NFT Collateralization

We have come a long way since Bitcoin as a concept was introduced to the world 13 years ago. While the first generation of blockchain dealt with transfers and storage of value; the launch of ethereum and subsequent programmable blockchains opened immense possibilities, some of which we are yet to be discovered.

Blockchain as a technology solution is disrupting existing landscapes and also pioneering new frontiers. While many of these disruptions are incremental improvements to their Web 2.0 precursors, the blockchain ecosystem as a whole has grown beyond the speculative realm. With the genesis of mainstream DeFi last year, many new projects & technologies have emerged as vital pieces of infrastructure for the future of Web 3.0.

In the past year, the DeFi vertical grew by 8,800% between May 2020 to May 2021 to reach a peak of USD 88 billion in TVL (total value locked). DeFi is steadily becoming a global parallel banking system with offerings like lending, borrowing, yield generation & decentralized fundraising.

The merits of such a system lie in its global accessibility, ease of use and hedge against capital destructive monetary policy outcomes such as hyperinflation & negative interest rates/deflation.

Blockchain as a technology enabled these opportunities via digital ownership powered by distributed ledger technology. This capability of enabling digital ownership & scarcity gave birth to NFT’s (non-fungible tokens).

Digital art started taking off a few years ago but it came with its own set of limitations. Due to lack of means of establishing ownership & providence, duplicates and imitations hindered the growth and viability of this landscape as a whole. Non-Fungible Tokens and the ERC 720/1155 standard solved these technical issues, and enabled the creation of the digital collectible asset market.

Problem #1 — Liquidity

Currently, the emergence of NFT’s and their popularity in the market represents a paradox of value. This value exists in a quantum state, as the technology behind NFTs are immensely promising, with NFTs being the “killer app” many in crypto were hoping to see after the creation of bitcoin and smart contract layers (such as ethereum). Just as the next iteration of gold should naturally should embody the properties and technology of bitcoin, art should also have properties of NFTs (providence, verifiable authenticity & ease of ownership transfer). Most other crypto projects/verticals (apart from DeFi) utilize distributed ledger technology to create products which should ideally be built around a centralized database.

However, the opposing truth that co-exists with this notion of NFT value is evident on virtually all NFT marketplaces. Illiquidity. Given the nature of art, and the lack of established reputations for most NFT artists, NFTs as an asset class suffers from wide disparities in terms of what buyers & sellers believe to be the fair market value of a piece of art to be(which is evident in wide bid-ask spreads on most pieces). We believe the abstraction being, these NFT’s value proposition appeals at the individual level, but not at the community level (aside from the few popular projects, such Ape NFTs/NBA topshots etc.).

Illiquidity- A Feature of Non-fungibility

As mentioned previously, most NFT’s & NFT marketplaces tend to suffer from illiquidity. If you venture onto OpenSea, Rarible and dozens of other NFT market places, you will notice that most pieces listed have 1–3, if not 0 bids. It is virtually a seller’s market (aside from the minority of famous artists/projects).

The nature of non-fungibility gives rise to this illiquidity problem, as bespoke pieces/products generally targets a narrow customer/investor base of individuals with specific interests, rather than a collection of investors coming together around a central vision/project/ fungible token/investment which as a by-product, creates liquidity.

If you take a step back and think about it, the buyers/sellers, lenders & borrowers of NFTs on a platform such as a Strip are in essence the same entity, just on different sides of the “financial ledger” momentarily to achieve different ends. At the end of the day, a borrower (receives a loan against their NFT) and the lender (collateralizes and loans out money against the NFT) should both find the acquisition of the NFT a desirable outcome(borrower buys due to his/her own interest, lender acquires it should liquidation occur). The end goal here is to attract highly desirable NFTs to the platform, and as a result, liquidity.

Problem #2- Price Discovery

As mentioned previously, the lack of price discovery in the non-fungible token market (mainly most art pieces) and subsequent illiquidity is a feature, not a bug of this asset class. Given this feature, price discovery naturally becomes a challenge, as illiquidity begets opacity in asset pricing.

