7 O’Clock Capital: Analyzing the Diversity of NFT Financialization as a Solution for Market Liquidity Issues

Author: Yoko, 7 O'Clock Capital

Preface

According to data from Dune Analytics, the NFT market began to explode in February 2021, with global monthly trading volume surpassing 200 million USD. By July of this year, the global monthly trading volume exceeded 17 billion USD. During this process, a large number of blue-chip NFT projects emerged, such as PUNK, BAYC, and Doodles. The entire industry was amazed by the growth rate of the NFT market; however, this wave lasted only a year and a half, and the monthly trading volume has shown a rapid decline trend.

(Data source: Dune Analytics)

The freshness that the NFT craze brought to the industry has now encountered a bottleneck. The gradual decline in trading volume indicates poor market liquidity. Although new NFT projects continue to enter the market, without generating liquidity, the entire NFT market cannot maintain its heat, leading to an increasingly sluggish state. The reasons can be summarized in two points: first, the continuous rise in NFT prices has led to an increasing participation threshold, meaning that users with small funds cannot enter the NFT market to provide trading volume; second, the unique nature of NFTs themselves, which cannot be traded on demand like ETH or other cryptocurrencies, as each NFT requires a corresponding individual buyer. This involves the interests and tastes of both parties, making the transaction difficulty of each NFT significantly greater compared to cryptocurrencies.

Undoubtedly, NFTs are a significant innovation in the crypto space, but how to rescue market liquidity has become a pressing issue. Therefore, the industry began to consider that although NFTs have their uniqueness, they ultimately belong to a type of asset. If the financial nature of crypto assets could be applied to NFTs, could it spark beautiful fireworks? Since DeFi, GameFi, and others have achieved success, NFTFi might also become a solution.

On March 2 of the same year, an anonymous borrower used 101 CryptoPunk NFTs as collateral on an NFT lending platform to borrow the equivalent of 8.08 million USD in DAI, setting a record for the highest NFT lending amount in history. This historical event also reminded industry practitioners that "financializing NFTs" may become an effective way to break the liquidity dilemma.

7 O'Clock Capital was established at the end of 2020, just before the NFT market was about to grow rapidly on a large scale. Therefore, leveraging the team's market capture ability and execution, it quickly joined this wave. Since its establishment, it has basically experienced the rise, explosion, growth, and decline of the entire NFT market. Through market tracking and investment research, it has also participated in investments in multiple projects based on NFT technology as the underlying layer, and has provided support in the gradually maturing areas of business consulting and post-investment empowerment, accompanying project growth in the long term.

Based on the current issue of poor liquidity in the NFT market, 7 O'Clock Capital has also conducted research and reflection. This article will classify and explain the attempts and strategies for NFT financialization currently in the market, analyzing the diversity of NFT financialization as a solution to market liquidity.

Table of Contents

1. Market Background of NFTs

2. Existing Liquidity Solutions in the Market

3. NFT Pricing and Oracles

4. Future Development Prospects of NFT Financialization

1. Market Background of NFTs

The NFT market is thriving, with a skyrocketing market value, reaching 2.24 billion USD compared to 70 million USD in January last year.

(Data source: NFTGO)

With the continuous emergence of projects in the primary NFT market, total sales have also set records. The rapid growth of the NFT industry has brought considerable returns to investors, but at the same time, concerns about liquidity among NFT investors have also intensified. Compared to token trading platforms where buy and sell orders can be placed or market prices can be chosen for trading, low liquidity means that NFT trading platforms can only choose to list sell orders, buy at market prices, or auction. When a user sells a non-popular NFT on Opensea, finding a suitable buyer can be very time-consuming and labor-intensive. At this point, NFT financialization becomes particularly important, allowing users to use their NFT assets as collateral for loans or lease idle NFTs to increase liquidity. This is especially crucial for owners of valuable NFTs who need funds in the short term.

2. Existing Liquidity Solutions in the Market

To solve market liquidity through NFT lending, some projects have already begun to experiment. The current methods include lending, leasing, or establishing liquidity pools, providing some momentum for the continued development of the NFT industry.

Specific performance models and corresponding typical projects include:

(1) P2P NFT Lending Protocol

• Advantages of P2P Model: Prices are the equilibrium point between supply and demand, and any form of NFT can be listed without being affected by the price fluctuations of a single NFT.

• Disadvantages of P2P Model: The utilization rate of NFTs is relatively low due to longer transaction cycles, and the jointly agreed price between both parties may not reflect the intrinsic value of the NFT, leading to NFT holders in need of funds potentially selling at overly cheap prices due to urgent cash needs. The trade-off between liquidity and price can lead to a market where P2P protocols enter a situation of excessive power for buyers (ETH providers).

