How Does NFT Lending Really Work? A Deep Dive

NFT marketplace Blur.io launched a new peer-to-peer NFT lending platform, cleverly called Blend, on May 1.

Within 24 hours, it facilitated over 500 loans worth over a total of 5,700 ETH. To put that in perspective, industry leader NFTfi’s daily loan volume was 328 ETH. Within just 3 hours of the launch, the platform’s trading volume doubled from 5,175.99 ETH to 11,010.77 ETH. 

The question on everyone’s mind: How does NFT lending work, and is this sustainable?

Key takeaways

• NFT lending is a way for NFT holders to borrow money using their non-fungible assets as collateral.
• This financing mechanism promises creators and owners new monetization opportunities.
• Market volatility and collateral pricing challenges have historically made it difficult for borrowers to get favorable terms.
• The latest perpetual peer-to-peer NFT lending model is an attempt to make the lending market more competitive for borrowers without exposing lenders to too much risk. 
• Concerns of increased financialization in an already hyper speculative market have many worried that the market will not be able to sustain a rush of borrower demand.

Read more: Peer-to-peer NFT Lending Is the Way to Go, Blur Says in Protocol Launch

How NFT loan platforms work

Prior to the launch of Blend , the majority of cumulative loans borrowed from NFT lending platforms came from 2 models: peer-to-peer lending (NFTfi) and peer-to-pool lending (BendDAO).

There is an endless list of model variations, but they all work to balance the needs of lenders and borrowers in a way that increases economic activity and liquidity in the NFT market. This mission is particularly difficult with NFT-backed loans because of the inherent non-fungibility of the NFT collateral. As a result, loan terms tend to impose higher interest rates on the borrower and stricter collateral health requirements. 

It is a classic chicken or egg conundrum – where liquid markets are needed to support NFT lending and markets need financing to increase liquidity.    

For the purpose of this explainer, we will compare these top models to the latest rivals of perpetual peer-to-peer (Blend) and three actors (Astaria).

Peer-to-peer 

A peer-to-peer NFT lending model is a financial system that enables direct lending and borrowing of cryptocurrencies using unique, indivisible digital assets (NFTs) as collateral.

As the unique quality traits and value proposition of an NFT is by definition indivisible, its appraisal can’t be reduced by the sum of its parts. Peer-to-peer NFT lending models like NFTfi are built on this assumption. They need lenders to individually appraise the value of NFT collateral when offering a loan. 

The borrower and lender then enter negotiation to find the fairest possible terms. This process is inefficient compared to the automation of decentralized lending platforms like Aave – where price oracles are able to reliably measure collateral value and enforce LTV requirements. These user experience expectations have made it difficult for NFT lending platforms to acquire the same level of adoption. Here is a step-by-step guide to how it works with NFTfi :

How NFTfi lending works 

1. Borrowers connect their wallets to the platform and list their NFT as collateral, setting their desired loan terms such as loan amount, duration and interest rate.
2. Lenders browse through NFT collections and propose term offers based on their appraisal of the NFT’s value.
3. Borrowers can review and accept an offer for wETH or a stablecoin transferred from the lender’s wallet.
4. The NFT is then automatically transferred to a smart contract, which holds the asset for the duration of the loan.

NFTfi generates revenue by charging lenders a 5% fee on the interest earned once the loan is paid back. If a borrower fails to repay the loan, the lender can initiate foreclosure. The platform then liquidates the NFT collateral from the smart contract and burns the promissory note, allowing the borrower to keep the loan amount.

Pros and Cons

Pros	Cons
– Both parties can renegotiate loan terms if they mutually agree. – There are no automatic liquidations before the loan expiration date, offering some stability to borrowers.	– Interest rates are typically higher due to the lack of liquidation if the floor price of the NFT drops below the loan amount. – Lower LTV ratios can make the loan terms less attractive for borrowers.

Perpetual peer-to-peer 

The perpetual peer-to-peer NFT model is a lending system that facilitates direct loans between lenders and borrowers without set expiration dates. The model introduced by Blur does not use price oracles to enforce liquidations like the peer-to-pool model. Instead it lets the lender exercise the right to sell the loan in a dutch auction or trigger liquidation when they feel their principal is at risk. The protocol also maintains the borrower’s right to repay the loan and interest at any time.    

The philosophy behind this model maintains the assumption that loan terms of NFTs need to be set individually. A key difference with the peer-to-peer model though, is that lenders make offers on an NFT collection basis instead of an individual case-by-case basis.

How Blur Blend Lending works

Steps for borrower

For borrowers in the perpetual peer-to-peer NFT lending model, the process begins with choosing between two options: “Buy now, pay later” to purchase an NFT, or borrowing ETH directly from Blend using an NFT as collateral.

1. Borrowers connect and fund their wallets, then select the NFT collection and list of items they want to purchase, or the NFT to use as collateral for borrowing ETH.
2. The protocol aggregates loan offers by price and interest rate, allowing borrowers to review their options.
3. They can then select the price they want to pay now for a selected NFT and an interest rate that suits them. Or they submit an NFT and request a loan amount and interest rate through their inventory page.
4. The loan doesn’t have an expiration date; borrowers can pay it off at any time, and lenders can request payment at any time.
5. If a lender requests payment, the Dutch auction style refinancing process begins.

Dutch auction style refinancing and liquidation

Dutch auction style refinancing involves the loan being automatically sent to a Dutch auction if the lender requests payment. In this competitive process, the auction starts at a 0% interest rate and gradually increases until a buyer accepts the offer, with the interest rate climbing up to a maximum APR of 1,000%. If a buyer picks up the loan, the borrower can retain the NFT at the new interest rate, as long as both parties are satisfied. However, if no buyer is found after 6 hours, the auction closes, and the borrower has 24 hours to pay back the loan. Failure to repay the loan within this period results in liquidating the NFT used as collateral.

