There is still more practical space for NFT, and we must focus on how to retain users.
Written by: JOEL JOHN, SAURABH
Compile: Block unicorn
I've been reading "The Sublimation of Man" by Jacob Bronowski. At the heart of the book is the idea that humans shape their environments to the same extent that environments shape humans. A TikTok teen shares something in common with his caveman ancestors in their desire to express themselves, just in different ways, and we create art because it allows us to escape the reality around us.
Humans are unique among animals in that our imagination allows us to empathize with and experience the stories of others without replicating their world. Society rewards artists for creating these fictional worlds, and J.K. Rowling (author of Harry Potter) and Epic Studios (production company of Fortnite) amassed billions of dollars by creating fictional worlds wealth. However, it took centuries for our society to value art as much as it does now. The following is a brief history of how this relationship developed.
Forex, bonds, and international trade arose in Florence, Italy in the 15th century. Many of the artists we admire today were sponsored by financiers of the time, and art became a status symbol. Depending on the rarity of the artwork and the sophistication of the style, a painting can retire. Sweden had art auction houses in the early 17th century. Meanwhile, the Dutch ponder whether tulips are a good store of value.
About 100 years later, auction houses such as Christie's and Sotheby's began to operate. However, investing in art remains difficult until crowdfunding becomes an option. In 1904, André Le Vere created the first modern art fund. He and his friends bought contemporary art and held it for ten years, quadrupling their assets. In the 1970s, the British Railways Pension Fund purchased 2,000 works of art of all kinds, giving art unprecedented credibility as an asset class.
As art transitions from a status symbol to an asset class, we created the Art Index. Artnet (1989) and Mei Moses (2002) provide benchmark datasets for investors and track prices in a heavily fragmented market. Securitization of works of art has not yet become common practice, and in the modern world there is often a conflict between finance and art. Just a few years ago, Taylor Swift fans sent death threats to the recording studio that owned the rights to her early work. The artist tweeted that she was restricted from performing the works live.
Another example of the fusion of art and finance is the Bowie bond. In 1997, singer David Bowie partnered with Prudential Insurance to raise $55 million through a bond offering. Investors paid the funds upfront to earn interest, which would come from revenue generated from the rights to Bowie's 25 albums. Can you see a trend here? Almost everything we discuss on Web3, from buying art to streaming royalties, has happened in the past. The field we are involved in is not a particularly complicated or advanced field.
But the infrastructure we are building can be used to move liquidity (USD) and track assets around the world, and the infrastructure and technology has huge potential to advance the art and financial industries. Over the past century, artists have been discovered through curatorial mentions or exhibiting their work in major museums. The Internet has lowered the cost of discovering new artists, and the blockchain has made it possible financially. Anyone around the world can bid and own an artist's work, just like Beeple sold his NFT for $70 million.
However, whales (big households) acquiring digital art and using them on a large scale are very different things. Buying an NFT on the spot market, with no financing options, is like expecting everyone to buy a house or car without a mortgage. The market is so small that even the iPhone needs to work with carriers to spread its cost to consumers through clever financing schemes to make it popular. Over the past few weeks, we have been following developments in the financial ecosystem surrounding NFTs. That's where this article comes from.
Sticky Trader, Harder to Leave JPEG
Let's get something clear, some of the promises made about NFTs may not have come true exactly as we expected. For example, artists, especially those who do not create visual art, cannot leverage these native properties to create new revenue streams unless they have solved the problem of distribution. Some NFT collectibles have indeed achieved multi-million dollar sales, but will NFTs have the same impact on the music industry that Soundcloud did to the music industry? Maybe it's too early to tell (but Audius (NFT music distribution platform) is already changing the way music is distributed).
Likewise, the gaming ecosystem is not very receptive to NFTs entering it. Sky Mavis has done a great job with Axie Infinity and Ronin, and some studios are exploring how to better use on-chain assets in games. But if you were to ask someone who spends more than a few hours on a console if they own an NFT in their game, the answer would probably be a firm no. That could change soon, however, as apps like Stepn and Axie Infinity gain App Store functionality rights in select markets, despite paying the Apple tax.
Recently, Meta started planning to remove all NFT integrations from their product. NFTs do not capture the psyche of the average retail customer. Demonstrating ownership of a Bored Ape on Instagram hasn't been as influential as owning other Veblen merchandise released by established brands like Gucci or Louis Vuitton, possibly in part because many scammers use these NFTs to showcase their wealth. It is very unfortunate that status symbols among early NFT adopters gradually became associated with scams in the minds of retail users.
So where are we seeing some progress? Much of this is centered on trading NFTs as spot assets, just like any other cryptocurrency. According to Nansen, the number of wallets transacting NFTs has grown from about 10,000 to more than 150,000 per day. According to the calculation of ETH, the top 10 most profitable NFT wallets spent a total of about 14,000 ETH, creating a profit of about 62,000 ETH. Among the top 1000 most profitable wallets, the median gain is around 92%.
