NFT Finance Part 3: How Genesis and Nexo are exploring NFT-backed loans

The market for loans backed by non-fungible tokens (NFTs) is still small — but it is rapidly growing. As we noted in the first part of this series, popular NFT lending marketplaces NFTfi and Arcade have seen combined volumes of nearly $100 million.

Unsurprisingly, this has caught the attention of some big-name crypto investors and lenders.

Leading the way are Genesis, a crypto-focused prime broker with a $12 billion loan book, and Nexo, a retail-focused crypto lending platform with 3.5 million users. The Block spoke with both companies to find out what they’re doing in this market and how it is evolving.

High interest for NFT loans

So far, Genesis has made around half a dozen loans, while Nexo has done 11, according to interviews with members of both companies. 

Both firms typically focus on the most well-known NFT collections, such as CryptoPunks and Bored Ape Yacht Club. Nexo only deals with NFTs worth more than $500,000.

The average size of Nexo’s loans are 35 ETH ($95,000), suggesting a total of around $1 million in loans. Genesis, which has worked with four or five different counterparties on its deals, has around $5 million in active NFT-backed loans, which vary in length but are either three to six months or as long as 12 months.

“Our thesis is that obviously NFTs are going to be here to stay, it’s going to be a huge part of web3, metaverse; it’s going to be something that our clients are going to be engaged in and interested in for a long time,” says Matt Ballensweig, co-head of trading and lending at Genesis.

Ballensweig says Genesis got into lending because its clients wanted a way to short bitcoin and ether before there were futures markets for those coins. Now it's starting to get demand for borrowing against NFTs. 

“We talked to a few of our institutional counterparties, the crypto-native hedge funds, and they’ve built pretty large portfolios of a variety of NFTs and they’re also currently borrowers from us,” he says. “They basically asked: ‘Is this something you guys would explore?’” 

Ballensweig stresses that this is still a pilot program and represents only a fraction of its business. “It’s still pretty small but obviously we have plans to scale that up on the institutional side of the market.”

In contrast, Nexo came up with the idea on its own to build an NFT lending product. Its team wanted to expand its footprint within the NFT space and drew up a list of new products and services it could develop. “No idea was too crazy, or too unfeasible” according to Kiril Nikolov, a DeFi strategist at Nexo. 

They landed on NFT lending as one product they could deliver quickly and at scale, without much additional risk.

Nikolov had low expectations and didn’t expect it to be profitable. He says he has been surprised by the uptake. “The market has been very accommodating for lending; a lot of demand.”

Nikolov says the opportunity to charge high interest rates is the key benefit of NFT lending because it creates a good risk-return profile.

What about the risks?

Indeed, NFT lending certainly comes with a higher level of risk relative to other kinds of lending. Companies like Genesis and Nexo, which are making large loans with customer funds, must ensure that they mitigate these risks as much as possible.

It starts with high interest rates. Genesis issues NFT-backed crypto or fiat loans at a 25% to 33% loan-to-value (LTV) ratio. That means the loan will be for only a quarter or a third the value of the underlying NFT, and in turn that the market would have to drop by 66% to 75% before the loan would be underwater.

Nexo is even more cautious. It only offers an LTV ratio between 10% and 20% — meaning they’re safeguarded up to an 80% crash in prices. 

Beyond this, both companies often make sure to have a buyer for the NFT, in case the borrower were to default on their loan. For some but not all loans, Genesis reaches out to its contact book and lines up backstop bids. 

In cases where Genesis doesn’t take a backstop bid, it makes sure that it has full recourse to the borrower outside of the NFT collateral. So if the borrower defaulted and the NFT’s value dropped 90%, Genesis would be able to go after the client’s other assets on its platform, in accordance with its standard master loan agreement.

Nexo similarly makes sure to have a backstop bid, or as Nikolov calls it, a put option on the NFT. It does this by going to hedge fund Three Arrows Capital (3AC) and asking for a price that the hedge fund would be willing to pay two months down the line. 3AC co-founder Kyle Davies told The Block that he had seen a couple of deals go through and expects, with the growth of the NFT market, that the “financialization” of NFTs will eventually take off.

Some risk mitigation steps are required by law. As a regulated entity and New York-based broker-dealer, Genesis is required to do due diligence on its clients, who are usually hedge funds, high-net-worth individuals or family offices. This means that while some NFT collectors might like to stay anonymous online if they want to use its service they do have to go through know-your-customer (KYC) anti-money-laundering (AML) procedures. 

Nexo also does KYC for all its clients to similarly comply with regulations.

Uncharted territory

The next issue is who controls the NFTs? Nikolov says that Nexo sometimes takes custody over the NFTs but not in all cases. This can get complicated, for example when NFT owners are waiting for some token or benefit they accrue from holding the token themselves. When Nexo doesn’t take custody of the NFT, it creates code on the blockchain that ensures that if the loan is not repaid, it gets transferred to Nexo’s control. 

For its part, Genesis takes custody over NFTs used for taking out loans through its platform, similar to its other loans.

Now we come to the even trickier problem: pricing.

NFTs are notoriously difficult to price en masse. That’s because their value to a buyer depends just as much on aesthetic appeal as it does on the more quantifiable aspects like rarity. Plus, markets for NFTs are largely illiquid and price discovery is slow — and an NFT might not even have any price history at all.

Genesis and Nexo currently have their own unique process for individually pricing each NFT. It’s done manually by looking at price data, floor prices for the collection, and factors like rarity. Both firms will reach out to their other clients to gauge opinions on prices, secure backstop bids, and to get a better understanding of how these investors value the NFT in question.

Nikolov says Nexo is still developing its pricing strategy. “I would honestly say we don’t necessarily have the finger on the pulse yet,” he says. “That’s why we rely on the put options as the best way to see what our partners think.”

In the future, NFT derivatives — for example, a token whose price is tied to the value of a single NFT or a collection — come about, they may help to determine pricing. Ballensweig says that such derivatives would help the market to determine the floor price of an NFT collection or type of NFT.

The key here is not to try and estimate the true value of the NFT, but what it would likely sell for under current market conditions. “We’re not trying to make a bet on the intrinsic value. We’re just looking at reality,” says Ballensweig.

While Nikolov sees opportunity in the NFT lending market, he acknowledges that it might not always have the same benefits for the company as it is today. As the market gets used to offering loans against NFTs and more companies offer these services, rates are likely to go down. 

Nexo is looking at how to streamline its operations as the market grows. It currently has an over-the-counter trading desk but also uses other NFT lending marketplaces. Over the long term, it’s looking for ways to automate the lending process, similar to how it has for its current loans collateralized by crypto tokens.

Genesis may go even further in this regard, and is open to the idea of creating a marketplace for NFT loans, similar to NFTfi and Arcade, but with a focus on institutional clients. This would be an alternative way to monetize this growing market while reducing the risk for Genesis in terms of defaults.

“For now, we’re just showing up in this space,” he says. “But we’re considering that.”

This is the third article in a three-part series focused on the financial applications of NFTs. Don't miss Part 1 and Part 2.

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