Author: Nan Zhi
Introduction
This article aims to explore the development path and trends of NFT lending by organizing the lending terms and liquidation mechanisms of various NFT lending protocols and important proposals that have been passed. The research subjects include BendDAO, LianGuairaSLianGuaice, JPEG’d, Blend, NFTfi, Arcade, Pine Protocol, and Sodium.
All parameters and proposals in this article come from protocol whitepapers and governance platforms, and the data comes from Blur, OpenSea, LooksRare, and X2Y2. The data is based on platform floor price data, and the deadline is July 30, 2023. The statistics are summarized through Dune.
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Overview of Liquidation Mechanisms
This article divides lending protocols into two categories:
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Point-to-pool type: Borrowers borrow from a collective fund pool;
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Peer-to-peer type: Borrowers and lenders match and trade directly.
Common features of point-to-pool lending protocols include:
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They all use decentralized oracles to provide pricing information. The basic algorithm is usually the Time-Weighted Average Price (TWAP) algorithm to avoid abnormal instantaneous fluctuations. The specific algorithm is not publicly disclosed to prevent floor price attacks;
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The borrowable ratios of BAYC, CryptoPunks, MAYC, and Azuki are significantly higher than other NFTs, and their liquidation thresholds are usually better than other series.
In point-to-pool protocols, because borrowers can borrow immediately and the overall market has not shown a clear upward trend since the NFT bull market in April 2022, to control risks, lending protocols only open lending functions for certain blue-chip NFTs and set relatively strict control parameters.
For example, in BendDAO, with an LTV of 30% and a liquidation threshold of 65%, a drop of 62.5% is required to trigger liquidation. In LianGuairaSLianGuaice, the liquidation drop is 53.8% with an LTV of 30% and a liquidation threshold of 65%.
Although subsequent market results have shown that multiple blue-chip series experienced drops of over 50%, the following is a price curve chart of Moonbirds starting from April 18, 2022. The floor price on that day was 18.9 ETH, reaching a peak of 37.6 ETH on April 24, 2022, and as of July 30, 2023, the floor price is 1.7 ETH, with a maximum drop of 95.5%.
Point-to-pool protocols improve the matching efficiency of blue-chip NFTs, eliminating the need for borrowers and lenders to reach a consensus on market conditions and enhancing the turnover ability of blue-chip NFTs. However, to ensure the security of the overall fund pool, the economic efficiency is generally lower. In addition, point-to-pool protocols alone cannot solve the problem of rapid deterioration in market conditions. For example, in the case of rapid liquidation after the issuance of Azuki Elementals, the project party had to take temporary measures outside the protocol mechanism to cope. Relying solely on auction liquidation mechanisms may result in bad debts.
Reference report: “LianGuairaSLianGuaice: Due to the drastic fluctuation of Azuki price, Azuki mining pool is temporarily suspended, including recharge, withdrawal, forced liquidation and other functions.”
In peer-to-peer lending agreements, common characteristics include:
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Usually not involving a floor price, with the timely repayment of the loan as the trigger for liquidation;
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Usually the lending party issues the offer (i.e. parameter settings for loan conditions), representing the lending party’s market advantage;
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Usually allows for extension, delaying liquidation.
Peer-to-peer agreements solve the lending problem of long-tail assets through matching, because the non-blue chip NFT market is relatively niche, the lending party has the advantage, so the lending party mainly issues offers, and only in Sodium because it allows for multiple loans in multiple steps, the borrowing party issues the offer. Liquidation is based on the repayment of the loan at maturity, avoiding the liquidation problem that peer-to-pool agreements may face if the price rapidly declines, but it also brings the risk that the borrowing party may not consider repayment if the price continues to decline without recovery. Pine Protocol has set up the function for the lending party to initiate liquidation, but an additional 5% liquidation fee is required.
In addition, peer-to-peer agreements usually support extensions, but only Blend and NFTfi support the re-negotiation of loan conditions. This mechanism can avoid significant differences between market conditions and the original loan conditions. Pine Protocol has made targeted settings for this, limiting the loan period to only 7 or 14 days, reducing the possibility of large fluctuations. Comparing to the traditional bond market, changes in market interest rates are balanced by reverse changes in bond prices, but NFT loan agreements do not have enough depth in the secondary market to support this balance for now. However, as the market size continues to grow, it is also a potential development direction. Pine Protocol V3 has made initial attempts to tokenize loan positions and transfer them between accounts. Therefore, for protocols that support loans with durations of more than a quarter, the function of re-negotiating loan conditions is indispensable.
Loan Terms and Liquidation Mechanism Proposal
In the initial versions of major lending protocols, the loan term parameters were relatively strict and lacked flexibility. In the process of development, in order to cope with the liquidation crisis caused by price declines or to improve economic efficiency and promote protocol development, restrictions have gradually been lifted. This section lists the proposals for important changes to loan terms and liquidation mechanisms mentioned in the previous section.
The proposals mainly have two directions: improving economic efficiency and improving liquidation.
