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Abstract narrative of NFTFi: Liquidity challenges, introduction of new roles, risk substitution.

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Whether it is DeFi or GameFi, the fundamental requirement of Fi is that its underlying assets have a certain ability to generate interest.

Original Title: "NFTFi's Abstract Narrative: Liquidity Challenges, Introduction of New Roles, Risk Substitution and Its Extensions | ZONFF Insight"

Original Source: Kylo, Investment Manager at Zonff Partners

From BendDAO's popularity that brought NFTFi's narrative on track, to Sudoswap introducing a new NFT trading paradigm, NFTFi has developed for nearly a year. Looking back at the opportunities that led to the rise of BendDAO and Sudoswap, there were some inevitabilities and some coincidences. The inevitability lies in the shift in user demand, while the coincidence is that an unlicensed product happened to appear at this opportune moment.

BendDAO is not the beginning of NFTFi. Many NFT Lending Protocols have come and gone, seizing the opportunity of NFT lending but failing to capture the market. Sudoswap is also not the first project to do homogenized NFT trading, with NFTX preceding it by at least a year. So what is the takeaway? An underdeveloped narrative actually exists in past stories, only this story has a new cover and has been forgotten in a corner. When people suddenly remember this story and can tell it in a different way, it becomes new again, but the core remains a narrative.

Starting with BendDAO

BendDAO is a story about a grass-roots boat borrowing demand. The BAYC airdrop has mobilized the demand of NFT holders to expand their NFT exposure. Borrowing ETH with NFT as collateral can maximize the benefits of holders. The advantage of BendDAO's permissionless collateral P2Pool lending model over previous P2P lending is that the borrowing experience is smooth. As long as BendDAO can solve the funding problem, the subsequent lending process will become natural.

The core of BendDAO is a lending protocol in DeFi, but the difference is that for traditional fund pool-based lending protocols, the user's collateral position is part of the lending supply. This means that the borrower is also providing excess liquidity to the lending protocol's fund pool. Excess liquidity here means that the funds deposited by the user into the lending protocol are greater than the funds borrowed by the user, without considering duplicate borrowing. Under this mechanism, the TVL of the lending protocol will be positively correlated with the borrower's demand. However, one difference with NFT lending is that the collateral itself does not have capital attributes or has weak capital attributes, and its commercial attributes cannot directly support the TVL of the lending protocol. This requires the protocol to use its own tokens as liquidity incentives to attract a large amount of assets that can be borrowed to be deposited into the fund pool of the NFT lending protocol, causing a certain degree of imbalance between the supply and demand of the protocol tokens.

The issue of tokens is secondary, and can be solved by raising the benchmark interest rate for borrowing and lowering liquidity incentives. The problems with BendDAO mainly focus on two areas: liquidation mechanisms and floor price manipulation. Currently, the trading scheme for NFTs still relies on order books, where sellers wait for buyers to make a move. This trading model is not suitable for liquidation mechanisms that require high liquidity. When the health factor of a certain NFT collateralized loan position in BendDAO is too low, the NFT collateralized position will be auctioned off in the secondary market. Due to the lack of liquidity for the NFT in the market, the number of NFTs that need to be auctioned off accumulates in the short term, causing further decline in the NFT floor price and panic among depositors. Floor price manipulation is very similar to oracle attacks in DeFi. Due to the lack of liquidity in NFT trading, whales can manipulate the NFT floor price by maliciously placing low-priced orders on the NFT Marketplace and self-trading, in order to deliberately clear the target NFT collateralized loan position.

Ultimately, the two aforementioned issues with BendDAO are fundamentally liquidity problems with NFTs. Insufficient immediate liquidity leads to an accumulation of NFTs that are liquidated, which can also affect the floor price. However, liquidity issues with NFTs have always been a "unique" problem with NFTs, and new trading paradigms such as Sudoswap have made some contributions to solving the liquidity problem with NFTs, mainly by building immediate liquidity pools that allow NFTs to be liquidated immediately around the floor price without a lengthy waiting process. Due to the fact that the market share of Sudoswap-like AMM NFT DEX is still too small and the heterogeneous characteristics of PFP NFTs, the mainstream solution is still order book-based.

What are the solutions?

