Watch Howard’s full presentation here:
#ByTheNumbers — The event was a huge success:
- 1827 total registrants for 41 different sessions
- 823 people attended the conference live
- 450+ people have watched the recordings so far
- On average, at least 80–140 people at each session
Recap by @CryptoKeith_
An NFT, or Non-Fungible Token, is essentially any asset that can be traded for a particular value. Thus far, the NFT space has been dominated by jpeg artwork, with some pieces selling for upwards of several million dollars. Needless to say, this is a market rife with promise for borrowers and lenders.
The rise of the NFT market has created unique opportunities across various digital sectors, and these opportunities have made their way into the world of DeFi. This week, Howard Krieger gave a talk at the NFT and DeFi Summit exploring the ways in which NFTs can be used strategically in the DeFi lending space.
Lending and Borrowing — The Basics
Howard began the seminar by explaining the basics of lending and borrowing. He broke down the definition of an annual percentage yield (APY %) and how APYs are determined.
He explained that the equation for calculating APYs is the probability of default multiplied by the loss if default occurs. As he said,
“Interest rates are a function of ability and willingness to pay, and likelihood of recovery in the event of a default.”
The associated risk must be incorporated into the equation for interest rates. There are several types of risks that must be considered.
Types of Risks
Interest rates are figured algorithmically by looking at a number of risk factors which create variance. These risk factors include:
- Inflationary risk, or the risk that the buying power of the principal will decline or increase during the term of the security.
- Interest rate risk, or the risk that overall interest rates will change from the levels extant when the security is sold, causing an opportunity cost or gain.
- Currency risk, or the risk that exchange rates with other currencies will change during the security’s terms, causing loss or gain of buying power in other countries.
- Default risk, or the risk that the issuer will be unable to pay the scheduled interest payments due to financial hardship.
- Repayment of principal risk, or the risk that the issuer will be unable to repay the principal due to financial hardship.
- Reinvestment risk, or the risk that the purchaser will be unable to purchase another security of similar return upon the expiration of the current security.
- Liquidity risk, or the risk that the buyer will require the principal funds for another purpose on short notice, prior to the expiration of the security, and be unable to exchange the security for cash in the required period at a loss of fair value.
- Political risk, or the risk that governmental actions will cause the owner to lose the benefits of the security.
- Market risk, or the risk of market-wide changes affecting the value of the security.
- Event risk, or the risk that externalities will cause the owner to lose the benefits of the security.
In our current system of anonymity, higher interest rates are to be expected. However, interest rates can be lowered by revealing more information about the borrower, thus allowing the lender to more easily assess risk on a case-by-case basis.
As Howard noted,
“If all of the borrowers in DeFi were doxxed and the only thing that was decentralized was the 1’s and 0’s, the interest rates would be significantly lowered since anonymity creates many questions to the risk calculation.”
Using NFTs as Collateral for Loans
One obvious question is, can an NFT be put up as collateral to make a loan?
The answer is yes. In fact, using an NFT as collateral for a loan has advantages over selling the NFT. Selling the NFT is a taxable event, while borrowing against it is not. This can save a significant amount of money and it also allows for you to retain the NFT. However, there are potential consequences for defaulting that include liquidation (the lender taking ownership) of the NFT to pay back the loan.
The use of collateral lowers the probability of default since there is an asset to recover. This means that, depending on the NFT, the use of NFTs as collateral can be an extremely useful strategy if done correctly.
If I have an NFT, how much can I borrow against it?
In determining the value of the NFT, Howard made an analogy to a museum borrowing against a piece of art. In such cases, a museum would typically hire a third-party appraiser, and the same strategy holds true for an NFT.
It is important to note that the appraisal does not work off of the current market price (floor) for the NFT. The real question is, how volatile is the price? It is the movement of the asset price that kills you as a lender.
“Presumably there is market competition, and if you aren’t thinking of the market volatility, the next person will. The person who is taking into consideration the price volatility shall be able to price the loan more precisely.”
An important metric to watch when appraising an NFT is volume of transactions. The lower the volume of transactions, the higher the volatility.
Howard used an example to demonstrate how to borrow against an NFT:
Step 1: Find a DeFi platform that accepts NFTs as supply.
Step 2: Borrow stablecoin from that platform.
Step 3: Invest in TradFi vaults using the borrowed stablecoin.
Supplied NFT: .05%
Borrowed USDC : -7%
Supplied TradFi : 10%
Net ROI : 3.05%
In the example, Howard used reNFT (a project that allows renting of NFTs) to supply a gallery to borrow some stablecoin and then find a TradFi vault (like eRSDL’s ReserveFunding vault) to monetize the NFT.
A supplied NFT earning 0.5%, with USDC borrowed at -7%, and the USDC supplied into ReserveFunding to earn 10%, would come out to an interest rate of 3.05%.
This would allow the user to maintain possession of the NFT while simultaneously profiting 3% overall. It would also allow the user to avoid the capital gains tax that would result from selling the NFT, likely 30–45%.
Deterministic Behavior vs. Stochastic Behavior
Acting as the bank, you don’t want your borrower to be liquidated. You want them to fulfill their loan and pay the agreed-upon interest. The same logic applies in the NFT market, and this will be one of the primary challenges for NFT lenders going forward.
Howard ended the seminar with two valuable predictions for the future lending markets. First, he anticipates credit grading of NFTs. Second, he anticipates DeFi lending rates and APYs to follow the path of finance risk assessment. As he noted,
“The ones who play too risky will not last, and the ones who play too conservative will be priced out.”
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