One of the major reasons for the illiquidity lies in the limitation of most NFTs to the Art Collectibles vertical. Given the subjective nature of art, determining the price of most pieces is a significant challenge.

Keeping this in mind, the Strip platform will actively seek (with the help of partners) NFTs, both art & financial based, that can attract a wider community of investors interested in buying/selling the pieces. For art NFTs, these pieces would entail works by famous artists and projects, with a history of creating highly liquid and sought after NFTs. For financial NFTs, the platform would list pieces that are derivatives of project tokens, LP tokens, vested contracts, or other yield bearing assets. The advantage of having financial NFTs on the Strip platform lies in the ability to “mark-to-market” these pieces, and reasonably determine a fair market value & risk assessment when underwriting loans.

Additionally, Strip Finance will curate NFT launches/offerings that provide transparency and data for consumers (lenders) to make informed decisions when underwriting risk and deploying capital, with the aim of enhancing the price discovery process for NFTs on the platform.

Landscape

Art & Collectibles Market

Despite COVID-19’s impact on galleries, auction houses and retailers, the global art market saw more than $50 billion in art transactions, while other collectibles such as coins and trading cards saw record sales. However, this market is still largely driven by auction houses which act as gatekeepers of the industry.

We believe the lack of transparency/accessibility in the art market has held back this industry from its true potential. While the HNI wealth doubled in a time frame of 10 years after the 2008 crash, the art market grew only by 8% in cumulative.

Brief History of Art Loans

There is evidence to suggest that the first art loan dates back to at least the 16th century when the sister of Salaì (a pupil of Leonardo da Vinci) took out a loan of 26 scudi using nine paintings as collateral.

Even in the 18th century, collectors were able to benefit from the use of leverage in a rising art market. In 1721, Cosimo Antonio dal Pazzo borrowed 6,000 scudi from a distant cousin secured by a Poussin painting. Although three additional works by Poussin had to be pledged by 1730 as collateral (due to an inability to satisfy the original debt obligation), Cosimo ultimately repaid in 1732, after the Poussins had appreciated in value and become worth more than the total sum of the outstanding debt.

The Impressionist market boom in the 1980s, which was closely linked to the Japanese “bubble economy,” marked the beginning of the modern-day art lending market. Encouraged by rising prices, collectors and speculators borrowed against works of art to finance new purchases and other investments, while dealers used Art Loans to grow their inventory.

NFTs- The next iteration of art

Non-fungible token (NFT) is a term used to describe a unique digital asset whose ownership is tracked on a blockchain, such as Ethereum. Assets that can be represented as NFTs range from digital goods, such as items that exist within virtual worlds, to claims on physical assets such as clothing items or real estate. In the coming years, we will see NFTs used to unlock entirely new use cases that are only made possible by crypto.

An NFT is created, or “minted” from digital objects that represent both tangible and intangible items, including: Art, GIFs, Videos, Collectibles, Virtual avatars and video game skins, Designer sneakers, Music etc.

The market for non-fungible tokens (NFTs) surged to new highs in the second quarter, with $2.5 billion in sales so far this year, up from just $13.7 million in the first half of 2020

Some NFT enthusiasts see them as collectibles with intrinsic value because of their cultural significance, while others treat them as an investment, speculating on rising prices.

In March 2021, a digital image sold for a record $69.3 million at Christie’s as an NFT. The second most expensive known NFT sale was a “CryptoPunk” which fetched $11.8 million at Sotheby’s.

The U.S. National Basketball Association Top Shot marketplace, which allows fans to buy and trade NFTs in the form of video highlights, has seen volumes and buyers fluctuate to 246,000 in June from 403,000 in March.

Collateralization in DeFi

In decentralized finance, collateralized loans are the backbone of open lending protocols. Given that DeFi empowers open, pseudo-anonymous finance, no one has a credit score or any sort of formal identity associated with the loan they are taking out. Therefore, similar to mortgages, most DeFi lending applications will require borrowers to collateralize their loan as an incentive to hold them accountable for repaying the debt. However, the key difference between traditional collateralization and DeFi collateralization (as it stands today), is that collateralizing a loan on DeFi platforms will require the borrower to over-collateralize the loan.

