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NFT’s Hidden Potential — NFT Finance | by @mimiLFG | Domica | Coinmonks

This is by no means a deep-coverage on the NFT finance sector, simply my personal views on it. Although I strive to deliver accurate data, all data presented in this piece is a snapshot on September 21, 2022.

NFT Market Overview

NFTs have been portrayed as the next generation of the art market and one of the strongest catalysts for crypto adoption with the sector achieving tremendous growth from September 2021 to January 2022. However, against the backdrop of the global capital market downturn, the sector’s weekly volume has quickly corrected with its growth diminishing since then.

Figure 1: Weekly USD NFT volume [1]

The NFT market is currently driven by less frequent but higher-valued trades.

Bigger trades (> US$10k transfers) still dominate the market by transaction volume (c.90% of the market’s trading volume), but, in terms of transaction counts, retail trades are much more prominent (accounting for 85% of the total transaction counts).

Figure 2: Shares of NFT transactions by transfer size[2]
Figure 3: Shares of NFT transactions by transaction volume by transfer size [2]

Such divergence is also reflected in the price outperformance of the higher-tier (i.e., blue-chip, e.g., BAYC, CryptoPunks) NFT collections compared to the broader market. Blue-chip collections have outperformed the broader NFT market by 12% YTD (as of September 28, 2022).

As these more established and blue-chip NFT collections continue to increase in value and dominate the market transaction size, NFT Finance, a subsector that revolves around the financialization/securitization of NFTs, has also been growing to promote NFTs’ liquidity and ensure their price stability. Unsurprisingly, a large number of these NFT finance protocols tend to focus on blue-chip collections.

Figure 4: Top 500 NFTs index vs established ‘Blue-chip’ collections (as of September 28, 2022) [3]
Figure 5: Wider NFT market vs established ‘Blue-chip’ collections (as of September 28, 2022) [3]

Currently, protocols in the NFT finance subsector mainly target to solve four core challenges faced by NFT holders/investors — 1) lack of market liquidity, 2) capital inefficiency, 3) sole reliance on asset price appreciation and 4) inadequate price discovery

1) Lack of Market Liquidity

There are three key reasons why NFTs generally lack market liquidity (besides their small market size):

  1. Non-fungibility: buyers need to spend more time to differentiate and purchase potential NFTs from the same collection attributed to their unique characteristics and fragmented liquidity across a collection
  2. Affordability: higher price barrier to purchase leading NFTs, lowering the user base on the leading NFTs (fewer buyers infers lower liquidity)
  3. Lack of utility: current NFT collections have yet to develop meaningful utilities and we believe that this is a strong reason for NFT’s lack of adoption (lower potential user base)

The following are the major protocols which target increasing NFTs’ market liquidity:

Figure 6: Types of NFT protocols increasing the liquidity of NFTs

A. Generalized marketplaces

They are relatively mature and are suitable for all types of NFTs across a collection, i.e., a general-purpose solution to facilitate the sale of NFTs.

OpenSea currently holds c.75% dominance in this space by trading volume [4], although different marketplaces with different mechanisms (token emissions, proprietary pricing models, lower fee rates) have been slowly eating OpenSea’s dominance.

B. Specialized marketplaces

They are still nascent but likely needed as the whole space further develops.

Currently, the use case of these specialized marketplaces is still limited to facilitating the trading of collections in a niche sector (e.g., virtual land), rare pieces in collections, and exclusive marketplaces for specific dApps.

C. Marketplace aggregators

Best positioned to capture the growth of different marketplaces and the fact they are fragmented.

By curating listings across multiple marketplaces, aggregators provide excellent UX and even out the battleground for newer (and more innovative) marketplaces with better price offerings.

Figure 7: Generalized, specialized, and aggregated marketplaces 3 months trading volume (without wash trading) [5]

D & E. NFT liquidity pools and NFT fractionalization

Fractionalization protocols focus more on fractionalizing a single NFT, whereas NFT liquidity pools typically fractionalize a pool of similarly-priced NFTs and could be further expanded to form collective investment networks (community venture groups). Given the overlap, NFT liquidity pools and NFT fractionalization are usually grouped together.

The main concern of these protocols is that they are not (yet) suitable for collections with utilities, which is where the NFT market should ideally head toward. This is because most fractionalized NFTs can hardly be formed back into the original asset.

