Created

Jan 19, 2023 8:01 PM

DeFi is rocket fuel for NFTs

“Financializing” NFTs via DeFi protocols addresses many of the issues that NFTs face today, specifically:

Accessibility

Because an NFT is by definition unique, buyers are often required to have specialized knowledge of a specific asset in order to make informed buy or sell decisions. In addition, the scarcity of unique assets could quickly drive up the price beyond that which is affordable for retail buyers. These two elements increase the barrier to entry for new buyers entering the market and hinder the value accrual of the NFTs themselves; because part of the value of an NFT comes from its underlying community, limiting access to the long tail of buyers makes it more difficult for the NFT to permeate across the internet. DeFi protocols could reduce the capital and knowledge requirements to participate in NFT markets and open the floodgates to a new wave of retail users.

Liquidity

Having a liquid market of buyers and sellers for a particular NFT leads to better price discovery because it increases the velocity that an NFT is traded in secondary markets (i.e. the more trading, the better sense of that NFT’s fair market value). This allows sellers to more easily monetize their work and makes it easier for inexperienced buyers to enter new markets because they could more easily exit an investment if they so choose.

Utility

Ownership and provenance are important properties of NFTs that are uniquely enabled by permissionless cryptonetworks but the value proposition hasn’t fully resonated with retail buyers. Greater utility, such as access to cash flows, content, and experiences, all enriched by DeFi protocols, will make it more attractive for the mainstream audience to own NFTs.

DeFi and NFT synergies

There are a variety of use-cases where DeFi and NFTs work well together:

Collateral

Banks have been offering loans using traditional art as collateral since the 1980s, and it is a big business; Deloitte estimated that the global value of art-secured loans was $21–24 billion in 2019.

One could do the same for NFTs by offering non-recourse loans for digital art, collectibles, virtual land, and other content. Rocket experimented with this in early 2020 and NFTfi* is building this today with a two-sided marketplace on Ethereum. It is still early days, however, with NFTfi having around $2.5M in loans to date.

Accepting NFTs as collateral in lending protocols increases the utility of the NFTs for the owner while increasing the economic activity of the protocol; it is a win-win.

An important related component is pricing, which is a broader issue for NFTs but particularly important if the assets are to be used in a financial context. In the absence of secondary market transactions, and especially during liquidation events, appraisals are likely required to estimate the value of an NFT. This is a widely-used practice in the traditional art & collectibles market either through licensed appraisers or informal venues like pawn shops. Upshot is doing something more akin to the latter for NFTs by crowdsourcing appraisals through a network of incentivized participants.

Crowdfunding

ICOs were the first killer app on Ethereum because the platform is ideal for global capital formation & distribution; this use case applies to NFTs as well. Users from around the world could invest in creative works at different stages of their lifecycle, which could lead to a renaissance in digital art and enable a new business model for a variety of content creators.

For example, a writer named Emily Segal was able to crowdfund ~$50,000 (25 ETH) for her next novel, giving away 70% of the work in the form of $NOVEL tokens, which represent fractionalized ownership of the NFT. The 104 $NOVEL token holders are entitled to their pro-rata share of profits if the NFT is sold at a higher price on the secondary market, as well as other benefits, such as a mention in the book’s acknowledgments.

Source: Mirror

Owning written content could offer a new business model for publishers as well. For example, an NFT of a New York Times column was recently sold for $560,000, likely much more than the company earned on advertising for that article.

Cooperatives

In the traditional business world, a cooperative is a corporation that is owned by its members, who are usually required to make a financial contribution to join. Decentralized Autonomous Organizations (DAOs) are the crypto-native analogy for this and have become the standard way to govern DeFi protocols. DAOs will be even more important for NFTs because there will be an order of magnitude more assets and communities forming around them.

