Collateralized NFTs and Stablecoins: Solving Decentralized Finance

In the traditional financial world, assets are routinely bundled and securitized, before being sold to investors. As NFTs garner more press and investor attention, they’re also being worked into another emerging business sector: DeFi. As that happens, there will be a move to develop ways to generate returns on the value NFTs represent, through DeFi and otherwise; and NFTs will become part of the solution to a problem that plagues decentralized finance, that of determining an adequate level of collateral for loans. 

As this happens, we will also see the emergence of a new class of stablecoin funded by pooled NFT assets.

In fact, all these processes are easy to predict because they have already begun.

Before we start looking to the future, we should define some terms and catch you up if you’re not familiar with NFTs, ABSs and the language of securitization. We’ll start with NFTs.

What’s an NFT?

We did a post about this that goes into some depth, so I don’t want to get super into it here; check that post out if you want more details. NFTs are Non-Fungible Tokens, blockchain-based tokens for assets that aren’t interchangeable, like artworks or real estate.

They’re currently being used mostly for selling and buying digital artworks (we just did a pretty good post about that, too) but they have enormous potential beyond their current use cases. We think they’ll be integrated into the developing digital assets and crypto economy in ways that haven’t yet been considered, but we also foresee them being a perfect vehicle for the entry of collateralized backed asset types into the digital asset space.

Let’s look at what collateralized backed assets are, then come around to the NFT use cases. (If you already know everything you want to about ABS and CDOs, feel free to skip ahead!)

Collateralized backed securities in the traditional financial world

Asset backed securities are, on the surface, a security backed by one or more assets. In practice, it’s more complex than that. We’ll look at some of it to make the later part of this post, which deals with collateralized backed NFTs, make sense. 

Asset backed securities, also known as asset backed bonds (ABS) are bonds backed by financial assets — debts, in other words. The asset pool is usually a group of small or illiquid assets that would be difficult to sell by themselves, but banks that hold them can pool them into financial instruments that are much more tempting to investors. It’s the process of pooling these assets into a package that constitutes securitization.

Asset backed securities can be based on assets including credit card receivables, mortgages, student loans, car loans, trade receivables, and even equipment lease income, intellectual property royalties and movie revenues. 

Some ABS are issued directly by the originating bank, in which case it simply packages and sells them to investors. However, there’s another variation on the ABS, known as a CDO — a Collateralized Debt Obligation which is structured slightly differently.

Creating a CDO

When they’re created, the originating bank usually sets up a separate company, referred to as a Special-Purpose Vehicle, which handles the process of securitization. This company creates and sells the asset-backed security and uses the income from that sale to pay back the bank that originated the underlying asset.

This is done for various reasons. Chief among them is to maintain distance between the issuing bank, such that if there are any failures of the securities over time they remain separate from the performance and credit results of the bank that created them. 

Let’s briefly walk through the process of setting up one of these.

First, a finance company that has made a lot of sales on credit and has a large pool of receivables wants to turn a long, slow income stream into a shorter, larger one. So they set up an ABS. The job of the ABS is to connect the customers who owe the finance company money with a company that wants to purchase the right to that income stream.

So it creates an SVP, which purchases the assets generating the receivables from the finance company, packages them, and sells them on to investors; as the receivables from those assets come in, they’re passed on to the investors. Sometimes there’s also a ratings agency involved, which checks on the quality of the assets for the investors. Sometimes, there’s a trustee appointed to manage the SVP and ensure that everyone is treated fairly. In some cases, a financial guarantee provider is also involved. However, the main purpose of the SVP is to hold the assets and ensure they’re separated from the originating bank, while ensuring they are available to investors.

The pools of assets are packaged into a tradable instrument whose value depends on the performance and cash flows of the underlying pool of individual assets. Once the assets have been packaged and transferred to the SPV, the originating bank can remove them from its own balance sheet, receiving cash in return. 

There are interactions with the rest of the financial system that don’t need to concern us here, but this is the basic flow for asset-backed securities. 

