NFT, or non-fungible tokens, have become a staple of the blockchain industry, and developers have been looking for ways to allow NFT owners to borrow money against the value of their tokens, but do so in a way safe and reliable is easier said than done. To understand the challenges of app lending/borrowing for NFTs and the risk they pose to their lenders, it helps to understand how cryptocurrency lending/borrowing apps work.
Decentralized finance (DeFi) lending/borrowing applications like Aave, Compound, or Maker Protocol allow users (borrowers) to deposit one or more cryptocurrencies and borrow a fraction of their value in stablecoins (cryptocurrencies stable against the dollar) to a lending pool that is provided by other users (the lenders). If the value of a borrower’s collateral falls too low or their outstanding interest payments rise too high, their deposit is liquidated to maintain the solvency of the lending pool, typically by selling the cryptocurrency on a decentralized exchange like Uniswap. The liquidation process is instantaneous, reliable and predictable, and can be done automatically using blockchain smart contracts. Lending/borrowing apps that follow this model can maintain near-perfect creditworthiness even in the most deadly market conditions, making them safe enough for lenders to earn interest on their stablecoin holdings.
The same cannot be said for NFT lending/borrowing apps. Although apps exist to borrow against NFTs, they are a totally different machine from DeFi apps. In these applications, lenders bear a much greater risk, because selling NFTs on marketplaces like OpenSea at a predictable price is a different story than buying them. Liquidity in the NFT market has dried up since the bursting of the NFT bubble, making NFT sales much more difficult. Different approaches are now needed to solve this problem. If an NFT lending/borrowing app pools deposits from its lenders to share risk and reward (as DeFi apps do), falling prices of NFT collections can harm all lenders in the pool. BendDAO is an example of this model, and although it is much more effective at securing lenders, it does not solve the problem of finding buyers to repay lenders.
NFTs require a different design for lending and borrowing
For a lending/borrowing application to be safe for its lenders, it must be able to liquidate its repossessed collateral for an amount greater than the borrower‘s outstanding loan, or shift the responsibility for liquidation to lenders. However, unlike fungible cryptocurrencies which can be sold to multiple buyers, selling a non-fungible NFT relies on finding a single buyer interested in buying the token. If market interest in a particular NFT collection dries up after a loan is granted, then it becomes impossible to find a buyer for that NFT after it is repossessed, and the lender loses everything they loaned .
NFT lending/borrowing apps such as NFTFi use a market-based system where borrowers list their NFTs while lenders scour the market for NFTs they are willing to lend to, bringing the liability for liquidation of NFTs to lender instead of application. This design is easy to build and maintain, but offers little guarantee of receiving a loan for borrowers, as it still relies on finding a single wealthy lender willing to take the risk. However, it is possible for a lending/borrowing application to implement fractional NFTs (or F-NFTs) in its design to distribute the cost, risk and reward of a single NFT to a group of smaller lenders, thereby which could improve accessibility and liquidity. problems in the NFT market.
Secure and efficient NFT lending/borrowing applications are a top priority for the DeFi industry, as they could one day form the basis for decentralized mortgage and lending services. However, NFTs in 2022 are struggling to attract buyers in the open market, making it difficult to attract wealthy lenders willing to risk their money on a potentially bad NFT loan. Building a lending/borrowing application for NFTs that reduces the financial risk for lenders is a major design challenge because NFT are not easy to sell at predictable prices on short notice, and solutions are still being tested.
Source: BendDAO, NFTFi