Analysis on NFT Liquidity: Problems & Solutions
Introduction
Recent waves of liquidation have triggered contagion fears in the crypto market, spreading from Three Arrows Capital to crypto lenders like Celsius Network, Babel Finance, BlockFi and Voyager Digital. Billions of dollars have been wiped off the market in the past few weeks due to the collapses and the slump in digital asset prices.
Liquidity issue is not only fatal to the development of DeFi but also (if not more of) such a case in NFT. In this report we will focus on NFT liquidity problems and solutions as it is seen as the major gateway to web3 given its lower threshold and more diverse use cases.
This report will cover the following topics:
I. Briefly describe current liquidity problems in NFTs
II. Why is there insufficient liquidity for NFTs?
III. What are the existing solutions for NFT liquidity?
IV. Other thoughts for NFT liquidity solutions
V. Closing thoughts
I. What are the NFT Liquidity Problems?
Despite NFT’s exuberance in 2021 and early 2022, the level of NFT transaction activity can only be described as lukewarm compared to DeFi. Top 15 NFT marketplaces have taken up the absolute majority of the global NFT market share and yet its aggregate trading volume is sub-2% of that of decentralized crypto exchanges, let alone centralized exchanges which reported a whopping $14trn+ in trading volume in 2021.
The NFT market fluctuations contributed by the current whale centralization also adds up to the liquidity problem. Across most of Ethereum-based NFT marketplaces, 0.06% of whales (with $1mn+ NFT holding value) hold NFTs worth $5.7bn and take up 25.7% of the $22.2bn global NFT market cap as of Jul 6, 2022.
II. Why is NFT Liquidity Insufficient?
(1) What sets non-fungible tokens (NFTs) apart from fungible tokens is its uniqueness in rarities and utilities. While fungible token investors can easily trade tokens like Ethereum and Solana via DEXs / AMMs, the pool of buyers for each NFT sale is much smaller and hence the relatively smaller trading volume shown above.
(2) NFT, despite its huge imagination with the narrative of ‘moving’ current physical assets on-chain, is still very novel to the mass market. The lack of historical data points and widely accepted valuation analysis is a key reason for the high speculation and pricing difficulty. Even NFTs within the same collection can be valued at significantly different prices due to rarity stats and subjective opinions. This leads to the low liquidity and unideal capital efficiency.
(3) Similar to illiquid assets like real estates, blue-chip NFTs are listed at a high price range of US$11K-120K on average even amid the bear market. The high entry price has caused many novel investors losing their appetites, giving rise to the advocate of NFT Fractionalization, which we will discuss in the section later.
(4) Many NFT investors are investing with a diamond hands strategy and are not willing to sell their NFTs in exchange of immediate liquidity. Hence, the development of NFT financialization is a much heated topic when it comes to resolving NFT liquidity problems.
III. Existing NFT Liquidity Scaling Solutions
Category A: NFT Trading & Value-adding Protocols
The market has seen the touting of these DApps and infrastructure protocols to facilitate NFT peer-to-peer trading in a smoother and less costly way: 1) NFT marketplace aggregators, 2) price discovery tools, 3) decentralized NFT trading protocols, and 4) NFT fractionalization.
(1) NFT marketplace aggregators
NFT marketplace aggregators are likely the most notable ones among current NFT liquidity solutions. An ggregator platform consolidates NFT listings across most of NFT marketplaces and provides unprecedented visibility to NFT investors. Moreover, by allowing users to make bulk purchase it saves them gas fees by up to ~40%. Currently, the top 3 aggregator brands are Gem (acquired by OpenSea), Genie (acquired by Uniswap Labs) and Flip.
The recent acquisitions of Gem and Genie show that aggregators are an effective front-end tool for individual marketplaces / DeFi pools to gain user traffic. They also allow for lower gas fees via bulk purchases and reduce frictions for NFT buyers. But despite the hype around NFT aggregators this year, they’re fundamentally akin to Deliveroo / Booking.com in web2 as they only aggregate information like NFT listing and pricing without injecting additional liquidity into the NFT market.
(2) Price discovery tools
This type of tools has emerged to solve the pricing difficulty and high speculation of NFTs, assisting users with their investing decisions. Furthermore, price discovery helps lay a crucial foundation for the development of NFT financialization. Unlike fungible tokens where the market prices are easily synced, NFT’s pricing is much trickier as the bid, ask and realized price can be rather inconsistent given its P2P trading feature.