Are these users trading between different collectibles? Here, the median wallet trades about 33 collectibles. There is one wallet that has interacted with over 1400 collectibles, and the top 100 wallets for interacting with collectibles have interacted with at least 200 different collectibles. As such, it has become common practice, at least among advanced users, to interact with many NFT collectibles, likely in the hope that one of them will be a hit, giving similar rewards as the Bored Ape NFT.
As we have seen before, the gradual financialization of art as we know it takes centuries to complete. Privately held art is worth about $2 trillion, while the lending business is only about $20 billion. The current NFT market size is only about 10 billion US dollars, which is relatively small. However, the financial infrastructure provided by the blockchain may lead to higher capital flow velocity. As Electric Capital's Avichal Garg recently pointed out, prior to eBay's IPO, NFTs traded roughly 30 times more than eBay (~$12 billion for NFTs vs. $350 million for eBay). While the quality of this metric is still up for debate, it is worth noting that users are willing to pay for these assets.
A crop of emerging startups are trying to capture some of this volume, and below we list some notable projects.
Discover the price of the trading platform
Like most assets, NFT exchanges are the building blocks of markets, and they facilitate price discovery. Here we see three basic models.
The first is a spot market, like the one on OpenSea. Users who hold NFTs simply list their asset for what they are willing to sell it for, while those who want to buy can submit an offer that they would like to receive the asset. This model was improved by platforms like Sudoswap when they moved to the AMM (Automated Market Making) model used in DeFi.
Sudoswap facilitates NFT transactions through AMM, and the price changes based on the bond curve (a function that determines price changes based on traders' behavior). They have two options, a linear curve, where the price moves linearly, or an exponential curve, where the price increases or decreases by the same multiplier factor.
Suppose two users both want to sell the same series of 5 NFTs at a starting price of 4 ETH, but one wants to sell in linear increments of 0.5 ETH while the other wants to sell in 10% increments. The chart below shows the difference in price over time for the two pools. Assuming these two pools are the only ones in the series, buyers will default to getting the lowest 8 of the top 10 listed above. The advantage of this model is that it provides liquidity for traders with large trading orders, making it easy to enter and exit the market.
Soon, it was realized that a thin layer could be built on top of the market, aggregating the best prices for NFTs. Platforms like Gem and Genie allow traders to get the best prices on bulk NFTs with the click of a button. However, once an aggregator develops to the point where users more often choose to go to the aggregator instead of the marketplace, it could pose a threat to the market.
Imagine the impact Amazon's recent launch of the electronic accessories marketplace has on competitors. OpenSea acquired Gem a year ago but has been too slow in launching tokens. Blur sensed an opportunity and launched their platform in Q3 2021 with a potential token airdrop as their marketing package. Before people realize it, most of the trading volume has started to concentrate on trader-oriented platforms like Blur.
Once the NFT market has enough users, a natural extension is to start offering leveraged trading. Doing this allows more users to generate higher transaction volume, potentially earning you better fees. This is achieved through the lending model, which we describe further below. Another way is through derivatives, which track the price of an asset and trade it without actually owning it. (There will be some financial jargon to come, skip to the lending section if not interested)
Let's say Sid is optimistic about the Bored Apes Yacht Club (BAYC) NFT, but he doesn't want to risk 60 ETH. If the price of the NFT is around 60 ETH, and his budget is only 10 ETH, Sid can trade BAYC without actually buying the NFT, using a protocol that offers up to 10x leverage. These futures contracts, like perpetual futures for fungible tokens, use the concept of funding rates to balance longs and shorts and ensure prices track the series floor.
The key consideration here is how the agreement obtains the floor price (the minimum selling price of the NFT), because the difference between the market price on the futures platform and the index price (the integrated floor price) determines the funding rate, and the funding rate drives the price on the platform. Incentives for the long or short side.
If the futures platform directly uses the floor price in the market, it will be vulnerable to manipulation (mixing transactions and deception in NFT are common). Nftperp is a perpetual futures platform specially designed for NFT, which uses a real bottom price mechanism to resist the above problems. They filter out outlier or blended transactions and use weighted average price (TWAP, the average price over a time period) to estimate the correct asset price.
JPEG Morgan of the Metaverse
Lending as a form of finance has existed for a long time, and people may want to "borrow" an NFT for a number of reasons. Three lending models have emerged. The first model is that the borrower and the lender are docked on the chain, peer-to-peer lending. The second model is that the peer-to-peer lender adds NFT to a fund pool that provides mortgage loans. The last model is The model is a collateralized debt position, similar to MakerDAO and DAI.
Peer-to-peer lending is the simplest form of NFT lending, and platforms like NFTfi allow borrowers to stake their NFTs in order to take out loans on them. Once a borrower accepts an offer from an interested lender, the NFT is placed in an escrow account. If the borrower repays the loan before maturity, the NFT will be returned to the borrower. If the borrower fails to repay the loan, the NFT will be returned to the lender. Smart contracts are very good at recovering debt collateral and handing it over to lenders, as anyone who has experienced loan liquidation in DeFi will know.
This is one of the easiest ways to facilitate NFT-based lending, and another positive is that the model does not rely on external factors such as reserve price oracles, making it safer than other lending methods. The downside is that matching takes a long time and there is often a liquidity shortage.
