• How Do NFTs Fit Into DeFi?

  • Non-fungible tokens may be an intriguing new technology, but one of their advantages in the crypto world is that they are not considered securities for regulatory purposes. This relieves marketplaces like OpenSea of the burden of registering as a broker-dealer, as well as other restrictions. The absence of that barrier is undoubtedly a major structural factor driving the current NFT frenzy.

    However, financialization has a powerful gravitational pull, particularly in crypto. I’ve previously written about non-fungible trusts (NFTs) that are transforming themselves into securities at the design level by including features such as dividends and governance rights.

    Simultaneously, the code underlying them, which is not dissimilar to the structure of a cryptocurrency token, makes it simple to integrate even simple image NFTs into more complex financial products. The most valuable NFTs are already being “fractionalized,” or divided into smaller pieces for sale to investors, a process overseen by the Securities and Exchange Commission.

    They could theoretically be used as collateral for decentralized finance loans or other instruments, but doing so would pose a technical challenge. You’d need to know a solid price for an NFT to use it as loan collateral, just like you’d need to know a solid price for a regular loan, but the NFT market is currently extremely volatile. More fundamentally, how do you value a truly one-of-a-kind object, whether digital or not?

    “It’s very difficult to produce that kind of price transparency and discovery in a single-asset market,” says Philipp Pieper, co-founder of Swarm Markets, a German-regulated DeFi protocol that focuses on tokenized equities as well as crypto.

    The problem is easier to solve for NFTs issued in large series, such as the CryptoPunks (I’ve previously written about the other market advantages of series NFTs). Pieper suggests that a few Punks (or lions or apes) be used as a price oracle for the rest of the assets out of a series of thousands.

    “In a liquidity pool, you can create an NFT basket to ETH pair,” Pieper explains. “At that point, you have an aggregated basket with a market value, and you’ve solved the entire price discovery problem.”

    Of course, CryptoPunks are a good example of one problem with this concept: there can be significant price differences between the lowest and highest prices in a series. Punks have recently sold for anywhere from a few hundred thousand dollars to several million dollars.

    According to Pieper, this means that some rebalancing, possibly algorithmic, may be required for an NFT oracle pool. “Perhaps something happens, and one of those punks’ value skyrockets. Then you must be able to extract that value in order to obtain the 10x value. It would then be unjust to price the remaining 999 on that basis.”

    That is not dissimilar to how index funds and other traditional financial products are managed, and Swarm claims to be working on the issue.

    “The technology is pretty much there,” Pieper says, “but there is a lot to figure out about pricing and economics.”

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