Currently, there’re several price discovery methodologies:
(a) Auctions particularly suit NFTs with high ticket values as they do in the traditional world. Opposite to the traditional English style with an ascending pricing model, Dutch auction that adopts a descending price method is widely adopted in NFT auctions where artists and auctioneers inform all potential collectors and gather all their bidding prices ahead of the auction to set the ceiling price. Then the auction will start at the ceiling price and drop by XX% for every predetermined period of time until all NFT collections get sold out at bidders’ designated bidding prices.
Auctions are in favor of NFT issuers but the market capital efficiency is hugely sacrificed for an accurate pricing result, given that they lock up bidders’ capital which in aggregate mostly likely surpass the value of the NFT being bidded for.
(b) NFT oracles like Chainlink can retrieve NFT collections’ floor prices from blockchains and compute their time weighted average prices (TWAP). This can provide investors with a reference price range by tracking the average prices.
However, its limit is it requires a huge transaction amount for the TWAP to be accurate and for that reason it’s also susceptible to oracle attacks and market manipulations.
© Machine learning-driven algorithms serve well for NFT collections with relatively abundant data points (e.g. rarity stats and traits) as it’s more effective to utilize quantitative analysis to do the price prediction.
For instance, NFTBank, an integrated NFT asset management firm, provides price discovery for ~1,900 NFT projects. It’s powered by a machine learning model with data inputs such as NFT metadata, sales history, trait values, categories, time of sales and more.
Another example is Upshot, which has developed specialized machine learning algorithms that ingest historical sales data, secondary market data, and NFT metadata to generate reliable appraisals. Using the algorithms, Upshot reprices 270K+ top NFT items including Bored Apes, Art Blocks and CryptoPunks every hour.
Since ML-driven algorithms require a large amount of data points to arrive at computational results, it’s more meaningful for NFT collections with rich historical sales data, rarity stats and traits, and lower volatility. Investors may find it inaccurate for newly minted NFT projects that have less comparable traits in the market.
(d) Peer-based appraisals include both mechanisms of 1) manual voting/recommendation and 2) behavior analysis and prediction. It’s hard to compute quantitative results for NFTs that are more subjectively priced like digital arts and thus collective judgment is probably a more reliable type of appraisal for such types.
The above-mentioned project, Upshot, also has its own NFT appraisal protocol that has established a set of data by incentivizing users to provide honest feedback and recommendations for NFT projects. It has built out the API for developers to integrate their data into various projects.
(3) Decentralized NFT trading protocols
OpenSea has announced in mid-June to migrate to Seaport Protocol, an open-source web3 marketplace protocol designed for safely and efficiently trading NFTs. OpenSea has moved one step ahead of its centralized DeFi peers by launching the protocol that features ~35% lower gas fees, discloses on-chain transactions transparently and allows for forking by other developers.
This move lowers the threshold for developers to build their own NFT marketplaces and moves transaction data on-chain. It may remove the pain points of many existing NFT tooling platforms as they can build their own marketplaces on top of Seaport Protocol, capturing value off their existing user base who normally come to find alphas and then switch to other marketplaces/aggregators for execution.
However, given the novelty of this protocol, whether it can actually create a liquidity network effect among the NFT tooling platforms is yet to be examined. One thing is for sure, we look to see more development in the space of permissionless NFT trading protocols.
(4) NFT fractionalization
NFT fractionalization means splitting a given NFT into multiple pieces which can be individually traded in the market. The process involves a s smart contract that divides ERC-721 tokens into a number of F-NFTs or fungible ERC-20 tokens. Since these ERC-20 tokens can be tapped into DeFi systems and valued by the market via yield farming on AMMs, it can hugely improve the price discovery and liquidity. Another more apparent reason is it encourages decentralization and democratization by allowing normal investors to gain exposure to otherwise high-value NFT items.
One of the most notable projects in this realm is fractional.art. One can connect a web3 wallet to fractional.art to purchase fractionalized NFT items which is in the form of ERC-20 tokens. As a fractionalized NFT token holder, you can participate in the vote of the NFT’s floor price. The platform has also set up a 7-day auction feature which can be triggered when an investor intends to buy up all the fractions of an NFT, i.e. to own the whole piece, so that everyone can participate in the bidding process.
PartyBid, developed by PartyDAO, has an NFT auction platform that supports NFTs on several marketplaces including OpenSea. Anyone can launch a ‘Party’ to contribute ETH to collectively bid for fractions of an NFT. This is achieved via PartyBid’s MarketWrapper contract which provides a general interface to aggregate all NFT bids. PartyBid is built on fractional.art to fractionalize the NFTs that are successfully bidded. Successful bids will get charged a 2.5ETH fee and 2.5% of the token value which will be transferred to the PartyDAO’s vault.