It strips away the underlying social benefits and utilities of an NFT, even though investors could still profit from the price movement. It is akin to investing in derivatives that track the price movement of an underlying asset but forgoing other non-financial benefits arising from holding the underlying asset directly.

If NFT’s market liquidity can be improved, investors will more likely consider them as an asset class. Amongst the four challenges above, this is also the area we have seen the most innovations and developments so far.

2) Capital Inefficiency

As one may recall, the initial development of DeFi revolved around swaps and lending protocols. Thanks to this, different DeFi protocols can now provide various pathways for investors to take on leveraged positions so they can maximize their capital efficiency much more easily than before.

The NFT sector is still lagging behind in this regard as NFTs are not as commonly accepted as collateral yet. That said, we are also starting to see more protocols aiming to improve this by enabling the usage of NFTs as collateral.

The following are the protocols that look to increase NFTs’ capital efficiency:

Figure 8: Types of NFT protocols unlocking locked capital when holding NFTs

A. P2P lending platforms

These platforms open a negotiable market for valuing NFTs as collateral.

On the one hand, since the prices and terms are agreed upon by each lender and borrower, the core strength of these P2P lending platforms is operating without an oracle. On the other hand, due to this semi-manual nature, P2P NFT loans could not be executed instantly and would only work best for long-tail assets.

B. P2Pool lending platforms

These platforms utilize pricing methodologies (oracles; see more solutions in challenge 4) to set up different parameters (collateral value, minimum collateral value, max loan duration, and interest rate) of the issued loans. The process is automated and, hence, provides instant liquidity for borrowers.

P2Pool lending platforms work best for ‘floor’ pieces in liquid collections as oracles heavily rely on historical data that illiquid assets lack.

However, relying on oracles exposes the protocols to oracle failure risks and limits the types of accepted collaterals. The recent BendDAO BAYC liquidation cascade is a prime example that highlights the need to reassess these P2Pool lending platforms’ mechanisms and parameters.

Figure 9: NFT lending platforms (P2P and P2Pool) aggregated borrow volume [6]

C. NFT derivatives

This segment is still vastly underexplored because of NFTs’ low trading volume (as compared to fungible tokens or legacy markets) and unique characteristics pose a huge barrier to implementing these derivatives seamlessly.

The segment’s increased development would allow for more comprehensive trading strategies. Derivatives would enable exposure to a price action with (leverage and) much fewer capital requirements. Like the crypto and legacy market, where derivatives stomp the spot market by trading volume, it is not unlikely to see a strong NFT derivatives market.

However, given the huge foundational requirements (high liquidity and accurate price) for a derivatives market, we do not see the NFT derivatives flourishing in the near future. To compromise for the current infrastructure, most platforms exclusively list highly-liquid NFTs and ignore detailed trait groups (classifying them into floor, mid, top-tier, etc.) or track the floor price of a collection as a whole.

We believe that such developments to improve NFTs’ capital efficiency can not only benefit the bulls but also investors who are looking to avoid taxable events.

The recent NFT market growth was a blessing to many. It was the turning point where people see NFTs as more than JPEGs but as a possible investment vehicle. However, the likeliness for the market to experience a similar growth rate is slim to none, at least not in the short term. This meant that people should rely less on asset price appreciation alone and seek more sustainable returns generating strategies.

This is the thesis of protocols allowing holders to generate cash flow.

Akin to the Trad A&C market, there have been developments in the NFT renting space. Due to the lack of utilities, NFTs are currently rented for showcases (e.g., museums renting them for an exhibition) or their (limited) underlying utilities (e.g., backstage access, special yields in DeFi protocols, etc.).

Another way for NFT investors to generate cash flows is by commercializing their IP ownership rights. One example is developing/licensing a restaurant brand centring around a BAYC NFT [7]. Some NFT collections have also adopted a model of rewarding their NFT holders with fungible tokens.

The following are the protocols/mechanisms that offer NFT holders cash flow:

Figure 10: Types of NFT protocols and mechanisms generating cash flow when holding NFTs

A. NFT renting

NFT renting highly hinges on their underlying utilities. As the market is currently dominated by PFP NFTs (with a lack of clear utilities), the NFT renting space has yet to gain traction. However, should the NFT market head towards Real-World Asset tokenization (e.g., representing properties with NFTs), the renting space will likely then have a more clearly defined use case.