There are many examples of peer-to-peer lending platforms in the Web2 world, such as LendingClub, Zopa, and Prosper, which offer borrowers an alternative to banks. Borrowers enjoy better rates on these platforms, but the scale has not scaled massively. A possible explanation is that lenders are hesitant to use these platforms for lending due to the lack of government guarantees. The risk premium for lending in peer-to-peer markets is high, but so is the risk of default.
The peer-to-peer lending model can be compared to order book-based transactions. Borrowers and lenders must agree on the details before a loan can be initiated. The time to find these matches makes this pattern difficult to scale. Decentralized exchanges such as EtherDelta initially adopted off-chain order books, but lack of liquidity prevented them from scaling. The real breakthrough of Uniswap is that it does not require buyers and sellers to come to a price agreement. In a sense, the use of passive liquidity is the ingenuity of Uniswap. Similarly, the peer-to-money pool (P2Pool) model is similar to an automated market maker (AMM), where users borrow and lend from the pool rather than from other users.
This design is similar to a money market, where users can take out loans, but their collateral is NFT instead of ERC-20 tokens or ETH. BendDAO, one of the first projects to facilitate this model, has an NFT lending pool. It can be compared to AAVE, users can deposit/loan different fungible assets or ETH, and can get ETH (or other available assets) loans immediately. In the case of BendDAO, NFTs deposited by borrowers act as collateral. If the collateral value falls below a defined threshold, the protocol needs to liquidate the NFT.
BendDAO also allows users to pay a certain percentage down payment (varies according to collectibles) to purchase NFT. This gap was bridged by a flash loan from AAVE. The flash loan is repaid by the protocol until the protocol recovers the loan from the buyer, who also becomes the borrower. This mechanism relies heavily on price oracles, which is honestly not the best practice.
Scaling this model is problematic because external factors such as NFT prices and liquidity can affect collateral ratios. This means the governing body has to vet new collectible listings, which can lead to bottlenecks. Another challenge arises when there are bad debts in the system. Assuming that a person submits NFT to the system as collateral and borrows, if there is insufficient collateral due to market fluctuations, there needs to be sufficient liquidity for liquidation. (Remember FTX's FTT loan? I think about it every day.)
Selling NFTs quickly could have a negative impact on the floor price, causing the protocol to suffer more losses, creating a liquidity cascade effect. In this case, selling an NFT may cause more bad debts to enter the system in order to cover bad debts. BendDAO faced a similar liquidity crisis in October 2022, and the protocol had to take corrective steps to ensure borrowers didn't lose their ETH. (You can check the information on BendDAO’s bad debt risk in February)
There are trade-offs between the P2P model (scale, capital efficiency) and the P2Pool/CDP (collateralized debt position) model (limited coverage, reliance on price oracles). MetaStreet Labs recently introduced a third option called the Automatic Tranche Maker (ATM).
In the ATM, the borrower chooses the price at which they are willing to lend to the NFT series. Different borrowers can choose different prices, which are then added together to provide instant liquidity to borrowers.
For example, there are three borrowers who want to make loans to CryptoPunk, but the three borrowers have different risk tolerance. Say a CryptoPunk is worth 100 ETH, and you have a set of lenders willing to lend NFTs in varying amounts of ETH.
In this example, Borrower A is willing to lend up to 10 ETH per CryptoPunk, Borrower B is willing to lend up to 30 ETH each, and Borrower C is willing to lend up to 45 ETH each.
These three borrowers deposit funds into the same CryptoPunk pool, each with a different order price.
When borrowers come to this CryptoPunk pool, they will see that their CryptoPunk can immediately obtain 45 ETH of liquidity, and then happily receive this payment. Behind the scenes, all three borrowers got the results they wanted.
Borrower A takes a position of 0-10 ETH, Borrower B takes a position of 10-30 ETH, and Borrower C takes a position of 30-45 ETH.
In the ATM model, borrowers would see a single rate and creditors would share the interest disproportionately so that Borrower C gets most of the return (in exchange for taking most of the risk), with shares of interest distributed tiered to the funds Each subsequent creditor in the pool.
The ATM model provides a collaborative lending strategy through a pool of funds, thereby achieving a lower cost of capital than the peer-to-peer lending market, while enabling each user to independently set their risk profile without the influence of other participants or third-party oracles.
Blur proposes a P2P lending design called Blend, which addresses some of the shortcomings of P2Pool (person-to-fund pool) lending. Blend borrows heavily from the way traditional lending works. It eliminates the need for oracles (which is the case for most P2P designs), and by default these loans have no maturity date. Creditors or borrowers can withdraw at any time. Creditors can initiate an auction at any time in order to sell their position, for whatever reason (such as they found a higher rate elsewhere), and borrowers have a stipulated time to respond with repayments of principal and interest.
If the borrower fails to honor the loan contract, the loan will be taken over by a bidder. If no bidder is found, the creditor takes ownership of the NFT (collateral), similar to how real-life loans work. From the borrower's point of view, if they want to exit, they can repay the loan at any time and cancel the loan contract. However, they must keep an eye on whether creditors initiate the auction.