In DeFi, there are few borrower protections associated with lending. Unlike in traditional finance where both borrowers and lenders have protections, such as loan insurance, DeFi is currently lacking in protection on both ends. In general, the primary protection mechanism associated with DeFi lending is the game theory and incentives behind over-collateralized loans.

Roadmap

Product

STRIP is in essence creating a marketplace where anyone owning a desirable NFT (as determined by platform parameters) can use it as collateral to borrow capital.

The asset pricing data on the Strip platform will be directly fetched from NFT marketplaces such as rarible, superare, opensea, and wazirx, all of which we will be partnering with. We will not be making any arbitrary changes to the pricing data. However, we will reserve the right to make adjustments to the valuation of the NFTs based on our own risk assessment.

Using an NFT as Collateral for a Loan

The value proposition for owners of NFTs follows the same principals in any lending/borrowing market. Having access to capital (loaned out against a collateralized asset) provides owners with access to liquidity for various ends, such as pursuing other investment opportunities, personal spending or hedging against market movements.

The possibilities of assets that can be tokenized via the NFT (ERC-720/1155) standard is limitless, with use-cases such as land deeds, art, certificates, digital domains, music & financial assets being a few.

Strip will provide owners of this asset class with access to capital in order to pursue other opportunities, while still maintaining ownership of their coveted NFTs.

Matching Lenders & Borrowers

The key element needed for the Strip platform to work is the matching of borrowers with lenders. In order to bring these two parties together in an effective manner, there must be both centralized & decentralized solutions for addressing two problems;

1. Valuing the NFTs: Art & Financial
2. Method of aggregating & deploying capital

Valuing Art NFTs- The Human Eye

Granted art NFTs are unique and distinct works, often times the role of an individual is vital when assessing the value of these assets.

A fantastic example of this is the Hasmasks NFT project; each NFT is generated via code, but some NFTs have unique features that the program could not have predicted. In these circumstances, a program would have no idea of its value or worth because those unique elements are designed to be appreciated exclusively by the human eye.Therefore we have been planning on involving humans in this process.

We have identified a solution where a faster mechanism for lending out capital can be achieved. For this process, specific pools would have a greater amount of liquidity (crowd aggregated) vs. that of what a normal individual could provide. Given this efficient means of capitalizing the lending pools, a borrower will be able to take an instant or flash loan. The amount of capital available for an instant loan will be the amount that is pledged by the underwriter in case of a default or sudden drop in the market price.

We are inviting NFT funds and studios to underwrite loans against NFTs on our platform. The funds/studios would either earn interest on their loaned capital if the amount is paid back on time, or in case the borrower defaults, they stand a chance to get the NFT at 50–60% of the market value (i.e the LTV underwritten would be 50–60%). In addition to providing capital for loans, we believe these firms would be able to enhance the price discovery & valuation process, given their access to data and collective experiences.

Valuing Financial NFTs

The methodology of assessing the value of financial NFTs is more straightforward than that of art, granted the quantitative (not qualitative) nature of these instruments (they are derivatives of a project’s token/assets, not merely an art collectible). The following non-exhaustive list of parameters would be assessed when valuing the financial NFTs (and subsequently the underlying token/asset of the NFT):

1. Debt duration & project age/availability of historical pricing data of the underlying token(older project, lower APR, ceteris paribus ). Main predictor of APR%.
2. Team, doxxed or not (no doxx, higher APR%)
3. Quality of partnerships (VC’s, other projects)
4. Exchanges listed on/liquidity (higher liq + better exchange = lower APR)
5. Valuation of collateral
6. Revenue (platform fees)

(the following list is taken from the debt financing product outlined below, where the financial NFT is effectively a derivative of a token/asset)

Aggregating & Deploying Capital — Decentalized P2P Lending

One way of determining the value of the NFTs on the platform is to crowdsource the value assessment process. Individual lenders will decide the fair value of the NFT by the amount of capital & APR% they require for loaning out their capital (with the NFT as collateral). The platform will provide lenders with data points such as artist profiles, social media metrics and sales history to inform the price discovery decision making process.

