Understanding NFT Financialization in One Article: Making Non-Fungible Tokens “Fungible”

Written by: Dmitriy Berenzon, Research Partner at Cryptocurrency Investment Fund 1kx Translated by: Li Ke

While non-fungible tokens (NFTs) have been around since early 2018, they were initially used by a handful of cryptocurrency enthusiasts for fringe use cases, such as collecting digital cats. Three years later, we’re seeing artists, designers, game developers, musicians, and writers begin to adopt the technology.

That's because NFTs, like Bitcoin and decentralized finance (DeFi), are a financial, social, and political movement. They make it possible to confirm the ownership and provenance of digital content, and allow people to purchase this content from creators around the world with instant value transfer. This movement is particularly driven by individuals from industries or regions of the world that have difficulty directly monetizing their work.

To some extent, we are still far away from widespread application of this technology and far from realizing its full potential.

The first phase of the technology application is to tokenize off-chain and on-chain media assets. The second phase will use DeFi protocols to finance these assets to improve their value proposition and apply them to new application scenarios.

In this article, I will discuss why DeFi protocols are beneficial for NFTs, describe several financial use cases that utilize NFTs, and explore the future prospects of NFT assets.

DeFi is the rocket fuel for NFTs

Financing NFTs through DeFi protocols solves many of the problems NFTs face today, especially:

Accessibility

Because NFTs are unique by definition, buyers often need to have expert knowledge of a specific asset in order to make an informed decision to buy or sell it. In addition, the scarcity of a unique asset can quickly drive its price beyond what buyers can afford.

These two factors increase the entry barriers for new buyers to enter the market and hinder the value accumulation of NFTs themselves; since part of the value of NFTs comes from their underlying communities, access to long-tail buyers is restricted, making it difficult for NFTs to penetrate the entire Internet. DeFi protocols can reduce the capital and knowledge requirements for participating in the NFT market and open the floodgates for a new wave of retail users.

Liquidity

A liquid market with buyers and sellers of a specific NFT leads to better price discovery because it increases the speed at which NFTs are traded on the secondary market - i.e. the more they trade, the stronger the perception of the fair market value of the NFT becomes. This makes it easier for sellers to profit from their work and makes it easier for inexperienced buyers to enter new markets because they can more easily exit their investment if they wish.

Utility

Confirmation of ownership and traceability are important attributes of NFTs, which are fully realized by permissionless encrypted networks, but their value proposition has not yet fully resonated with retail investors. The rich and powerful utility of DeFi protocols, such as accessibility to cash flow, content, and experience, will attract more mainstream audiences to purchase NFT assets.

DeFi and NFT synergies

There are many good use cases that combine DeFi and NFT:

Collateral

Banks have been offering loans secured by traditional art since the 1980s, and it’s big business: Deloitte estimates that the value of art-secured loans was $21 billion to $24 billion globally in 2019.

One can do the same with NFTs by providing non-recourse loans for digital art, collectibles, virtual spaces, and other content. The Rocket project experimented with this in early 2020, and the NFTfi* project is building a two-way market on Ethereum that supports NFT lending. However, these are still early days, and NFTfi currently has about $2.5 million in loan volume.

Accepting NFTs as collateral in lending protocols increases the utility of NFTs to their owners while increasing the economic activity of the protocol, which is a win-win.

An important related component is pricing, which is a broader issue for NFTs, but is particularly important if these assets are to be used in a financial context. In the absence of secondary market trading, especially during liquidation activities, appraisals may be required to estimate the value of NFTs. Appraisals through licensed appraisers or informal venues such as pawn shops are a widely used practice in traditional art and collectibles markets. The Upshot project does just that, crowdsourcing asset valuations for NFTs by incentivizing network participants.

Crowdfunding

ICOs are the first killer app on Ethereum because the platform is ideal for global capital formation and distribution. This use case also applies to NFTs. Users from all over the world can invest in creative works at different stages of their life cycle, which could lead to a renaissance in digital art and provide new business models for various content creators.

For example, an author named Emily Segal raised about $50,000 (25 ETH) for her next novel by giving away 70% of the work in the form of NOVEL tokens, which represent fractional ownership of NFTs. If the NFT is sold at a higher price on the secondary market, the holders of the 104 NOVEL tokens are entitled to a pro-rata share of the profits, as well as other benefits, such as being mentioned in the book’s acknowledgments.

