5 Ways NFTs can plug into Decentralized Finance (DeFi)
andrew_4k
0x3312
July 14th, 2022

Back in 2021, you couldn’t stop hearing about NFTs. Whether it was about skyrocketing prices, or record-setting CryptoPunk sales, it seemed like NFTs were going to be the thing that brings about mass adoption to crypto. Whether or not you believe in NFTs and art as a use case, there’s so much more we haven’t quite seen yet. Below we’ll be talking about what NFTs are and their broader use cases within DeFi (decentralized finance). For some background, decentralized finance offers decentralized access to financial services and eliminates intermediaries to make transactions secure and transparent.

For the past few years, DeFi’s main use cases have been traditional financial services such as lending, trading, payments, insurance, and derivatives via exchanges and other types of platforms. NFTs add a newer layer of complexity and efficiency to the DeFi world and truly mark the next wave of the web: Web3.

What is DeFi?

DeFi is a blockchain-based system of financial services and management. Decentralized finance allows people to leverage financial services like payments, borrowing, lending, saving, margin trading, and trading––all in a fast, secure, and on a P2P (peer to peer) model. THis means that DeFi essentially cuts out any needless middlemen and third parties like banks or other financial institutions.

What makes all of these services possible would be dApps (decentralized applications). If we were to think about the internet protocol, there are many layers built on top of it that make it much more functional and accessible for users. dApps do exactly this.

What are the main benefits of DeFi?

Not only do these advantages differentiate DeFi from the traditional financial world, but also capture the ethos of the crypto movement.

  • No centralization: this means that no one person or entity has the power to tamper with transactions or suddenly change the terms and conditions.
  • Transparency & accessibility: all information stored on the blockchain (ledger) is open for anyone and everyone to verify. And because blockchain is the underlying technology, that means anyone can make transactions 24/7/365.
  • Immutability: no one can come along and change any information on the blockchain.
  • Permissionless: anyone has quick access to a full range of financial services. Gone are the days of having to wait for requests and buy/sell orders to be verified.
  • Interoperability: the beauty of dApps is that you can build them on multiple protocols where they can all interact with each other.

Overview of NFTs

An NFT, or non-fungible token, represents real-life items recorded on the blockchain as unique digital assets. Think of them as a unique way of storing value. The main use case for NFTs in 2021 was art. If you owned the Mona Lisa, you could have an NFT that represents your ownership of the painting. Every NFT is one of a kind and has specific and distinct characteristics.

And like DeFi, NFTs allowed artists to make a profit on their works without middlemen like galleries or auction houses (sound familiar?). Now let’s breakdown the key factors that make NFTs so unique:

  • Proof of ownership: the information about the author/owner/creator is permanently stored on the token’s metadata. No matter how many times the NFT has been sold, the creator will always be recorded in the metadata.
  • Uniqueness: being non-fungible means that each NFT is unique and has no duplicates. 
  • Transparency: like DeFi, all NFT metadata is open to anyone to verify or authenticate. Not to mention you can see all previous owners and the price action over time.
  • Store of value: now that the NFT world is evolving past just art, we are now seeing very interesting use cases for real world assets such as collectibles, real estate, and more. We’ll get into this shortly.

How can NFTs plug into DeFi?

It’s pretty clear that the advantages of DeFi and NFTs overlap, so how can they plug into each other?

If we look at centralized finance, we see a system that is controlled and regulated by governing authorities that supervise and oversee all transactions, investments, and trades. They deem what is acceptable and what isn’t. But because of this system, we face massive inefficiencies and most importantly, a walled garden only open to those that are accredited investors. Not only are there massive delays due to verification and approvals, there are also high fees. The more people or entities involved, the greater the cost and chance of fraud.

Many companies are now adopting NFTs as a store of value that serves as proof of ownership. In the same step DeFi unlocks even more value by being able to utilize tokenized assets. This is what Web3 is all about. The physical (assets) meeting the digital (DeFi).

Here are 5 ways NFTs can plug into decentralized finance (DeFi):

1. Loan collateralization

In the traditional finance world, a bank determines what can be collateralized for a loan and how much you can collateralize. Because of the peer-to-peer nature of DeFi, users won’t have to go to a bank––they can name their terms, including putting up NFTs as collateral.

NFTs can therefore make securing collateralized loans much more seamless. The borrower can present crypto and NFTs to mitigate the lender’s risk in case the loan is defaulted. From there the lender can make a more insightful decision to move forward with the loan. This year we saw the largest ever NFT-backed loan with 101 CryptoPunk put up as collateral.

What can be tricky about NFTs is that because they typically do not represent a physical asset, it can be hard to determine the value in the market.

2. Payments and proof of ownership

The music industry is a prime example of a system that is failing and continues to disincentivize artists. Like other centralized industries, the music industry has many middlemen. NFTs allow artists to have ownership rights and even royalties sent directly to them. They can now earn a direct share of their streaming revenue or collect royalties from collaborations and sampling. And because NFTs are so immutable, their earnings are verified in case they want to put up their NFTs as collateral for a loan. Taking it one step further means that NFTs also open doors to opportunities like licensing and copyright ownership. 

3. Fractional ownership

If you can’t own the whole pie, why not a part of it? Whether it’s an expensive painting, car, watch, or NFT, all of these can get pretty expensive.Now if you’re able to somehow break up the pie and fractionalize it, you have something that is way more accessible. Because an NFT is a token, you’re able to fractionalize an asset where the price can be divided between the number of buyers. This makes the high value asset that much more liquid.

In our modern world we have stocks––where we buy shares (or fractions) of companies. In the future people will buy fractions of assets: wine, cars, real estate, watches, and collectibles where they can diversify their funds, and better yet make returns on their investment.

A real world example would be taking a $50,000 Rolex and fractionalizing it. Then multiple people can own one watch and the possibilities of ownership are endless. You can treat the watch as a timeshare where owners can borrow it for special occasions, as the asset appreciates owners are compensated, use it as collateral of a loan to purchase another watch, put it into a savings account to yield interest, and so much more.

4. Brand activation and gamification

One use case that isn’t talked about a lot is brand activation and gamification. Imagine a company that is able to distribute NFTs and rewards to their shareholders or most loyal customers. What if brands are able to gamify customer loyalty programs? For more traditional companies, NFTs are a way for customers to buy into the company––whether it’s making a first purchase or receiving a unique NFT that creates a personal touch.

5. Bringing the physical to the digital

The biggest gap to solve right now is bridging the physical to the digital. It’s one thing to have artwork NFTs, but it’s another to create NFTs for physical illiquid assets like watches, real estate, jewelry, cars, collectibles, handbags, sneakers, alcohol and then bring them into DeFi. Physically-backed NFTs are going to be the next phase of the NFT wave. 

NFTs also make it much easier to buy/sell these items because of logistics, shipping, commissions, insurance, and the added fees every step of the way. Users will not only own the physical item, but also the NFT that proves their ownership. And with physically-backed NFTs, the possibilities are endless:

  • Taking out a loan against your Rolex watch
  • Fractionalizing your watch
  • Asset verification for events
  • Creating an NFT pool
  • Earn yield on your otherwise illiquid assets
  • And so much more!

Here at 4K we are solving this physical-digital problem. We’re building a decentralized protocol for connecting the on-chain and physical worlds. Be sure to give us a follow on Twitter and Instagram or chat with our team on Discord.

What are some other ways NFTs can plug into DeFi? Let us know!

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