IOSG Ventures: How to Make NFT-Fi Liquid?

Author: Ishanee, IOSG Ventures

This article is excerpted from IOSG Ventures WeChat public account article.

The financialization of NFTs is a challenging journey, and it is difficult for us to understand all aspects involved. However, it can be observed that both the primary and secondary markets for non-liquid assets are continuing to grow, which is a positive signal for assets that originally lacked liquidity.

Waiting for Adoption: NFT-Fi 1.0

As the scale of asset classes grows, so does the risk for investors. The accompanying risks of illiquidity and volatility are hard to ignore. Essentially, NFTs are assets with poor liquidity, but their ETH denomination makes them volatile and exposes them to currency risk, as investors often measure profit/loss using a single accounting method—USD or local currency.

While it is difficult to change the valuation methods for NFTs, enthusiasts have created many alternative protocols out of passion, such as NFTX, Unicly, and Fractional. Although their mission is to bring liquidity to these markets, they themselves also face liquidity issues:

• NFTX tracks the floor price of its ERC 20 tokens; this means that the protocol's treasury is more likely to attract the interest of holders of low-value NFTs. Most NFT investors do not use the protocol unless they wish to speculate on the NFT floor price, which is actually driven by market sentiment.

• Fractional and Unicly offer a more customized approach that does not require tracking floor prices but heavily relies on a large number of investors and whales to speculate on NFT prices. Acquiring entire collections is also difficult (though not impossible), as it requires participation from whales/investors with deep financial resources to allow the ERC20 token holders of the collection to exit.

Most assets stored in alternative protocols are also considered non-productive assets like PFPs, and it seems there is no real reason to borrow them other than vanity.

Classification of NFTs

1. Productive NFTs

The concept of productive NFTs has emerged with the rise of guilds like YGG and the intellectual property of collectors like BAYC.

2. Royalty NFTs

Royalty-supported productive NFTs are gaining increasing attention, a trend possibly initiated by Yuga Labs and music NFTs. They earn revenue from commercially licensed NFTs and distribute the income to holders.

These royalty-based NFTs are unlikely to be borrowed/rented out, as holders do not have a "trigger"—royalties are collected as long as the underlying intellectual property is commercially licensed. Typically, the transaction process is initiated by centralized entities like Yuga Labs or Recur Forever. As holders, the collected royalties are passive income.

Game NFTs

Game NFTs provide core utility to their holders, subsequently spawning an entire industry of guilds and learners. Guilds, acting as asset managers and resource allocators, purchase game NFTs in bulk and then rent them out to a group of players using NFTs to play games like Axie. The rewards earned in P2E games are then distributed back to the players, with guilds and intermediaries referred to as managers. Currently, this entire process is centralized, requiring a high level of trust between managers and participants.

For game NFTs with scarce supply and unlimited demand (players), access issues arise. NFTs do not generate passive income—they need to be used in games to earn rewards, also known as "triggers." To make NFTs productive, owners are now incentivized to lend/rent out NFTs. Supply shortages and profit potential are the incentives that drive players to borrow/rent from owners. Some players may purchase directly from the market, but through the case study of Axie, we know that most "scholars" or players are not crypto-native, do not own ETH, and are primarily motivated by $SLP income.

Currently, most crypto gamers are pay-to-win players. As "play-to-earn" and guilds become mainstream, it is clear that more "time" and "fame" players will enter the market. Inevitably, a new group of players will emerge—star players, or esports teams in cryptocurrency games, who engage in high-stakes PvP games for substantial token rewards.

As games mature, new players will join gradually. Therefore, their player composition will shift—from pay-to-win players to time players. However, just like today's F2P games, most revenue is earned by a small portion of players, and money- and fame-oriented players will dominate trading activities in the market, earning in-game rewards through PvP tournaments. As this situation unfolds, guilds and asset owners will need to allocate their NFTs to the right players. We expect the decision-making process to become more data-driven than it currently is, driven by the key metrics shown in the figure below.

Guild Operations (Centralized Governance)

The centralized approach to guild operations management has been increasing. The case study below shows how a guild manages its Axie assets. The manager's Ronin wallet has the ability to natively assign NFTs to scholars via QR codes. These codes are assigned to scholars. Sub-accounts can use NFTs to play games but cannot move assets. They handle daily payroll, while guild managers manually transfer these earnings.

Key issues emphasized here include:

a) Excessive management issues - Managing QR code assignments and payroll

b) Scholars must trust and rely on managers/guilds to pay their earnings on time

This has prompted guilds and founders to create their own smart contract solutions. Once implemented, guilds take on the primary role of asset managers. Their main responsibility is to allocate appropriate resources to the right players based on past performance to maximize their returns on NFT assets.