Source: Mirror

Owning written content can also offer publishers a new business model. For example, an NFT of a New York Times column recently sold for $5.6 million, which could have been much more than the company would have earned from advertising on the article.

cooperative

In the traditional business world, a cooperative is a company that is jointly owned by its members, who usually need to contribute capital to join. Decentralized Autonomous Organizations (DAOs) are similar cooperative organizations in crypto, and have become the standard way to govern DeFi protocols. DAOs will be even more important for NFTs because the assets and communities formed around them will increase by an order of magnitude.

These “collector co-ops” have caught our eye because they allow groups to invest in NFTs that would be costly for any individual to buy. The DAOSaka project experimented with this in late 2019, and the FlamingoDAO project is doing this today, both raising funds from individuals and collectively deciding which NFTs to buy and sell. Collector co-ops can form spontaneously and grow organically. For example, PleasrDAO initially raised funds to buy a specific NFT, then later expanded the scope to buy an NFT from Edward Snowden for $5.5 million. In both cases, the DAO won the auction by outbidding a single wealthy buyer.

Economic sharing

Public provenance records can enable use cases that were previously impossible or difficult to achieve, such as royalties for artworks and other assets sold on secondary markets.

Rarible* and SuperRare implement royalties at the market level with varying degrees of flexibility, while Zora implements royalties at the protocol level by extending the ERC-721 standard to incorporate optional “creator fees” into the NFT itself. Mirror implements royalties through an application layer with a “share” feature that enables authors to distribute a portion of the economic value to others every time a work is sold.

Royalties may apply to content beyond digital art and music. For example, the rebellious dance on TikTok made Charli D'Amelio an overnight celebrity. While both Charli, who now has over 112 million followers, and TikTok benefited financially, the person who created the dance, a 14-year-old girl named Jalaiah, received no recognition for her work. NFTs can solve this problem by providing the ability to tag such content and provide creators with a share of the profits when it generates revenue. In the future, athletes, dancers, photographers, and other creators will be able to issue their works directly through NFTs to receive compensation and rewards for their work.

Economic shares can also be distributed to multiple and specific NFT owners through programs. The Planck project recently experimented with a concept: publishing the results of scientific research as NFTs and will deploy a feature called "divergence" that allows NFTs to distribute part of their future sales revenue to NFTs that have been cited or used.

Source: Matt Stephenson

In academia, this aims to create a social graph of citations to scientific papers, incentivizing and funding academic research by making tiered payments to the owners of these NFTs in perpetuity.

trade

The ability to trade between NFTs is important because it improves liquidity and enables price discovery by opening up a range of potential trading pairs, but this functionality is difficult to achieve due to the illiquid design nature of NFTs.

The 0x protocol first addressed this problem in 2019 with ZEIP-28, which enabled NFT-to-NFT trading by enabling buyers to use another NFT as a fee token in a trading pair to pay for the NFT, but this still required the buyer to specify the NFT to purchase. 0x later deployed asset-based orders, which enabled buyers to create offers to buy any asset with a specific set of properties. In effect, this liquidity is based on certain properties (but liquidity is still fragmented for a given type of NFT).

Other solutions attempt to facilitate trading by leveraging an intermediate fungible ERC20 token. NFT20 achieves this by minting an ERC20 token that each represents a different type of NFT, and aggregating these tokens based on their type. These NFT types can then be traded across multiple pools using CFMM routing with a common unit of account.

For example, if there is a MASK20/ETH pool and an MCAT20/ETH pool, users can directly swap MASK for MCAT on Uniswap. This solution is particularly useful for collectibles with a small number of valuable assets and a long tail of low-value assets with well-understood floor prices.

Additionally, due to the atomicity of Ethereum transactions and the composability of DeFi protocols, developers can link together multiple intermediate tokens and liquidity pools in a single transaction to enable transactions across multiple NFTs.

Decentralization

Decentralized ownership is an effective way to democratize access to assets and has historically been used for high-value assets such as vacation properties. Otis approaches traditional art and collectibles by purchasing assets, storing them in a vault, and issuing tokens that represent ownership of those assets.