The CDP (Collateralized Debt Position) model borrows heavily from MakerDAO's design. This type of lending uses a synthetic asset that users can mint against their collateral NFT. JPEG'd was one of the first protocols to introduce CDP lending for NFTs. Just like users can mint DAI by locking collateral in Maker's vaults, users can mint pUSD by locking NFTs in JPEG'd vaults. Borrowers can get their NFT back by repaying the loan (with interest). Collectibles that can be used as collateral are a subset of screened NFTs, meaning users can get instant loans on their NFTs.
Another advantage is that the marginal cost of making new loans is zero. From the supply side, the model is scalable. However, it also has some drawbacks. It requires oracles, which we know are inherently vulnerable to the risk of manipulation. Mandatory whitelisting creates bottlenecks and acts as a barrier to scaling. Finally, only native stablecoins can be minted, which means that projects need to be widely adopted to achieve scale and cannot take advantage of the network effects of existing stablecoins.
NFT Leasing
This model can be thought of as renting a house. When someone leases an NFT, they enjoy all of its benefits during the lease period. At the end of the lease, the NFT will be returned to the owner. Renting NFTs can be used in different ways, as an example, let’s say you need an NFT to play a specific game for a few hours: instead of spending a few hundred dollars to buy that NFT, you can rent it for a small fee and share it with the NFT The owner shares a portion of any capital gains, which is how the rate of return grows rapidly in games like Axie Infinity.
Guilds retain ownership of the NFT, but players use it in-game and generate revenue, which is shared with the guild. This trend could carry over in an ecosystem where NFTs have hot utility features, another scenario that could happen is in Stepn, an app that rewards users for walking in specific shoes. However, (virtual) shoes can be worth thousands of dollars. If you can lease it out to third parties, and share the rewards with them, you will unlock a whole new level of smart contract-driven capitalism.
In the "metaverse" as we know it, there is currently not enough attention to support a large NFT rental ecosystem. Simply put, there is no corresponding incentive mechanism yet, but vanity is one of the areas where it may take off. Say you own a $400,000 limited-edition firearm, like one of the Counter-Strike guns. It stands to reason that a third party will rent it from you and show it off live on Twitch. This assumes, of course, that Counter-Strike is a decades-old brand with an audience of millions, a level that Web3-native games are not yet at.
Another possible area is social clubs. Rather than a single person spending tens of thousands of dollars to access a digitally-heavy community like Foster, multiple people can pay a fee to purchase a single NFT and use it to gain access to the community. An artist's fan club can collectively raise funds to purchase NFT-based tickets that are valid for a season, and individuals in the club can rotate based on who can attend the artist's events. These are all assumptions, and more retail users need to accept these native functions. Currently, we only have the technology and not the users.
Beyond Speculation
In perhaps one of the strangest comebacks in the tech world, vinyl records now outsell physical CDs. the reason is simple. If you stream music from a platform like Spotify, you risk losing all your music if the relationship between the artist and the platform (like Spotify) sours. While Jay Z was trying to grow Tidal (the music streaming platform) into a meaningful business, some of my favorite Jay Z songs were temporarily pulled from Spotify.
Having a physical record means you can continue to listen to music after the platform shuts down. This shows that people want to own assets directly related to their favorite artists. A similar trend can be seen in gaming as well. Recently, a gun in CS GO sold for $400,000, and many of the behavioral patterns we're excited about in Web3 also exist in the traditional realm.
Passing royalties or ownership of digital goods does not necessarily require issuing a speculative token. The user base in Web3 cannot scale because we are often distracted by incentives (tokens) and ignore the importance of attracting and retaining users.
The challenge is that you can't start a functional economy in your application without a sufficient number of users. The assumption is that building secondary products is usually acceptable because customers are like speculators, and incentives (such as tokens) confuse consumers long enough. But in a 4% interest rate environment, I don't think that's going to happen. The industry can only grow by building linkable products that integrate with blockchain technology that is invisible to users, and tools like account abstraction are already enabling users to do just that.
Other technological advances that could speed up the process are also taking place. An example is the recently introduced ERC-6551 standard for accounts tied to tokens. This helps to create a smart contract wallet for each ERC-721 token (NFT). This means that NFTs can own assets and interact with applications. For example, you could play a game where the NFT represents your character. And this character can accumulate tokens in the game as rewards. Therefore, if you transfer NFT, you transfer all the assets accumulated in the game. Or you can buy an NFT that represents an entire portfolio of tokens, like the example shown below.
I've always wondered whether better infrastructure always translates to more economic activity. Ironically, this happened in my city. Dubai has become a global trade hub by improving its infrastructure and developing economic policies that attract entrepreneurs and investors. And they've been doing it for over a century. Blockchains are similar to cities in that they are empty and often generate little economic activity. But reducing fees (monetary policy) and providing tools (infrastructure) can attract developers (entrepreneurs and investors) who want to build applications on these blockchains.
