NFT as Collateral: Borrowers Can Now Secure a Loan with NFT(s)

Backed by noted crypto investors including Franklin Templeton and Pantera Capital, Arcade, a decentralized finance (DeFi) marketplace, has closed a $15 million Series A round to bring forth its secured financing business that allows borrowers to secure loans with the NFTs that they own.

According to the news, Arcade has previously facilitated "the largest and first, permissionless, on-chain loan of $800,000 against an NFT portfolio" in its private release and is now taking a step further to launch its NFT-collateralized financing feature, aiming to provide liquidity to general NFT owners while enabling institutional and high-net-worth lenders to access a new source of income. With such a feature, the borrower may choose to secure a loan with one NFT or a single "wrapped NFT", which, as indicated by Arcade, consists of multiple NFTs bundled together to reduce the processing costs (i.e., gas fees). Once the borrower and the lender agree on the loan terms and the loan proceeds are to be disbursed, the pledged NFT(s) will be "escrowed" in the smart contract deployed by Arcade and will remain irretrievable unless the loan is fully paid or defaulted. As of this writing, the Arcade platform supports "45 to 50 NFT collections" that have "some amount of value against them", such as CryptoPunks and Bored Ape Yacht Club.

As one can discern from Arcade's new feature, securing a loan with NFT(s) is in nature very similar to conventional secured financing arrangements, in which borrowers would secure a loan with equity interests and/or assets that have determinable value. However, novel issues might still arise because the arrangement concerning NFT-collateralized loans are in early stages of development, and the risk allocation for NFT-collateralized loans might therefore differ from those established in conventional secured financing settings.

For instance, one issue to look out for is the risk allocation arrangement for the loss of the collateral. In conventional secured financing settings, a borrower pledging equipment to secure a loan is usually required by the lender to obtain insurance coverage for the pledged equipment because more often than not the physical possession of the equipment is retained by the borrower after the loan proceeds are disbursed. Accordingly, even if the pledged equipment is destroyed, the lender's interest is still protected because the borrower will receive insurance proceeds and will assign such proceeds to the lender as the replacement for the destroyed equipment.

In the NFT world, however, to request the borrower to obtain insurance coverage for the pledged NFT might not be appropriate because the NFT would be escrowed in a third party's smart contract rather than being possessed by the borrower. In absence of insurance coverage, can the lender request additional collaterals from the borrower if the third party smart contract is breached and the escrowed NFT is stolen? Or, should the third party assume the risk and obtain insurance coverage for all the collateral? Besides, would insurance coverage even be considered as an effective risk allocation arrangement between the borrower and the lender given the nature of DeFi (i.e., the majority of transactions are automated by codes with minimal to no human interventions)?

Another issue to look out for is the fluctuation in the determined value of the collateral. In conventional secured financing settings, the value of the collateral is mostly determinable and not subject to dramatic changes because such value can be objectively assessed by referencing independent factors. (For instance, the value of an offshore wind farm's generator provided as a collateral for a syndicated facility can be determined by referencing the price of the same type of generator currently available in marketplace.) The value of a NFT, however, is largely based on subjective assessment and might thus fluctuate over time. For instance, if, in a very short period of time, the general public sees CryptoPunk NFTs as "old fashioned creations" and all the CryptoPunks are traded at $1, could the lender request additional collaterals from the borrower if the loan was originally secured by a CryptoPunk then traded at $500,000?

No answers are currently available to these issues as using NFTs as a collateral is still at its early phase. It would take time for the market to form customary practices, and such issues, in the end, might not even occur. Nonetheless, it is worth observing the extent to which the NFT-collateralized loan will differ from conventional financing arrangements and what the borrower and lender will be entitled to when NFTs are pledged as a collateral.