How NFTs Fit Into DeFi

However interesting non-fungible tokens (NFT) might be as a new technology, one of their superpowers within the crypto space is they’re not considered securities for regulatory purposes. This frees marketplaces like OpenSea from the burden of becoming a registered broker-dealer, among other constraints. That missing hurdle is certainly a major structural factor underlying the current NFT frenzy.

But financialization has a powerful gravity, especially in crypto. I’ve already written about NFTs that are turning themselves into securities at the design level by adding things like dividends and governance rights.

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At the same time, the code underlying them, not much different from the structure of a cryptocurrency token, makes it easy to integrate even simple image NFTs into more complex financial products. The most valuable NFTs are already being “fractionalized,” or split up into more affordable chunks for sale to investors, a process that is overseen by the U.S. Securities and Exchange Commission.

They could also theoretically be used as collateral for decentralized finance loans or other instruments, but that entails a technical problem. As with a regular loan, you’d have to know a solid price for an NFT to use it as loan collateral, but the NFT market right now is extremely volatile. More fundamentally, how do you value a truly unique object, digital or otherwise?

“If you have a single-asset market, it’s very hard to produce that kind of price transparency and discovery,” says Philipp Pieper, co-founder of Swarm Markets, a German-regulated DeFi protocol focused on tokenized equities in addition to crypto.

The problem is more solvable for NFTs issued in large series, like the CryptoPunks (I’ve written previously about other market advantages of series NFTs). Out of a series of several thousand, Pieper suggests that a few Punks (or lions or apes) could be used as something like a price oracle for the rest of the assets.

“You can create an NFT basket to ETH pair in a liquidity pool,” Pieper explains. “Then you have an aggregated basket that has a market value, and you’re unlocking the whole price discovery problem.”

Of course, CryptoPunks are a good illustration of one challenge to this idea – there are sometimes huge spreads between the lowest and highest prices of items in a series. Punks have recently sold for prices ranging from the low $100Ks to several million.

Pieper says that means some rebalancing, perhaps algorithmic, might be necessary for an NFT oracle pool. “Maybe something changes and one of those punks goes 10x in value. Then you have to be able to extract that to get the 10x value. It would then be unfair to have the other 999 priced on that average.”

That’s not too different from the way index funds and other conventional financial products are managed, and Swarm says it’s working on the problem.

“The tech is pretty much there,” according to Pieper, “but there’s a lot to figure out about pricing and economics.”