Faced with the current temporarily unsolvable NFT liquidity problem, the NFTFi project can actually choose to solve the liquidation mechanism and floor price manipulation problems in other ways, mainly by transforming collective risk into individual risk and implementing a separate NFT pricing mechanism.

Hybrid Mechanism

Collectivism is a description of the P2Pool model. As the common creditors of the NFT lending position are the ETH fund pool, the assets that will be returned in case of default will definitely be ETH. Therefore, the P2Pool model must go through the process of asset conversion from NFT to ETH, which must rely on good NFT liquidity to achieve. However, the difference with the P2P model is that there is no auction process in the nature of the final settlement. After default occurs, it only needs to be realized through the transfer of NFT, thus bypassing the liquidity problem of NFT. However, the P2P model also has an inefficient problem, so the NFT lending project can actually adopt a hybrid model, with P2P as the core and P2Pool as the surface. The possible manifestation is to first attract ETH Lenders to open NFT Lending Pools for different NFTs, and set the conditions for borrowing and lending in the Lending Pool, such as interest rates, supported NFTs, and borrowing periods, etc. People who meet the conditions can borrow unconditionally. The primary responsible person of the NFT Lending Pool belongs to the creator of the Lending Pool. The Lending Pool can accept third-party deposits and serve as the direct creditor of the Lending Pool creator. Therefore, the above mechanism constructs a hierarchical structure:

Third-party depositor -> Lending Pool creator -> NFT collateral borrower.

Lending Pool creators act as direct creditors of NFT collateralized borrowers. In the event of default, the NFT collateral will be deposited into a multi-signature address, and then third-party depositors, as creditors of the Lending Pool creators, will reclaim their ETH deposits. At this point, the Lending Pool creators can choose to sell the NFT or retain it to repay their debt to the third-party depositors. If the Lending Pool creators fail to repay their debt within a certain period of time, they will forfeit ownership of the NFT and be penalized a portion of the funds, and the protocol will liquidate the NFT and return the auction proceeds to the third-party depositors.

The above mechanism is a possible form of the hybrid mechanism, which utilizes a hierarchical architecture to give first-tier creditors the right to dispose of NFTs. They can choose to auction or retain them. More choices and extended auction time are also beneficial for smoothing the price curve of NFTs. Moreover, since the above mechanism is generally a fixed-term loan, there is no default or liquidation issue during the loan period. Default and liquidation only occur after the loan period ends, thus avoiding the situation of mass liquidation caused by market conditions. This mechanism retains the option of liquidation, and it can quickly integrate the NFT liquidation pool after the liquidity problem of NFTs is solved in the future. Compared with the closed nature of the pure P2P model, the hybrid mechanism has future-oriented openness.

NFT Pricing

The determination of the liquidation line in NFTFi is generally directly related to the floor price of the NFT collection. In the current situation of insufficient NFT liquidity, relying the core of the NFTFi stabilization mechanism on a pricing mechanism that is easily manipulated will bring risks to the entire system. One possible solution is to price each NFT separately and set a uniform LTV. The main methods include machine learning pricing and asset category substitution.

Machine Learning Pricing Methodology

The machine learning pricing method is the most nonsensical one. It estimates the price of different features of NFT by using empirical data and combining it with a certain curve. Due to the scarcity of trading data for certain features of NFT, this price estimate is very inaccurate. Another problem is that this pricing model lacks scalability and ecological integration. Due to the inaccurate estimation of NFT pricing, this data is difficult to be used by NFTFi applications as a fair price, so it is more of a price reference. Then the problem arises again, the interpretability of the machine learning model is weak, and there is no comparability between the models trained in the absence of accurate data feeding. Therefore, it is impossible to know which toy model is more effective.