B. Copyright and intellectual properties (IP)

NFTs are generally marketed as owning a piece of art, but due to the still unclear regulations regarding digital assets, collections face a huge barrier when it comes to granting their owners full copyright and IP rights.

C. Native token emissions

Several NFT collections have also integrated native token emissions, where NFT holders will be rewarded with tokens for locking and not selling their NFTs.

But, without a complete ecosystem of use cases, it is inevitable for the holders to sell the tokens. The selling pressure could potentially start a negative flywheel effect that further pushes down the token price making the yields even more unsustainable.

As the NFT market matures, asset price growth is expected to decline. We believe that protocols/mechanisms offering cash flow for holding NFTs may allow investors to maximize their returns through a combination of asset price appreciation and yield premiums.

How should NFTs be priced?

This is the foremost question that needs to be addressed before all three aforesaid problems can be truly solved. Yet, we placed this at the end because it is one of the areas where we have seen the slowest/least innovations so far.

Currently, pricing mechanisms can be loosely classified into two:

Figure 11: Types of NFT protocols solving price discovery

A. Oracle-based pricing

The status quo is relying on oracle-based pricing methodologies to value NFTs used in other NFT finance protocols.

These oracles usually extract key parameters (e.g., floor prices, TWAP, VWAP, historical prices, etc.) across various marketplaces to determine NFTs’ fair value. More comprehensive solutions in the market might implement machine learning algorithms to extrapolate price trends and group similar trait ranks.

Oracle-based pricing works best on highly-liquid collections or collections with traits’ variances that are closely distributed. But given NFTs’ volatility, a wide margin of error should be expected.

Protocols with various risk tolerance and mechanisms must customize their parameters to accommodate these errors. In addition, relying on historical price data also means not pricing in the news/roadmap.

B. Optimistic Proof-of-Stake pricing

To further enhance NFT pricing, one of the most publicly anticipated approaches is the optimistic proof-of-stake pricing mechanism by Abacus Spot.

Inspired by optimistic rollups and the proof of stake consensus mechanism, this pricing model relies on users’ collective valuations to price an NFT instead of using historical data. As such, it is most suitable for long-tail pieces (i.e., pieces that lack historical data) and those with expected low future sales turnover.

Users would value an NFT by collectively depositing $ETH (for a defined period; at least 1 week) into an NFT valuation pool. The NFT owner could use the corresponding valuation pool as “collateral” or valuation proof to (lending) protocols.

In the case of default, the underlying NFT is auctioned and if the sales price exceeds the valuation pool size (total $ETH locked), sales proceeds are distributed proportionally to the valuators. If the auctioned value is less than the valuation pool, sales proceeds are distributed in a FIFO manner (the latest valuators bear the risk of mis-valuation) to the valuators.

The model is optimistic as it assumes that the price agreed upon by the valuators is right. It is derived from the Proof of Stake consensus mechanism as valuators back their appraisals with their funds (and their stake could be lost in a mis-valuation).

The drawback of this pricing model is capital inefficiency as it requires an asset to guarantee the NFT’s claimed value.

As most of the protocols solving the other three challenges rely on pricing mechanisms, the development of this segment would be groundbreaking. It unlocks the ability for protocols to be more price-sensitive and may help in tackling the three other challenges.

NFT finance aims to add (financial) utilities to NFTs. Without a proper financial aspect, NFTs can hardly be perceived as more than collectables with immutable records of ownership. NFT finance expands the scope (and market size) of how far NFTs can go. We believe that developments in the sector might help NFTs be recognized as a proper investment class that is comparable to the traditional A&C market.

The current landscape of NFTs (especially PFP NFTs) is strongly tied to the project’s branding and marketing capabilities. As the NFT finance sector becomes increasingly relevant, project creators will have no choice but to adapt. They can leverage this by treating financialization as another feature of their collection. An example of this adoption would be project creators allocating a certain amount of their sales proceeds or treasury to non-marketplace liquidity protocols (e.g., lending platforms and liquidity pools).

The ease of financialization of a collection can act as a moat. When existing established projects incorporate financialization, the barrier of entry to creating a successful collection will increase. This may indirectly force newer projects to innovate to compete, driving the NFT space on a positive trajectory.

The future looks bright with the potential unlocked by NFT finance. However, before the NFT space can expand outwards, internal problems need to be addressed. These problems currently revolve around reaching a consensus on how NFTs should be valued. In addition, more developments and innovations (exploration of use cases) are needed to conclude just how big NFTs can be.

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