Methods to improve economic efficiency include: increasing the proportion of loans for top blue chip NFTs, or increasing the proportion of loans for rare editions in a blue chip series. For example, in BendDAO, the initial version’s LTV for BAYC was only slightly higher than other NFTs, and in BIP#15, the gap was expanded to 30%. In version 1.4 of LianGuairaSLianGuaice, the LTV for LianGuai skins BAYC and Koda has increased by 6 times.
There are several ways to improve liquidation, including reducing liquidation, such as JPEG’d PIP-61 allowing partial repayment and extending the time of liquidation. Another way is to ensure the success of liquidation and prevent auction failures. BendDAO’s BIP#9 removes the minimum bid limit, greatly increasing the profit margin of liquidation. Major protocols are also shortening the auction time. According to JPEG’d statistics, most auctions occur in the last few hours or minutes, so it is only necessary to ensure that users have enough reaction time to participate in the auction.
To study the relationship between research and market conditions, the following time references are based on the start voting time of the proposal.
BendDAO
Improving liquidation: BIP#9 (2022/8/22)
Remove the requirement that the liquidation bid price must be higher than the floor price by 95%.
Adjust the liquidation threshold to 70%, completed in three stages.
Adjust the auction period to 4 hours: “The design of the 48-hour window is to protect NFT holders from liquidation without waking up to lose their PFP. But now we have on-chain Oracle with TWAP protection, which means that attacking the floor price will be very difficult. So we hope to reduce the time from 48 hours to 4 hours to improve auction liquidity.”
Improving economic efficiency, improving liquidation: BIP#10 (2022/8/23)
Adjust the liquidation threshold to 80%.
Adjust the auction period to 24 hours.
Improving economic efficiency: BIP#15, BIP#15-1 (2022/11/11)
LianGuairaSLianGuaice
Improving economic efficiency: LianGuairaSLianGuaice v1.4 (2023/1/28)
Increase the value of rare NFT collateral, such as Koda collateral being six times that of regular Otherdeed.
Increase Otherdeed LTV from 30% to 35%-40%.
JPEG’d
Improving liquidation: PIP-51 (2023/4/29)
Reduce the repayment time after liquidation from 72 hours to 48 hours.
Improving economic efficiency: PIP-58 (2023/6/11)
Increase the LTV of each collateral, with a minimum of 5% and a maximum of 25% (BAYC).
Add the function of increasing the LTV by pledging tokens.
Improving liquidation: PIP-61 (2023/6/15)
Allow partial repayment to avoid liquidation.
Improving liquidation: PIP-71 (2023/7/17)
The auction time has been reduced from 24 hours to 12 hours.
NFTfi
Improved Liquidation: Loan Renegotiations (2022/8/30)
NFTfi borrowers and lenders can renegotiate loan terms at any time before the loan is redeemed (i.e., liquidated) by NFTfi.
Pine Protocol
Improved Liquidation: PIP-8 (2023/4/28)
Liquidation fees are levied and paid by the borrower when initiating liquidation, amounting to 5% of the loan amount.
Improved Economic Efficiency: PIP-12 (2023/7/12)
The loan term is limited to only 7 or 14 days, enhancing market predictability and reducing decision complexity.
Improved Economic Efficiency: Pine V3 (2023/1/13)
In Pine Protocol V1 and V2, the addresses of lenders and borrowers are directly written into the loan smart contract. This cannot be changed as long as the loan position exists. To make it more decentralized and flexible, loan positions are marked as NFT in the design of the Pine V3 smart contract. Any blockchain address holding these NFTs will become the lender and borrower of the corresponding loan position.
NFT Blue Chip Index and Major Change Timeline
Based on the prices of 7 blue-chip NFTs such as BAYC, MAYC, Azuki, Pudgy Penguins, CloneX, Doodles, and Moonbirds on 2022/4/18, the NFT Blue Chip Index is obtained by averaging the daily percentage changes in prices. CryptoPunks are excluded because there have been no transactions in this series for multiple days, which can cause distortions.
The following conclusions can be drawn from the relationship between the time of each proposal initiation and the index:
Proposals for improving liquidation are usually made during price downturns. For example, BendDAO had four instances of loan interest rates exceeding 100% in 2022, and when this situation occurred for the second time in August, BendDAO made significant changes to the liquidation mechanism by removing the minimum bid requirement.
Measures to improve economic efficiency have no apparent relationship with NFT prices. Proposals such as BendDAO BIP#15 and JPEG’d PIP-58 to increase LTV were proposed during price downturns or related to the protocol’s own development needs. Another potential factor is the health of NFTs borrowed on the platform. Since BendDAO experienced the fourth instance of loan interest rates exceeding 100% in September 2022, the remaining three months saw loan interest rates at yearly lows, indicating a higher loan health coefficient and becoming a window of opportunity to increase LTV.
With the crisis brought by Azuki Elementals resolved, various lending protocols have the opportunity to improve their protocol mechanisms and parameters. Whether lending protocols can become a booster for NFT recovery or another liquidity crisis will occur remains to be seen.
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