1. Typical Case - Arcade

Official website: https://www.arcade.xyz/

Arcade is a non-custodial liquidity infrastructure specifically built on NFT lending. It promotes the growth of NFTs as a financial asset class. Arcade enables end users (including NFT creators, collectors, and liquidity providers) to utilize their NFTs in numerous financial use cases. NFT holders can use one or more of their assets as collateral to apply for loans through the Arcade application. Users simply link their MetaMask wallet, select an asset (from the supported collection list) as collateral, and then request a loan with specified terms.

The platform uses smart contracts to create a packaged NFT (or wNFT) representing the borrower's loan collateral, which is used when applying for a loan. The wNFT is locked in a custodial smart contract that records when the principal funds are sent to the borrower and repaid to the lender. Arcade earns a percentage of the revenue from each transaction completed on the platform.

The project completed a Series A funding round of 15 million USD on December 22, 2021, with participation from institutions such as Pantera Capital, Castle Island Venture, Franklin Templeton Investments, and Eniac Venture.

2. Typical Case - NFTFi.com

Official website: https://www.nftfi.com/

NFTFi.com is a P2P NFT lending platform that uses an auction format, allowing NFT holders to pledge their NFTs to obtain funds (WETH and DAI) without selling them. Lenders provide WETH or DAI and earn interest; if the borrower fails to repay by the due date, the platform will transfer the NFT to the lender.

NFTFi.com recognized the issue of poor NFT liquidity and the long time frame from listing to transaction completion. The NFTFI platform acts like a second mortgage from a bank, solving the problem for users with a large number of NFTs who suddenly need funds but do not want to sell their NFTs.

Currently, the platform charges a 5% service fee on the interest from each successful loan from lenders, and if the loan defaults, no service fee is charged.

The project completed a seed round of 5 million USD on November 16, 2021, with participation from institutions such as Sound Venture, Reciprocal Venture, Scalar Capital, SkyVision Capital, A.Capital, Fenbushi Capital, Galaxy Digital, and Longhash Venture.

3. Typical Case - Nexo

Official website: https://nexo.io/nft-lending

Nexo is a centralized NFT lending platform that only accepts blue-chip NFT collectibles valued over 500,000 USD. These collectibles include high-value NFTs such as CryptoPunks and Bored Ape Yacht Club. Whales holding these blue-chip NFTs can obtain instant liquidity without having to sell their assets.

Nexo assigns a dedicated account manager to loan applicants. Once the application is approved, the applicant can obtain the loan without a stringent credit check or credit history review. The NFTs used as collateral will not be liquidated, even if their value fluctuates during the loan period.

(2) P2Pool Lending Protocol

• Advantages of P2Pool Model: It can significantly increase capital utilization while providing NFT pledgers with more reasonable interest rates and reducing pricing chaos caused by low-volume NFTs through series-based pooling.

• Risks of P2Pool Model: The pricing method is mostly public, and the oracle's price feed becomes a crucial aspect, so it may lead to liquidation due to price manipulation (large amounts of left-hand trading with right-hand trading) or price volatility issues.

1. Typical Case - Pine Loan

Official website: https://pine.loans/

Pine is a decentralized protocol supporting NFT lending. The Pine Protocol allows Ethereum NFTs traded on OpenSea to be used as collateral for loans paid in ETH. In the alpha version, the collateral value is calculated based on the floor price over the last seven days using the OpenSea API. If the borrower fails to repay the debt before the loan's due date or exceeds the LTV, the asset will be liquidated. Currently, the lending function is only open to PineDAO and a few whitelisted institutions. In addition to Ethereum, the Pine Protocol plans to support Solana, BSC, Polygon, Avalanche, and Fantom in the future. The Pine platform also offers unique features to enhance user experience: the "Pine Now, Pay Later" feature allows anyone to purchase NFTs through collateral in the open NFT market, supporting flexible financing terms.

For lenders, they can earn returns through the borrowed cryptocurrency, and they can also purchase NFTs at discounted prices. For borrowers, they can use NFTs as collateral to obtain loans, and instant loans mean no need for back-and-forth negotiations with lenders, making it convenient and quick.

Currently, it has completed a seed round of 1.5 million USD, led by Sino Global Capital, Amber Group, and Spartan Group, with participation from Alameda Research, Shima Capital, Impossible Finance, Gate Ventures, and 7 O'Clock Capital.