Asset Category Replacement

The general logic of asset category substitution is that a third party locks in additional liquidity to form an asset package to back the value of a single NFT, and then uses the asset package as collateral for borrowing and lending. This approach essentially creates a nested structure, where the NFT holder pays interest twice for their borrowing and converts the liquidation asset from NFT to ERC-20 asset. The specific structure is as follows:

NFTHolder -> NFTHolder —> -> -> ERC-20 -> ERC-20 资产包 -> Asset package —> -> -> DeFi -> DeFi 抵押借贷 -> Mortgage lending

The first interest payment is the bribe paid when obtaining ERC-20 asset packages from C-end. There are two points to note in the bribery process: first, this mechanism is generally aimed at high rarity NFTs. Due to the fact that mainstream NFT lending protocols are priced at floor prices, high rarity NFTs are generally excluded from the NFTFi ecosystem. Through this pricing model, NFTholders can participate in NFTFi in a form close to their true value after paying a certain fee, and bribery is only the cost that needs to be paid in this process; second, C-end users who evaluate the price of the NFT "must bear more costs after receiving the money". Each price evaluation has a certain fixed period, and the ERC-20 assets paid by C-end users and the NFTs held by NFTholders are both managed by the pricing protocol. NFTholders can use ERC-20 asset packages to participate in DeFi mortgage lending and earn interest, and the amount of assets that can be borrowed is LTV x $(ERC-20 asset package). Therefore, the main risk faced by C-end when evaluating the price of NFTs is that when the price evaluation period expires, if the borrower thinks that the value of the NFT is less than LTV x $(ERC-20 asset package), they have the motivation not to return the assets borrowed from DeFi, and the corresponding ERC-20 asset package will be liquidated, and the C-end price evaluator can only get the NFT in the end.

The core essence of the above mechanism is essentially a game process. First, NFT holders transfer the risk of NFT to Counterparty through P2P after paying a certain cost, and obtain the asset package of ERC-20. Then, they participate in DeFi lending using the asset package, and convert the final settlement into ERC-20 settlement instead of NFT settlement, directly avoiding the liquidity problem of NFT. This NFTFi-DeFi exchange mode is theoretically feasible, and compared with machine learning pricing method, this method is more reasonable in complexity and logic.

NFT Liquidity Solutions - Common Trading Paradigms

The four trading modes of order book, aggregator, fragmented protocol, and AMM constitute the core of NFT transactions. Currently, NFT trading volume is mainly concentrated in the order book and aggregator, while fragmented protocols and AMM serve as supplements for NFT instant liquidity. These four paradigms have been continuously iterated since their inception, reflecting their respective problems, development directions, and improvement trends.

Order Book NFT Marketplace

NFT Marketplace is divided into two types: corporate and community. The corporate type, represented by Opensea, aims to provide NFT trading as a service to customers and earn transaction fees. The community type of NFT Marketplace aims to use a reasonable token model to give rebates to community users, represented by X2Y2 and LooksRare.

Currently, the leader in the NFT Marketplace order book is still Opensea, which is company-owned. According to the rational assumption, NFT traders would have the motivation to switch to X2Y2 platform for trading, as it offers the lowest transaction fees and also allows them to earn a portion of the transaction mining income. However, in reality, this kind of conversion has not occurred. The main reason may be related to the current profile of NFT traders. Most NFT speculators are not from token speculators, and their wealth appreciation mainly comes from the premium of NFT. Therefore, for them, trading is mainly a service. Compared to better, faster, and smoother trading services, as well as more and better NFTs, a little trading rebate is insignificant. Therefore, for community-owned NFT Marketplaces, it is necessary to fully recognize the disconnection between NFT speculators and token speculators, and to design an economic model with this disconnection in mind. In fact, the mainstream community-owned NFT trading platforms that have already issued tokens have not carefully considered the disconnection problem between the two types of participants in the design of their token economy.

The main issues include:

- The governance token does not provide any trading convenience or privileges for NFT traders.

- Due to the lack of motivation for NFT traders to purchase governance tokens, they do not retain the token rewards for transaction mining, resulting in significant selling pressure.

- Token holders can obtain platform fee sharing through staking, but the potential huge selling pressure reduces the motivation for token holders to stake.

- NFT traders and governance token holders have fundamentally conflicting interests, so there may be irreconcilable conflicts between the two in terms of community governance.

In summary, the token economy design of the currently issued NFT Marketplace does not bind the interests of the community, tokens, and NFT traders to some extent. The core of solving the problem is how to make NFT traders actively hold tokens. The demand for holding tokens should be in line with the essential needs of NFT traders, which include two points: better access to whitelist NFTs and better trading of NFTs. Better access to NFTs needs to be considered from the perspective of the community, while better trading of NFTs needs to be considered from the perspective of product, liquidity, and price.

