NFT Backed Loans Are Crashing the NFT market

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Avatar for Govawaya
9 months ago
Topics: NFT, Bank, Earn, Bitcoin, Bull Market, ...

Do you ever wonder how anybody affords all these fancy NFTs? Sure, the price of iconic NFTs like BAYC, Crypto Punks and even the much-hyped Goblin Town have dropped dramatically since the peak earlier this year. The fact that people were paying hundreds of thousands to own these pieces of digital art is mind boggling. Where did they get that kind of scratch? It is easy to assume that they were just splashing their crypto after getting in early, but turns out there is another way to finance these digital beanie babies. Enter the world of NFT lending.

NFT lending…what’s that?

Turns out that the world of financialisation caught up with NFTs fast. You see, NFTs are not as easy to trade as crypto. With Bitcoin, you can sell it pretty quickly and get some fiat to pay for whatever else you need out there in the real world. NFTs are different. They are NON-FUNGIBLE. This means they are unique, not every NFT is the same. You must list it for sale and hope that somebody loves your monkey character, pixel punk or goblin as much as you do…or did. This means you could be sitting there hitting refresh on your auction for a while. To solve this problem, financial tools have been made available that let you use your NFT as collateral, and security for a loan. It’s like going to the bank and asking for $100,000. The bank will give you the money, but they will want to some assurance that if you don’t pay it back, they can take something you own and cash it in for themselves to get their money back. NFT lending works the same way.

By putting your NFT up as collateral, you receive crypto which you can either use to purchase more NFTs, hold or exchange for fiat and hit the town. Of course, not every loan is the same. Some assets are safer than others. Houses for example, are considered pretty safe… ‘safe as houses’ they used to say until the 2008 GFC hit and turned the housing market upside down. Well, it turns out that NFTs aren’t the most stable investments either.

As we have seen over the last few months, the broader crypto market is having a bit of a financial meltdown of its own. The Ethereum floor price of the BAYC NFT collection has dropped to the lowest point this year. The floor price is basically the lowest price point that a BAYC NFT will sell for. As the price has come down, the collateral held by the bank as security for the loan becomes worth less and less, which means if you want to continue to hold the loan, you will need to find more security. If the bank decides that the value of the security is worth less than the loan, they will force a sale. This is known as liquidation, and it helps protect the bank from having assets worth less than what they have lent out. If those assets are worth less than the value of the loans and those loans default, the bank can go under. This is bad news for anyone who had their funds stored in these banks.

The BendDAO liquidity crisis

This brings us to the case of BendDAO. BendDAO is like a decentralised bank. More accurately, it is a Peer-to-Peer lending service. Customers can take out loans for ETH by using their NFTs as collateral, up to 40% of their floor price. NFTs are given a health factor which is defined as a “numeric representation of the safety of your deposited NFT against the borrowed ETH and its underlying value.” If that health factor happens to drop below 1, the NFT is put up for auction over the course of 48 hours. The highest bidder will receive the NFT if the borrower defaults. Now here’s the kicker — there are currently 72 BAYC NFTs dangerously close to slipping below 1, with health factors hovering under 1.2. In plain terms, if the BAYC falls a further 17% and those loans are unable to be repaid, those 72 NFTs are up for auction. Combine this with the fact the BAYC floor price is down 57% from its all-time high recorded in May, and 2.57% of the BAYC collection linked to BendDAO, there could be further pain on the way for the NFT market.

Preventing a market crash

BendDAO obviously wants to make sure this doesn’t happen, so they have come up with a plan. Being a DAO or decentralised autonomous organisation, they put a proposal to their community members. The proposal was to reduce the liquidity threshold to avoid a massive sell off. Instead of NFTs being liquidated at 85%, the new liquidation threshold would be 70%. Other measures included reducing auction time from 48 hours to 4 hours, reducing loan interest rates from 100% to 20% and removing the condition that the minimum bid be 95% of the floor price. This is all in the hope of preventing an NFT market crash. The proposal was popular in the community and has since been passed, with over 97% of voters in favour of the new improvements. Crisis averted!

Is NFT lending worth the risk?

Why use NFTs for collateral at all? Ask any economist and they will probably tell you the idea is ridiculous and bound to burn lenders, investors and borrowers alike. The truth is, we are still learning how to use these digital assets and mistakes are going to be made along the way. NFTs got swept up in a lot of hype over the past two years and when any financial product is hyped, it doesn’t end up well. We have learned this lesson over and over for the past five hundred years since modern capitalism began and we will most likely keep getting schooled for many years to come. This isn’t to say that using digital assets for security on a loan is a bad idea. We need to better understand the risks before exploring the world of DeFi and know that there are no guarantees, especially when the market is running red hot. Never invest, borrow or lend what you cannot afford to lose.

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Avatar for Govawaya
9 months ago
Topics: NFT, Bank, Earn, Bitcoin, Bull Market, ...