NFT as Collateral Part II- Developments in Defi Lending

After a few weeks following the rollout of its secured financing feature, Arcade, the decentralized finance (DeFi) marketplace that allows borrowers to obtain a loan and secure it with NFT(s), has facilitated $10 million in loans and expects the volume to be tenfold by the end of the year.

According to the news, several mid-sized loans have been generated, including a $1.25 million loan secured by a set of $5 million-worth NFTs and an approximately $4 million loan secured by "two rare zombie cryptopunk NFTs," while Arcade gradually offers its NFT-as-collateral feature to the general public. Arcade's CEO indicated that so far Arcade has more than $20 million of "blue chips NFTs" in escrow in exchange for loans and that the average annual interest rate for loans generated on Arcade is 20%, depending on the duration of a loan and the liquidity of pledged NFT(s). In general, the platform's secured financing feature is "comparable to fine art lending," except that the term is generally shorter (averaged three months) and the interest rate is higher.

Notwithstanding the common grounds shared by Arcade's secured financing feature and conventional fine art lending (or conventional secured financing), certain differences still exist in terms of risk allocation and loan structure, and it is worth observing how such differences would pan out in the DeFi lending setting.

As indicated in our previous post, risk allocation has been one of the core considerations underlying conventional financing arrangement, and insurance coverage is commonly obtained by a borrower (and sometimes a lender) as a risk mitigating measure addressing the potential loss of collateral. For instance, many insurance policies are readily available to cover the damage or loss of art collections, and Bank of America has identified "insurance certificate" as a requisite document for the disbursement of a loan on its webpage designated for borrowers using "art collection as collateral." However, when it comes to insuring against the loss of NFT(s), the market has not yet come across a comprehensive insurance policy that is specifically offered for NFT(s) and the associated risks. S&P Global reported in its article that such lack of insurance policy might be due to certain factors, such as "the need for NFTs to hit ‘critical mass'" and the "ever-changing valuations of cryptocurrencies and thus NFTs." Accordingly, for a loan that an insurance coverage for collateral is indispensable due to the size of the loan or the underlying risks, a lender or a borrower having NFT(s) as the collateral might be required to resort to a smart contract audit service before the collateral is put in escrow in the smart contract and the loan proceed is disbursed. After all, when the remedy mitigating the occurrence of certain incidents is not available, the best (and maybe the only) alternative would be the enhanced due diligence that aims to discover any undesirable incidents before their occurrence.

As to the loan structure, the term and the interest rate of a DeFi loan might be fundamentally different from those in the conventional secured financing setting, especially in terms of how such material terms are structured in relation to other key provisions of a loan. In general, the term of a conventional loan secured with collateral would be in the range of multiple years with certain acceleration clauses embedded to mitigate the lenders' risk exposure. (For instance, a lender would have the contractual right to declare a loan default if the borrower has breached its representations and warranties or certain covenants stipulated in the loan documents.) In the world of DeFi lending, however, the term of a loan is relatively short (e.g., a few months), and the need for an acceleration clause (or event) might not even exist. Accordingly, the interest rate for such short-term loans (e.g., more than 20%, as indicated by Arcade's CEO) tends to be much higher than conventional loans (e.g., below or around 10%). Such difference in the loan structure would inevitably alter the risk allocation between the lender and the borrower, thereby resulting in different risk mitigating measures adopted by the lender and/or the borrower.

As the DeFi lending and the use of NFT(s) as collateral are still at their early stage of development, it is worth observing how the material terms and the loan structure would evolve over time and whether wisdoms from conventional financing settings can be leveraged.