NFT Liquidity: What’s Wrong? What solutions are there?

The recent wave of liquidations has sparked fears of contagion in the crypto market, from Three Arrows Capital to crypto lenders like Celsius Network, Babel Financial, BlockFi, and Voyager Digital. Over the past few weeks, billions of dollars have evaporated from the market due to the crash and the collapse in the price of digital assets.

Liquidity issues are not only fatal for the development of DeFi, but also in NFTs (if not more so). In this report, we will focus on NFT liquidity issues and solutions, which are seen as the main gateway to web3 given its lower barriers to entry and more diverse use cases.

This report will cover the following topics:

1. Briefly describe the current liquidity problems of NFT

2. Why is the liquidity of NFT insufficient?

3. What are the existing solutions for NFT liquidity?

4. Other thoughts on NFT liquidity solutions

V. Conclusion

1. What is the NFT liquidity problem?

Although NFTs are booming in 2021 and early 2022, the trading activity of NFTs can only be described as tepid compared to DeFi. The top 15 NFT markets account for the absolute majority of the global NFT market share, but their combined trading volume is less than 2% of that of decentralized cryptocurrency exchanges, not to mention centers that report as much as $14 trillion in trading volume in 2021 exchange.

NFT Liquidity: What's Wrong? What solutions are there?

The volatility of the NFT market caused by the current concentration of whales also exacerbates liquidity problems. As of July 6, 2022, in most Ethereum-based NFT markets, 0.06% of whales (holding NFTs worth more than $1 million) hold a total of $5.7 billion worth of NFTs, accounting for a global NFT market cap of 22.2 billion 25.7% of USD.

NFT Liquidity: What's Wrong? What solutions are there?

2. Why is NFT liquidity insufficient?

(1) The difference between non-fungible tokens (NFTs) and homogenized tokens lies in their uniqueness in rarity and utility. While homogenized token investors can easily trade tokens like Ethereum and Solana via DEX (Decentralized Exchange)/AMM (Automated Market Maker), the buyer pool for each NFT sale is much smaller, So the transaction volume is relatively small.

(2) NFTs are still very novel to the mass market, despite their enormous imagination in terms of “moving” the current narrative of physical assets on-chain. The lack of historical data points and widely accepted valuation analysis are key reasons for the high degree of speculation and difficulty in pricing. Even within the same series of NFTs, price valuations can vary widely due to rarity statistics and subjective opinions. This leads to illiquidity and suboptimal capital efficiency.

(3) Similar to illiquid assets such as real estate, even in a bear market, the listing price of blue-chip NFTs averages between $11,000 and $120,000. The high entry price has turned off the appetite of many novice investors, giving birth to the proposition of NFT fragmentation, which we will discuss in later chapters.

NFT Liquidity: What's Wrong? What solutions are there?

(4) Many NFT investors invest with a diamond hand strategy and are reluctant to sell their NFTs in exchange for instant liquidity. Therefore, the development of NFT financialization is a very hot topic when it comes to solving the NFT liquidity problem.

3. Existing NFT Liquidity Expansion Solutions

NFT Liquidity: What's Wrong? What solutions are there?

Category A : NFT transactions and value-added agreements

The market has seen the tout of these DApps and infrastructure protocols to facilitate NFT peer-to-peer transactions in smoother and less expensive ways: 1) NFT market aggregators; 2) Price discovery tools; 3) Decentralized NFTs Transaction agreement; 4) NFT fragmentation.

(1)  NFT Market Aggregator

NFT market aggregators are perhaps the most compelling of current NFT liquidity solutions. An aggregator platform consolidates NFT listings for most NFT markets and provides NFT investors with unprecedented visibility. Additionally, it can save users up to 40% in gas fees by allowing users to make bulk purchases. Currently, the top 3 aggregator brands are Gem (acquired by OpenSea), Genie (acquired by UniswapLabs) and Flip.

NFT Liquidity: What's Wrong? What solutions are there?

The recent acquisitions of Gem and Genie show that aggregators are effective front-end tools for individual marketplaces/DeFi pools to capture user traffic. They also allow for lower gas fees through bulk purchases and reduce friction for NFT buyers. However, despite the hype surrounding NFT aggregators this year, they are fundamentally similar to Deliveroo/ in web2 in that they only aggregate information like NFT listings and pricing without injecting additional liquidity into the NFT market sex.

