In-depth Analysis of the New Paradigm of NFT Collateralized Lending: Pooling Model
Why is the current mainstream P2P model for NFT collateralized lending not thriving?Original Author: Dyo Hu@Axia8 Ventures
Original Source: Mirror
Value of This Article
The current NFT market has reached tens of billions of dollars; however, the valuation of NFT collateralized lending is often below one hundred million dollars, indicating a significant value gap that implies a huge opportunity.
This article will discuss why the current mainstream P2P model of NFT collateralized lending is not thriving, and why I believe that the liquidity pool model will create a new paradigm, liberate the 99% of NFTs currently sitting idle in wallets, and open up the NFT collateralized lending space.
- Content of This Article
Scale of the NFT collateralized lending space
Why the current Peer-to-Peer model has not effectively solved the problem
Why I believe the liquidity pool model is a better approach and how it works
Notable projects in both models
If the article is too long, you can jump directly to the conclusions of sections 3 and 4.
Scale of the Space
NFT collateralized lending means that NFT owners use their NFTs as collateral to borrow money from liquidity providers.
For NFTs to serve as collateral assets, they must meet the following criteria:
Sufficient value consensus: The market must recognize that the NFT series has value, have confidence in its price, and not collapse due to short-term price fluctuations, while liquidity providers are willing to accept the collateral.
Sufficient demand and trading volume: A lack of market activity can lead to an inability to liquidate NFTs in a timely manner, resulting in potential losses for liquidity providers.
There are seven series on OpenSea with over 100,000 ETH in volume: CryptoPunks, BAYC, MAYC, Art Blocks, Clone X, Decentraland, and SandBox. These seven series alone represent a market of 10 billion dollars, which is also the market scale for NFT collateralized lending projects.
OpenSea data - 2022/2/1
In 2022, other leading projects and more capital are expected to flow in, and Financial Voucher NFTs like Solv Protocol with clear pricing will also start to gain traction. I believe that leading NFT projects in 2022 can reach a market value of over 20 billion dollars, and NFT collateralized lending projects can also emerge with valuations in the billions.
Why the Current Peer-to-Peer Model Has Not Effectively Solved the Problem
Introduction to the Peer-to-Peer Model
The biggest issue with using NFTs as collateral is pricing; each NFT has different rarity, leading to varying prices. Therefore, the current NFT collateralized lending is mostly in a Peer-to-Peer model, where NFT owners and liquidity providers negotiate acceptable prices through agreements, with the project acting as a platform to facilitate transactions.
Taking the relatively mature P2P platform NFTfi.com as an example, the process involves NFT owners collateralizing their NFTs on the platform and filling out the desired loan amount and duration.
Liquidity providers can browse the desired loan amounts for various NFTs on the platform, and they submit the loan amount they are willing to provide along with the required interest.
The entire process resembles an auction, where NFT owners select an acceptable offer from several liquidity providers' terms to complete the transaction. Upon loan maturity, they must repay the principal and interest to retrieve the NFT from the smart contract; otherwise, the NFT will be transferred to the liquidity provider.
Advantages of P2P
- Obtaining Current Market Consensus Prices
Due to the uniqueness of NFTs, the P2P mechanism can solve the pricing issue for any NFT, with liquidity providers determining the valuation and quoting prices. The risk and return depend on the judgment of the liquidity providers. This is especially important for highly rare NFTs or those with low trading volumes, which require the P2P model to provide appropriate market prices.
- Applicable to Various NFTs
Whether mainstream or niche NFTs, collectibles or game items, as long as there is supply and demand, transactions can be completed through P2P, making it highly extensible.
Disadvantages of P2P
- Long Transaction Process
Once NFT owners list their NFTs, they can only wait for others to make offers, not knowing when someone will submit a bid. They need to constantly check back, and every NFT owner hopes to have multiple offers to compare, with transaction times usually measured in days.
Often, collateralized loans are needed urgently, and the P2P model can only optimize transaction time through increasing the number of liquidity providers, but fundamentally it still cannot accelerate the process. For NFT owners in urgent need of funds, this uncertain experience is less friendly, potentially forcing them to accept unfavorable offers.
- Few Owners with Professional Valuation Skills, High Interest Rates
The P2P model tends to deter most interested but unskilled liquidity providers. P2P liquidity providers must possess professional valuation skills, which is a high requirement; providing an incorrect quote risks incurring losses after liquidation.
Only a handful of NFT owners can understand the value range of each NFT in a series, so aside from BAYC, CryptoPunks, and ArtBlock, other series like MAYC, Axie, and SandBox generally receive no bids.
Even for BAYC and CryptoPunks, there are only a few offers, and the interest rates demanded by liquidity providers typically range from 30-40%, with even 60%-100% being seen. For borrowers, unless they can ensure higher returns during the loan period, there is a significant risk of loss, greatly affecting their willingness to supply.