In this scenario, the borrowers are limited in their ability to negotiate; they will have to either accept or reject the offer. There will be a time limit within which the borrower needs to respond or else the offer will be rejected.

The lender can propose an interest rate and duration, which when accepted by the borrower transfers the NFT to an escrow. If the amount due (principal + interest) is returned under the stipulated time frame, the borrower gets the NFT (collateral) back, or else the ownership rights are transferred to the lender.

To initiate the lending process, the borrower will upload their NFT asset on the lending marketplace by selecting the asset from their wallet, entering the following information (terms);

1. Desired Asset Value
2. Capital Requirement (amount of money borrower is requesting)
3. Loan duration
4. Number of Installments (frequency of coupon or coupon+principal payments)

The Strip Platform will provide boundary recommendations (min/max parameters for terms), to help the borrower determine their desired terms.

The terms are then published on the platform, with lenders having access to the aforementioned information. The borrowers/lenders will have the option to accept/reject the proposals and subsequently the loans/transactions. We will begin with a simple offering, merely accept/reject transactions, with dynamic negotiations (bids/asks) planned for later on in the project development cycle.

Aggregating & Deploying Capital- Centralized Pool Lending

The second option for aggregating and deploying capital on the platform will be via the use of capital pools. The Strip team along with various partners will identify unique assets/offerings (NFTs) to collateralize and offer loans to individuals/entities on the platform (such as the debt financing product outlined below), while pooling the capital from lenders in a decentralized manner. We consider this method as “centralized”, as the offerings will be in a sense “curated”, with the risk and terms being underwritten by a centralized entity (strip finance & strategic partners).

In this product offering, the NFT holders/entities would submit a proposal to get a fair price evaluation & terms. Once the assets have been pledged by the underwriters, a fast lending option will be available to the borrower. In case of default, the pledged amount from the underwriter will be distributed to the pool and the assets will be transferred to the underwriter.

No Different than Using Physical Art as Collateral

Physical paintings, sculptures, books, and other mediums of art have been used as collateral for as long as humans have been making art. And using NFTs as collateral is no different. It fits a model closer to how pawnbrokers operate, although via more technological means.

As the NFT market grows, and their value continues to develop, expect more lenders to accept them as collateral.

Liquidation Practices for Marketplace Lending

After each borrower commits to the loan amount, a loan package is created (containing terms such as : # of installments, duration, liquidation terms etc). Liquidation rules will be activated in the following scenarios:

• No repayment

In case of no repayment by the borrower after an active loan package has been created, a Settlement Action will be created and the lender will receive the NFT asset. After 3 missed installments, the lender will have the option to call the loan and complete the Settlement Action by receiving the NFT asset.

• Partial repayment

In the case of partial repayment by the borrower, followed by no repayment, a Settlement Action will be created and the lender will receive the NFT asset. After 3 missed installments, the lender will have the option to call the loan and complete the Settlement Action by receiving the NFT asset.

Penalties for Missed Installments

In the case of missed installment the following rules apply:

1. A borrower that misses one installment will have to pay a penalty of 10% from the total installment value. The penalty will be paid only once and the penalty will be deducted from the installment value when they call the pay installment function to pay the missed installment. If this is the last installment that must be paid, the borrower will be allowed to call the pay installment function for the duration of 1 more installment period. If the installment is not paid, the NFT asset will be lost to the lender in the case of marketplace lending or the Strip Liquidity Pool in the case of pool lending.
2. A borrower that misses 2 consecutive installments will have to pay a penalty of 20% from each missed installment value when he calls the pay installment function to pay the missed installments. If these are the last 2 installments that must be paid, then the borrower will only be allowed to call the pay installment function for the duration of 1 more installment period after the time when the last installment was expected to be received. If the installment is not paid, the NFT asset will be lost to the lender in the case of marketplace lending or Strip liquidity pool in the case of pool lending.