2. Typical Case - Bend DAO

Official website: https://www.benddao.xyz/

BendDAO is the first NFT liquidity protocol based on a decentralized peer-to-pool model. Depositors provide ETH liquidity to the loan pool to earn interest, while borrowers can use NFTs as collateral to borrow ETH from the loan pool. The Bend protocol allows NFT assets to be pooled and converted into NFTs representing ERC721 bindings for NFT loans. Once borrowed through BendDAO, the pledged NFTs become non-transferable until the loan is repaid or liquidated. For depositors: if a borrower fails to repay the loan, the NFT collateral will be auctioned off to ensure the safety of the principal. The project has a built-in 48-hour liquidation mechanism, triggered when the loan amount/market value of the collateral = 90%. Considering the high volatility of the NFT market, borrowers can repay the loan within 48 hours.

The target users of the project are mainly holders of blue-chip NFTs, so BendDAO's airdrop primarily targets holders of blue-chip NFTs such as Crypto Punks, Bored Ape YC, Mutant Ape YC, Cool Cats, Doodles, CLONE X, and Azuki. The support from blue-chip NFT holders for this project will provide brand effect, helping the project's development.

(3) NFT Leasing Protocol

Currently, the application scenarios for NFTs include profile pictures, game assets, virtual land in the metaverse, domain names, etc. Users holding these NFT assets can use them for display, in games, or for recreation. Most NFTs have both collectible value and utility value. Instead of transferring ownership, "leasing" these utility NFTs is also a way to appreciate or realize value. Thus, a corresponding NFT leasing market has emerged. NFT holders can lease their NFTs to users in need to earn additional income; correspondingly, users renting NFTs can experience the fun of using NFTs without spending high prices to purchase them. In the NFT leasing market, the lessor generally defines the leasing price, collateral, and maximum leasing period for the NFT asset. The lessee chooses the leasing period and pays the collateral and rent. Currently, NFT leasing is mainly applied in on-chain gaming scenarios, with leaseable NFT assets mostly being game equipment, props, or characters.

1. Typical Case - Double Protocol

Official website: https://double.one/

Double Protocol is a leasing protocol that attempts to solve the separation of usage rights and ownership. It proposed the EIP-4907 standard NFT in April this year, which has passed the final review by the Ethereum development team, becoming the 30th ERC standard on Ethereum with a status of "Final."

This standard achieves the separation of NFT ownership and usage rights through a dual-role setup and introduces an automatic reclaiming of usage rights upon expiration. The application of the "ERC-4907" standard will greatly reduce the development and integration costs of leasing Utility NFTs such as games, metaverse, and membership cards, making NFT assets more liquid. Currently, 12 projects have confirmed the application of the "ERC-4907" standard.

Double Protocol deploys dual-role contacts to ensure that in-game assets have two roles: owner and user, and then creates a doNFT corresponding to the original NFT to represent user permissions. Once the borrower pays the rent, the doNFT will be minted for the lessee according to the doNFT contract. During the leasing period, the lessee has the right to various usage rights, which may include subleasing, splitting, merging, and even financial derivatives. At the end of the leasing period, the doNFT contract automatically revokes the borrower's usage rights.

The doNFT itself has multiple SDK and API interfaces, and has the same non-transferable characteristics as NFTs, allowing doNFT to potentially enter other game worlds in the future, increasing its liquidity and usability in other environments. This separation of usage rights and ownership can effectively address issues such as airdrop snapshot misjudgment, value overlap, and the important infrastructure for GameFi development, as long as the SDK and API ports continue to support it, the mapping of NFTs will safeguard the rights of NFT borrowers.

The project secured 1.5 million USD in funding on March 17, 2022, with participation from Matrixport, Shima Capital, Youbi Capital, LucidBlue Ventures, Red Building Capital, Capital 6 Eagle, and 7 O'Clock Capital.

2. Typical Case - IQ Protocol

Official website: https://iq.space/

IQ Protocol is a leasing protocol that allows users to rent GameFi and Metaverse assets (such as weapons, characters, and skins) for a fixed period. Currently, the TVL exceeds 8 million USD, generating over 500,000 USD in rental fees, with more than 50 projects operating in the ecosystem.

In the context of NFTs, IQ provides the ability to create NFT "leasing pools"—allowing participants to lend and lease NFTs in a digital space. Users renting NFTs from the leasing pool will gain real digital access to these NFT assets, such as avatars, wearable devices/skins, and assets in the gaming world like weapons, property, or other valuable items.