(2) Price Discovery Tool

Such tools have emerged to solve the pricing difficulties and high speculative nature of NFTs and assist users in making investment decisions. In addition, price discovery helps lay an important foundation for the development of the financialization of NFTs. Unlike homogenized tokens whose market prices are easily synchronized, NFT pricing is much more complicated, because of its P2P transaction characteristics, the bid price, ask price, and actual price may be quite inconsistent.

Currently, there are several methods of price discovery:

(a) Like the auction function in the real world, auctions are especially suitable for NFTs with high ticket prices. Contrary to the traditional British-style up-price model, Dutch auctions with a down-price method are widely used in NFT auctions, where artists and auctioneers notify all potential collectors before the auction and collect all their bids to set a ceiling price . The auction will then start with the highest price and drop by XX% at regular intervals until all NFT holdings are sold out at the bid price specified by the bidder.

Auctions benefit NFT issuers, but greatly sacrifice market capital efficiency for accurate pricing results, as they lock in bidders’ capital that, in aggregate, is likely to exceed the value of the NFT being auctioned.

(b) NFT oracles like Chainlink can retrieve reserve prices for NFT holdings 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 volume to be accurate, so it is also vulnerable to oracle attacks and market manipulation.

(c) Machine learning-driven algorithms are well suited for NFT collections with relatively rich data points (e.g., rarity statistics and features), as quantitative analysis is more effective for price prediction.

For example, NFTBank, an integrated NFT asset management company, provides price discovery services for about 1,900 NFT projects. It is powered by machine learning model technology, and the data input includes NFT metadata, sales history, feature values, categories, sales time, etc.

Another example is Upshot, which has developed specialized machine learning algorithms that can take historical sales data, secondary market data, and NFT metadata to generate reliable assessment results. Using these algorithms, Upshot reprices over 270,000 top NFT projects every hour, including BoredApes, ArtBlocks, and CryptoPunks.

Since ML-driven algorithms require a large number of data points to arrive at computational results, it makes more sense for NFT holdings with rich historical sales data, rarity statistics and characteristics, and lower volatility. Investors may find it inaccurate for newly minted NFT projects with less comparable characteristics in the market.

NFT Liquidity: What's Wrong? What solutions are there?

(d) Peer-based evaluation includes two mechanisms: 1) human voting/recommendation; 2) behavioral analysis and prediction. For NFTs with high subjective pricing like digital art, it is difficult to calculate quantitative results, so collective judgment may be a more reliable type of assessment for this type.

The above-mentioned project Upshot also has its own NFT evaluation protocol, which has established a set of data by incentivizing users to provide real feedback and suggestions for NFT projects. It builds APIs for developers to integrate their data into various projects.

(3) Decentralized NFT transaction protocol

OpenSea had announced in mid-June its migration to the Seaport Protocol, an open-source web3 marketplace protocol designed to trade NFTs securely and efficiently. OpenSea launched the protocol one step ahead of its centralized DeFi peers, featuring around 35% lower gas fees, transparent on-chain transactions, and allowing for forks from other developers.

NFT Liquidity: What's Wrong? What solutions are there?

This move lowers the barriers for developers to build their own NFT marketplaces and move transaction data on-chain. It can remove the pain points of many existing NFT tool platforms, as they can build their own marketplaces on top of the Seaport protocol, extracting value from their existing user bases that typically come to find alpha and then switch to other Executed on the market/aggregator.

However, given the novelty of the protocol, it remains to be tested whether it can actually generate liquidity network effects between NFT instrument platforms. To be sure, we would like to see more development in the field of permissionless NFT transaction protocols.

( 4 ) NFT fragmentation

NFT fragmentation means splitting a given NFT into multiple parts that can be traded separately on the market. The process involves smart contracts that divide ERC-721 tokens into multiple F-NFTs or homogenized ERC-20 tokens. Since these ERC-20 tokens can enter the DeFi system and be valued by the market through AMM’s yield farming, price discovery and liquidity can be greatly improved. Another, more obvious reason is that it encourages decentralization and democratization, allowing ordinary investors to gain exposure to other high-value NFT projects.

NFT Liquidity: What's Wrong? What solutions are there?

One of the most high profile projects in this area is Users can connect their web3 wallet to to buy NFT fragments in the form of ERC-20 tokens. As a fractional NFT token holder, you can participate in voting on the NFT floor price. The platform has also set up a 7-day auction function, which can be triggered when an investor intends to buy all parts of the NFT, i.e. own the entire NFT, so that everyone can participate in the bidding process.