NFTs need an app, just as Pokémon GO did for augmented reality and ChatGPT did for artificial intelligence. Applications such as Axie and Stepn are examples of what happens when an application enables users to easily interact with these cryptographic primitives. But I don't believe that we can only think of two examples, and there is more practical space for NFT.
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The content is for reference only, not a solicitation or offer. No investment, tax, or legal advice provided. See Disclaimer for more risks disclosure.
When Decentralized Finance (DeFi) meets NFT
Written by: JOEL JOHN, SAURABH
Compile: Block unicorn
I've been reading "The Sublimation of Man" by Jacob Bronowski. At the heart of the book is the idea that humans shape their environments to the same extent that environments shape humans. A TikTok teen shares something in common with his caveman ancestors in their desire to express themselves, just in different ways, and we create art because it allows us to escape the reality around us.
Humans are unique among animals in that our imagination allows us to empathize with and experience the stories of others without replicating their world. Society rewards artists for creating these fictional worlds, and J.K. Rowling (author of Harry Potter) and Epic Studios (production company of Fortnite) amassed billions of dollars by creating fictional worlds wealth. However, it took centuries for our society to value art as much as it does now. The following is a brief history of how this relationship developed.
Forex, bonds, and international trade arose in Florence, Italy in the 15th century. Many of the artists we admire today were sponsored by financiers of the time, and art became a status symbol. Depending on the rarity of the artwork and the sophistication of the style, a painting can retire. Sweden had art auction houses in the early 17th century. Meanwhile, the Dutch ponder whether tulips are a good store of value.
About 100 years later, auction houses such as Christie's and Sotheby's began to operate. However, investing in art remains difficult until crowdfunding becomes an option. In 1904, André Le Vere created the first modern art fund. He and his friends bought contemporary art and held it for ten years, quadrupling their assets. In the 1970s, the British Railways Pension Fund purchased 2,000 works of art of all kinds, giving art unprecedented credibility as an asset class.
As art transitions from a status symbol to an asset class, we created the Art Index. Artnet (1989) and Mei Moses (2002) provide benchmark datasets for investors and track prices in a heavily fragmented market. Securitization of works of art has not yet become common practice, and in the modern world there is often a conflict between finance and art. Just a few years ago, Taylor Swift fans sent death threats to the recording studio that owned the rights to her early work. The artist tweeted that she was restricted from performing the works live.
Another example of the fusion of art and finance is the Bowie bond. In 1997, singer David Bowie partnered with Prudential Insurance to raise $55 million through a bond offering. Investors paid the funds upfront to earn interest, which would come from revenue generated from the rights to Bowie's 25 albums. Can you see a trend here? Almost everything we discuss on Web3, from buying art to streaming royalties, has happened in the past. The field we are involved in is not a particularly complicated or advanced field.
But the infrastructure we are building can be used to move liquidity (USD) and track assets around the world, and the infrastructure and technology has huge potential to advance the art and financial industries. Over the past century, artists have been discovered through curatorial mentions or exhibiting their work in major museums. The Internet has lowered the cost of discovering new artists, and the blockchain has made it possible financially. Anyone around the world can bid and own an artist's work, just like Beeple sold his NFT for $70 million.
However, whales (big households) acquiring digital art and using them on a large scale are very different things. Buying an NFT on the spot market, with no financing options, is like expecting everyone to buy a house or car without a mortgage. The market is so small that even the iPhone needs to work with carriers to spread its cost to consumers through clever financing schemes to make it popular. Over the past few weeks, we have been following developments in the financial ecosystem surrounding NFTs. That's where this article comes from.
Sticky Trader, Harder to Leave JPEG
Let's get something clear, some of the promises made about NFTs may not have come true exactly as we expected. For example, artists, especially those who do not create visual art, cannot leverage these native properties to create new revenue streams unless they have solved the problem of distribution. Some NFT collectibles have indeed achieved multi-million dollar sales, but will NFTs have the same impact on the music industry that Soundcloud did to the music industry? Maybe it's too early to tell (but Audius (NFT music distribution platform) is already changing the way music is distributed).
Likewise, the gaming ecosystem is not very receptive to NFTs entering it. Sky Mavis has done a great job with Axie Infinity and Ronin, and some studios are exploring how to better use on-chain assets in games. But if you were to ask someone who spends more than a few hours on a console if they own an NFT in their game, the answer would probably be a firm no. That could change soon, however, as apps like Stepn and Axie Infinity gain App Store functionality rights in select markets, despite paying the Apple tax.
Recently, Meta started planning to remove all NFT integrations from their product. NFTs do not capture the psyche of the average retail customer. Demonstrating ownership of a Bored Ape on Instagram hasn't been as influential as owning other Veblen merchandise released by established brands like Gucci or Louis Vuitton, possibly in part because many scammers use these NFTs to showcase their wealth. It is very unfortunate that status symbols among early NFT adopters gradually became associated with scams in the minds of retail users.