P2P platforms promote liquidity providers with high APY to attract more funding, reducing transaction times, but this means NFT suppliers must pay high interest, leading to a poor experience for the key NFT providers in the entire model.
- Small Transaction Amounts on the Platform, and Loan Funds Cannot Remain in the Protocol
The unfriendliness of P2P for liquidity providers lies in the loan amounts being limited by the number and value of NFTs, and offers must compete with other bidders in an auction, with uncertainty about when a conclusion will be reached, requiring constant checking back on the platform. If not selected by the NFT owner, they also bear the time cost of their funds.
At the same time, funds cannot remain in the protocol to earn interest; liquidity providers must continuously seek new projects to bid on, which only retains heavy users.
Summary
The P2P model theoretically solves the issue of varying NFT prices, but low capital efficiency, long transaction times, and high interest rates are significant drawbacks.
Therefore, I believe that P2P is most suitable for high-value NFTs and long-tail NFTs, where NFT owners do not urgently need funds and can wait a few days. Alternatively, projects like Kyoko that provide Guild to Guild / Dao to Dao large-scale P2P lending services and focus on long-tail game items. For general scenarios and users, the P2P mechanism still has considerable room for improvement in user experience, which is why I am optimistic about the liquidity pool model.
Why I Believe the Liquidity Pool Model is a Better Approach and How It Works
In the liquidity pool model, NFT owners can immediately borrow loans after over-collateralizing their NFTs into the pool, and the entire process is similar to using AAVE or Compound.
On the other hand, liquidity providers looking to earn interest can deposit their stablecoins or ETH into the pool to earn interest. The interest paid by NFT owners depends on the amount of borrowing funds in the pool and the supply of NFTs. If NFT owners cannot repay or if the NFT price falls below the liquidation threshold, the NFT will be auctioned on OpenSea, and the funds will be returned to the liquidity providers.
Oracle Problem
How to price NFTs in the liquidity pool model -
Current solutions primarily use on-chain data to calculate TWAP (time-weighted average price), excluding extreme values and averaging based on a period's floor price. This means that regardless of how rare an NFT is within a series, the floor price is used as its value, preventing price manipulation.
Advantages of the Liquidity Pool Model
- Fast Transactions and Clear Loan Amounts
Most crypto lending is for trading, which emphasizes timing and knowing how much capital can be invested. The liquidity pool model allows Punks and BAYC users to receive a clear loan amount immediately upon collateralization, without waiting for price discovery.
- Low and Stable Interest Rates, Funds Can Remain in the Protocol
Liquidity pools can liberate a large amount of lending capital. Many people can understand the value of BAYC and CryptoPunks, but those who can discern the value of each NFT may be less than 5%. The liquidity pool model allows anyone who has consensus on a series to provide funds to the pool and earn interest. Compared to the P2P model, the amount of borrowing funds in the protocol can significantly increase, and I predict this will stabilize NFT owners' interest rates from the 30%-100% range typical in P2P to a more stable 10%-20%.
Finally, funds can remain in the protocol to earn interest, eliminating the need to frequently check back for bids.
Disadvantages and Risks of the Liquidity Pool Model
The most obvious disadvantage is that it cannot provide fair loan amounts for NFTs priced above the floor price, making NFTs further from the floor price less willing to participate. This issue cannot currently be resolved; in the future, there may be a separate pool for NFTs with specific rarity traits, using a floor price + X% approach. Therefore, I believe that highly rare NFTs are not the primary target for liquidity pools at this stage.
Another major risk is price manipulation or sudden drops, which can be divided into several scenarios:
Rapid Decline in NFT Prices:
If the NFT series declines too quickly, NFTs may be liquidated and listed on the trading market, causing panic and further declines, leading to losses for borrowers. This is why I believe the liquidity pool model is currently more suitable for NFT series with strong consensus, ensuring that there are buyers ready to purchase during liquidation.
Malicious Attacks on the Protocol:
Another common concern is if users continuously sell NFTs far below the floor price to themselves, potentially manipulating the floor price to drop quickly, affecting the interests of protocol participants, even if it does not benefit hackers.
TWAP uses multiple time dimensions as data sampling sources while excluding extreme values to create a comprehensive floor price. Additionally, multiple transactions of the same NFT within a time frame can only be counted once to avoid attacks.
Raising Prices, Borrowing, and Intentional Liquidation:
Large holders may use multiple NFTs to artificially inflate the floor price within a timeframe, then borrow large amounts from the pool and fail to repay, leading to the protocol liquidating NFTs that are not worth that much. This is particularly easy for long-tail NFT series. Therefore, the liquidity pool model indeed carries higher risks for non-mainstream NFTs, and it is foreseeable that liquidity providers' interest rates for such projects will be higher, requiring investors to be more cautious.
For mainstream projects like BAYC and CryptoPunks, assuming a pool collateralization rate of 30%, a 50 ETH floor price would allow borrowing of 15 ETH. If one wants to profit by raising the floor price to borrow, even collusion between large holders would require raising it to over 150 ETH to see a profit, while also assuming that the intrinsic value of BAYC remains at 50 ETH and does not increase, making the cost far outweigh the potential gains.