Large guilds like YGG and Merit Circle may create their own custom solutions, but micro-guilds (defined as guilds with fewer than 100 players and less than $10,000 in financial resources) will more likely use generic SaaS platforms like GuildFi, GuildOS, 0xAdventure, Blockchain Space, etc.

Assuming data becomes the next key, all guilds will seek to gain an advantage over others and subscribe to services to track players' off-chain data. Platforms like GuildFi achieve this through their guild IDs and leaderboards—features that are very prominent in mobile games like Clash of Clans. While centralized platforms are efficient, they require players to have verifiable records or allow the platform to collect the necessary information. While this is common practice for current internet companies, tracking player data for crypto natives may not be a viable solution.

Way Forward

While centralized solutions have changed the game for most guilds, the centralized nature of tracking player data and services creates single points of failure, which becomes critical as platforms evolve from SaaS to DeFi centers for NFT lending, renting, and collateral solutions.

• Player data that was once used by guilds for allocation decisions will be used as credit scores for players wishing to borrow ERC20 or NFTs against their future earnings.
• Renting NFTs is done in a custodial manner, so any hacking or restrictions on the platform can lead to loss of players' funds and assets. This becomes particularly high-risk for players from sanctioned countries.
• Heavy reliance on platforms as gateways for trading or fiat currency.

Path to Decentralization

There is hope that lending, renting, and collateral solutions will be provided on-chain with minimal human intervention. Most of the outer frameworks for these solutions have already been established and will continue to evolve as the entire industry becomes scalable infrastructure through the use of L2 and faster L1.

• As more games embrace blockchain features like Monster Hunter or DeHorizon, most player data will be accessible via Dune, Graph, or CyberConnect.

• NFT lending and renting can be accessed using vaults like ReNFT or IQ Protocol. Pegaxy is a game on Polygon that already has internal lending capabilities, eliminating the huge demand for guilds as asset managers.

• NFT collateral protocols allow players and guilds to purchase NFTs, earn rewards through them, and use the generated income to pay off debts (Alchemix model).

Next, let’s break down some of the main challenges currently hindering guilds/games in DeFi:

1. Third-party NFT lending/renting protocols

These solutions, like ReNFT and IQ Protocol, act as intermediaries and charge a small promotional fee. P2P lending/renting protocols will allow asset owners to store and lock NFTs in vaults and then rent them out to interested parties in exchange for small rental fees. The actual NFTs never leave the vault, but the gaming rights (utility) of the NFTs are forwarded to the renter's address.

The key challenge for third-party protocols is that they require games to integrate with their protocols. Games do not gain any material benefit from making third parties do so. Due to the open-source nature of cryptocurrency, games can easily derive their own versions of Ronin QR codes/reNFT vaults. The current recipe for Ronin is completely closed-source, and the key barrier for games to develop their own versions is the lack of resources and energy to build auxiliary modules that do not directly contribute to gameplay.

However, some games like Pegaxy have already established this functionality. Technically, they do not need guilds but continue to collaborate with them to ensure community participation and as a means of customer acquisition. We can expect more games to continue down this path in the future.

2. Collateral Solutions

The collateral solutions for game NFTs have a unique positioning in the market. As the free-to-play business model continues to thrive, premium NFTs will continue to maintain paid services. Premium NFTs = enhanced game rewards, thus guilds and asset owners will continue to purchase NFTs.

Compared to cash or revenue-sharing models (guilds), using debt to finance NFT purchases will be the preference of star players (also known as esports teams). Due to the different play styles of players, esports teams are very sensitive to ownership of their assets when playing MMO or TCG games. The potential plundering of these assets by guilds or centralized guild platforms or asset owners on ReNFT poses a threat to their income, making ownership of these assets the most rational choice.

A decentralized collateral solution will continue to require significant governance/human oversight due to the nature of NFTs and game economies. Creating smart price oracles for NFTs at different price tiers is still an unresolved issue and a bottleneck for all DeFi projects wishing to use NFTs in the system.

Conclusion

We have seen GameFi and guilds emerge in 2021. Many new primitives, ideas, and incentive structures are being experimented with, and although this field is relatively early, it is mature for the financialization of NFTs.

Some aspects worth noting:

• On-chain gameplay

• On-chain player identity systems

• Trustless NFT delegation

• Transparent credit scoring for gamers

GuildFi may start from a centralized system until we address some structural issues: such as NFT price oracles, smarter assessments and analyses, and better risk models for games and their economies. Once these three issues are resolved, the GuildFi industry will begin its path to decentralization. Of course, it may take years before we see mass adoption.