So where are we seeing some progress? Much of this is centered on trading NFTs as spot assets, just like any other cryptocurrency. According to Nansen, the number of wallets transacting NFTs has grown from about 10,000 to more than 150,000 per day. According to the calculation of ETH, the top 10 most profitable NFT wallets spent a total of about 14,000 ETH, creating a profit of about 62,000 ETH. Among the top 1000 most profitable wallets, the median gain is around 92%.
Are these users trading between different collectibles? Here, the median wallet trades about 33 collectibles. There is one wallet that has interacted with over 1400 collectibles, and the top 100 wallets for interacting with collectibles have interacted with at least 200 different collectibles. As such, it has become common practice, at least among advanced users, to interact with many NFT collectibles, likely in the hope that one of them will be a hit, giving similar rewards as the Bored Ape NFT.
As we have seen before, the gradual financialization of art as we know it takes centuries to complete. Privately held art is worth about $2 trillion, while the lending business is only about $20 billion. The current NFT market size is only about 10 billion US dollars, which is relatively small. However, the financial infrastructure provided by the blockchain may lead to higher capital flow velocity. As Electric Capital's Avichal Garg recently pointed out, prior to eBay's IPO, NFTs traded roughly 30 times more than eBay (~$12 billion for NFTs vs. $350 million for eBay). While the quality of this metric is still up for debate, it is worth noting that users are willing to pay for these assets.
A crop of emerging startups are trying to capture some of this volume, and below we list some notable projects.
Discover the price of the trading platform
Like most assets, NFT exchanges are the building blocks of markets, and they facilitate price discovery. Here we see three basic models.
The first is a spot market, like the one on OpenSea. Users who hold NFTs simply list their asset for what they are willing to sell it for, while those who want to buy can submit an offer that they would like to receive the asset. This model was improved by platforms like Sudoswap when they moved to the AMM (Automated Market Making) model used in DeFi.
Sudoswap facilitates NFT transactions through AMM, and the price changes based on the bond curve (a function that determines price changes based on traders' behavior). They have two options, a linear curve, where the price moves linearly, or an exponential curve, where the price increases or decreases by the same multiplier factor.
Suppose two users both want to sell the same series of 5 NFTs at a starting price of 4 ETH, but one wants to sell in linear increments of 0.5 ETH while the other wants to sell in 10% increments. The chart below shows the difference in price over time for the two pools. Assuming these two pools are the only ones in the series, buyers will default to getting the lowest 8 of the top 10 listed above. The advantage of this model is that it provides liquidity for traders with large trading orders, making it easy to enter and exit the market.
Soon, it was realized that a thin layer could be built on top of the market, aggregating the best prices for NFTs. Platforms like Gem and Genie allow traders to get the best prices on bulk NFTs with the click of a button. However, once an aggregator develops to the point where users more often choose to go to the aggregator instead of the marketplace, it could pose a threat to the market.
Imagine the impact Amazon's recent launch of the electronic accessories marketplace has on competitors. OpenSea acquired Gem a year ago but has been too slow in launching tokens. Blur sensed an opportunity and launched their platform in Q3 2021 with a potential token airdrop as their marketing package. Before people realize it, most of the trading volume has started to concentrate on trader-oriented platforms like Blur.
Once the NFT market has enough users, a natural extension is to start offering leveraged trading. Doing this allows more users to generate higher transaction volume, potentially earning you better fees. This is achieved through the lending model, which we describe further below. Another way is through derivatives, which track the price of an asset and trade it without actually owning it. (There will be some financial jargon to come, skip to the lending section if not interested)
Let's say Sid is optimistic about the Bored Apes Yacht Club (BAYC) NFT, but he doesn't want to risk 60 ETH. If the price of the NFT is around 60 ETH, and his budget is only 10 ETH, Sid can trade BAYC without actually buying the NFT, using a protocol that offers up to 10x leverage. These futures contracts, like perpetual futures for fungible tokens, use the concept of funding rates to balance longs and shorts and ensure prices track the series floor.
The key consideration here is how the agreement obtains the floor price (the minimum selling price of the NFT), because the difference between the market price on the futures platform and the index price (the integrated floor price) determines the funding rate, and the funding rate drives the price on the platform. Incentives for the long or short side.
If the futures platform directly uses the floor price in the market, it will be vulnerable to manipulation (mixing transactions and deception in NFT are common). Nftperp is a perpetual futures platform specially designed for NFT, which uses a real bottom price mechanism to resist the above problems. They filter out outlier or blended transactions and use weighted average price (TWAP, the average price over a time period) to estimate the correct asset price.
JPEG Morgan of the Metaverse
Lending as a form of finance has existed for a long time, and people may want to "borrow" an NFT for a number of reasons. Three lending models have emerged. The first model is that the borrower and the lender are docked on the chain, peer-to-peer lending. The second model is that the peer-to-peer lender adds NFT to a fund pool that provides mortgage loans. The last model is The model is a collateralized debt position, similar to MakerDAO and DAI.