We are already seeing traction for these “collector cooperatives” because they allow groups to invest in NFTs that are cost-prohibitive for any single individual. DAOSaka experimented with this in late 2019 and FlamingoDAO is doing this today, both pooling funds from individuals and collectively deciding which NFTs to buy and sell. Collector cooperatives could form spontaneously and evolve organically; PleasrDAO, for example, initially pooled funds to purchase a specific NFT and later expanded their scope when they purchased an NFT from Edward Snowden for $5.5 million. In both cases, the DAO outbid a single wealthy buyer to win the auction.

Economic Attribution

An open record of provenance enables use-cases that were previously impossible or difficult to enforce, such as royalties for art and other assets sold in secondary markets.

Rarible*, SuperRare, and Zora all implement royalties with varying degrees of functionality and interoperability. Mirror implements this at an application level with a feature called “splits”, which allows the author to assign a portion of the economic value to others whenever the piece is sold.

Royalties could apply to content outside of digital art and music. For example, the “renegade” dance on TikTok made Charli D’Amelio a celebrity overnight. While both Charli, who currently has over 112 million followers, and TikTok benefited economically, the person who created the dance, a 14-year old girl named Jalaiah, received no recognition for her work. NFTs could address this issue by providing the ability to tokenize such content and provide economic attribution to the creator as it is monetized. In the future, athletes, dancers, photographers, and other creators will directly mint their content via NFTs to get credit and compensation for the work they’re producing.

Economic attribution could also be programmatically distributed across multiple and specific NFT owners. Planck recently experimented with the concept by publishing the results of a scientific study as an NFT and will be implementing a feature called “SplitStream”, which allows an NFT to direct a portion of future sales to other NFTs.

Source: Matt Stephenson

In the context of academia, this aims to incentivize and fund academic research by creating a social graph of citations and a cascading stream of payments to those NFT owners in perpetuity.

Exchange

The ability to exchange one NFT for another is important because it improves liquidity and price discovery by opening up the universe of potential trading pairs, but this is difficult to implement due to the illiquid-by-design nature of NFTs.

0x Protocol first addressed this issue in 2019 with ZEIP-28, which enabled NFT-to-NFT trades on their order book-based protocol by providing the ability for a buyer to pay for a listed NFT with another NFT as the fee token, but this still required the buyer to specify which NFT they wanted to purchase. 0x later implemented property-based orders, which enabled a buyer to create an offer to purchase any asset that has a specific set of properties. In effect, this pooled liquidity based on certain attributes (but still fragmented liquidity for a given “type” of NFT).

Other solutions try to facilitate trading by utilizing an intermediary fungible ERC20 token. NFT20 implements this concept by minting ERC20 tokens that each represent different types of NFTs and pooling those tokens according to their type. Those NFT types could then be traded across multiple pools via CFMM routing using a common numeraire.

For example, if there is a MASK20/ETH pool and an MCAT20/ETH pool, a user is able to instantly trade MASK for MCAT on Uniswap. This solution works particularly well for collectibles that have a small number of valuable assets and a long-tail of lower value assets with a well-understood floor price.

Furthermore, due to the atomicity of Ethereum transactions and composability of DeFi protocols, developers could “chain together” multiple intermediary tokens and liquidity pools in a single transaction to enable trading across a variety of NFTs.

Fractionalization

Fractional ownership is an effective way to democratize access to assets and has historically been used for high-value assets, such as vacation properties. Otis does this with traditional art & collectibles by purchasing the assets, storing them in a vault, and issuing shares representing ownership of those assets.

NIFTEX* is doing this for NFTs as well. It allows the owner of a specific NFT to deposit that NFT in a smart contract and issue “shards” (ERC-20s) representing that asset. The underlying NFT could be redeemed by acquiring all of the “shards” or via a buyout clause.

One could also fractionalize the ownership of a bundle of assets. Metakovan did this with the B.20 token, which contains 28 assets, including Beeple’s cryptoart and digital land in Cryptovoxels, Decentraland, and Somnium Space.

Index Funds

Index-based investing in traditional financial markets has surged in popularity over the past decade because it provides a transparent and low-cost way to achieve diversified exposure across a variety of markets.