Liquidation Practices for Pool Lending

In the case of pool lending, lenders commit liquidity to a pool and the installments paid by borrowers are equally distributed to lenders. In case of liquidation, the amount pledged by the underwriters will be distributed back to the pool and the NFT will be transferred to the underwriters.

Debt Financing Product for Projects/Teams

In traditional finance, companies can lower their cost of capital via debt & equity financing. In other words, to raise funds for development and capital investments, a company can either sell equity (stock), or finance through debt (bond/note issuance). The optimal mix of both (calculated via WACC, the weighted average cost of capital), produces a lower cost of capital (fundraising cost).

This is such a vital piece of financial infrastructure, and it is surprising how it has not been thought of/created already. This presents a massive opportunity for Strip!

As depicted above, the idea is straightforward. Assuming STRIP can underwrite a loan for a great project, as time progresses, the token value will increase. What we are doing is providing teams (of the project) to access capital now, rather than having to sell off a large portion of their dev funds to grow the project.

As shown above, if the price today is $1, and the team needs $10M, then they would have to sell 10M tokens (not a realistic case, just illustrative). If they can access capital today (via debt), then in the future, they can sell a significantly lower amount of tokens (1M tokens@ $10), paying back the principal with exponentially fewer tokens (and drastically lowering their development cost).

Additionally, this would significantly benefit communities, as there is no dilution/extra circ supply added (in the short term). The teams could also burn the remaining 9M tokens, causing a significant price increase/deflation.

As depicted above, the platform would work similarly to any other lending protocol. The caveat here being, we are providing liquidity/loans to an area of the market which has yet to be served, early stage projects.

The following basic points will be considered when determining the APR%, and subsequently, the risk being underwritten :

1. Debt Duration & Project age/availability of historical pricing data (older project, lower APR). Main predictor of APR%.
2. Team, doxxed or not (no doxx, higher APR%)
3. Quality of partnerships (VC’s, other projects)
4. Exchanges listed on/liquidity (higher liq + better exchange = lower APR)
5. Valuation of collateral
6. Revenue (platform fees)

*Strip Finance & our underwriting partners will determine on a case by case basis which projects are eligible for interest only loans (with principal paid back at maturity). For all other projects seeking to raise debt capital, the payments will entail interest +principal payments/installments.

Strip Platform Revenue Model

The Strip Platform will primarily derive its revenue from the fees generated as performing a “facilitator” role of transactions between the borrower and the lender.

The platform will charge a 1% of the loan amount fee from the borrowers for facilitating the transaction. This charge will be incurred at the time the bid is matched between the lender and borrower.

In addition to this, Strip Finance will also charge a 10% fee on the total amount of the interest to be paid.

The lender will pay the fee to Strip upfront at the time of the loan origination (creation), while the interest repayments will be made separately to lenders throughout the duration of the loan.

For example, let’s pretend that borrower “A” receives USD 1000 of stable coin against their NFT as collateral as a loan. The proposed interest rate is 10% APR for a period of 1 year. This is how it would work:

1. The total interest amount to be paid back to lenders= $100 (10% interest rate on $1000 of loaned capital= $100). This will be paid throughout the duration of the loan in installments, or at the end of the loan…total to be paid back to LENDERS= $1000 principal +$100 interest = $1,100.
2. Strip Finance will take their 10% fee upfront=$10 (10% of $100 interest=$10), this means the lender will receive $990 as the total loan amount at the origination/creation of the loan (from the very start).

Again, the 10% Strip Platform fee on the TOTAL INTEREST paid back to lenders will be collected upfront from the Strip platform. This is separate from the interest payments to lenders.

As mentioned under Pool Lending, we will create liquidity pools. To incentivize participation we have an LP tokens program. On the other hand, there is also a penalty of 1% for the lender/ liquidity provider whenever the liquidity is withdrawn.

