NFTs, A Potential For DeFi Collateral?

Jun 25, 2021
Read 4 min
Expert
collateral
Key Takeaways:
—The world of NFTs has rapidly increased as tokenized assets and tradable goods have gained attention in art, gaming and valued collections.
— In traditional finance, it’s possible to put up physical objects like a house, car or art collection as collateral. In decentralized finance, NFTs have the potential to make effective collateral to get a loan.
— As the industry is still nascent, it’s unsurprising that there are a few challenges, such as volatility and authenticity, that need ironing out. Despite this, the pros are set to counter the cons.

The NFT and DeFi revolution is fascinating, and it’s about to go to the next level, how? Let’s find out how NFTs have to the potential to become a DeFi collateral.

NFTs have been exploding recently gaining massive popularity amongst digital artists, gamers, collectors and traders of digital assets. As tokens that can digitally represent anything (literally), NFTs have been revolutionizing how we see digital ownership. Hand-in-hand with decentralized finance (DeFi), NFTs have incredible potential to become effective collateral. How? Well, let’s get into it!

Crash course 1: What is a NFT?

NFT stands for a non-fungible token, basically meaning one NFT cannot be changed for another NFT and each unique token has its own value. (As opposed to a fungible token, like Bitcoin where one BTC equals another BTC).

Crash course 2: What is collateral? 

Collateral refers to any asset that someone will offer as security to get a loan. It’s basically a pledge from the borrower to say that they’ll uphold paying back the loan and it is protection for the lender so that they won’t suffer major losses if the borrower can’t pay back the loan.

Okay, you’re ready. Let’s take a deep dive:

The nifty nature of NFTs and how these tokens can be used as DeFi collateral

Traditionally, a valuable asset can be used as collateral in return for a loan or for credit. Typically an asset like a car, house, or land is used as a pledge but we also see authentic art collections used as collateral. The key factor is that collateral requires something that has an esteemed value attached to it. 

And the digital realm holds the same notion: Collateral for a loan requires a valued asset to act as security. Thus, enter NFTs.

NFTs have proven that they can be valued extremely highly (take this digital collage that went for a whopping $69 million dollars as a quick example) and many NFTs are collectable, varying in rarity and desirability. Because of the potential to hold value, NFTs make great collateral in the digital world. The owner of the NFT could put up the digital asset as collateral and take out a loan through smart contracts. 

This is beneficial for both: The lender will be protected with the NFT as collateral and the borrower will have the opportunity to receive a loan without having to jump through the numerous hoops of the traditional financial system.

Typically, the NFT will be valued equal to or more than the loan and if the borrower can’t return the loan, the NFT will be liquidated so that the lender can be reimbursed for the loan. On paper, this sounds ideal, right? Right! But in practice, there are a few things that need resolving as the industry evolves.

Challenges NFTs need to overcome before being used as DeFi collateral

1. Complex copyright – Authenticating and certifying NFTs

One of the big challenges is the authentication of NFTs. As unique tokenized assets, the major value of NFTs lies in the ownership – something that is represented on the blockchain. NFTs provide a verifiable history of transfer and ownership, but the underlying artwork isn’t often part of this, so copyright becomes a little complicated.

2. Assessing and appraisals – Volatility and value strength

Volatility is a well-known obstacle in the world of cryptocurrency. While the NFT market can be treated differently from crypto, there is still underlying volatility with digital assets that makes appraisals and evaluations of the tokenized assets challenging. With digitally created assets, there’s the added layer of valuing something in an inherently subjective industry. It’s a challenge to value art physically and the digital realm is no different.

3. Tricky tokenizing – Physical assets vs digital assets

Tokenizing physical assets opens up massive potential for individuals looking to liquidity, but it becomes a little tricky and requires looking at regulation and legal compliance. In the same way that there’s a process – and usually expensive legal teams involved – when putting up your house or a car up as collateral, tokenizing physical assets requires a legal and regulatory framework.

4. Safety and security – Setting up strong storage

Blockchain is well known for its immutability and there’s incredible security within the technology. However, there are chinks in the armour when it comes to how individuals might choose to store their NFTs. In the same way that art can be stolen, there are digital art heists that have made the news and fraudulent NFTs have hit the market with deceptive minters looking to make money off original NFTs. Combatting this particular challenge, though, isn’t difficult if you remember “not your key, not your NFT ” and store and safeguard your NFT responsibly.

P.S. In case you didn’t know, you can safeguard your NFTs and tokenized assets with Ledger for ultimate security! (Find a very handy how-to store your NFTs safely here.)

Despite the challenges, the pros tend to outweigh the cons. 

As mentioned, NFTs can be anything (yes, still literally) – provided it can be tokenized and represented digitally. Yes, like your property or your car. And if you’re able to tokenize your assets, you’re able to access liquidity. 

While responding to regulations is still a necessity, the ability to borrow loans through decentralized finance means that the door is opened wide to for individuals without relying on the traditional system. The beauty of this possibility is that more people can access financial services and funds. It alleviates the need to go through the legacy system – with suited bankers and executives saying who can and who can’t apply for money.

The world ahead – from traditional to digital collateral 

So where might this go?

Well, the industry is still new and is evolving rapidly. There’s so much to be explored in how both digital and physical NFTs can be used as collateral and fit into the financial system.

Considering that art can be used as collateral currently and that physical assets can be tokenized, we might be looking at a world where individuals can access liquidity without stepping foot in a bank or filling out a plethora of forms to get a loan. It’s an exciting notion that aptly represents the sweet freedom that decentralized finance offers to the everyday person.


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