According to A16z’s recent report on the “State of Crypto 2023,” NFT activity appears to be rising as promising new uses and applications emerge. After a frenetic speculative period and subsequent cooldown, NFT purchases are once again showing positive growth.

As the world of finance evolves, non-fungible tokens have emerged as a player in the industry, opening the door to new opportunities such as NFT-backed financing (NFT-fi). 

NFT-backed financing holds the potential to reshape the financial landscape and create new investment opportunities for both traditional and crypto-based institutions. According to the “Non-fungible Token Global Market Report 2023,” this sector — which grew from US$21.48 billion in 2022 to US$32.89 billion in 2023 at a compound annual growth rate (CAGR) of 53.1% — stands as a testament to the significant impact of NFTs on the financial industry. To harness the full potential of NFT-financing, the development of best practices and strong regulatory frameworks as well as the integration of traditional finance principles are essential, to ensure stability, foster trust, and contribute to the sustainable future of the NFT-fi industry.

In this new landscape, crypto-native blockchain engineers, alongside traditional finance veterans, are building protocols to harness the potential capital efficiency of idle NFTs as a means to access instant liquidity and increase the utility of these digital assets.

Demystifying NFT-backed financing

NFT-backed financing, also known as “NFT lending,” is a form of decentralized finance that allows individuals to use their non-fungible tokens (NFTs) as collateral to obtain a loan or line of credit.

In this model, the borrower pledges their NFTs as collateral for the loan, and the lender evaluates the value of the NFT based on its market price and other factors. If the NFT meets the lender’s requirements, the borrower can receive a loan in cryptocurrency or stablecoins. The borrower is responsible for paying back the loan with interest within a specified timeframe. If they fail to repay the loan, the lender may take possession of the NFT collateral.

Unlocking the value of NFTs

Liquidity for NFTs has always been one of the biggest issues in the space, and NFT-backed financing is proving to be an innovative way for investors to access liquidity via the value of their NFT assets. With NFT-lending, users in need of instant liquidity no longer need to sell their digital assets, especially if the market price is low. This approach has several advantages over traditional lending models, including lower transaction fees, faster approval times and greater flexibility. 

As NFT-backed financing gains traction, it can democratize access to capital, foster innovation by supporting creators and artists, and provide a new avenue for investment opportunities in the digital realm.

What’s driving the growth of NFT-backed financing?

Investors are drawn to the burgeoning market’s potential for high returns, as seen in high-profile NFTs such as Beeple’s EVERYDAYS: THE FIRST 5000 DAYS that sold for over US$69 million, former Twitter CEO Jack Dorsey’s first-ever tweet that sold for US$2.9 million, and LeBron James’ legendary dunk that sold for US$208,000. 

These sales back in 2021 propelled a craze for NFTs, and the expansion of the market fueled the growth of NFT-fi. The NFT market has since grown tenfold over the past two years and is expected to continue growing. While traditional illiquid relative to other digital assets, the growing demand for NFTs has popularised liquidity solutions, causing the NFT lending space to expand thirty-fold over the past year.

Understanding the risks involved

While NFT-backed loans offer an opportunity to unlock additional liquidity from digital assets, they also pose significant risks due to the volatility of NFTs. A case in point from 2021 involves an “Elevated Deconstructions” NFT used as collateral for a US$12,000 loan. Initially valued at approximately US$39,600, the NFT’s value surged to around US$300,000 within a month following endorsements from prominent figures like Snoop Dogg. Despite this appreciation, the borrower defaulted on the loan, ultimately forfeiting the high-value NFT.

Such scenarios bring the lend-to-own policy into the limelight, a strategy embraced by some lenders to acquire potentially lucrative NFTs if the borrower fails to pay back the loan. However, lenders also face downside risks — the volatile nature of the NFT market means that the value of the collateral can fluctuate significantly over the loan period due to intangible factors like scarcity and popularity shifts. For instance, the first quarter of this year was a roller coaster in the NFT market, with trading volume seeing a sharp increase peaking at 74,550 ETH on Feb. 22 and declining gradually after March. This market volatility can affect even blue-chip NFTs, challenging their reliability as collateral.