Peer-to-peer lending is the simplest form of NFT lending, and platforms like NFTfi allow borrowers to stake their NFTs in order to take out loans on them. Once a borrower accepts an offer from an interested lender, the NFT is placed in an escrow account. If the borrower repays the loan before maturity, the NFT will be returned to the borrower. If the borrower fails to repay the loan, the NFT will be returned to the lender. Smart contracts are very good at recovering debt collateral and handing it over to lenders, as anyone who has experienced loan liquidation in DeFi will know.
This is one of the easiest ways to facilitate NFT-based lending, and another positive is that the model does not rely on external factors such as reserve price oracles, making it safer than other lending methods. The downside is that matching takes a long time and there is often a liquidity shortage.
There are many examples of peer-to-peer lending platforms in the Web2 world, such as LendingClub, Zopa, and Prosper, which offer borrowers an alternative to banks. Borrowers enjoy better rates on these platforms, but the scale has not scaled massively. A possible explanation is that lenders are hesitant to use these platforms for lending due to the lack of government guarantees. The risk premium for lending in peer-to-peer markets is high, but so is the risk of default.
The peer-to-peer lending model can be compared to order book-based transactions. Borrowers and lenders must agree on the details before a loan can be initiated. The time to find these matches makes this pattern difficult to scale. Decentralized exchanges such as EtherDelta initially adopted off-chain order books, but lack of liquidity prevented them from scaling. The real breakthrough of Uniswap is that it does not require buyers and sellers to come to a price agreement. In a sense, the use of passive liquidity is the ingenuity of Uniswap. Similarly, the peer-to-money pool (P2Pool) model is similar to an automated market maker (AMM), where users borrow and lend from the pool rather than from other users.
This design is similar to a money market, where users can take out loans, but their collateral is NFT instead of ERC-20 tokens or ETH. BendDAO, one of the first projects to facilitate this model, has an NFT lending pool. It can be compared to AAVE, users can deposit/loan different fungible assets or ETH, and can get ETH (or other available assets) loans immediately. In the case of BendDAO, NFTs deposited by borrowers act as collateral. If the collateral value falls below a defined threshold, the protocol needs to liquidate the NFT.
BendDAO also allows users to pay a certain percentage down payment (varies according to collectibles) to purchase NFT. This gap was bridged by a flash loan from AAVE. The flash loan is repaid by the protocol until the protocol recovers the loan from the buyer, who also becomes the borrower. This mechanism relies heavily on price oracles, which is honestly not the best practice.
Scaling this model is problematic because external factors such as NFT prices and liquidity can affect collateral ratios. This means the governing body has to vet new collectible listings, which can lead to bottlenecks. Another challenge arises when there are bad debts in the system. Assuming that a person submits NFT to the system as collateral and borrows, if there is insufficient collateral due to market fluctuations, there needs to be sufficient liquidity for liquidation. (Remember FTX's FTT loan? I think about it every day.)
Selling NFTs quickly could have a negative impact on the floor price, causing the protocol to suffer more losses, creating a liquidity cascade effect. In this case, selling an NFT may cause more bad debts to enter the system in order to cover bad debts. BendDAO faced a similar liquidity crisis in October 2022, and the protocol had to take corrective steps to ensure borrowers didn't lose their ETH. (You can check the information on BendDAO’s bad debt risk in February)
There are trade-offs between the P2P model (scale, capital efficiency) and the P2Pool/CDP (collateralized debt position) model (limited coverage, reliance on price oracles). MetaStreet Labs recently introduced a third option called the Automatic Tranche Maker (ATM).
In the ATM, the borrower chooses the price at which they are willing to lend to the NFT series. Different borrowers can choose different prices, which are then added together to provide instant liquidity to borrowers.
For example, there are three borrowers who want to make loans to CryptoPunk, but the three borrowers have different risk tolerance. Say a CryptoPunk is worth 100 ETH, and you have a set of lenders willing to lend NFTs in varying amounts of ETH.
In the ATM model, borrowers would see a single rate and creditors would share the interest disproportionately so that Borrower C gets most of the return (in exchange for taking most of the risk), with shares of interest distributed tiered to the funds Each subsequent creditor in the pool.
The ATM model provides a collaborative lending strategy through a pool of funds, thereby achieving a lower cost of capital than the peer-to-peer lending market, while enabling each user to independently set their risk profile without the influence of other participants or third-party oracles.
Blur proposes a P2P lending design called Blend, which addresses some of the shortcomings of P2Pool (person-to-fund pool) lending. Blend borrows heavily from the way traditional lending works. It eliminates the need for oracles (which is the case for most P2P designs), and by default these loans have no maturity date. Creditors or borrowers can withdraw at any time. Creditors can initiate an auction at any time in order to sell their position, for whatever reason (such as they found a higher rate elsewhere), and borrowers have a stipulated time to respond with repayments of principal and interest.
If the borrower fails to honor the loan contract, the loan will be taken over by a bidder. If no bidder is found, the creditor takes ownership of the NFT (collateral), similar to how real-life loans work. From the borrower's point of view, if they want to exit, they can repay the loan at any time and cancel the loan contract. However, they must keep an eye on whether creditors initiate the auction.