Developed by PartyDAO, PartyBid has an NFT auction platform that supports NFTs on multiple marketplaces including OpenSea. Anyone can start a “party” to raise ETH and collectively bid on the shard portion of the NFT. This is achieved through PartyBid’s MarketWrapper contract, which provides a common interface to aggregate auctions across NFTs.PartyBid is built on the basis of and fragmented NFTs that have been successfully auctioned. A successful bid will be charged a fee of 2.5ETH and 2.5% of the token value, which will be transferred to PartyDAO’s vault.

NFT Liquidity: What's Wrong? What solutions are there?

While NFT fragmentation may be the next big trend because of its positive impact on democratization and liquidity, it is not without risks. F-NFTs could raise regulatory concerns as they could be considered unauthorized ICOs. SEC (Securities and Exchange Commission) Commissioner Hester Peirce warned in 2021 that F-NFTs could be considered securities.Furthermore, depending on the characteristics and types of NFTs, managing intellectual property and publicity rights can be tricky and complex.

Category B : Passive Income for Diamond Hand NFT Investors

As we mentioned at the beginning of this report, one of the key factors causing NFT liquidity problems is that investors prefer to hold NFT assets rather than realize their profits. In order to solve the liquidity problems caused by this behavior, in reality, the traditional financial community has 3 major measures to serve these long-term NFT investors, namely 1) NFT-backed loan/collateralized loan position (CDP); 2) NFT Liquidity pool; 3) NFT leasing/lending.

They both provide a passive income stream for NFT investors, increasing capital efficiency while providing additional liquidity to the market. Note also that many platforms under this category have been consolidated into solutions under Category A, as they serve both categories of measures in various ways.

(1)  NFT -backed loans /CDPs

Compared to the global art market, which has a debt penetration rate of about 35% ($24 billion/$65 billion), as of May 1, 2022, NFT debt penetration is only 0.5% ($250 million/$37 billion) ), therefore, liquidity is expected to increase as the total market size grows.

There are two types of loan originators: peer-to-peer (P2P) and peer-to-peer protocol (P2Protocol). Most of the loans are made through P2P lending platforms such as NFTFi and Arcade. The rest are issued by P2Pool loan providers such as BendDAO, DropsDAO, PineDAO, GoblinSax, etc.

The current total accessible market size for NFT-backed loans exceeds $250 million. Due to the high volatility, NFT lenders can earn higher expected returns than traditional cryptocurrency-backed loans.

a)  Lending platform supported by P2P NFT . 

The two largest platforms in this space are NFTFi and Arcade, with a total loan origination of about $240 million to date.Currently, given the high volatility and uncertainty of other long-tail NFT projects, these P2P platforms only support blue-chip NFTs.

NFTFi is built on top of the NFT lending protocol MetaStreet. It allows NFT owners to borrow wETH or DAI using their NFTs as collateral, and lenders can earn interest by making these loans. A 90-day loan for NFTFi requires an annual interest rate of up to 1,000%, while the average annual interest rate for a long-term loan is around 90%. Since its inception in May 2020 (as of July 5, 2022), the company has processed $217 million in loans involving 13,363 loans. NFTFi charges 5% of their interest income to lenders with successful loans (excluding defaulted loans). Collateralized NFTs include wrapped CryptoPunks (about 29% of loans) and BAYC (about 23% of loans).

NFT Liquidity: What's Wrong? What solutions are there?

Arcade ($20 million) is built on the Pawn protocol and has facilitated about $20 million in loans since its inception in 2022.In addition to wETH and DAI, users can also borrow USDC by staking NFTs from the selected list. Unlike NFTFi, Arcade charges borrowers a fixed 2% upfront payment on loan origination.

Neither of the above-mentioned P2P lending platforms take any risk and do not rely on algorithmic pricing to scale.However, scalability is limited by its custom loan terms, and matching can be slow as borrowers have to wait for a repayment.

b)  Loans backed by P2Protocol NFTs 

The size of the P2Protocol lending market is still small ($30-$50 million). Major players include BendDAO, Drops, Pine, Goblin Sax, JPEG’d, and Defrag. Some lending platforms, such as BendDAO, employ vote-custodial token economics to incentivize NFT holders to provide liquidity in various loan pools. Similar to DeFi liquidity pools, they issue governance tokens to boost lenders’ interest rates.