Users can rent assets of interest (avatars, digital skins, etc.), and after use, consider whether they want to purchase the asset themselves. This provides a new experience for NFT leasing, and this solution also has significant practicality, as it allows users to experience luxury goods online. For example, with Beeple's Everydays digital art, its current owner Metakovan cannot actively tokenize the artwork. However, placing "Everydays" on IQ allows interested parties to rent the NFT, with rental funds flowing to Metakovan, while allowing others to enjoy the artwork, and the owner retains the original copy.

In this new model, a brand-new NFT consumption economy is generated, benefiting all parties involved in this new process.

Currently, the project has completed 12 million USD in funding, led by Crypto.Com Capital, with participation from Republic Capital, Kronos Research, Genblock Capital, Axia8, GSR, Genesis Block Ventures, BreederDAO, MEXC Global, 7 O'Clock Capital, Argo Labs, and Cryptology AG.

(4) NFT Liquidity Pool Protocol

Most NFT liquidity protocols create liquidity by facilitating the creation of liquidity pools, where individuals can deposit similar NFTs into the pool and redeem them at any given time. The benefit of such protocols is that they effectively establish liquidity pools for NFTs based on a set of assets.

Typical Case - NFTX

Official website: https://nftx.io/

NFTX is a market and liquidity protocol that facilitates the buying and selling of NFTs. NFTX allows NFT holders to deposit entire NFTs into the NFTX vault and mint replaceable tokens (vTokens) representing the value of the NFTs. At any time, collectors can use their vTokens to randomly purchase assets from the vault. Alternatively, individuals can redeem specific tokens from the same vault by paying an additional fee. To earn transaction fees from the vault, collectors must stake their vTokens in their respective liquidity pools (e.g., SushiSwap). Each time an individual sells or buys an NFT, stakers earn a fee.

One feature of the NFTX model is that users can gain instant liquidity for NFTs with high vToken liquidity. For example, a BAYC owner can immediately deposit their Bored Ape into the NFTX vault and receive BAYC vTokens. However, the owner can sell the token on a decentralized trading platform like SushiSwap instead of pledging the BAYC vToken. If liquidity is poor, NFT owners may sell their NFTs at prices lower than those on trading platforms like OpenSea; however, the ability to gain instant liquidity often justifies the price reduction.

(5) NFT Fragmentation Protocol

As non-fungible tokens, the main feature of NFTs is the uniqueness and indivisibility of each NFT token, with the minimum trading unit being one. NFT fragmentation protocols do not fragment the NFT artwork itself into many pieces but rather split the ownership of the artwork, converting it into multiple homogeneous tokens, with each token holder gaining partial ownership of the NFT asset (artwork). Once non-fungible tokens can be converted into fungible tokens, it means that liquidity can be added in the trading market, facilitating user exchanges.

1. Typical Case - Unicly

Official website: https://www.unic.ly/

Unicly is a permissionless platform that allows users to combine NFT collections and fragment them by creating uTokens. The fragments of the collection (ERC-721 and ERC-1155 tokens) can then be traded, mixed with AMM, and used for yield farming on Unicly, rather than going to third-party trading platforms.

Once an NFT collection is tokenized, specific collections (e.g., uPunks, which are ERC-20 tokens representing the NFT collection) are locked in Unicly's smart contract until a sufficient number of token holders choose to unlock the collection. Unicly's largest vault, JennyDAO, has chosen to collect and manage all their NFTs on Unicly. The uJenny token is used to govern the DAO's vault. As of now, the DAO must reach a 50% threshold to unlock the collection.

The surge in the number of fragmented NFTs roughly corresponds with the peak of this year's NFT market cycle. Unicly's usage has slightly declined, partly due to the launch and popularity of its fragmentation competitor, Fractional.

Currently, the project has secured 10 million USD in funding, with investments from BlockChain Capital, Animoca Brands, Morningstar Venture, and 3Commmas.

2. Typical Case - Fractional

Official website: https://fractional.art/

Fractional allows anyone to buy, sell, and mint fragmented NFTs. An NFT or NFT collection owner can use Fractional to fragment their tokens. Curators essentially act as asset managers for each NFT or NFT collection being fragmented and charge fees from each auction. Collectors can create fragments of an NFT as replaceable tokens, which can be combined to redeem the NFT or purchased at prices above the reserve price. If partial NFT owners want to sell the entire NFT, they first vote on the reserve price. If a buyout occurs or the ETH deposit is greater than or equal to the reserve price, the partial owners of the NFT can redeem their portion of the tokens.

Currently, it has secured 7.9 million USD in funding, with investments from Paradigm, Divergence Venture, FlamingoDAO, Variant, and Delphi Digital.