The CDP (Collateralized Debt Position) model borrows heavily from MakerDAO's design. This type of lending uses a synthetic asset that users can mint against their collateral NFT. JPEG'd was one of the first protocols to introduce CDP lending for NFTs. Just like users can mint DAI by locking collateral in Maker's vaults, users can mint pUSD by locking NFTs in JPEG'd vaults. Borrowers can get their NFT back by repaying the loan (with interest). Collectibles that can be used as collateral are a subset of screened NFTs, meaning users can get instant loans on their NFTs.
Another advantage is that the marginal cost of making new loans is zero. From the supply side, the model is scalable. However, it also has some drawbacks. It requires oracles, which we know are inherently vulnerable to the risk of manipulation. Mandatory whitelisting creates bottlenecks and acts as a barrier to scaling. Finally, only native stablecoins can be minted, which means that projects need to be widely adopted to achieve scale and cannot take advantage of the network effects of existing stablecoins.
NFT Leasing
This model can be thought of as renting a house. When someone leases an NFT, they enjoy all of its benefits during the lease period. At the end of the lease, the NFT will be returned to the owner. Renting NFTs can be used in different ways, as an example, let’s say you need an NFT to play a specific game for a few hours: instead of spending a few hundred dollars to buy that NFT, you can rent it for a small fee and share it with the NFT The owner shares a portion of any capital gains, which is how the rate of return grows rapidly in games like Axie Infinity.
Guilds retain ownership of the NFT, but players use it in-game and generate revenue, which is shared with the guild. This trend could carry over in an ecosystem where NFTs have hot utility features, another scenario that could happen is in Stepn, an app that rewards users for walking in specific shoes. However, (virtual) shoes can be worth thousands of dollars. If you can lease it out to third parties, and share the rewards with them, you will unlock a whole new level of smart contract-driven capitalism.
In the "metaverse" as we know it, there is currently not enough attention to support a large NFT rental ecosystem. Simply put, there is no corresponding incentive mechanism yet, but vanity is one of the areas where it may take off. Say you own a $400,000 limited-edition firearm, like one of the Counter-Strike guns. It stands to reason that a third party will rent it from you and show it off live on Twitch. This assumes, of course, that Counter-Strike is a decades-old brand with an audience of millions, a level that Web3-native games are not yet at.
Another possible area is social clubs. Rather than a single person spending tens of thousands of dollars to access a digitally-heavy community like Foster, multiple people can pay a fee to purchase a single NFT and use it to gain access to the community. An artist's fan club can collectively raise funds to purchase NFT-based tickets that are valid for a season, and individuals in the club can rotate based on who can attend the artist's events. These are all assumptions, and more retail users need to accept these native functions. Currently, we only have the technology and not the users.
Beyond Speculation
In perhaps one of the strangest comebacks in the tech world, vinyl records now outsell physical CDs. the reason is simple. If you stream music from a platform like Spotify, you risk losing all your music if the relationship between the artist and the platform (like Spotify) sours. While Jay Z was trying to grow Tidal (the music streaming platform) into a meaningful business, some of my favorite Jay Z songs were temporarily pulled from Spotify.
Having a physical record means you can continue to listen to music after the platform shuts down. This shows that people want to own assets directly related to their favorite artists. A similar trend can be seen in gaming as well. Recently, a gun in CS GO sold for $400,000, and many of the behavioral patterns we're excited about in Web3 also exist in the traditional realm.
Passing royalties or ownership of digital goods does not necessarily require issuing a speculative token. The user base in Web3 cannot scale because we are often distracted by incentives (tokens) and ignore the importance of attracting and retaining users.
The challenge is that you can't start a functional economy in your application without a sufficient number of users. The assumption is that building secondary products is usually acceptable because customers are like speculators, and incentives (such as tokens) confuse consumers long enough. But in a 4% interest rate environment, I don't think that's going to happen. The industry can only grow by building linkable products that integrate with blockchain technology that is invisible to users, and tools like account abstraction are already enabling users to do just that.
Other technological advances that could speed up the process are also taking place. An example is the recently introduced ERC-6551 standard for accounts tied to tokens. This helps to create a smart contract wallet for each ERC-721 token (NFT). This means that NFTs can own assets and interact with applications. For example, you could play a game where the NFT represents your character. And this character can accumulate tokens in the game as rewards. Therefore, if you transfer NFT, you transfer all the assets accumulated in the game. Or you can buy an NFT that represents an entire portfolio of tokens, like the example shown below.
I've always wondered whether better infrastructure always translates to more economic activity. Ironically, this happened in my city. Dubai has become a global trade hub by improving its infrastructure and developing economic policies that attract entrepreneurs and investors. And they've been doing it for over a century. Blockchains are similar to cities in that they are empty and often generate little economic activity. But reducing fees (monetary policy) and providing tools (infrastructure) can attract developers (entrepreneurs and investors) who want to build applications on these blockchains.
NFTs need an app, just as Pokémon GO did for augmented reality and ChatGPT did for artificial intelligence. Applications such as Axie and Stepn are examples of what happens when an application enables users to easily interact with these cryptographic primitives. But I don't believe that we can only think of two examples, and there is more practical space for NFT.