While NFT fractionalization may be the next big trend given its positive impact created around democratization and liquidity, it’s not without risk. F-NFTs may give rise to regulatory issues as they are likely treated as unauthorized ICOs. SEC’s commissioner Hester Peirce warned in 2021 that F-NFTs may be considered to be securities. Additionally, managing intellectual property rights and publicity rights can be tricky and complex subject to the traits and types of NFTs.
Category B: Passive Income for Diamond-Hand NFT Investors
As we mentioned in the beginning of this report, one of the key factors that contributes to the NFT liquidity problem is investors prefer holding NFT assets and not realizing their profits. To resolve the liquidity issues derived from this behavior, 3 main measures mirrored from existing traditional finance world are aiming to serve these long-term NFT investors: 1) NFT-backed loans/ Collateralized Loan Positions (CDPs), 2) NFT liquidity pools and 3) NFT renting/lending.
Both of them provide passive income streams and improve capital efficiency for NFT investors while supplying extra liquidity to the market. Also note that many platforms under this category have incorporated the solutions under Category A since they serve for these 2 types of measures in various ways.
(1) NFT-backed loans / CDPs
As compared to the global fine art market where the debt penetration is ~35% ($24bn/$65bn), NFT debt penetration is only 0.5% (~$250mn/$37bn) as of May 1st, 2022 and hence is expected to boost the liquidity as the total market size grows.
There’re 2 types of loan issuers: peer-to-peer (P2P) and peer-to-protocol (P2Protocol). The majority of loans are issued through P2P loan platforms such as NFTFi and Arcade. The rest are issued by P2Pool loan suppliers such as BendDAO, DropsDAO, PineDAO, Goblin Sax and etc.
Current total addressable market for NFT-backed loans is over $250mn by loan volumes. With a higher volatility, NFTs loan lenders can get higher expected returns than traditional crypto-backed loans.
a) P2P NFT-backed lending platforms. The two largest players in this space are NFTFi and Arcade, of which the aggregate loans issued to date has amounted to ~$240mn. Currently, only blue-chip NFTs are supported on these P2P platforms given the high volatility and uncertainty in other long-tail NFT items.
NFTFi is built on top of the NFT lending protocol, MetaStreet. It allows NFT owners to borrow wETH or DAI using their NFTs as collaterals and lenders get to earn interests by supplying these loans. NFTFi’s 90-day loans require an APR up to 1,000% while longer-duration loans’ average at ~90%. The company has handled a loan volume of $217mn across 13,363 loans since its May-2020 inception (as of Jul 5, 2022). NFTFi charges 5% on lender’s interest revenue upon successful loans (excluding defaulted ones). Some of the collatealized NFT include wrapped Crypto Punks (~29% of loans) and BAYC (23% of loans).
Arcade ($20mn) is built on the Pawn protocol and has facilitated ~$20mn loans since inception in 2022. Other than wETH and DAI, users can also borrow USDC by collateralizing NFTs from the selected list. Unlike NFTFi, Arcade charges borrowers a fixed 2% of principal upfront when the loan is originated.
Neither of the above P2P lending platforms underwrites any risk and does not rely on algorithmic pricing to scale. However, the scalability is limited by its bespoke loan terms and potentially slower matching as borrowers must wait for counteroffers.
b) P2Protocol NFT-backed loans
The size of P2Protocol lending market is still small ($30mn-$50mn). Major players include BendDAO, Drops, Pine, Goblin Sax, JPEG’d and Defrag. Some lending platforms, e.g. BendDAO, adopt vote-escrow tokenomics to incentivize NFT holders to supply liquidity in various loan pools. Similar to DeFi liquidity pools, they emit governance tokens to boost interest rates for lenders.
To resolve P2P lending marketplaces’ slow matching issue, P2Protocol lending projects allow for instantaneous time-to-liquidity as the matching process is handled by the protocol. But the downside is automating loan terms requires rich data points such as real-time prices and rarity stats, and hence limiting the NFT selections to the already liquid ones with quantitative properties.
Even with the over-collateralization (50% at least) for NFT-backed loans, NFT-backed lenders still assume a bigger risk than traditional crypto asset-backed loan providers due to a higher possibility of “voluntary” defaults. This happens if borrowers give up on repaying loans when the value of NFT is less than loan amount. To mitigate such risks, accurate price discovery, credit risk analysis and insurance are all crucial value-added services that many lending platforms have integrated or are actively exploring.