The NIFTEX* project also applies this approach to NFTs. It allows the owner of a specific NFT to deposit the NFT into a smart contract and issue "Shards" ERC-20s tokens representing the asset. The underlying NFT can be redeemed by acquiring all "shards" tokens or through a buyout clause.

It’s also possible to split ownership of a basket of assets into several parts. Metakovan did this with the B.20 token, which consists of 28 assets, including crypto art and Cryptovoxels from Beeple, digital plots in Decentraland and Somnium Space.

Index Funds

Index-based investing in traditional financial markets has surged in popularity over the past decade as it offers a transparent and low-cost way to achieve diversified investments across a variety of markets.

Similarly, NFT-focused index funds can give investors exposure to a specific category of NFTs without requiring them to evaluate a specific NFT.

NFTX achieves this by creating index funds for various collectibles (such as Cryptopunks), where each fund is backed 1:1 by the underlying NFT. For example, a PUNK-ZOMBIE ERC20 can be redeemed for a CryptoPunk from the pool at any time.

Index funds focused on NFTs can also improve liquidity and price discovery of the underlying NFTs by attracting more users and more user demand.

Rent

Sometimes people want to rent rather than buy, and the art world has accepted this fact for decades, with the Museum of Modern Art, for example, having rented its art since 1957. Art and collectors gain an additional revenue stream, while renters enjoy expensive art at a fraction of the price.

Source: Ottowa Daily News, March 15, 1980

This model can also be applied to NFTs such as art and digital land. The ReNFT project is trying to do this through a peer-to-peer market for NFT rentals. Like most DeFi protocols, this is currently an overcollateralized solution. Borrowers can rent NFTs by depositing collateral equal to the market value of the NFT and paying additional rent. That said, the EIP-2615 proposal is making improvements at the protocol level, which supports the rental function of the ERC-2615 token itself and no longer requires a deposit.

Yield Guild Games has a slightly different model in the gaming environment, lending Axies (virtual land and equipment) to new players in exchange for a share of the SLP token rewards that gamers receive in the game. In effect, players are renting Axies with a portion of their future earnings from playing the game.

Synthetic

Synthetic assets are financial instruments that simulate other instruments. Although most NFTs today are not true financial instruments in the traditional sense, the concept can still be used to enhance the liquidity and market access of these NFTs.

One of the problems with minting NFTs on multiple blockchains is that it becomes more difficult to purchase the asset. Additionally, there may be a group of buyers who only want to speculate on the price of an NFT, rather than actually own it. For these users, there is an opportunity to provide synthetic price exposure to specific NFTs. For example, one could use a price oracle to provide Ethereum users with price exposure to the NBA Topshot asset on Flow.

That is, some NFTs (such as Uniswap V3 flow pool shares) are actually financial instruments. From this perspective, multiple flow pool shares can be combined to replicate the income structure of various types of derivatives.

The Future of NFTs

Over time, we will see more unique, complex, and interconnected cryptographic mediums that will leverage multiple DeFi protocols to achieve value propositions and use cases that are not possible in the traditional world. These design patterns can be, but are not limited to:

Bundling: Index Coop* can provide users with an easy way to gain exposure to a wide range of NFTs by creating an equally weighted index of the AXIE, MASK, and PUNK index funds from NFTX (since they are already ERC-20s).

Decentralize + Bundle: Subdivide 1 unit of Axie, Catalog, Cryptopunk, and Sandbox* virtual land into 100 ERC-20 tokens each, and deposit 25 tokens of each asset into Charged Particles to mint an NFT representing a diversified basket of decentralized assets.

Synthesis: Multiple NFTs can be synthesized together, or functions and value can be added to existing NFTs. The AlchemyNFT project achieves the latter through AutographNFT, which implements the function of signing existing NFTs through digital signatures. Punkbodies is doing the former, which allows users to merge their CryptoPunk (an ERC-721 token) with PunkBody (also an ERC-721 token) to create a new Punkster token that can be downloaded or minted. Locking the original ERC-721 token to mint a new Punkster NFT, users can destroy the synthesized NFT to unlock the original token. These newly synthesized NFT tokens inherit the traceability and utility of the original tokens, while adding new features or utilities.

Source: Bankless

Over the next few years we’ll see a flurry of experimentation around these concepts, and it’ll be exciting to watch how developers, creators, and communities work together to make this a reality.