NFTs as Collateral
Alice has just finished work for a major client and needs to pay her staff at the end of the month. Unfortunately the client has told her that the payment will be one month late. Alice was relying on that payment as she doesn’t have enough liquidity on hand to meet all her short term expenses.
Bob just sold an NFT and doesn’t need this money right now. He notifies the community about his position and Alice reaches out to him.
Bob will give Alice money now and in one months time, Alice will repay Bob the original amount plus interest. Bob has never met Alice and is aware of the following risks:
- Alice might be a scam artist, her story could be false and she could take his money with no intentions of paying back.
- Alice might be genuine, but if her client doesn’t pay her next month, she won’t be able to repay him. Or worse, what if Alice dies before the repayment date.
Alice has an NFT but she is reluctant to sell it. This NFT has a unique combination of traits that are meaningful to Alice and she knows that if she sells it now, there is little chance she will be able to repurchase it again if the new owner is unwilling to sell it. Also Alice has heard rumours that this particular NFT project is going to be doing an airdrop soon and so the price of the NFT is expected to increase in the coming weeks.
Bob is interested in this same NFT collection but doesn’t have enough liquidity to buy in at the floor price.
Alice is very confident that she will be able to repay the loan in the future and so offers to put up her NFT as collateral to the loan with Bob. Bob agrees as the loan amount is lower than the NFT floor price. Thus if Alice doesn’t repay the loan in time, Bob will receive an NFT at a discounted price that he can either add to his collection or quickly sell at whatever the floor price is going to be in the future.
To facilitate this transaction, an escrow smart contract can be created. Bob will first send the loan amount to the smart contract along with the additional interest amount and the future date it needs to be settled by. If Alice is happy with the loan amount, interest amount and future date, she will send her NFT to the escrow smart contract. The escrow smart contract will then hold onto the NFT and send the loan amount to Alice. If Alice repays the loan amount plus the additional interest before the future date to the escrow smart contract then her NFT will be returned to her. If she doesn’t, the escrow smart contract will send the NFT to Bob.
But this method requires Alice to give up ownership of the NFT and this isn’t ideal as if any airdrop is made during the loan period, she will forfeit it. Also Alice uses this NFT as her profile picture on Twitter and if she sends it to an escrow smart contract, she won’t have the verified hexagon shape and her community will think that she has sold out and left them.
In the future we could see NFTs with new embedded functions that allow the above to occur without the need of an escrow smart contract. The new function could be called Delayed Transfer and will require a price, duration and interest amount.
Bob would then send a Delayed Transfer offer to Alice’s NFT. If Alice is happy with the price, duration and interest then she will accept and immediately receive the price amount. The Delayed Transfer can be cancelled at any time before the end of the duration if Alice pays Bob the price plus interest. If Alice doesn’t cancel the Delayed Transfer before the duration date, the NFT is transferred to Bob.
Alice could also be the one to create the Delayed Transfer offer and set the price, duration and interest amount on her NFT. If Bob is happy with the terms, he can accept by paying the price to Alice now and then wait to see if she cancels the transfer in the future. The Delayed Transfer function also needs to prevent Alice from transferring the NFT to anyone else until she cancels it.
The big advantage of this method is that Alice retains ownership of the NFT and thus gets to enjoy whatever benefits come from holding onto it. Some escrow smart contracts charge a fee for the service and so this method will be cheaper.
Risk Management
The Delayed Transfer function can be used to facilitate a loan agreement where an NFT is used as collateral. It can also be used as a sort of Put Option on an NFT. A Put Option gives the holder the right but not the obligation to sell an asset at a specific price at a specific date in the future. Let’s consider an example.
Cato is worried about buying an NFT for $5000 as he fears the price might drop to zero and doesn’t have the appetite to lose that much money. Cato wants exposure to the NFT project and thinks its price will increase in the future but the most he is prepared to lose is $2000. Cato can purchase the NFT and immediately offer the Delayed Transfer at a price of $3000 with a duration that meets his time horizon and an interest rate that is market competitive. If the NFT project fails then Cato simply keeps the $3000 and allows the Delayed transfer to go through, thus forfeiting the NFT and experiencing a loss that was within his risk limit. If the NFT project is a success then Cato cancels the Delayed Transfer by repaying the $3000 plus the additional interest before the end of the duration.
Alice used the Delayed Transfer function to access liquidity because her cash flows became misaligned due to a late payment from her client.
Bob used the Delayed Transfer function to either get an NFT at a bargain price or make a decent return on his surplus capital.
Cato used the Delayed Transfer function to manage his risk exposure to an NFT project that had a high floor price.
Generally people tend to be more risk averse than risk seeking. The evidence for this is:
1. Insurers are able to charge above the expected loss for a given risk and make a profit.
2. The global stock market has historically outperformed the global bond market and rewarded its investors with a risk premium.
This means that there are numerous potential NFT investors that are aware of the technology and have the capital to purchase them, but aren’t doing so because of their risk averse nature. The Delayed Transfer function allows them to tailor their risk exposure. Cato could have set the delayed sale price at $2000 if he was more risk seeking or $4000 if he was more risk averse. At $2000, his interest repayment would be lower than that of $4000 because of the counterparty’s exposure that needs to be compensated for.
Now if we have a mechanism that is going to make risk averse investors more comfortable, then more investors are going to get into the NFT market and basic economics tells us that this will put considerable upward pressure on the price, so in my opinion it is only a matter of time before risk managing functions get embedded into the next generation of NFTs. Because Yes, you can use an escrow smart contract with the NFT as collateral, but currently that means giving up ownership and losing the benefits of holding that NFT for the given duration.
And yes, more functions will increase the gas price of interacting with NFTs but that is where the next generation of blockchain technology like Polygon, that is so much cheaper than Ethereum, comes in and saves the day.
If you want to learn more about NFTs and the financial dimensions to them, follow me here and on Twitter where we will continue to explore this new and exciting technology.
