A Comprehensive Experiment on the Financialization of NFTs: Making Non-Fungible Tokens "Fungible"

This article was published on the 1kx fund's medium, author: Dmitriy Berenzon, research partner at the cryptocurrency investment fund 1kx, translated by Li Ke.

Although non-fungible tokens (NFTs) have existed since early 2018, they were initially only applied by a handful of cryptocurrency enthusiasts in niche use cases, such as collecting digital cats. Three years later, we are witnessing artists, designers, game developers, musicians, and writers beginning to adopt this technology.

This is because NFTs, like Bitcoin and decentralized finance (DeFi), represent a financial, social, and political movement. They enable the authentication and provenance of digital content and allow people to purchase this content from creators around the world in an instant value transfer manner. This movement is particularly driven by individuals from various industries or regions that find it challenging to monetize their work directly.

To some extent, we are still far from the widespread application of this technology and have yet to fully realize its potential.

The first phase of the technology's application is the tokenization of off-chain and on-chain media assets, while the second phase will involve using DeFi protocols to finance these assets to enhance their value proposition and apply them to new use cases.

In this article, I will discuss why DeFi protocols are beneficial for NFTs, present several financial use cases utilizing NFTs, and explore the future prospects of NFT assets.

DeFi is the Rocket Fuel for NFTs

Financing NFTs through DeFi protocols addresses many of the challenges NFTs face today, particularly:

Accessibility

Since NFTs are unique by definition, buyers often need specialized knowledge about specific assets to make informed buying and selling decisions. Additionally, the scarcity of unique assets can quickly drive up their prices, making them unaffordable for buyers.

These two factors increase the barriers to entry for new buyers in the market and hinder the value accumulation of NFTs themselves; since part of the value of NFTs comes from their underlying communities, limiting access for long-tail buyers makes it difficult for NFTs to penetrate the entire internet. DeFi protocols can reduce the capital and knowledge requirements for participating in the NFT market and open the floodgates for a new wave of retail users.

Liquidity

Liquidity markets with specific NFT buyers and sellers lead to better price discovery, as they increase the speed at which NFTs are traded in the secondary market—i.e., the more transactions occur, the stronger the perception of the fair market value of NFTs. This makes it easier for sellers to profit from their work and allows inexperienced buyers to enter new markets more easily, as they can exit their investments more readily if they wish.

Utility

Authentication and provenance are important attributes of NFTs, fully realized by permissionless cryptographic networks, but their value proposition has yet to resonate fully with retail investors. The rich utility of DeFi protocols, such as access to cash flow, content, and experiences, will attract a broader mainstream audience to purchase NFT assets.

Synergies Between DeFi and NFTs

There are many excellent use cases that combine DeFi and NFTs:

Collateral

Banks have been providing loans secured by traditional art since the 1980s, which is a big business: Deloitte estimates that the global art-backed loan market was valued at $21 billion to $24 billion in 2019.

By offering non-recourse loans for digital art, collectibles, virtual spaces, and other content, people can do the same with NFTs. The Rocket project experimented with this in early 2020, and the NFTfi project is building a two-way market for NFT lending on Ethereum. However, these are still in the early stages, with NFTfi currently having around $2.5 million in loan volume.

Accepting NFTs as collateral in lending protocols can increase the utility of NFTs for their owners while also boosting the economic activity of the protocol, creating a win-win situation.

An important related component is pricing, which is a broader issue for NFTs, but is particularly crucial if these assets are to be used in financial contexts. In the absence of secondary market trading, especially during liquidation events, appraisals may be needed to estimate the value of NFTs. Assessments conducted by licensed appraisers or pawn shops are widely used practices in the traditional art and collectibles market. The Upshot project does just that by crowdsourcing NFT asset evaluations through incentivizing network participants.

Crowdfunding

ICOs were the first killer application on Ethereum, as the platform was ideal for global capital formation and distribution. This use case also applies to NFTs. Users from around the world can invest in creative works at different stages of their lifecycle, potentially leading to a renaissance in digital art and providing new business models for various content creators.

For example, a writer named Emily Segal raised about $50,000 (25 ETH) for her next novel by gifting 70% of the work in the form of NOVEL tokens, which represent partial ownership of the NFT. If the NFT is sold on the secondary market for a higher price, the 104 holders of NOVEL tokens are entitled to a proportional share of the profits and other benefits, such as being acknowledged in the book.

