introduce
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Concerns are spreading across the crypto market amid the recent wave of liquidations, from Three Arrows Capital to crypto institutions such as Celsius Network, Babel Finance, BlockFi and Voyager Digital. The market has lost billions of dollars over the past few weeks as digital asset prices plummeted.
The liquidity problem is not only fatal to the development of DeFi, but also to NFT. In this report, we will focus on the liquidity problem of NFT and its solution, not only because it is regarded as the main portal of Web3, but also because it has lower barriers to entry and more diverse use cases.
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This report will cover the following topics:
Briefly describe the current liquidity problem of NFT
Other Ideas for NFT Liquidity Solutions
Summarize
Summarize
What is the liquidity problem of NFT?
Although NFT is active in 2021 and early 2022, compared with DeFi, the level of NFT trading activity can only be said to be good. The top 15 NFT marketplaces account for the vast majority of the global NFT market, yet their combined trading volume is less than 2% of decentralized cryptocurrency exchanges, let alone centers with trading volumes of over $14 trillion in 2021 Exchange.
Data updated on July 6, 2022
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Data updated on July 6, 2022
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Why is there insufficient liquidity for NFT transactions?
fewer buyers
What separates NFTs from fungible tokens is their rarity and utility. NFT investors can easily trade tokens like Ethereum and Sol via DEX/AMM, but the pool of buyers per NFT sale is actually much smaller, so the transaction volume shown above is also relatively small.
Pricing is difficult
Although NFT has a huge imagination in the narrative of "moving" the current physical asset chain, it is still very new to the mass market. The lack of historical data points and widely accepted valuation analysis is a key reason why hype is difficult and pricing is difficult. Due to differences in rarity and subjective opinion, even NFTs in the same series can have wildly different prices. This leads to low liquidity and unsatisfactory capital efficiency.
high price
Not to be sold
Many NFT investors adopt the diamond hand strategy (referring to the strategy of intending to firmly hold stocks or other assets) to invest, and are unwilling to sell their NFT in exchange for immediate liquidity. Therefore, the development of NFT financialization is a hot topic to solve the NFT liquidity problem.
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Existing NFT Liquidity Expansion Solutions
Type A: NFT transactions and value-added agreements
Facilitate NFT point-to-point transactions in a smoother and lower-cost way: 1) NFT market aggregator; 2) price discovery tool; 3) decentralized NFT trading protocol; 4) NFT sharding.
NFT Market Aggregator
NFT marketplace aggregators are perhaps the most compelling of the NFT liquidity solutions out there. An aggregation platform integrates NFT listings in most NFT trading markets and provides NFT investors with unprecedented "vision". Additionally, gas savings of up to 40% can be achieved by allowing users to buy in bulk. Currently, the top three aggregators are Gem (acquired by OpenSea), Genie (acquired by Uniswap Labs), and Flip.
The recent acquisitions of Gem and Genie demonstrate that aggregators are effective front-end tools for individual marketplaces/DeFi pools to acquire user traffic. They also allow for lower gas fees through bulk purchases and reduce headaches for buyers of NFT transactions. However, despite all the hype this year, NFT aggregators are fundamentally similar to Deliveroo/Booking.com in web2, in that they only aggregate information such as NFT listings and pricing, without injecting additional liquidity into the NFT market.
price discovery tool
This type of tool can solve the difficult and highly speculative pricing problems of NFTs to help users make investment decisions. In addition, price discovery lays a vital foundation for the development of NFT financialization. Unlike fungible tokens, whose market prices are easily synchronized, pricing for NFTs is much more complicated, as bid, ask, and realized prices can be quite inconsistent due to their P2P transaction nature.
Currently, there are several price discovery methods:
(a) As in the traditional world, auctions are especially suitable for high-value NFTs. In contrast to the traditional English auction model, a Dutch auction uses a reduced price method, in which the artist and auctioneer notify all potential collectors and collect all their bids before the auction to determine a ceiling price. The auction will then start with a ceiling price and drop by XX% every predetermined period of time until all NFTs are sold at the bid price specified by the bidder.
Auctions are beneficial to NFT issuers, but accurate pricing results can greatly sacrifice market capital efficiency because it locks up bidders' capital, and the sum of these capitals is likely to exceed the value of the NFT transactions purchased by bidders.
(b) NFT oracles like Chainlink can retrieve the lowest prices for NFT collectibles from the blockchain and calculate their time-weighted average price (TWAP). This can provide investors with a reference price range by tracking the average price.
However, its limitation is that TWAP requires huge transaction amounts to be accurate, so it is also vulnerable to oracle attacks and market manipulation.
© A machine learning-driven algorithm could well serve NFT collectibles that are relatively rich in data points, such as rarity statistics and characteristics, as it more effectively leverages quantitative analysis for price prediction.
For example, NFTBank, a comprehensive NFT asset management company, provides price discovery services for more than 1,900 NFT projects. It is powered by a machine learning model whose data inputs include NFT metadata, sales history, feature values, category, sale time, and more.
