Traders are consistently seeking new ways to beat the market. Short selling NFTs in adverse macro conditions could be incredibly lucrative. But is this ethical, or beneficial for the long term health of the NFT market?

This article will focus on the Traditional Finance (“TradFi”) concept of Short Selling (“Shorting”) and overlay this with trading in the Non Fungible Token (“NFT”) sector.

Article Outline

• Background

  • TradFi Shorting

  • How would it work?

    • TradFi Shorting

    • NFT Shorting

• Benefits of Shorting NFTs

• Risk Considerations

• Closing Remarks

Background

1/ TradFi Shorting

Shorting is betting that the price of the underlying asset will fall. If the asset price does fall, the short seller subsequently buys it back at a lower price and returns it to the person lending the asset. The short seller’s profit is the difference between the asset sale price and the repurchase price.

Shorting in tradFi typically involves speculative trading strategies; however, it can be used to hedge risk. The speculation is linked to the market risk around the price action of the stock/asset.

Michael Burry entered into a short position with the subprime mortgage fiasco. His review of lending practices led him to believe that the real estate, and associated bonds related to the mortgages, were overpriced. A deeper dive into the underlying tranches led to a downgrade on these bonds and subsequent housing market collapse. There was even a film made about it: “The Big Short” with Christian Bale.

A more recent short position to hit the headlines was in relation to GameStop (GME). Several hedge funds, the largest being Mervin Capital, opened short positions against the company following a decline in profitability. However, millions of retail investors collaborated to go long GME, following articles released on Reddit. This caused a short squeeze, significant losses for the hedge funds, a flurry of news headlines and a regulatory inquiry into the activities for market manipulation.

Shorting is a perfectly legitimate practice in free capital markets. It’s taking a bearish stance on a stock or asset, perhaps because it has seen astronomical gains over a recent time period. Price corrections are normal and capitalizing on these can be healthy by realigning the asset price with what fair value should be, once all information is priced in.

It is worth noting, however, that regulators have been known to step in to prevent further adverse cascading effects and aid recovery.

2/ How Does it Work?

TradFi Shorting:

You would typically need a margin account to short. This enables the short seller to borrow the underlying stock from a broker and then has collateral within the account to provide a buffer, in the event the stock price increases.

If the stock price rises more than the available collateral then a margin call occurs. This is the broker requesting more collateral to continue the trade. If no further collateral is deposited then the short position is closed and the loss is realized.

NFT Shorting:

If we follow the typical method of short selling and apply it to NFTs, it can be executed in several ways. Albeit rather crudely now, given the lack of infrastructure.

The following illustration will help you visualize how this is theoretically executed in the NFT market:

Benefits of Shorting NFTs

Traders are constantly looking for ways to profit. Short selling NFTs in adverse macro conditions could be incredibly lucrative, particularly for an illiquid, volatile asset class that can experience 90% swings in price. Besides the typical speculative strategies, there are other reasons that short sellers open positions.

1/ Highlights Fraudulent Activity

If a trader believes the fundamentals of a project don’t stack up they could open a short position to indicate their bearish sentiment towards the current price of the NFT collection. In tradFi there is a disclosure requirement for a short selling position in excess of a certain threshold, which helps with pricing efficiency and market awareness for potential scams.

It realigns fair market value and reduces the opportunity of scam projects or “rug pulls” to continue further than necessary. For instance, the tradFi short selling positions opened on Wirecard helped bring to light the $2 billion of missing funds within the company. In these examples short sellers believe the asset is overpriced due to fraud and will eventually reduce.

If an NFT collection is reaching a ridiculously high floor price it could be seen as an overinflated valuation. Short selling helps realigning the collection price to fair value. If an NFT project only had several hundred items in a collection then this could be artificially inflated through coordinated “HODLING.” A short position on these projects could better align the floor price to market value, or the price an active participant is willing to pay for the project.

2/ Hedging

Some assets are correlated. NFTs are more volatile assets than your traditional stock; however, there will be correlations traders can find. Opening a short position on a specific NFT collection can reduce their overall portfolio exposure if there is another collection that is relatively positively correlated.

This can also be done with the underlying blockchain currency. For instance short selling Ether while long on an Ethereum NFT collection can reduce the exposure during a hawkish macro environment. The alternative is to sit in cash, but some traders may want to keep some exposure to these assets. For risk management refer to the OriginsNFT portfolio allocation article.

3/ Provides Market Liquidity

It provides an ask position for the underlying asset. Without liquidity an asset price can become extremely volatile and the market lacks efficiency.

Risk Considerations

1/ Non-fungibility

NFTs are by definition unique from one to the next, hence the non fungibility. This means that there could be difficulties when returning the borrowed asset to the owner. If the lender is ok with receiving a different “floor” NFT from the same collection, then this strategy can work. However, if the lender would require the original item back then this could mean that NFT may need to be purchased for a premium or over the counter to obtain and return. If the counterparty realizes that the NFT purchased is part of a short selling arrangement they may charge a premium for this asset as they become aware of the downside risk of the short seller.

2/ Short Squeeze

If the NFT continues to rise in value then the exposure for the loss can be significant and the downside risk can be uncapped. The lender of the NFT or broker may have concerns over the recovery of the loss and request the NFT to be returned even though the short seller may want it to remain open. This is similar to a margin call - the short seller is required to post collateral or add to their position to prevent the position being closed.

This can be exacerbated by other traders, who may artificially inflate the price through co-ordinated bids to drive the price above the short sellers liquidation threshold. This happened with Gamestop in 2020 when retail investors took on the Wall Street Hedge Funds by purchasing the company stock while the hedge funds shorted.

We see this frequently in crypto. Leverage is washed out of the market, causing cascading liquidations amplifying price volatility.

3/ Leverage and Borrowing Costs

There is additional risk when short selling given the liability incurred with the requirement to repay the asset to the lender/broker. There may also be additional broker or interest costs to compensate the counter party for the risk taken on with lending their asset. This would be the cost of borrowing the NFT.

4/ Adverse Impacts on the NFT Space

There may be artificial price action on collections to capitalize on short selling arrangements. The smaller collections may be more susceptible to this manipulation and as such lending protocols should be wary about the types of collections that the products are offered to.

5/ Regulatory

There may be regulatory restrictions over when and where short selling can take place. If the short selling is harmful for the market this may be banned, and penalties incurred for executing these types of trades on decentralized platforms or over the counter. Alternatively centralized platforms may not offer the ability to borrow NFTs or may impose restrictions around selling borrowed assets.

6/ Timing in the Market

Dollar cost averaging into a position or NFT project has historically been the least volatile way of profiting or mitigating losses. Timing the market can be incredibly hard to do, speculative in nature and attributed to luck to execute this perfectly most of the time. The speculative nature of short selling can expose the trader to untimely price fluctuations that can cause the position to be liquidated.

Closing Remarks

The infrastructure is primitive for derivative trading with NFTs. Lending platforms are relatively novel concepts that are being developed as the NFT market matures. Current state protocols being developed will offer spread betting style solutions on a token that will be tied to the underlying floor price of an NFT collection.

As these product offerings come into fruition the market will become more interconnected, with increased systemic risk. We see leverage flushed out in the crypto/fungible token market with cascading liquidations causing increased volatility. It’s important that we take the lessons learned from tradFi and ensure that any knock on effects from short selling.

As crypto becomes more regulated, there could be bans on short selling also as a method of stemming any contagion. It will certainly be interesting to see how this is executed given the decentralized nature of the NFT market.

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