Source: Mirror

Owning written content can also provide publishers with a new business model. For instance, an NFT of a New York Times column recently sold for $5.6 million, which could far exceed the company's advertising revenue from that article.

Cooperatives

In the traditional business world, cooperatives are companies jointly owned by their members, often requiring capital contributions to join. Decentralized Autonomous Organizations (DAOs) are crypto-native cooperative-like organizations and have become the standard way to govern DeFi protocols. DAOs will be even more important for NFTs, as the assets and communities formed around them will scale by an order of magnitude.

These "collector cooperatives" have caught our attention because they allow groups to invest in NFTs that would be prohibitively expensive for any individual. The DAOSaka project experimented with this at the end of 2019, and the FlamingoDAO project is doing this today, raising funds from individuals and collectively deciding which NFTs to buy and sell. Collector cooperatives can form spontaneously and develop organically. For example, PleasrDAO initially raised funds to purchase a specific NFT and later expanded its scope, purchasing an NFT from Edward Snowden for $5.5 million. In both cases, the DAO outbid individual wealthy buyers, winning the auction.

Revenue Sharing

Public provenance records can enable previously impossible or difficult use cases, such as royalties for artworks and other assets sold on the secondary market.

Rarible and SuperRare implement royalties at the market level with varying degrees of flexibility, while Zora implements royalties at the protocol level by extending the ERC-721 standard to include optional "creator fees" within the NFTs themselves. Mirror achieves royalties through an application layer with "revenue sharing" features that allow authors to allocate a portion of the economic value to others each time a work is sold.

Royalties could apply to content beyond digital art and music. For instance, the rebellious dance on TikTok made Charli D'Amelio a celebrity overnight. While Charli, who currently has over 112 million followers, and TikTok both benefit financially, the creator of that dance, a 14-year-old named Jalaiah, has not been recognized for her work. NFTs can address this issue by marking such content and providing profit-sharing to creators when it generates revenue. In the future, athletes, dancers, photographers, and other creators will issue their works directly through NFTs to receive compensation and rewards for their creations.

Revenue sharing can also be programmatically allocated to multiple and specific NFT owners. The Planck project recently experimented with a concept: publishing the results of scientific research as NFTs and deploying a feature called "streaming" that allows NFTs to distribute a portion of future sales revenue to the NFTs they have referenced or used.

Source: Matt Stephenson (Matt Stephenson)

In academia, this aims to create a social graph of citations for scientific papers, incentivizing and funding academic research through tiered payments to these NFT owners permanently.

Trading

The ability to trade between NFTs is crucial, as it enhances liquidity and enables price discovery by opening up the potential range of trading pairs, but this functionality is challenging to achieve due to the illiquid design characteristics of NFTs.

The 0x protocol first addressed this issue in 2019 with ZEIP-28, which allows buyers to use another NFT as a fee token to pay for the purchase of an NFT in a trading pair, enabling NFT-to-NFT trading, but this still requires buyers to specify the NFT they wish to purchase. 0x later deployed asset-based orders, allowing buyers to create offers to purchase any asset with a specific set of attributes. In practice, this liquidity is based on certain attributes (but liquidity remains fragmented for a given type of NFT).

Other solutions attempt to facilitate trading by utilizing intermediate fungible ERC20 tokens. NFT20 achieves this by minting ERC20 tokens representing different types of NFTs and aggregating these tokens based on their types. These NFT types can then be traded across multiple pools using a common pricing unit with CFMM routing.

For example, if there is a MASK20 / ETH pool and an MCAT20 / ETH pool, users can directly swap MASK for MCAT on Uniswap. This solution is particularly suitable for collectibles with a small number of valuable assets and long-tail low-value assets where the floor price is easy to understand.

Moreover, due to the atomicity of Ethereum transactions and the composability of DeFi protocols, developers can link multiple intermediate tokens and liquidity pools in a single transaction to facilitate trading across various NFTs.

Decentralization

Decentralizing ownership is an effective way to democratize asset acquisition and has historically been used for high-value assets, such as vacation properties. Otis handles traditional art and collectibles by purchasing assets, storing them in a vault, and issuing tokens representing ownership of those assets.

The NIFTEX project also applies this method to NFTs. It allows specific NFT owners to deposit NFTs into a smart contract and issue "Shards" ERC-20 tokens representing that asset. The underlying NFT can be redeemed by acquiring all "shards" tokens or through buyout terms.