Inspired by NFT marketplace aggregators, NFT-backed loan aggregators and infrastructures may be on the next trend as NFT lending marketplaces are still fragmented (esp. in P2Protocol). Apart from MetaStreet mentioned above, Spice Finance is a newer project that aims to consolidate existing P2Protocol loans onto one single platform by integrating various NFT P2Protocol protocols. On top of that it has built out a machine-learning NFT appraisal tool and credit risk system to underpin the integrated loan platform.
The biggest risk for such aggregators comes from the high level of integration and composability as the projects inherit the risks of all the underlying applications.
(2) NFT liquidity pools
NFT liquidity pools can be categorized into staking liquidity pools and trading liquidity pools, which are mirrored from DeFi liquidity pools. The main variation is users can mint fungible tokens (e.g. ERC-20 tokens) by depositing NFTs of similar traits/floor prices into the same liquidity pool. The fungible tokens are a representation of and can be swapped for any random assets in the pool. Liquidity providers can enjoy faster time-to-liquidity by depositing NFTs, minting corresponding fungible tokens and swapping them easily via DeFi AMMs (e.g. Sushiswap if using NFTX). Apart from NFTX, another key platform is NFT20. As liquidity pools involve the minting of fungible tokens, this types of services is often times powered by NFT fractionalization protocols.
Same as DeFi, users can arbitrage out an NFT if it’s mispriced and hence facilitate the price discovery. Additionally, liquidity providers usually get LP tokens and can stake them for boosted rewards. Given NFT’s higher volatility and speculation, however, the risk of slippage may be a challenge for both platforms and investors to handle.
(3) NFT renting
Renting provides another direction for NFT owners to generate passive income. Double Protocol’s ERC-4907 standard has just become the 30th official ERC standard on Ethereum, which takes an innovative approach by adding an ‘expires’ feature that authorizes automatic expiration for the ‘user’. In this way, projects that are built upon ERC-4907 standard can easily segregate users’ ownership from the right of use that will automatically cease upon the end of the renting period. This will fuel up the development of NFT renting and give rise to more derivatives built around it.
NFT renting can be applicable to a variety of use cases including gaming, art, PFP, membership NFTs and so on. For example, art exhibitions, brands or events may rent out specific digital art NFTs that match with their pop-up shows/events. Or someone who want to join a community for a period of time before making a long-term commitment may rent out a membership NFT for one month (sounds like subscription to paid contents).
The most promising use case for NFT renting is gaming given the imagination of the size of metaverse. Virtual lands may drive up some hypes as many owners invested in a large amount of lands so that they can count on them to generate passive rental income from different types of uses as the game onboards more users and brands. Furthermore, in-game assets such as skins, gears, pets, characters and other items are either required to play the game or granting advantages to players. You may find an example from my article about how players rent out the Hero characters in the game. In cases where players can’t afford or simply don’t want to buy in-game NFTs due of all sorts of reasons, they will opt for renting, boosting NFT liquidity further.
IV. Other Thoughts for NFT Liquidity Solutions
When it comes to NFT trading, what can drive liquidity further seems to come from communities where users are aligned on tastes and values for the NFT projects that grow out of the community. Often times, the marketplace is a vertical one which is decided by the theme / vibe of the community behind. Such an NFT marketplace is great for NFT projects to exert the tokens’ influence and utilities among community members. Project owners will also have this sense of belongingness and ownership as they can take part in the voting of marketplace design to deliver certain user experience.
DAOs sound like an organic place for such a marketplace to develop especially with the aforementioned Seaport Protocol that lowers the threshold of developing. Additionally, centralized NFT marketplaces are also actively exploring the community features, such as Coinbase’s beta version of its NFT marketplace has a focus on creating a social community for both buyers and sellers.
V. Closing Thoughts
All the above liquidity solutions are trying to resolve issues based on the current NFT market size. What drives NFT liquidity fundamentally in the long term will have to come from its own penetration in various industries.
We are on an exciting journey into the future of NFTs, where we’ve seen prestigious businesses and celebrities from sports, fashion brands, music streaming services and education forming their partnerships with metaverse-like projects and blockchain technologies. The ultimate way to boost the NFT liquidity is through mass adoption. Along the journey of NFT financialization and further adoption, NFT trading platforms are likely to be made subject to more stringent regulations regarding anti-money laundering and security investments.
Fasten your seat belt and stay tuned.
