Non-fungible tokens have the potential to profoundly impact the decentralized finance ecosystem. As DeFi continues to gain momentum with greater institutional adoption and improvements to various applications, I believe NFT technology will likely play an important role. Most notably, NFTs offer new opportunities in loan collateralization, fractional ownership, insurance, debt management, and KYT and compliance.
Loan Collateralization
By definition, in collateralized loans, the borrower pledges certain assets. If the borrower defaults and is unable to make payments on the loan, the lender can take possession of and liquidate the collateral. As NFTs have become a promising asset class, they are becoming increasingly used as collateral.
How does it work? The borrower lists their NFT so potential lenders can decide whether they want to offer a loan. The lender then makes an offer including its fair assessment of the NFT’s value, the loan-to-collateral ratio, the length of the term and the interest rate. The borrower can then accept the offer, at which point they receive funds from the lender while the NFT is locked as collateral.
As DeFi and NFTs both live on-chain, smart contracts can facilitate the process. When a loan offer is accepted, a transaction creates a new loan contract, which sends the NFT to an escrow smart contract, transfers the loan from the lender’s to the borrower’s wallet and issues a promissory note in the form of a new token to the lender. As this entire process happens in one transaction on the blockchain, it is “trustless” meaning there is no risk that an NFT will be sent without the borrower receiving funds and vice versa.
The loan, which now lives on the blockchain, is “managed” by smart contracts, which continuously monitor its health. If the borrower fails to repay the lender by the term of the loan, the escrow smart contract will automatically transfer the NFT collateral to the lender’s wallet. Alternatively, when the borrower repays the loan in whole, the NFT is automatically unlocked and returned to the borrower’s wallet upon which the promissory note token is burnt.
Using NFTs as collateral simplifies the lending process and comes with many of the broader benefits of DeFi. For borrowers, it eliminates risk of lender discrimination, ensuring the borrower can obtain fair market terms on their collateral no matter their demographic or financial standing. For lenders, it mitigates the risks in the case of default as collateral seizure happens automatically. For both parties, it reduces cost and speeds transaction time—no long underwriting process, legal fees, complex paperwork or closing process.
Fractional Ownership
A fractional NFT is one that is divided into smaller fragments, meaning ownership can be split across multiple buyers. Smart contracts make it possible to predefine a number of tokens linked to an original indivisible NFT.
Fractional ownership reduces the capital barrier to entry. If a collector wants to join a particular NFT community or speculate on its expected growth, fractionalization makes ownership of a collection much more obtainable in cases where they would have otherwise been priced out.
Additionally, fractional ownership improves liquidity because the asset subsequently becomes easier to resell.
Insurance
Similar to collateralized loans, NFTs can facilitate insurance policies. Ownership can be more easily transferred, bought, sold and tracked via blockchain’s distributed ledger. Because NFTs are immutable and data on the blockchain itself is transparent and verifiable, NFTs provide a reliable way to prove ownership and prevent tampering with insurance policies.
Furthermore, NFTs can streamline the entire insurance policy underwriting and purchase process, which normally requires encumbering paperwork and information. These NFTs can also help prevent fraud in the case of claims since their smart contracts can be verified to pay out claims.
Debt Management
Debt management is perhaps the area of DeFi that stands to benefit the most from NFT technology. Debt management strategies rely on either an individual’s own self-discipline and self-management or on a third party. Both are subject to human error and require a significant amount of time spent on calculations and approvals.
Instead, smart contracts can be used to make calculations and automatically execute required actions, reducing time spent and human error. Thanks to NFT technology, all data stays on the ledger so details can be verified at any time and tracked.
KYT And Compliance
“Know your transaction,” or KYT, and compliance are vital to any DeFi business process or operation. Verifying the identity of all parties involved in a transaction, such as the source of funds, can reduce fraud and criminal activity. By leveraging blockchain technology, users can use NFTs to streamline the KYT process and thus the overall transaction. Instead of running an identity verification process every time, a user can share the NFT containing the stored identity data.
Challenges Facing NFT Adoption Within DeFi
While promising, there are several challenges that come alongside implementing NFT technology within DeFi, such as the volatility of the NFT market and security concerns associated with these assets.
To use an asset as collateral, both parties need to know its exact current value and have the ability to project its value into the future. This becomes difficult to pinpoint and forecast when prices constantly fluctuate—which is unfortunately the case in this volatile NFT market.
Furthermore, NFTs have been the victims of scams and unauthorized duplication by malicious parties, creating security concerns around utilizing them within DeFi—especially because these use cases involve tying them to user funds. Fortunately, there are technology solutions to protect users and DeFi platforms from these types of threats. However, until users and platforms are more widely aware of these kinds of solutions and actually implement them, they may remain hesitant toward engaging with NFTs from a financial standpoint.
Closing Remarks
In this burgeoning decentralized world, NFTs could drive user adoption. They streamline otherwise complicated processes and make implementation much more straightforward. In the case of DeFi, NFTs can help unlock the value of a decentralized economy and financial system.
Originally posted on Forbes.
