What is NFT lending, and how does it work?

NFT lending explained

NFT lending allows NFT holders to take out loans against their assets. It has grown in popularity as a way for investors to unlock liquidity and access borrowing. 

Nonfungible tokens (NFTs) can be bought and sold, held, or traded, and they are also now part of other decentralized finance (DeFi) arrangements, including NFT lending. Demand for NFT lending has risen in part because the nonfungible, or unique, nature of NFTs makes them difficult to utilize in other DeFi sectors. For instance, it’s not possible to stake or yield farm NFTs in the same way investors can with fungible cryptocurrencies.

There is less liquidity in the NFT market when compared with cryptocurrencies like Bitcoin (BTC). This is because NFTs can be completely unique, and it can take an owner a long time to find an interested buyer for an NFT.

NFT loans allow NFT owners to unlock liquidity, access borrowing and diversify their portfolios. However, NFT loans also carry risks because of price volatility, regulatory uncertainty and other factors. 

There are several types of NFT lending: 

Peer-to-peer NFT lending

In peer-to-peer NFT lending, NFT owners use a platform to list an NFT as collateral to receive loan offers from other users. 

Peer-to-protocol NFT lending 

This refers to NFT lending directly from a DeFi protocol or platform. Borrowers collateralize NFTs by locking them into a protocol’s smart contracts.

Nonfungible debt position

In this method, a unique asset is created on the blockchain by a platform or provider representing a nonfungible debt position (NFDP) as a transparent record of a loan agreement. An NFDP can also be traded, similar to how MakerDAO’s collateralized debt position (CDP) allows users to collateralize Ether (ETH) for the stablecoin Dai (DAI). 

NFT rentals

NFT assets are transferred from one user’s wallet to another via an NFT rental platform for the period of a “tenancy” to access the perks or benefits offered by the NFT.

How NFT lending works

DeFi platforms enable peer-to-peer NFT lending or peer-to-protocol lending. NFT owners lock up their assets in smart contracts as collateral for loans. 

To access peer-to-peer NFT lending, owners use an NFT marketplace or NFT lending platform where they can list NFTs as collateral and receive loan offers from lenders. The platform may provide valuation tools or market data to help determine the NFT’s fair value. The NFT owner can choose an offer they like, accept it and receive the loan, typically in a stablecoin, in their wallet. 

The platform will put the NFT into an escrow smart contract for the duration of the loan period. If the borrower pays the loan plus the interest before the expiration of the loan period, the NFT is returned. The marketplace will typically charge a fee based on the principal amount of the loan. If the borrower defaults on the loan, then the lender receives the NFT, which is usually worth more than the loan value. Also, the lender may either liquidate the NFT to recoup their losses or keep the NFT.

Peer-to-protocol lending works a little differently. The NFT owner borrows directly from the lending protocol, depositing the NFT as collateral, which is then locked up in the protocol’s smart contracts. NFT lending platforms use liquidity providers that add cryptocurrencies to the lending protocol pool so that crypto funds are available to borrowers.

How NFT fractionalization and lending help investors unlock liquidity

The fractionalization of NFTs can make high-value NFTs accessible to more investors and allow owners to mint tokenized fractional NFTs to unlock liquidity.

The nonfungible nature of NFTs usually makes them indivisible. They have to be bought or sold as a whole. This is in contrast to fungible cryptocurrencies like BTC, which are divisible; investors can own fractions of Bitcoin, called satoshis. 

The NFT loan space now features NFT fractionalization. Fractionalized NFTs are represented by smaller, fungible tokens, with each token representing a share of ownership in the original NFT. Nonfungible token owners, particularly those with high-value NFTs, can mint tokenized fractional NFTs, another way to unlock liquidity in their NFTs. It allows investors to access these assets and their value and makes high-value NFT investments more accessible to investors who can’t afford the whole NFT. 

NFT lending and fractionalization both aim to increase the liquidity of NFTs. Furthermore, NFT fractionalization expands the investor pool for NFT lending and can even lead to strategies where owners combine fractionalization and lending to unlock capital from their NFTs.

An NFT owner may sell shares they have fractionalized to raise quick funds. They can then obtain a loan in the NFT lending market by using the remaining, unfractionalized portion of the NFT as collateral. Owners are able to access a larger amount of capital with this method than they could with fractionalization or lending alone.

Benefits of NFT lending

Unlocking NFT liquidity for owners and digital art creators, NFT lending facilitates borrowing without the need for credit checks.

NFTs can represent anything from digital art and collectibles to real estate and other tokenized assets. The value of NFTs varies, but some collections have NFTs that sell for extremely high prices. However, there are many other NFTs with far more modest values.

Accessing liquidity and capital

NFT lending allows owners to access or unlock liquidity without needing to sell NFTs from their collections. Investors may use this avenue if they want to quickly unlock capital to purchase other assets or use it for different purposes. 

DeFi and digital art

Digital art NFTs have proven popular in the crypto space. NFT lending provides a cross-over between DeFi and digital art. Serious collectors and artists have an opportunity to leverage the space.

Zero credit checks

NFT loans, like other DeFi loans, don’t require the credit checks needed in conventional finance. Borrowers with poor or low credit scores can access lending through the crypto space. However, some NFT lending platforms might perform basic Know Your Customer (KYC) checks to comply with regulations and reduce risks of fraud.

The risks of NFT loans

The volatility of NFTs adds risk, smart contracts can be vulnerable to attacks, and regulatory uncertainty impacts the market.

Along with the general risks associated with cryptocurrencies, there are specific risks to NFT lending. 

Volatility

The value of NFTs is volatile, similar to cryptocurrencies. This complicates appraising the value of an NFT to collateralize a loan. If an NFT value falls below the loan value, it could lead to liquidation, where the borrower defaults on the loan and the NFT is transferred to the lender. 

Liquidity

NFT lending can be attractive because it allows NFT holders to unlock liquidity when NFTs are difficult to sell. However, the same lack of liquidity of NFTs means if a borrower defaults on a loan, the lender and new owner may have the same trouble selling the NFT to recover or access their funds.

Smart contracts

Collateralized NFTs and loan terms are locked into smart contracts, but there is always a risk of bugs or attacks that result in the loss of NFTs or funds.

Regulation

The same regulatory uncertainty that applies to crypto and the DeFi space extends to NFT lending. Changes to regulation risk significantly impact the market and the viability of NFT lending, or they could require stakeholders to change or adhere to compliance requirements.

NFT lending can answer the issue of low liquidity for NFTs and let owners make use of their assets rather than just holding them to accumulate value. There are further drawbacks, though: NFT minting can be energy-intensive, and Ethereum gas fees for validating transactions can be high.