Another example is Upshot, which has developed specialized machine learning algorithms that can collect historical sales data, secondary market data, and NFT metadata to generate reliable estimates. Using an algorithm, Upshot reprices 270K+ top NFT items every hour, including Bored Apes, Art Blocks, and CryptoPunks.
Since ML-driven algorithms require a large number of data points to arrive at their calculations, it makes more sense for NFT collectibles with rich historical sales data, rare attributes and characteristics, and lower volatility. Investors may find that it is not very accurate for NFT projects that do not have much comparable in the market.
(d) Peer-based evaluation includes 1) human voting/recommendation; 2) behavior analysis and prediction mechanism. Like digital art, the pricing of NFTs is more subjective, making it difficult to calculate quantitative results, so for these types of evaluations, collective judgment may be the more reliable type.
The Upshot project mentioned above also has its own NFT evaluation protocol, which builds a set of data by incentivizing users to provide honest feedback and suggestions for NFT projects. It builds APIs for developers to integrate their data into various projects.
Decentralized NFT trading protocol
OpenSea announced in mid-June that it would be migrating to the Seaport Protocol, an open-source Web3 marketplace protocol designed to safely and efficiently trade NFTs. OpenSea is a step ahead of its centralized DeFi counterparts by launching a protocol that lowers gas fees by 35%, transparently exposes on-chain transactions, and allows other developers to fork.
This move lowers the barriers for developers to build their own NFT marketplaces and transfers transaction data to the chain. It can eliminate the pain points of many existing NFT tool platforms, because they can build their own marketplaces on top of Seaport Protocol, capture value from their existing user base, who usually come to find alpha, and then switch to other marketplaces / aggregator to execute.
NFT sharding
NFT sharding refers to splitting a given NFT into multiple parts that can be traded individually in the market. The process involves a smart contract that divides an ERC-721 token into several F-NFTs or fungible ERC-20 tokens. Since these ERC-20 tokens can be used in the DeFi system and can be valued by the market through AMM’s liquidity mining, it can greatly improve price discovery and liquidity. Another more obvious reason is that it encourages decentralization as it gives ordinary investors exposure to high-value NFT projects.
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Split a CryptoPunk NFT into 100 ERC-20 tokens
One of the most notable projects in this space is fractional.art. You can connect web3 wallet with fractional.art. Buy sharded NFTs as ERC-20 tokens. As an NFT shard token holder, you can participate in voting for the NFT reserve price. The platform has also set up a 7-day auction function, which can be triggered when investors intend to buy all parts of the NFT, that is, own the entire part, so that everyone can participate in the bidding process.
Developed by PartyDAO, PartyBid is an NFT auction platform that supports NFTs on multiple marketplaces including OpenSea. Anyone can initiate a "Party" to contribute ETH to jointly bid for NFT shards. This is achieved through PartyBid's MarketWrapper contract, which provides a common interface to aggregate all NFT bids. PartyBid builds on fractional.art for sharding NFTs of successful bids. Successful bids will be charged a fee of 2.5ETH and 2.5% of the token value, which will be transferred to PartyDAO's vault.
Sharding of NFTs could be the next big thing because of its positive impact on liquidity, but it is not without risks. F-NFTs may raise regulatory issues as they may be considered unauthorized ICOs. SEC Commissioner Hester Peirce warned in 2021 that F-NFTs could be considered securities. Additionally, managing intellectual property and publicity rights can be tricky and complex, depending on the characteristics and type of NFT.
Category B: Passive income for diamond hand NFT investors
As we mentioned at the beginning of this report, one of the key factors causing the liquidity problem of NFT assets is that investors prefer to hold NFT assets instead of realizing their profits. In order to solve the liquidity problem stemming from this behavior, 3 main measures in the existing traditional financial world aim to serve these long-term NFT holding investors: 1) NFT-backed loans/mortgages; 2) NFT transaction flow 3) NFT transaction leasing/loaning.
They both provide passive income streams and increase capital efficiency for NFT investors while providing additional liquidity to the market. It is worth noting that many of the platforms in this category already incorporate solutions under Category A, as they serve both types of measures in various ways.
NFT-backed loans/CDPs
As of May 1, 2022, compared with the global art market with a debt penetration rate of about 35% (US$24 billion / US$65 billion), the NFT debt penetration rate is only 0.5% (about US$250 million / US$37 billion) ), so liquidity is expected to increase as the total market size grows.
There are two types of loan issuers: peer-to-peer (P2P) and peer-to-peer protocol (P2Protocol). Most of the loans are issued through P2P lending platforms such as NFTFi, Arcade, etc. The rest are issued by P2Pool loan providers such as BendDAO, DropsDAO, PineDAO, Goblin Sax, etc.
The total market size for NFT-backed loans currently exceeds $250 million. Due to the higher volatility, NFT lenders can earn higher expected returns than loans backed by traditional cryptocurrencies.
a) P2P lending platform supported by NFT. Two of the largest players in this space are NFTFi and Arcade, with loans issued to date totaling around $240 million. Currently, due to the high volatility and uncertainty of other long-tail NFT projects, these P2P platforms only support blue-chip NFTs.
