Think of them as a movie or concert ticket, they allow entry into an event to a specific person. Even if your concert ticket (with your details were stolen) the new holder will have to prove they are you in order to attend the event.

Indivisible

Like a Bitcoin can be divided into a million satoshis or a $100 bill to one hundred $1 bills. An NFT cannot be divided into secondary units. This destroys their value proposition, which is given to one holder. 

Specific use

You can’t use an NFT to buy a cup of coffee. You can only use it for its intended purpose, whether it is – listening to music, attending an exclusive party, or raising a cat.

We’ve learned that NFTs, no matter what form have a value proposition and some key characteristics. Can this be leveraged via DeFi?

DeFi – unlocking value

What you need to understand about DeFi is – DeFi works with all kinds of financial instruments, processes, and solutions. Adding NFTs to the mix is like adding an additional asset to its pre-existing portfolio. But which stream would it impact? 

Since NFTs are value-based assets – either growth (the asset’s value can grow) or income (the assets will accrue income to the owner) let’s see how they can be used in DeFi. For starters, several DeFi projects offer loans. These loans are typical to encourage commerce using cryptocurrencies.

Let’s say Adam has to buy goods from Ron worth $80,000. He has 100 ETH which is worth $160,000 today. 

He can use this ETH to buy the goods, but Adam doesn’t want to let go of the ETH because he wants any potential upside. To keep his ETH and pay Ron, he turns to DeFi. He can take a loan worth $80,000 in the stablecoin DAI. This stablecoin’s price will remain roughly equal to $1. He puts his entire ETH holdings as collateral to take 80,000 DAI as a loan. Here, it’s important to note that Adam has over-collateralized his loan. This means that despite the loan value being $80,000, he’s putting up ETH worth $160,000 as collateral. This is to safeguard against any volatility. ETH’s price can rise or fall, but the stablecoin’s price will be stable. This is why Adam has to over-collateralize the loan. 

What does Adam get from it? He can pay Ron the $80,000 and receive the goods. Once he makes $80,000 from his business, he can return it to the DeFi protocol and get back his ETH. In this way, he keeps his ETH (and any potential future upside) and pays Ron for the goods.

NFT – price-sensitive collaterals

We’ve seen how NFTs have value, and how DeFi can unlock value. Can DeFi do the same for NFTs? This seems wayward because of an obvious reason. The pricing method for NFTs is not straightforward.

NFTs have a niche market – rapper fan engagement, digital art, or digital real estate. This cannot be easily priced for a financial function like the pricing of a loan. Pricing of assets in the DeFi space is done by price oracles. These are data retrieving agents. They allow several DeFi protocols to integrate a variety of price-data. From bonds to stock prices, to cryptocurrencies, and more. But can you adequately retrieve the price of an NFT?

The process of selling and eventually distributing NFTs is via an auction. Take Jack Dorsey’s first tweet, which received bids over $1 million. Would you pay so much for a tweet? The price discovery of this is in the eye of the bidder. Similarly, there is no standardized method to price Dorsey’s first tweet, the Kings of Leon’s new album sold via an NFT, or Grimes’ artwork. However, there’s a nascent secondary market in the works.

Source: CryptoArt.io

Platforms like Nifty Gateway, which recorded $75 million in sales of crypto art in February 2021 are a secondary market for NFTs. It allows users to buy, sell and even store their art on the platform. Users can cash out via the cryptocurrency exchange Gemini, allowing easy liquidity. Other secondary markets for NFTs are OpenSea, SuperRare, and Zora. 

With such platforms, price discovery is possible. But it still doesn’t solve the focal problem. Since a token’s price is decided by the buyer, how can the market effectively put one price tag on the token? This is all the more important when determining the collateral for a loan.

NFT loans – flip the choice

Let’s recap before we dive into this part – NFTs have value, DeFi mobilizes assets with value, secondary markets like Nifty Gateway determine what value NFTs have. The problem is who values these tokens since the value varies between people. Why not flip the choice? Instead of a system determine the price of an NFT, whether it be a virtual cat, or digital real estate, why not the lender? 

In a traditional loan, the bank determines the collateralization amount, why not lenders determine this in DeFi? The borrower will put up the loan amount they’d like and the NFT used for collateral. The lender will value the loan amount and the collateralized NFT based on – the owner’s price tag, a secondary market value (like Nifty Gateway), and their own calculations. If the lender feels the NFT is valuable collateral, the loan is disbursed.

A platform that allows this operability is nfti on the Ethereum blockchain. They allow lenders to offer loans, and borrowers to offer NFTs as collateral. Let’s see how this works with an example.

Let’s say Adam owns a CryptoKitty called ‘Snappy’ worth 50 ETH, or $80,000. He wants to take a loan on nfti worth $40,000. He puts up Snappy as collateral and waits for potential lenders to bite. Ron is willing to lend out 40,000 DAI because he’s also interested in CryptoKitties.. Since Ron prices Snappy in the same manner that Adam does, the NFT can be used as collateral. Ron sends Adam the 40,000 in DAI, and Adam’s Snappy is locked in a smart contract. A smart contract is an auto-executing contract. Adam’s Snappy will be given to Ron. This is how an NFT is used in a DeFi ecosystem. 

NFT – Eye of the lender

The supply and demand of NFT are never equal. The number of people willing to issue loans for NFTs is lower than the people borrowing for their NFTs. Hence, each lender has a choice of what kind of NFT they want to lend against. They might prefer a Grimes’ masterpiece to the rapper Yachty’s fan engagement, or a virtual cat to digital real estate. As the saying goes – beauty is in the eye of the beholder. In the NFT space – an NFT’s value is in the eye of the lender and the borrower. DeFi is helping unlock this value.

You can learn more about DeFi and NFTs here:

How did we get from Bitcoin to DeFi | Ethereum, NFT, Smart Contracts

How Peer-to-Peer Lending Works in DeFi

Why is DeFi Important?