Getting a better NFT whitelist depends on the NFT Marketplace's strong community resources, which make many NFT project parties willing to benefit the community members of the NFT Marketplace. Better products, liquidity, and prices require full consideration of the trading needs of NFT Traders, whether royalty fees need to be charged, and the setting of transaction fees.

NFT Trading Aggregator

The differentiation competition strategy of aggregators has been a long-standing issue since Gem and Genie. From the beginning of Car, to safe mode, to gas monitoring, and to the finer-grained secondary K-line, aggregators have iterated their products step by step towards a more professional trading experience. At the same time, various data platforms such as NFTnerds and Uniswap have also started NFT trading, and currently, the competition in the NFT aggregator field is fierce.

Regarding NFT trading aggregators, there are a few basic recommendations:

One is to carefully divide the user groups of NFT traders and capture the underlying needs of different types of traders. NFT traders are divided into professional traders and ordinary traders. The simple and concise UI of Blur and the finely-grained K-line chart are prepared for professional NFT traders at the product level. Too much information interference will make the experience of professional traders very bad. Element is mainly aimed at ordinary traders, and the page has rich NFT information, which is easy for ordinary traders to get started. This is a typical example of designing products based on user groups.

The second benefit is the beta of the experience of hard roll products, but exploring the potential collaborations between NFT trading aggregators and other areas of NFT is the alpha.

Fragmented Protocol and AMM

NFTX and Sudoswap are both democratized instant liquidity pools that treat non-fungible assets as fungible and act as market makers. However, the fragmented protocol has undergone multiple narrative changes since its inception, from share fragments to trading and now to collective ownership. Share fragments is likely an outdated narrative, while NFTX currently leads the trading narrative and collective ownership is a new narrative proposed by Tessera.

Regarding trading, there is no difference in mechanism between NFTX and Sudoswap. The only differences are in their form, which can be summarized in two points:

NFTX has added a fragmentation and minting process during trading;

For NFT pricing, NFTX uses the ERC-20UNIV2 pricing model, while Sudoswap uses a price curve (linear or exponential).

除了可以满足 NFT 交易的需求外，NFTX 等碎片化协议在叙事上可以扩大化：

Translation:

In addition to meeting the needs of NFT transactions, fragmentary protocols such as NFTX can also expand the narrative:

Like Sudoswap, it serves as a liquidation liquidity provider pool for NFTFi.

NFT DeFi intermediation;

As the middle layer of NFT DeFi, this sentence may be somewhat abstract. Currently, there are actually some NFT options, NFT futures, and NFT structured products. In essence, the above three types of products are speculating on the price fluctuations of NFT. Similarly, based on fragmented NFT, derivatives based on the ERC-20 standard will be more detailed in granularity than NFT, and various derivatives based on the ERC-20 standard currently have a relatively complete and mature system. However, even so, it may be too early to do NFT derivatives at this stage. The bottom layer of NFT liquidity has not been properly resolved, and the derivatives field with higher liquidity requirements than lending protocols will face more serious price manipulation and liquidity problems.

So where does the value of Sudoswap lie? Sudoswap is based on the existing NFTX, which was created in response to the demand from individual traders for non-royalty, fast trading, and close-to-floor-price speculation. Therefore, as long as the demand for close-to-floor-price NFT speculation from NFT traders does not disappear, Sudoswap will continue to exist as a reasonable trading model. In addition, due to the homogenized nature of Sudoswap trading, Pass Card NFTs with semi-homogenized colors that require NFT integrity and GameFi NFTs are naturally suitable for Sudoswap trading.

What could be the new trading paradigm to solve NFT liquidity?

Existing trading paradigms are battling it out on the original continent and gradually forming a stalemate. One way to break the current stalemate is to open up new continents and introduce more NFT asset categories. Another way is to introduce new participating roles and unite different stakeholders. Just as the increase in NFT lending products will spur the emergence of NFT aggregation lending markets, AMM DEX such as Sudoswap and royalty fees will give rise to professional NFT market makers.