Any kind of platform charges mentioned above will be paid in the native utility token — STRIP.

Potential Risks & Mitigation

• Price Volatility & Borrower Default

We understand that NFTs are quite a volatile being in the early stages, we will cap the LTV (Loan to Value) ratio at a maximum 50–60% even for the best creators and otherwise typically range between 35–60% for moderate ones. For financial NFT’s, the LTV will depend on the underlying asset/token/project. Granted we are operating in a very volatile market (NFTs and crypto), we found it prudent to limit the LTV’s to the aforementioned level. In case of a very reasonable decline in the market/prices, this low LTV will provide a buffer for borrowers, giving them opportunities to post additional capital to avoid liquidation (by posting/depositing Strip tokens/USDT to maintain their position).

There is always a probability that the borrower might default. To reduce this we are incorporating several ways to reduce risk by sharing insights with lenders that might help them make an informed decision. These data points include but are not limited to — artist profile; past sales aggregates and frequency of sales volume, NFTs trading history, owner’s credit and risk score etc. For financial NFTs, we will provide information in regards to the underlying assets/tokens, where all the data is accessible on sites such as coingecko & exchanges.

Potential Headwinds

• Absence of lenders for particular assets

Art and collectibles have a highly individualistic value and NFT market primarily consisting of digital art, animation at the moment. Not every assessor or potential buyer/lender/underwriter would express the same level of interest or desire in placing bids for all kinds of NFTs. Initially, when the participants on the platform are fewer, not all bids might go through.

• Marketplace price manipulation

As a collateralized lending platform, we rely on the data provided by our marketplace partners who facilitate the sale and purchase of these said assets. The data points along with others also include LTP (Last Traded Price) which often acts as the base for determining the collateral value. Some users might engage in wash trade on these marketplaces before bringing the asset on our platform for collateral. We expect that the lenders would consider other data points such as the artist’s previous creation’s performances, borrower’s history etc.

• Susceptible to security and technical glitches

Like any technology platform, ours too is vulnerable to security bugs which might impact in small or large scale the functionings of the platform. These are not limited to our internal security issues arising from our mistakes but also involves ethereum blockchain and others.

We would engage security agencies from time to time to ensure best practices are followed in every sphere.

STRIP Token utility

• Leverage — Whenever there is a fall in the price of NFTs to the extent that it crosses the risk threshold meaning that a further price reduction might lead to the price becomes lower than the loan amount, the borrower would have to extend their leverage position to avoid getting liquidated. They can do so with additional leverage by depositing STRIP tokens of the leverage value.
• Platform Charges — The token would function as a native platform utility token used to pay fee for availing different services of the platform that include but are not limited to commission payment, borrower fee, lender’s interest, liquidity penalty etc.
• DAO Governance — Implementing project governance will help us bring transparency and trust to the platform. As we build a decentralized system, STRIP tokens would drive every major decision on the platform like updates, airdops, burn schedule, developer and community grants etc. This will also help us involve the community as holder would have the right to propose and vote.
• Liquidity mining- Under both P2P & Pool Lending, we will incentivize users to extend liquidity to the platform. In the case of pool lending, we will create liquidity pools that will invite participation from time to time. To incentivize participation we have an LP tokens program. The lenders can farm STRIP

Conclusion

The NFT market continues to evolve and grow exponentially. There are new use-cases and applications of this revolutionary technology being explored everyday. We believe that providing a means of collateralizing NFTs and providing liquidity, brings value to the asset class as a whole. To us, the deployment of capital to underwrite risk and financially back NFTs (via accepting it as collateral for a loan) brings legitimacy and transparency to this digital asset class.

Whether it was oil on canvas art hundreds of years ago, land or jewelry, the acceptance these assets as collateral for loans has reflexively contributed to their value. We believe the next iteration of valuables will exist in the digital realm with assets such as NFTs gaining global prominence. Strip Finance is building a core piece of infrastructure (capital market) to enable the growth and acceptance of this asset digital class.

-Abe, Associate — The NewField Fund