3. NFT Pricing and Oracles

Whether for NFT lending or leasing, the biggest pain point for these projects is the issue of pricing. Currently, the most intuitive pricing mechanism relies on using oracles (such as Chainlink oracles) to index on-chain data/prices, which help predict the fair valuation of NFTs.

ERC-20 + AMM

The simplest method for NFT pricing is the combination of ERC-20 assets and AMM liquidity, whether through fragmentation via the Fractional protocol or 1:1 conversion via the NFTX protocol. NFTX uses this form to price NFTs; for example, if a user deposits an NFT into the NFTX vault and receives an ERC-20 representing that NFT, they can provide liquidity for ETH:$NFT on Sushiswap.

Chainlink

Most protocols choose the simplest method and then build more complex valuation models. A common practice in oracle protocols is to use the floor price of collectibles (the lowest price at which the collectible is sold at a given time), as theoretically, it ensures that the loans they issue do not exceed the price the market pays for that collectible. Other common valuation methods include calculating the minimum trading volume over a given period or calculating the average of the lowest-priced items over a given period.

Since each NFT is unique and has distinct attributes, considering this information in the valuation adds significant complexity to the pricing model. Because of this, other projects, such as JPEG'd or DropsDAO, create custom valuation models for each collectible, thus only whitelisting blue-chip projects.

Custom valuation models must be developed for each NFT collection, detailing its attributes, which is both time-consuming and not scalable. For this reason, protocols like Upshot have developed machine learning models that consider all available information (NFT characteristics, last sale price of the NFT, last sale price of NFTs in the collection, etc.) to predict the fair valuation of NFTs at any given time.

4. Future Development Prospects of NFT Financialization

The NFT market is expected to continue rising, as the industry recognizes that there is still much potential in many assets yet to be developed. However, NFT trading volume on Ethereum has already exceeded 13 billion USD, and as new assets are tokenized on the blockchain, trading volume will continue to increase over time.

In the past, blue-chip NFTs (such as Punks) had the highest liquidity in the market, but due to their exorbitant prices, many collectors could not access them. As a result, NFT liquidity protocols have adopted various methods to address this.

Market demand and space: NFTs are indivisible and have poor liquidity, similar to real estate. Blue-chip NFTs can be compared to the luxury housing market, where the transaction scale of luxury homes is much smaller than that of the mortgage lending market. Once products solve the liquidity needs and leverage effects of blue-chip NFTs, they can unleash tremendous potential. NFT financialization bridges the needs of DeFi users and NFT players; ETH holders need to find high-yield protocols, while NFT players do not want to sell blue-chip NFTs but need to solve liquidity issues.

Future Competitive Landscape of NFT Lending Products:

1. NFT lending products are likely to become a monopoly, which is entirely different from the competitive landscape of DeFi. Other NFT lending products can only overtake if they copy any financialization model, which is a slim chance.

2. The credit chain accumulated by the product is crucial. High-value users like blue-chip holders are insensitive to interest rates; what matters to them is product safety and experience.

3. Part of the user group facing NFT lending is blue-chip holders, a limited and defined group. Community culture leads to high behavioral similarity among these individuals, and product usage will spread through the community, making it easy for one product to dominate. In contrast, the user group facing DeFi is a large-scale market, and each product will have its own product-market matching model, making the competitive landscape relatively fragmented.

4. NFT lending products, beyond the technical aspect, also place great importance on community culture. Blue-chip users will only support products that understand their community; even if a product with the same technical capabilities is launched, the community cultural attributes behind the product are also a very important consideration for users.

Conclusion

In summary, NFTs should be viewed as a foundational infrastructure in the blockchain industry, supported fundamentally by decentralization and uniqueness, thus giving rise to more diverse NFT projects. The current landscape of NFT financialization can be referenced in the following diagram:

Additionally, data shows that while the market value of NFTs has exceeded 20 billion USD, it is negligible compared to the total crypto market value of over 940 billion USD. Of course, the current innovations in NFTs are still limited to images, games, virtual land, digital collectibles, etc., representing just the tip of the iceberg for the overall explosion and application scenarios of NFTs, with significant limitations. This also means that the future market will be limitless, requiring the industry to strive to break through the current NFT bottleneck and achieve diversified innovation.

At this stage, the serious issue of poor liquidity has gradually made NFT financialization a solution. Lending is not only a huge cake in the traditional financial industry but also in the blockchain industry, and in the NFT field, it can still become one of the markets with great potential. 7 O'Clock Capital will continue to pay attention to the methods and forms of NFT financialization, witnessing the "Compound" in NFTs together with industry partners in the future!