As for why professional market makers appeared after Sudoswap, the main reason is that Sudoswap protocol itself does not charge LP market-making fees and profits, while for order book marketplaces, the transaction fees for each transaction need to be paid in the form of service fees. On the other hand, the existence of royalty fees makes market makers based on Opensea bear high market-making costs. Sudoswap and the subsequent NFT Marketplace royalty fees have sharply reduced market-making costs. Under the premise of sharp decline in market-making profits based on ERC-20 currencies, NFT itself has higher volatility and higher slippage for each transaction. In the case of reasonable market-making, the market-making profits of NFT projects may be higher than those of ERC-20 market-making. Therefore, based on the principle of arbitrage, the original on-chain ERC-20 market makers have the motivation to turn to NFT market makers.

The introduction of NFT market makers will bring some new changes to the entire NFT field. Before the emergence of on-chain NFTFi market makers, the value circulation of NFTs could be represented as:

Individual investors' ETH and NFT -> NFTFi -> NFT liquidation -> NFT Marketplace

The emergence of market makers will add another layer to the above path:

Individual investors' ETH and NFT -> NFTFi -> NFT liquidation -> NFT market maker -> NFT Marketplace

As a liquidity provider, market makers play an important role in revitalizing the entire NFT Marketplace. To ensure that Delta Neutral market makers have the incentive to take on excess liquidity, they collect NFT buy orders from various NFT Marketplaces before accepting them. Having enough NFT buy orders also implies the possibility of NFT Swap for NFT market makers. The core of NFT Swap is to obtain as many potential NFT buy orders from the market as possible, and to exchange them by providing an ETH fund pool for matching between different buy orders. This mechanism can serve as a supplement to the current order book trading model.

NFTFi's Extension: The Relationship Between Gaming Guilds and NFT Leasing Agreements

Game guilds often have an NFT leasing system built in to facilitate gold farming for guild members. The commonly used solutions involve building on-chain and off-chain account systems, multi-signature or MPC co-management. Game guilds have strong regional characteristics and are able to attract a large number of local GameFi gold farming players. Guilds can also use this as leverage to obtain NFT gold farming assets for many GameFi games at a lower price. Returning to the motivation behind GameFi project teams collaborating with game guilds, are they coveting the regional characteristics of game guilds or the gold farming players represented by them? If it is the gold farming players of game guilds that they covet, then how does having an NFT leasing agreement with the same number of users compare to game guilds in terms of advantages?

NFT leasing agreements and game guilds both essentially provide users with leasing functions, so for a rent collection system, user volume is the main indicator that determines the platform's upper limit. Admittedly, game guilds can generate revenue through NFT premiums, but this model is also feasible for NFT leasing agreements. For game guilds, having strong regional characteristics is both an advantage and a disadvantage for future expansion, as the number of GameFi gold farming players in a region is limited. However, for NFT leasing agreements, their users are GameFi gold farming players on the entire chain; in addition, the GameFi game assets that game guilds can provide gold farming services for need to be purchased, and it is impossible for them to purchase all GameFi NFT assets on the chain for users to use. But for NFT leasing agreements, in theory, liquidity incentives and other means can encourage all NFT holders to provide NFT leasing liquidity in the leasing agreement. However, game guilds and NFT leasing agreements are not completely competitive. Currently, game guilds are still strong, and NFT leasing agreements often cooperate with them in the form of becoming an embedded NFT leasing system within the game guild.

NFTFi is a pseudo-narrative?

Is NFTFi a real demand? How can doing something based on a real demand be considered a false narrative? Currently, the market size of NFTFi is still very small, either due to the liquidity of NFT or the fact that NFT assets are too single, mainly PFP. PFP NFT has no utility other than social attributes, so how can the logic of Fi be implemented in a closed loop? Whether it is DeFi or GameFi, the basic requirement of Fi is that its underlying assets have a certain ability to generate income: DeFi's underlying assets can generate income through currency exchange, and GameFi's underlying assets can realize value feedback through leasing. So I think that aside from all the factors that currently limit the development of NFTFi, the logical gap of PFP NFTFi may lie here.

Note: The projects mentioned in the article do not constitute any investment advice. The article only represents the author's current personal views and cannot represent Zonff Partners. The information and opinions published in the article may no longer be accurate due to changes in the situation or other factors after the publication date.