Profiting and trading with CDOs

CDOs in the traditional financial world are largely the preserve of institutional investors who are looking for ways to balance timed income flows and risk exposure — concerns they typically don’t share with smaller-scale and retail investors, who usually don’t have access to them. 

But smaller investors can still profit from CDOs by exploiting the valuation difficulty that can come with low liquidity. When assets aren’t moving, it becomes more difficult to accurately value them. When complex assets, composed of multiple underlying assets, have periods of low liquidity, valuing them becomes a skilled business and one in which day traders can generate significant returns by shorting — if they are accurate.

Risk tranches maximize

Tranches, from the French word for slice or portion, are sections of a pool of securities that are divided up by criteria like time to maturity and risk, so they can be sold to different investors. Risk tranches are among the most common forms of tranching, and divide securities by the level of risk they carry. Typically, investors who are more risk averse will opt for a tranche offering a lower, but more certain, return; others will seek to maximize returns at the risk of potential losses.

So how does this relate to NFTs?

NFTs are proof of ownership — just the same way a stock certificate is, except that they’re more secure. They’re also tradable in secondary markets; you can buy an NFT and then treat it just like any other token, trading it across multiple exchanges or simply holding on to it. You can ascribe any asset or group of assets to an NFT. They can facilitate loans — and the NFT loan can then be instrumentalized just like an ABS.

Let’s start with the NFT loan industry.

NFTs meet DeFi: the emergence of NFT loans

DeFi is Decentralized Finance; the nascent blockchain-based financial services industry. NFT loans are the most recent addition to a space that includes yield farming and high-speed multiple-token currency speculation, and that has grabbed headlines for its ability to generate real yield for investors.

NFT loans aren’t loans of NFTs; they’re loans based on the value of NFTs. Mason Nystron, writing in Messari (paywall), points to NFTFi as an example of the growing business case for NFT loans.

Launched in May 2020, NFTfi is a platform that lets its users deposit their NFTs as collateral and get a loan based on them, denominated in ETH. 

Right now, NFTfi is small with just 60-some users when Nydstrom wrote it up, and compared to the giants of crypto it’s financially small too. However, it’s indicative of where the space may be headed. It’s in an increasingly crowded company.

Niftex, a platform that makes fractional ownership of NFTs possible, is reworking its platform to offer an enhanced feature set that includes allowing creators to earn royalties on trades of fractions, granting governance of the underlying NFT asset for fraction holders, and other tools that permit more fine-grained forms of ownership. 

Charged Particles is a protocol aimed at letting users wrap or embed any NFT in a range of ERC 20 tokens. That means it could be wrapped in interest-earning tokens like Aave, helping to associate risky NFTs with a known source of value. It also means mating a non-fungible token to a fungible token, which is new in the crypto world.

Here’s where we’re seeing serious innovation aimed at extracting maximum value from NFTs and tying them into the wider crypto finance ecosystem.

DeFi loans and NFTs

Lending is a key part of any financial ecosystem, but there’s a balance to be struck between low-cost access to money and security. Right now, DeFi errs on the side of caution; partly because crypto can see sharp swings in value, most DeFi loans are collateralized at around 150% or even higher. 

This means borrowers would need to provide $150 worth of assets to borrow $100.
It does mean that the system is more stable, but it also imposes sharp limits on growth, dissuading new participants from joining a system reliant on peer-to-peer interactions.

However, the instability in prices of key cryptocurrencies, particularly ETH and BTC, mandates higher collateralization than in the traditional financial system.

NFTs provide a solution to this problem. NFT value is far more stable than crypto value, meaning a lower nominal value in assets can be staked as collateral. That’s how Rocket operates.

An NFT loan platform, Rocket recently issued a loan of 20,000 DAI — its largest loan ever as of March 2021. That’s interesting for two reasons. First, the loan was denominated in a stablecoin; DAI is pegged 1:1 with USD. Second, the collateral on the loan was an NFT: real estate on Decentraland property valued at $100,000. NFTs don’t just have the potential to solve the collateralization problem facing DeFi; they’ve already started doing it. Stablecoins are a crucial part of the solution.