Ownership of a bundle of assets can also be divided into several parts. Metakovan achieved this using the B.20 token, which contains 28 assets, including Beeple's crypto art and digital plots in Cryptovoxels, Decentraland, and Somnium Space.

Index Funds

In the past decade, index-based investments in traditional financial markets have gained popularity as they provide a transparent and low-cost way to achieve diversification across various markets.

Similarly, NFT-focused index funds can give investors exposure to specific categories of NFTs without requiring them to evaluate individual NFTs.

NFTX achieves this by creating index funds for various collectibles (like Cryptopunks), where each fund is backed 1:1 by the underlying NFTs. For example, a PUNK-ZOMBIE ERC20 can be redeemed for a CryptoPunk from the pool at any time.

NFT-focused index funds can also enhance the liquidity and price discovery of the underlying NFTs by attracting more users and demand.

Renting

Sometimes people prefer to rent rather than buy, a fact that the art world has accepted for decades; for example, the Museum of Modern Art has been renting out its artworks since 1957. Artists and collectors can gain an additional source of income, while renters can enjoy expensive artworks at a fraction of the price.

Source: Ottawa Journal, March 15, 1980

This model can also be applied to NFTs such as art and digital land. The ReNFT project is attempting to create a peer-to-peer marketplace for NFT rentals. Like most DeFi protocols, this is currently an over-collateralized solution. Borrowers can rent NFTs by depositing collateral equal to the market value of the NFT and paying additional rent. That said, the EIP-2615 proposal is being developed at the protocol level to support the rental functionality of ERC-2615 tokens themselves, eliminating the need for collateral.

Yield Guild Games has a slightly different model in the gaming environment, lending Axies (virtual land and equipment) to new players in exchange for a share of the SLP token rewards earned in the game. In reality, players are renting Axie using a portion of the future earnings they will gain from playing the game.

Synthetic Assets

Synthetic assets are financial instruments that mimic other tools. Although most NFTs today are not true financial instruments in the traditional sense, the concept can still be used to enhance the liquidity and market access of these NFTs.

One of the issues with minting NFTs across multiple blockchains is that purchasing assets becomes more complicated. Additionally, there may be a group of buyers who only want to speculate on the price of NFTs rather than actually own them. For these users, there is an opportunity to provide synthetic price risk exposure to specific NFTs. For example, people can use price oracles to provide Ethereum users with price risk exposure to NBA Topshot assets on Flow.

That said, certain NFTs (such as Uniswap V3 liquidity pool shares) are indeed financial instruments. From this perspective, multiple liquidity pool shares can be combined to replicate the yield structures of various types of derivatives.

The Future of NFTs

Over time, we will see more unique, complex, and interconnected crypto media that leverage various DeFi protocols to realize value propositions and use cases that are not possible in the traditional world. The design patterns for these can include, but are not limited to:

Bundling: Index Coop can provide users with a simple way to access various NFTs by creating an equally weighted index of AXIE, MASK, and PUNK index funds from NFTX (as they are already ERC-20s).

Decentralization + Bundling: One unit of Axie, Catalog records, Cryptopunk, and virtual land from Sandbox can be subdivided into 100 ERC-20 tokens, with 25 tokens of each asset deposited into Charged Particles to mint an NFT representing a diversified basket of decentralized assets.

Synthesis: Multiple NFTs can be synthesized together, or features and value can be added to existing NFTs. The AlchemyNFT project achieves the latter through AutographNFT, which allows for the signing of existing NFTs through digital signatures. Punkbodies is doing the former, allowing users to merge their CryptoPunk (an ERC-721 token) with a PunkBody (also an ERC-721 token) to create a new downloadable or mintable Punkster token. Locking the original ERC-721 token to mint the new Punkster NFT allows users to destroy the synthesized NFT to unlock the original token, with the new synthesized NFT inheriting the provenance and utility of the original token while adding new features or utility.

Source: Bankless

In the coming years, we will see a series of experiments around these concepts, watching how developers, creators, and communities work together to make it all a reality, which will be incredibly exciting.

Note: “*” indicates a 1kx portfolio company

Special thanks to Jake Brukhman, Richard Chen, Christopher Heymann, and Peter Pan for their feedback on this article.