Life imitates art, or is it the other way round? Net wealth locked up in illiquid JPEGs is a running gag in crypto. After all, liquidity is a huge pain point in NFT trading and investment. Meanwhile, having access to liquidity via your digital assets - whether they’re JPEGs or not – unlocks the door to a wealth of opportunities and investment in web3.

“One of the issues with NFTs today is the fact that they are extremely illiquid, and the most popular ones are often worth quite a sum of money,” says Steven, a founding member of Yunt Capital, an early-stage crypto fund and DAO, speaking to Culture3. 

But a recent wave of blockchain protocols and platforms, powered by the tools of DeFi, is trying to change the liquidity game in NFTs. So far Steven has borrowed and fully repaid 231 wETH on NFTfi, an NFT lending protocol that’s facilitated over 12,000 loans worth a collective $208 million (£170 million). Finding a counterparty for NFT trades on short notice is often tricky, he said, and “being able to take an over collateralised loan against your NFTs is much needed in the space.”

The potential for NFT lending is massive, even by conservative estimates. “Over the next 6-12 months we could observe an almost Cambrian explosion of NFT financialisation projects," predicts Stephen Young, CEO of NFTfi, adding that "we can now clearly see the outlines of the emerging NFT finance space.” He explains that compared to other similar markets, only a very small slice of NFTs are used as collateral.

When it comes to traditional art and collectibles, 20% of the value of those markets are locked up as collateral to let their owners access liquidity; the value of real estate collateral used for borrowing is a full 50% of the total real estate sector. By contrast, NFT lending currently represents just 1% of the overall NFT market. That gives some illustration of the significant growth potential for NFT lending – even if the NFT market remains at the current levels.

Access to liquidity is a big deal. By helping asset owners raise capital, lending can and unlock new opportunities and investments. In March, an NFT photographer named Harri appealed to lenders on NFTfi: he needed to buy an off-road vehicle to bring aid to Ukraine, and was using his Doodle as collateral. Young explains that “one of the lenders on NFTfi stepped in and provided a 0% APR loan right away. Just a few minutes later, Harri had 4 ETH in his wallet.”

“Over the next 6-12 months we could observe an almost Cambrian explosion of NFT financialisation projects.”

— Stephen Young, CEO of NFTfi

Collateralising digital assets like NFTs is uncommon, but the concept is certainly proven. YouTuber Mike Majlak, who last April bought Bored Ape #9049, told the story of how he later needed cash to pay the deposit for his new home. Unwilling to sell the furry JPEG, Majlak collateralised it instead for a $200,000 USDC loan. In doing so, he may have become “the first person to leverage an NFT to buy a house” – or at least the first to go public about it.

“Mike contacted us a few weeks ago about his idea to collateralise a BAYC NFT for a down payment on a home he was buying. We appraised his asset and found a lender willing to fund the loan,” says Gabe Frank, founder of Arcade, the NFT liquidity protocol that has facilitated a total loan volume of $15 million to date. Arcade is one of the larger players in the decentralised NFT liquidity sector, where companies connect creditors with borrowers. Pine operates a competing lending protocol in which pools have so far lent out $1 million, whilst JPEG’d specialises in lending against blue-chip NFT collections like CryptoPunks, with $8.13 million on its books to lend (the Total Value Locked in by creditors).

Another innovative use is the ‘NFT mortgage’ strategy, exemplified by Pine’s other service, its 'pine-now-pay-later' protocol. Borrowers can pay a deposit towards an NFT purchase and immediately collateraliase the asset in the same transaction, as one would do to buy a house, but without the paperwork. 

Darius Kozlovskis explains that ‘NFT leverage’ is increasingly popular at Drops, the NFT liquidity protocol he founded. Customers can take this far further than a mortgage on one digital asset, and can even collateralise a handful of NFTs (often two or three) to borrow ETH and buy more NFTs from the same collection with the borrowed capital. “That way users with conviction get the biggest exposure to their favourite NFT collection,” Kozlovskis said. “I didn't think people would do that, but I saw the possibility of using it as leverage.” Drops has supplied a total of $3 million in loans so far.

Unlike traditional DeFi lending protocols like Aave, maximum loan-to-value ratios are often less stringent in NFT lending, meaning that more cryptocurrency can be borrowed in a loan for a specific asset with a given value. Those who set up lending pools can decide what LTV ratios they will accept, but the common practice for Pine pools is to have a right to recall loans with LTVs above 95%, according to Alex Ho, Head of Product at Pine.

For example, you might collateralise an asset worth 180 eth and borrow 95 eth, implying an LTV ratio of 50%. But the asset could decline in value, meaning that creditors would get paid out less in the event of a default. To mitigate this risk, creditors can recall a loan when the asset depreciates by a certain amount; the 95% threshold would be reached when the asset fell to 100 eth. Frank has observed many lenders on Arcade preparing for more frequent defaults. “We’re seeing a lot of lenders tighten up on LTVs and the type of collateral they accept. Most lenders are bullish on the underlying collateral, though.”

NFT lending primarily benefits investors with high-value, illiquid NFTs who are seeking capital to make a purchase or investment, but creators can also benefit from the practice. “We’re in a sort of ‘creator renaissance’ right now, and NFTs are how digital IP gets transferred and captured. So I think there is a lot to explore,” Frank told Culture3. “Some ideas would be loans against previous works to finance the next piece, or reserve bids.”

Young explains that NFT loans already increase the value of NFTs for creators: when investors access liquidity without selling, removing downward pressure on the floor price. Further, creators often hold their own collections themselves, meaning they can also leverage their assets to access liquidity without creating downward price pressure. That provides them with the financial flexibility to grow their community and make genuine progress in their work.

But what gets builders most excited is the fact that the technology to provide liquidity for NFTs is not necessarily limited to digital assets. Kozlovskis argues that Drops is well-positioned for the future development of the sector. “I believe that tokenisation brokerages will start popping up that will allow tokenising real-world assets. Our underlying technology will be able to support those NFTs as well. Perhaps KYC will be required in some cases, but it's definitely an area where the market will be progressing.” If this happens, holders of illiquid assets across the world will have access to a far larger pool of lenders to borrow from, providing them with further opportunities to invest in themselves and their enterprises.

“More and more titles will become NFTs, and so our total addressable market is 40 trillion, taking into account global assets. Not 4 billion or so of the total JPEG NFT market cap,” says Ho. If that's even slightly true, JPEGs are just a tiny fraction of the market over the long term, heralding a major change in how asset holders access liquidity in the 21st century.

“More and more titles will become NFTs, so we think our total addressable market is $40 trillion.

— Alex Ho, Head of Product at Pine