NFT Finance Part 1: Demand is exploding for loans backed by NFTs

Putting up NFTs as collateral for a loan sounds futuristic. But the core concept is not new.

For years, pawnbrokers have let customers hand over valuable physical items — like a watch, diamond bracelet or a work of art — and receive a loan, typically with a high interest rate. If the borrower doesn't pay the interest or the loan back, the pawnbroker keeps the valuable item. 

It was Gabe Frank’s experience working with pawnbrokers as part of his family business that helped him see that NFT-backed loans were inevitable.

“When I started collecting NFTs, I realized it was a new asset class and I knew a credit market would form," Frank says. When he launched his own NFT lending platform, he called it PawnFi. It has since been re-named Arcade, but it still runs on the Pawn Protocol.

What Frank didn’t anticipate, however, was how big the business would get — so quickly. 

Arcade was operating in a private release for its first four months and only opened up to the public at the end of January. In that time, it has already recorded $11 million of volume for NFT-backed loans, with $5 million of that coming since it went public. Arcade charges a 2% fee on the interest paid for every loan that goes through its platform. 

Arcade isn’t the only company supporting NFT-backed loans, or even the biggest. Its rival NFTfi, which has been live since June 2020, has seen $85 million in volume for more than 5,000 NFT-backed loans.

A booming market

The sudden growth of the NFT lending market also took NFTfi founder and CEO Stephen Young by surprise. “I knew it was going to happen but I didn't know if it was 18 months or 36 months away,” he says. “It’s happened way faster than I think anybody in this space expected.” 

Young says that volumes on NFTfi have been exploding in recent months. In January, the platform saw $20 million in volume. That’s already half of what it saw in all of 2021.

“It’s really, really crazy,” says Young. NFTfi takes a 5% cut on the interest paid for loans.

Both NFTi and Arcade have also seen some massive loans.

Arcade saw its highest value NFT loan a couple of weeks ago. The individual who took out the 1,250 ETH ($3.4 million) loan used two zombie CryptoPunks as collateral. It had an annual interest rate of 34%. 

Frank says it was a deal that came through its over-the-counter desk. The first thing Arcade did was try to value the NFTs before reaching out to its connections to see if anyone would lend against them. While it initially had little success, eventually the borrower found a high-net-worth individual who wanted to earn some yield on their ether (ETH). 

Arcade matches up offers on its own computer systems first, using digital signatures for participants to prove that they’re willing to make the transactions. The loans are then processed on the Ethereum blockchain using smart contracts. The NFTs are held in a decentralized escrow until they're unlocked at the end of the loan period.

Arcade has also settled some large loans on behalf of other lenders. Genesis, which has been exploring the NFT lending market, used the platform to issue a $1.25 million loan on a collection of 10 NFTs (mostly one-of-a-kind art pieces and one plot of land for Decentraland) that was wrapped as a single NFT.

The loan, which was taken out by an NFT collector called SilverSurfer, is for six months at a 15% interest rate.

The biggest loan on NFTfi was for 101 CryptoPunks and the capital was provided by MetaStreet DAO, which gives funding to anyone who wants to access capital through NFT-backed loans. It had a 10% interest rate.

It also saw a loan for $1.4 million, which used an Autoglyph NFT as collateral, and was also provided by MetaStreet DAO. The loan was issued to a pseudonymous crypto user called KrypToniK, who wanted a low-interest loan of 10%, according to Young.

High risk, high reward

It’s not hard to see why NFT holders would take advantage of NFT-backed loans. But what are lenders getting out of it? After all, NFTs are illiquid assets and commonly have wildly variable price swings that could leave the lender at a loss if the borrower defaults and they have to liquidate the collateral.

Therein lies the answer. Lenders can charge higher interest rates because of the perceived higher risk. Rates start in the range of 18% to 25% for established collections like CryptoPunks or Bored Ape Yacht Club — but can rise to between 40% and 60% for other, less established collections, according to Young.

Plus there’s an added potential bonus. Young says that some lenders are making loans with the hope that the borrower defaults and coughs up the coveted NFT. This has already happened: in October, one lender received a $340,000 NFT when the owner defaulted on a $12,600 loan that had been settled on NFTfi.

Nonetheless, lenders are still taking a risk that they might be left with an NFT that is worthless. 

Besides high interest rates, some measures have emerged to prevent this, however. For a start, loans are typically worth a percentage of the purported value of the NFT, in order to hedge against a drop in price. 

For collections like CryptoPunks, the so-called loan-to-value (LTV) ratio will typically range from 40% to 50%, says Young, meaning that the value of the loan is less than half of the estimated value of the NFT. So were the borrower to default, the value of the NFT could drop in half and the lender wouldn’t be out of pocket.

When it comes to lesser-known collections, the LTV can drop to 30%. And for individual one of one art pieces, it be as low as 20%, according to Frank.

Young says that some lenders look at the on-chain histories of borrowers to determine the likelihood that a prospective borrower might default. But most of the time, defaults are based on dramatic market movements and they often all come at the same time. “Lenders typically look at the actual asset and market to determine their risk, as opposed to looking at the borrower,” says Young.

This story is the first article in a three-part series focused on the financial applications of NFTs.