Similarly, NFT-focused index funds could give investors exposure to a particular class of NFTs without requiring them to appraise a specific NFT.

NFTX is doing this by creating index funds for various collectibles, such as Cryptopunks, where each fund is backed 1:1 by an underlying NFT; for example, a PUNK-ZOMBIE ERC20 could redeem one zombie CryptoPunk at any moment from the pool.

NFT-focused index funds could also improve liquidity and price discovery for the underlying NFTs by attracting additional demand and trading activity from a larger user base.

Renting

Sometimes people want to rent instead of buy, and the art world has embraced this fact for decades — the Museum of Modern Art, for example, has been lending its artwork since 1957. Artists and collectors gain access to an additional revenue stream, while renters are able to enjoy the artwork at a fraction of the price.

Source: The Ottowa Journal. March 15, 1980

This model could be applied to NFTs such as art and digital land as well. ReNFT is attempting to do this today with a peer-to-peer marketplace for NFT rentals. As with most DeFi protocols in crypto — this is currently an over-collateralized solution; a borrower is able to rent an NFT by depositing collateral equal to the market value of that NFT, along with an additional rental fee. That said, improvements are being made at the protocol level with the EIP-2615 proposal, which natively supports rental functions within an ERC-2615 token itself and no longer requires security deposits.

Yield Guild Games does this in a gaming context with a slightly different model by lending Axies to new players in exchange for a percentage of the SLP tokens that are rewarded to them from playing the game. In effect, the player is renting an Axie in exchange for a portion of future revenue.

Synthetics

A synthetic asset is a financial instrument that simulates other instruments. While most NFTs today are not really financial instruments in the traditional sense of the word, the concept could still be applied to enhance liquidity and market access for these NFTs.

One of the issues with having NFTs minted on multiple blockchains is that buying the asset becomes more difficult. In addition, there is likely a cohort of buyers who just want to speculate on the price of an NFT rather than actually own it. For these users, there exists an opportunity to provide synthetic price exposure to specific NFT. For example, one could use a price oracle to give price exposure to an Ethereum user for an NBA Topshot asset on Flow.

That said, some NFTs, such as Uniswap V3 LP shares, are indeed financial instruments. From this perspective, one could combine multiple LP shares to replicate the payoff structures of various types of derivatives.

The Future of NFTs

Over time, we will see more unique, complex, and interconnected cryptomedia that will leverage multiple DeFi protocols to enable value propositions and use-cases that were not possible in the traditional world. The design patterns here could be, but are not limited to:

Bundling²: Index Coopcould offer retail users an easy way to get exposure to a variety of NFTs by creating an equally-weighted index of the AXIE, MASK, and PUNK index funds from NFTX (since they are already ERC-20s).
Fractionalizing+Bundling: Fractionalize an Axie, Catalog record, Cryptopunk, and Sandboxland, each into 100 ERC-20 tokens, and deposit 25 tokens of each asset into Charged Particles to mint an NFT which represents a diversified basket of fractionalized assets.
Composing: One could combine multiple NFTs or layer additional utility and value onto existing NFTs. AlchemyNFT is doing the latter with AutographNFT by providing the ability to “sign” existing NFTs with digital autographs. Punkbodies is doing the former by allowing users to combine their Wrapped CryptoPunk (an ERC-721) with a PunkBody (also an ERC-721) to create a Punkster they can either download or mint. The implementation locks the original ERC-721s to mint the Punkster NFT, and users could burn the composed NFT to unlock the originals. These composed NFTs inherit the provenance and utility from their original(s) while providing additional features or utility.

Source: Bankless

The next few years will see a flurry of experimentation around these concepts and it will be exciting to see how developers, creators, and communities will work together to bring them to life.

If you are building something at the intersection of DeFi and NFTs, please reach out!

Denotes 1kx portfolio companies

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

Fungible Non-fungibles: The Financialization of NFTs