CDOs in the NFT world

The DeFi world moves fast. Opium Protocol has already created collateralized debt obligations (CDOs) for DeFi, offered through Compound Finance’s automated lending markets. 

The development allows investors to put up the Compound debt token cDAI and reintroduces the risk tranching that traditional CDO investors are already familiar with. Compound tokens, also known as ‘cTokens,’ are created by smart contracts also known as ‘asset gateways’; when users deposit tokens into Compound, they receive cTokens which are ERC 20 tokens that represent their lending or supply balance, along with any interest. cDAI is pegged to DAI at 50:1, so 50 cDAI is 1 DAI.

Opium offers two tranches, senior and junior. 

Senior tranche participants can expect a fixed 7% return on their cDAI at maturity; if actual earnings are above 5% they will be allocated to the junior tranche, and if they’re below 5% they receive compensation from the junior tranche.

Junior tranche participants receive all the interest that remains after paying 5% to the senior tranche. It’s a smaller, riskier pool with a better chance of high rewards — and a risk of loss too.

CDOs have come with some downsides in the past. Bundling the underlying assets has sometimes made them opaque and led to inflated valuations – which was a key factor in the 2008 subprime mortgage crisis. However, blockchain-based assets like NFTs are inherently transparent. The record of purchase and ownership is publicized, secure, and immutable. So accurate valuations based on future trading value of collateralized backed tokens might still be challenging, but an accurate idea of the value of the underlying assets is much easier to get. 

Collateralized backed stablecoins

Currently, stablecoins come in three ‘flavors,’ depending on what they’re stable in regard to.

Fiat-backed stablecoins are backed by a fiat currency. They’re necessarily centralized and pegged to an asset whose future value is still somewhat uncertain. The value of the US dollar, for instance, fluctuates less than that of BTC — but it still rises and falls sharply.

Crypto-collateralized stablecoins are backed by a crypto asset, or even a portfolio of crypto assets. They’re essentially a loan against the underlying assets as (usually) ERC 20 tokens. They’re subject to the same over-collateralization issues as other crypto loans, which tends to stifle liquidity and makes them less attractive to investors.

Non-collateralized backed stablecoins are algorithmically backed with expansion and reduction of coin supply being mathematically determined, and with no collateral backing the issuance — in a mechanism that looks much like conjuring money out of thin air, and strongly resembles the process for fiat currency issuance.

However, NFTs offer scope for a new type of stablecoin, one collateralized by a pool of NFTs with known value that isn’t likely to change. These NFT-backed collateralized stablecoins could be collateralized at a lower percentage than the current generation of crypto-backed stablecoins, without involving fiat currencies at all — and while maintaining the decentralization, security and transparency of the blockchain. 

The process of creating such coins has already begun; this is Opium Protocol’s business model by another name. But there the emphasis is on the loan itself; soon, collateralized backed stablecoins will find their place in the token ecosystem as a price-stable, reliable currency and value token in secondary markets and exchanges.

Conclusion

The crypto loan is an infancy industry, but we already see some key trends. One is familiar from across the crypto world: it will take what it needs from the traditional finance world, transfiguring traditional finance in the process, and use it in ways that make sense in a decentralized, transparent, and rapid ecosystem. So the appearance of CDOs on the blockchain isn’t a big surprise. 

Another is that crypto brings its own unique set of challenges. The requirement for overcollateralization is one of these. Without removing this liquidity roadblock, it will be difficult for the DeFi loan industry to access its potential — a potential which is growing by the day as the whole digital economy attracts increasing investment and interest from the institutions whose large, stable investments underpin the traditional financial system.

We think there are good reasons to foresee that NFT-backed securities will become a popular investment vehicle, solving the over-collateralization problem and offering solutions suitable for all types of investors. 

Not stopping there, we also see the development of new tokens based on collateralized NFTs, ones that combine the known benefits of stablecoins with access to the assets and liquidity of the burgeoning NFT world. This is where experienced stablecoin design and issuance businesses will enter the workflow. We can expect to see this happening very shortly. Remember, the first NFT sale was only 2017…