Wash trading in the NFT market further complicates this landscape. Data aggregator CryptoSlam detected over US$577 million worth of wash-traded NFTs related to the NFT marketplace since February 2023 and over US$635 million in NFT wash trades on Ethereum in April alone. (CryptoSlam and Forkast are both part of Forkast Labs.) This malpractice, which would be illegal in U.S. securities markets, involves an investor acting as both buyer and seller to generate more trading volumes and pump up prices, and it extends beyond Ethereum to taint other blockchains such as Solana, Binance, Polygon, Cardano, Flow and Arbitrum. These distortions call for a standardized valuation method, leveraging technological innovations like big data analytics, machine learning algorithms and AI tools to provide reliable and accurate NFT valuation, essential for sound NFT-backed financing.

Borrowers, too, must tread carefully, particularly given the steep interest rates associated with these loans. In 2022, annual percentage rates (APR) reached as high as 302% for seven days on NFT-fi, and loan terms went up to 90 days. Furthermore, just like traditional finance, borrowers also risk damaging their credit scores with loan defaults, potentially making it more difficult for them to secure future loans.

Best practices for lenders and borrowers

Indeed, NFT-fi adoption requires education and awareness to foster trust in NFT-backed financing among potential borrowers and lenders. While regulatory frameworks and robust technological infrastructure will ensure the stability NFT-fi, there is also the need for a set of best practices to ensure the security of NFT-backed loans.

To proactively address risk, here are four best practices for lenders:

  • Diligently assess the value and liquidity of NFT collateral, considering factors such as rarity, demand, and market trends.
  • Evaluate borrower creditworthiness to minimize risk through credit scores and on-chain credit history.
  • Manage risks by diversifying loan portfolios to minimize the impact of market fluctuations.
  • Monitor market behavior closely and adjust lending criteria accordingly to reduce exposure to high-risk assets.

To ensure security, here are four best practices for borrowers:

  • Provide data on past sales, market trends, and potential future demand to give assurance to lenders about the value and stability of their NFT assets.
  • Diversify their NFT collateral mix to reduce reliance on a single asset’s performance, providing a buffer against market volatility and, very importantly, offering a more attractive risk profile to lenders.
  • Present a clear plan for the loan including future income generation to show repayment capabilities.
  • Maintain a healthy debt-to-income ratio and priorities loan repayments in a timely manner.

Well-defined responsible practices can contribute to a thriving NFT-backed financing ecosystem.

Role of traditional finance in NFT-fi

As NFTs and the emerging field of NFT-fi continue to grow, traditional finance principles will play a crucial role in shaping a sustainable future for this market and propelling it forward.

As with any financial product, NFT-fi will need to be designed and managed in a way that minimizes risk for investors. This may involve the use of hedging strategies, diversification and other risk management techniques.

Transparency will be critical for building trust in the NFT-financing market. Investors will want to have a clear understanding of the underlying assets that back NFT-fi products. Pricing, valuation and liquidity will also be relevant for NFT-fi. 

These principles will help ensure that NFT-fi products are priced fairly, accurately valued and have sufficient liquidity to meet the needs of investors.

Democratizing the future of finance

As we navigate the landscape of NFT-backed financing, we must recognize the transformative potential this Web3 innovation holds for the future of finance.

NFT-backed financing is propelling the utility of NFTs by unlocking liquidity, lowering entry barriers and enhancing market efficiency. As a result, it is expected to play a significant role in the ongoing development and adoption of NFTs in the coming years.

While NFT financing is a relatively new concept in the world of finance, the emergence of NFT-based lending and borrowing platforms, allowing individuals to lend or borrow money using NFTs as collateral, provides a new avenue for financing, particularly for those who may not have traditional forms of collateral.

NFT-financing exhibits promising potential to democratize financing and make it accessible to all, underpinned by the traditional finance principles of risk management, transparency and regulation.