Loan repayment options:

When it comes to loan repayment options, borrowers have two main choices. They can either sell the borrowed NFT on the platform to automatically pay back the loan plus interest, or they can choose to pay off the loan in its entirety and keep the NFT. In either case, the borrower fulfills their repayment obligations, and the loan is considered closed.

Steps for lender

1. The process starts with connecting the lender’s wallets and funding them with the necessary assets.
2. The lender then chooses the maximum amount they’re willing to lend using a single NFT within a specific collection as collateral. This decision will impact the lender’s Blur Points, a user loyalty rewards system.
3. Lenders then set their desired annual percentage yield (APY) for the loan, keeping in mind that lower interest rates may result in more rewards. 
4. Once their offers are set, they wait for borrowers to review and accept the loan terms. 
5. After a borrower accepts a loan, the lender can close it at any time and claim the interest accrued.
6. If the lender requests repayment, the borrower has 30 hours to pay back the loan. During this period, the Dutch auction style refinancing process may take place to help the borrower find new loan terms, as previously explained.

This system of no expiration dates and collection specific loan offerings have so far resulted in a more efficient market. But to get a deeper understanding into its ability to gain substantial long term market share keep an eye out for our outlook on the model. 

Pros and Cons

Pros	Cons
– Flexibility for borrowers and lenders due to the absence of loan expiration dates. – Dutch auction refinancing can help borrowers find new loan terms.	– Higher risk for lenders since they need to monitor the value of NFTs actively. – The process can be more complex than traditional peer-to-peer NFT lending.

Peer-to-pool 

The peer-to-pool NFT lending model enables borrowers to directly obtain loans from a protocol by using their NFTs as collateral. With platforms like BendDao , anyone can borrow ETH from a pool of liquidity providers. Borrowers can access up to 40% of the floor value of their NFT collateral. 

They can also use these loans to buy NFTs at a fraction of the cost and pay later. First, borrowers use Aave flash loans to acquire the NFT. Next, they leverage the obtained NFT as collateral to secure an instant NFT-backed loan. This loan is then used to repay the initial flash loan.

This model is a departure from the philosophy of peer-to-peer lending platforms. Like Blend, these loans don’t have an expiration date. But inorder to incentivize more liquidity providers, the protocol aims to make the process as passive as possible. Here’s how it works with BendDao.  

How BendDao lending works

1. Borrowers begin the process by connecting their wallets and selecting an NFT to use as collateral.
2. The protocol automatically calculates the loan amount a borrower can obtain by using price oracles to determine the NFT’s floor price. 
3. An algorithm calculates the interest rate based on available liquidity. It increases the rate when liquidity is low to attract more lenders.
4. The protocol also sets a health factor, determining the conditions under which the NFT collateral may be liquidated before the loan’s duration ends.

The process for lenders is intended to be straightforward and passive. They can deposit and withdraw funds from the liquidity pool at any time. No lockups are required. Yield will fluctuate with the demand for lending.  

Pros and Cons

Pros	Cons
– Provides a more streamlined borrowing experience with automatically calculated interest rates and loan amounts. – No repayment deadline offers flexibility for borrowers.	– Risk of collateral liquidation if the health factor conditions are met. – May not be suitable for NFTs with fluctuating floor prices, as it could lead to premature liquidations.

Three-actor model

The three-actor model is a hybrid alternative to peer-to-peer and peer-to-pool NFT lending, incorporating a third party, known as a strategist, to facilitate loan transactions between borrowers and lenders. Astaria was the first platform to implement this model, which simplifies the term agreement process.

How Astaria lending works 

1. Borrowers connect their wallets and choose NFTs to use as collateral.
2. Strategists, acting as third parties, create public vaults designed to attract liquidity, similar to lending pools. However, unlike lending pools that use universal loan terms for every NFT, strategists customize the terms for each collateral.
3. Liquidity providers search for a vault offering terms that align with their investment strategy.
4. When borrowers list their collateral, the strategist employs a set of oracles to automatically appraise the loan and match it to a public vault with sufficient liquidity.
5. Borrowers then select the loan amount, APR, and duration available in the chosen vault.
6. Finally, borrowers review and approve the loan, executing the transaction.

Pros and Cons

Pros	Cons
– Instant liquidity without back-and-forth negotiations with lenders.Option to refinance when better terms become available. – Liquidations only occur after the loan expiration date if the borrower fails to repay the loan. – Liquidity providers can evaluate the risk and return of different vaults, allowing for greater choice.	– The strategist’s involvement adds an extra layer to the loan process. – Success hinges on the strategist’s expertise and efficiency. – As a newer model, it may face challenges gaining widespread use.

NFT lending sustainability concerns

The power of NFT loans are in the eye of the beholder. Like any financing mechanism, it can be used to generate capital and economic activity or to leverage speculative investment. 

At a time when the NFT investing narrative is driven by a trader-first ethos, there is a concern that lower rates will spark a tinderbox of degen flippers starving for momentum. But as with all concerns wrapped in fear and uncertainty, context is needed. 

The NFT market is inherently illiquid and difficult to quantify, so the mechanics of cheap debt play out differently from its more fungible counterpart. It is hard to predict the impact it can have on demand. 

Many prominent creators argue that the NFT industry needs a divorce from price speculation incentives. Instead of optimizing projects for a dwindling audience, they need to build for new use cases in media, physical goods and experiences, gaming and so on. They believe these innovations will attract the audience needed to kick off a new cycle. If this is the case, the NFT market may not need this type of leveraged investing to reach its market fit. 

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