To solve the slow matching problem in the P2P lending market, the P2Protocol lending project allows instant liquidity as the matching process is handled by the protocol. But the downside is that automating loan terms requires rich data points, such as real-time price and rarity statistics, so NFT choices will be limited to those that have quantitative properties and are already liquid.

Even if NFT-backed loans are overcollateralized (at least 50%), NFT-backed lenders still take on greater risk than traditional crypto-asset-backed lenders due to a higher probability of “voluntary” default. This can happen if the borrower forgoes repaying the loan when the value of the NFT falls below the loan amount. To mitigate such risks, accurate price discovery, credit risk analysis and insurance are all key 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 lending market is still fragmented (especially in P2Protocol). In addition to the MetaStreet mentioned above, Spice Finance is a newer project that aims to consolidate existing P2Protocol lending on one 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 support a comprehensive lending platform.

The biggest risk for such aggregators comes from a high degree of integration and composability, as the project inherits all the risks of the underlying application.

(2)  NFT liquidity pool

NFT liquidity pools can be divided into pledge liquidity pools and transaction liquidity pools, which are similar to DeFi liquidity pools. The main difference is that users can mint homogenized tokens (such as ERC-20 tokens) by depositing NFTs with similar characteristics/floor prices into the same liquidity pool. A homogenized token is a representation of any random asset in the pool and can be exchanged with it. Liquidity providers can enjoy faster liquidity times by depositing NFTs, minting corresponding homogenized tokens, and easily swapping them through DeFi AMMs (such as Sushiswap using NFTX). Besides NFTX, another key platform is NFT20. Since liquidity pools involve minting homogenized tokens, such services are often powered by NFT fragmentation protocols.

As in DeFi, if NFTs are mispriced, users can arbitrage them, facilitating price discovery. Additionally, liquidity providers typically receive LP tokens and can stake them for higher returns. However, given the high volatility and speculative nature of NFTs, slippage risk can be a challenge for both platforms and investors.

(3)  NFT Leasing

Leasing provides another direction for NFT owners to generate passive income. Double Protocol’s ERC-4907 standard, which just became the 30th official ERC standard on Ethereum, takes an innovative approach by adding an “expires” feature that authorizes “users” to expire automatically. In this way, projects built on the ERC-4907 standard can easily separate the user’s ownership from the usage rights, which will automatically terminate at the end of the lease period. This will drive the growth of NFT leasing and spawn more derivatives built around it.

NFT Liquidity: What's Wrong? What solutions are there?

NFT leasing can be applied to a variety of use cases, including gaming, art, PFP, membership NFTs, and more. For example, art exhibitions, brands or events may rent out specific digital art NFTs to match their pop-up exhibitions/events.Alternatively, someone who wants to join the community for a while before making a long-term commitment might rent out a month’s worth of membership NFTs (sounds like a subscription to paid content).

Given the scale of the Metaverse, the most promising use case for NFT leasing is gaming. Virtual land may generate some hype, as many owners invest heavily in land so that as the game attracts more users and brands, they can rely on the land 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 to play the game or give the player an advantage. You can find an example of how players rent out hero characters in the game from my article. If players cannot afford or simply don’t want to buy in-game NFTs for various reasons, they will choose to lease, which further increases the liquidity of NFTs.

4. Other ideas for NFT liquidity solutions

When it comes to NFT trading, the impetus that can push liquidity further seems to come from the community. In these communities, users have consistent tastes and values ​​for NFT projects developed from the community. Usually, the market is a vertical one, determined by the theme/vibe of the community behind it. Such NFT marketplaces are ideal for NFT projects to exert the influence and utility of tokens among community members. Project owners will also have this sense of belonging and ownership, as they can vote on market designs to provide a certain user experience.

The DAO sounds like an organic place for such a market to develop, especially with Seaport Protocol lowering the barriers to development. Additionally, centralized NFT marketplaces are actively exploring community features, such as Coinbase’s NFT marketplace beta focused on creating a social community for buyers and sellers.

V. Conclusion

All of the above liquidity solutions try to solve the problem based on the current NFT market size. In the long run, what fundamentally drives NFT liquidity must come from its own penetration across industries.

We are embarking on an exciting journey to the future of NFTs, and we have seen established businesses and celebrities from sports, fashion brands, music streaming services and education enter into partnerships with Metaverse-like projects and blockchain technology relation. The ultimate way to boost NFT liquidity is through mass adoption. In the process of NFT financialization and further adoption, NFT trading platforms may be subject to stricter anti-money laundering and securities investment regulations.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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