Smart Contract Risks:
The liquidity pool model is relatively complex; even though most logic is similar to Compound and AAVE, there are still risks associated with smart contracts.
Summary of Liquidity Pool and P2P Models
Currently, most NFTs do not have collateralized lending value because if liquidated, no one wants them; most NFTs still lack turnover in 2022. The P2P model can theoretically serve all NFTs; however, there is currently a lack of sufficient liquidity providers and quality NFT supply, with only series like BAYC and CryptoPunks receiving bids, while other series lack enough professional appraisers. Compared to the P2P model, the liquidity pool lowers the threshold for liquidity providers, allowing it to serve a broader range of mainstream NFT series.
Thus, the key for NFT collateralized lending projects at this stage lies in who can secure the most mainstream project supply and who can serve more mainstream series. In a saturated market, if your protocol secures one more BAYC, another protocol loses one supply. Rapidly capturing mainstream NFT supply to drive lending capital and lower interest rates creates a positive cycle and establishes an advantage. This is why I believe that in the current market landscape, I am more optimistic about the liquidity pool model driving the explosion of the NFT collateralized lending market, fundamentally because it can truly attract blue-chip NFT supply into the financial market.
Notable Projects in Both Models
Liquidity Pool Model
Launched an NFT collateralized lending liquidity pool in February, featuring BAYC and CryptoPunks pools. Current fully diluted market cap is approximately 30 million dollars.
Has existing business as an Ethereum investment tool, has issued tokens, market cap unknown. P2P lending services will be launched in Q1, with plans for a liquidity pool.
P2P Model Projects
Most have not issued tokens, many projects have other existing businesses.
Invested by Pantera Capital, currently in beta testing.
Currently the most mature P2P market, has not issued tokens.
Centralized lending platform, invested by Three Arrows Capital. Launched centralized NFT collateralized lending services, with a maximum loan of 20% of the offer, market cap of 1.1 billion dollars, FDV of 2 billion dollars.
Other Projects
Users can borrow money to buy NFTs and pay fixed interest to liquidity providers, market cap of 5.8 million, FDV of 162 million dollars.
After collateralizing NFTs, users can obtain protocol-provided PUSD from the pool, with a collateralization rate of 32%, has not issued tokens.
A flash loan project for programmers that allows for flash loan borrowing.
Stopped updating in October, progress is uncertain.
Solana project, invested by CB, Solana, and Jump, mechanism still unclear.
How to Validate Whether NFT Collateralized Lending Projects Are Successful
Current judgments are subjective and static; however, market changes are dynamic, and determining correctness, new influencing factors, and whether projects can operate effectively requires continuous validation over time.
- Is Avatar NFT Collateralized Lending a Necessity?
The current NFT collateral market targets top-tier NFTs, but whether these avatars and land have sufficient liquidity and good pricing in the long term is still a question. The lukewarm performance of the P2P model may be due to poor user experience or that most top NFT buyers do not have this need, similar to how wealthy individuals would not use their valuable paintings as collateral.
- Quantity of Mainstream NFT Supply
The most critical data to observe is the quantity of mainstream NFT supply. Currently, only mainstream projects have collateralized lending value; the primary direction of mainstream NFT projects will determine the leading projects in the space.
- Discussion Volume in Mainstream NFT Communities
Mainstream NFT projects form their own communities; if a product addresses community pain points, it will inevitably generate sufficient discussion volume.
- Ability to Serve More Series
Finally, this is a bonus point: the ability to develop NFT series beyond BAYC and CryptoPunks, with real and sufficient supply and demand.
These are the dimensions for validating project thinking after product launch.
Future Judgments
The NFT collateralized lending space is more about the angle of entry and operational capability. The liquidity pool is currently most suitable for mainstream series, while P2P will be applicable to any series or scenario once the overall number of NFT buyers and sellers is sufficient, offering greater extensibility.
Therefore, I believe that future P2P protocols may incorporate liquidity pool models, and liquidity pool models may add P2P modules, allowing both parties with different lending needs to be satisfied within a single protocol.
NFT collateralized lending can help stabilize floor prices and increase the value of NFT projects. If a project can ensure that holding NFTs allows for borrowing within the lending protocol while also receiving protocol token rewards, it provides buyers with more incentives to participate.
Thus, if a collateralized lending protocol has a DAO and allows token holders to vote on which NFT series to add, and rewards are determined based on votes, there is also an opportunity for competition for token voting rights among various NFT projects, similar to Curve.
Whether avatars and land are the most suitable for collateralized lending will also require time to validate; at least for land NFTs, I believe they may be more suitable for NFT leasing provided by IQ Protocol rather than collateralized lending.
I also believe that game assets are high-quality targets for collateralized lending, but this market still needs to wait for the GameFi industry to develop, which is why Kyoko is also a project I am paying close attention to.