NFTFi is built on MetaStreet, an NFT lending protocol. It allows NFT owners to borrow wETH or DAI using their NFTs as collateral, and lenders can earn interest by making these loans. NFTFi’s 90-day loans require APRs as high as 1,000%, while longer term loans average 90% APR. Since its inception in May 2020 (as of July 5, 2022), the company has processed 13,363 loans valued at $217 million. NFTFi charges lenders 5% interest income on successful loans (excluding defaulted loans). Some collateralized NFTs include wrapped Crypto Punks (about 29% of loans) and BAYC (23%).
Arcade ($20M) builds on the Pawn protocol and has facilitated about $20M in loans since its inception in 2022. In addition to wETH and DAI, users can also borrow USDC by staking NFTs from a select list. Unlike NFTFi, Arcade charges borrowers a 2% upfront payment at loan inception.
Neither of the aforementioned P2P lending platforms takes any risk and does not rely on algorithmic pricing to scale. Scalability, however, is limited by its customized loan terms, and potentially slow matching, as borrowers have to wait for a counteroffer.
b) Loans backed by P2Protocol NFT
The size of the P2Protocol lending market is still small ($30M-50M). Key players include BendDAO, Drops, Pine, Goblin Sax, JPEG'd and Defrag. Some lending platforms, such as BendDAO, employ voting escrow tokenomics to incentivize NFT holders to provide liquidity in various lending pools. Similar to DeFi liquidity pools, they issue governance tokens to boost lenders’ profits.
In order to solve the problem of slow matching in the P2P lending market, the P2Protocol lending project allows instant liquidity because the matching process is handled by the protocol. But the downside is that automated loan terms require rich data points like real-time price and rarity statistics, thus limiting the liquidity of quantitative attributes that NFT options already have.
Even with NFT-backed loans that are overcollateralized (at least 50%), NFT-backed lenders still take on greater risk due to the higher likelihood of "voluntary" default. When the value of the NFT is less than the loan amount, the borrower forgoes repaying the loan. To mitigate such risks, accurate price discovery, credit risk analysis, and insurance are all important value-added services that many lending platforms have integrated or are actively exploring.
Inspired by NFT market aggregators, NFT-backed loan aggregators and infrastructure could be the next trend as the NFT loan market is still fragmented (especially in P2Protocol). In addition to the MetaStreet mentioned above, Spice Finance is a new project that aims to integrate existing P2Protocol loans into a single platform by integrating various NFT P2Protocol protocols. In addition to this, it has built a machine-learning NFT assessment tool and credit risk system to underpin the comprehensive lending platform.
The biggest risk of this type of aggregator comes from the high degree of integration and composability, because the project inherits all the risks of the underlying application.
NFT liquidity pool
NFT liquidity pools can be divided into pledge liquidity pools and transaction liquidity pools, which are consistent with DeFi liquidity pools. The main difference is that users can mint fungible tokens (e.g. ERC-20 tokens) by depositing NFTs with similar characteristics/base prices into the same liquidity pool. Fungible tokens are representations of any random asset in the pool and can be exchanged. By storing NFT, generating corresponding fungible tokens, and easily exchanging them through DeFi AMM (such as Sushiswap using NFTX), liquidity providers can enjoy faster liquidity time. Besides NFTX, another key platform is NFT20. Since liquidity pools involve the minting of fungible tokens, this type of service is often powered by NFT sharding protocols.
As with DeFi, if an NFT is mispriced, users can arbitrage it, facilitating price discovery. Additionally, liquidity providers typically earn LP tokens and can increase returns through staking. However, given the high volatility and speculation of NFTs, the risk of downside could be a challenge for both platforms and investors.
NFT leasing
NFT leasing can be suitable for a variety of use cases, including gaming, art, PFP, membership NFTs, and more. For example, art exhibits, brands, or events might lease specific digital art NFTs that match them. Or some people want to join a community for a while, they may rent out NFT members for a month (sounds like a subscription to paid content).
Given the size of the Metaverse, the most promising use case for NFT leasing is gaming. Virtual lands are likely to spark a boom because as games attract more users and brands, many owners invest in large amounts of land so that they can rely on them to generate passive rental income from different types of uses. Additionally, in-game assets such as skins, gear, pets, characters, and other items are either necessary for players to play the game or give them an advantage. If players cannot afford or do not want to buy in-game NFTs for various reasons, they will choose to rent them, thereby further improving the liquidity of NFTs.
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The DAO sounds like an organic place for such a market to grow, especially with the aforementioned Seaport Protocol lowering the barrier to entry for development. In addition, centralized NFT markets are also actively exploring community functions. For example, Coinbase’s beta NFT market focuses on creating a social community for buyers and sellers.
Summarize
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All the above liquidity solutions are based on the current NFT market size to solve the problem. In the long run, the fundamental factor driving NFT liquidity must come from the penetration of NFT into various industries.
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