Non-fungible tokens (NFTs)have recently taken headlines as digital art NFTs have become widely traded. This post will explore how NFTs can be used as a financial instrument such as by collateralisation or by leasing assets. The concept of using NFTs as a financial instrument has not been fully explored, but will grow as NFTs gain wider adoption and use. We will introduce three examples to show how NFTs can be used as a financial instrument in the future and one to show their limitations.
NFTs as Collateral
Physical assets of value can be used as financial instruments through collateralization. This is most commonly seen through mortgages when a home is used as collateral for a loan. While It is easy to borrow against a home, many other assets are difficult to collateralise. Because NFTs are easily exchanged, they are liquid and easy to value at fair market. In the future, NFTs will give users an easy and secure way to use many digital and physical assets as collateral for loans.
When a user takes out a collateralized loan from a lender, they will be paid out from the lender’s account. The NFT will be locked into a smart contract. If the loan is repaid, then the NFT will be transferred back to the user, and if the loan is not repaid in time, the NFT and any underlying rights to digital and physical assets will be transferred to the lender. A current example of this service is the platform NFTFI.
NFTs for Lease
Today you can find almost any physical asset for rent, whether it be a supercar, a power tool, or a designer bag. While NFTs could be used to lease rights to physical assets, they will also facilitate the leasing of digital assets, enable users to generate a side income.
For example, a character in a popular video game may be represented by an NFT. The character is rare and has special powers inside the video game. Using smart contracts, the owner of the character can lease the NFT out to other users to use temporarily and enjoy while the owner can generate an income.
Raising Capital with NFTs
Often in business, it is necessary to raise capital, whether it be to build a prototype, pay employees, or invest in infrastructure. Traditionally capital has been available primarily through equity, where businesses give part ownership in exchange for capital. For specific business cases, NFTs may present an alternative to the equity model.
Picture a Subscription-based business, for example, “Bondex.” Bondex wants to build a company that will offer financial services to subscription holders at the price of $250 monthly. To launch the business and develop their service offerings Bondex will need approximately $2,500,000. Bondex does not want to give up any equity in their company. NFT could present a solution for Bondex to raise capital without equity.
Bondex decides to release 1000 unique NFTs at the price of $2,500. The NFT gives the user access to financial services products at a reduced price of $100 monthly. Representing annual savings of $1,800. This savings incentivises users to contribute capital in order to unlock savings because there is a quantifiable value. Investors may also contribute capital, hoping that they will resell the token for more than they paid. On top of this, the NFTs could also be subleased. An investor may buy two tokens for 5,000 and lease them out for $2,000 each. This transfers $1000 of savings to the lessee while generating an 80% annual return for the investor. If Bondex wanted to, they could require a royalty for every time a token is leased.
Now, let’s consider who benefits from this type of arrangement. Bondex was able to raise capital without having to give up Equity. They might have similarly tried to pre-sell subscriptions for a discount. However, this proposition creates a risk for users if the services are poor. NFTs create opportunities for profits which act as incentives for investors and users to negate risks associated with the upfront costs. Users who buy the NFT benefit from future savings. Investors who buy the NFT can sell or lease the NFT at a profit once Bondex starts to provide services. Even a user who buys or an NFT from an investor. NFTs present a way to raise capital in which everyone can have a positive outcome.
Automated Market Making for NFTs
The limitations of NFTs as a financial instrument are only really apparent when looking at exchangeability. In most cryptocurrency markets, automated market makers facilitate exchanges by always buying and selling tokens at the market rate. This keeps exchanges accurate and efficient and makes most cryptocurrencies very liquid.
It is impossible to implement automated market makers for NFTs because of their core property: non-fungibility. Non Fungibility implies that each token has individual properties that determine its market value. As an example, each parcel of virtual land in Decentraland have different characteristics that determine the market value, such as:
- Dimensions of the parcel
- Position on the map
- How much income the parcel is already generating
- Daily traffic
When discussing this problem, we considered that you might be able to wrap similarly priced and most traded NFTs, into fungible ERC-20 tokens in order for them to be added to a liquidity pool. However, because trading prices for NFTs could be manipulated for an asset to fit into a given pool, this is not feasible without constant auditing making it impractical.
The only exchange solution currently suitable for NFTs is a peer-to-peer market that necessitates a buyer and a seller to agree on a price. While this means that NFTs are not as liquid as fungible tokens, we do not anticipate it will hinder their use as a financial instrument.
The many use cases for how NFTs can be used as a financial instrument are only just starting to be discovered and explored. Over the coming years, we are bound to see countless new ways that NFTs can be used to access capital and to generate income.
Musan, D. I. (2020). NFT.finance Leveraging Non-Fungible Tokens. London, UK: Imperial College London Department of Computing.