Authored by Coinchange Research team: Jerome O., Pratik W., Rohit S.
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Coinchange and its Research department are happy to share their second Research report on NFTs which will be a two-piece series. The first report is about the NFT landscape and insight on adoption and misconceptions which you can read here. The second report found below is about NFT financialization and potential yield opportunity in this new sector. Similar to our first research report on rDeFi (link here), the approach taken has been both to educate Coinchange internal stakeholders as well as trying to provide a clear overview of the NFT sector and its ramifications. Through these research reports, we aim to shed light on sectors, protocols, and varied aspects of the crypto space to allow a broad spectrum of new, and existing participants to easily understand trends and the opportunities available.
As part of our continuous improvement process, feel free to share via email any research subject you would like to have covered by our team. Also, we would gladly appreciate your feedback being sent to the following mail address: email@example.com
The NFT Financialization report has highlighted several key insights on the NFT sector and its potential growth in the future.
- The growing financialization of NFT seems to follow in the steps of art & rare collectibles financialization in the 2010s. With what seems to be a foregone conclusion crypto innovation might create new primitive unseen in the traditional market so far.
- All yield farming follows the same basic building blocks which when used cleverly can create new financial premia. The report builds upon this knowledge to understand if current NFT innovation is venturing into the creation of such building blocks.
- Such innovation, although in its infancy, is proving to become an entire sector in DeFi as the building blocks for NFT yield are being created as we speak. With teams building protocols that are pushing the boundary between financial engineering and smart contract innovation.
- As the basis for yield generation with NFT follows the same patterns as in DeFi in general, the only limitation to potential yield is creativity alongside risk aversion. As the market is still maturing, those strategies are for investors with a strong knowledge of DeFi yield farming mechanisms alongside proper due diligence skills to use those protocols.
Download the research paper "NFT Financialization Report" as a PDF.
Introduction - Why NFT Financialization will be next on the road
The notion of yield and usage
As touched on in the rDeFi report, DeFi protocols allow end users to generate “passive” income through yield farming in a trustless and permissionless manner that would otherwise not be possible in the traditional financial world. Yield farming in the crypto ecosystem refers to the aggregated revenue that someone can earn through the composability of decentralized applications and protocols. The yield is effectively a value capture of the various types of revenue in DeFi markets - trading fees, lending interest, and staking / token rewards.
With sufficient knowledge of the available building blocks and some creativity, anyone can create powerful earning strategies, which ultimately benefit all users once the protocol is democratized. The building blocks themselves are various protocols and decentralized applications where DeFi users incur fees for engaging in transactional activity on the selected networks - these fees are then distributed to protocol stakeholders for engaging with the protocol.
NFTs, as a budding sector of the crypto industry, has evolved in front of our eyes, from standalone collections such as Cryptopunks and Bored Apes having their floor price bid up to hundreds of thousands of dollars, to new entrants trying to distinguish themselves by creating their governance tokens. Although this subsector of the crypto market is in its infancy, NFT trading volumes have been growing exponentially with big spikes in both August 2021 and January 2022.
The chart below from Dune Analytics user @rantum shows this clearly - at the beginning of January 2022, the top 100 NFT collections totaled approximately 390,000 ETH worth of trading volume in a single day (approximately $1B at the time with ETH trading at ~ $2,600). One important detail to take into consideration was that the January peak in NFT trading volumes coincided with the launch of the LooksRare NFT marketplace, which tried to heavily incentivize traders to use the platform by distributing 100% of net trading fees to their governance token stakers. The average daily NFT trading volume was hovering around 70,000 ETH in March 2022 (worth approximately $210M at a market price of $3,000 / ETH as of Mar 23, 2022), which is a decrease of approximately 85% from the peak earlier this year and a total dollar-denominated decrease of around 91% to August trading volume of around 10,000 ETH (worth approximately $18.8M at a market price of $1,880 / ETH). Some of the data in this report are taken from March 2022, as we believe it to be a fair representation of the usage of these protocols in terms of trading volumes and fees generated.
Fine art and NFT financialization
Physical art and other miscellaneous rare collectibles are already a mature segment of the investable asset landscape; however, the market was not very popular and took a while to bloom into its current state a decade ago. According to a 2012 research article published by Deloitte on the topic of Fine Art, the financialization of art was not very well developed at the time. Only specialized boutiques spread around the world would let owners use their artwork as collateral for loans, acquisition financing, or revolving lines of credit.
At that time, the market was driven mainly by experts in both art & finance. This industry blossomed as it found a product market fit driven by art & finance experts once it started to become recognized as a new & alternative asset class in the years to follow. This trend is further evidenced by a subsequent Deloitte report on Art & Finance, published in 2021, where the financialization of Art & Collectibles (mainly used as collateral) was offered by 71% of wealth managers in 2021 compared to just 21% of wealth managers in 2011.
We can derive a comparison here between the growing innovation currently found in the NFT market and the growing financialization of art & rare collectibles in the 2010s. In this report, the Coinchange Research Team will try to understand the current state of NFTs as financial assets to be used in Decentralized Finance and how this sector can become one of the primitive building blocks for Financial innovation in DeFi.
101 Overview of The Different Protocols Type Enabling Financial Innovation
To understand the potential use cases for generating yield using NFTs, we must understand the various types of interoperable protocols or money legos available to DeFi users. We start by highlighting the various protocol types that are used in yield farming activities together with their use cases:
Decentralized Exchanges (DEXs)
Decentralized Exchanges, or DEXs for short, are protocols or decentralized applications allowing anyone with an internet connection and crypto wallet to trade freely between any crypto-crypto pair available on the market. DEXs and Automated Market Makers (AMMs) are often used interchangeably, but AMMs are a subcategory of DEX. There are two main categories of DEXs that are used in Protocols or dApps today:
- AMM (Automated Market Maker) like Uniswap and Sushiswap, are decentralized liquidity pools, where traders can buy or sell digital assets from these pools of liquidity that represent the various trading pairs available (i.e ETH/USDC). Each liquidity pool (i.e a trading pair) is different in an AMM. This type of DEX allows permissionless and trustless trading thanks to a mathematical formula called Bonding Curves, as a substitute for centralized order books currently found in most Centralized Exchanges.
- SMM (Single-Sided Market Maker) like Bancor versions 2 & 3 are also decentralized liquidity pools where traders can buy or sell digital assets from pools of liquidity that represent the various trading pairs (i.e ETH/BNT) available. What sets this apart from AMMs described above is that every liquidity pool has the same denominator. In the case of Bancor, it’s their native BNT token. This puts liquidity providers in a much safer position since the protocol will cover the cost of impermanent loss incurred by depositors using swap fees earned from protocol-provisioned liquidity (BNT).
DEX revenue comes from trading fees incurred by traders. Those fees can vary and depend on the protocol or dApp implementation and choice of its distribution to stakeholders of the platform.
Money Market Protocols
Money market protocols are networks that allow users to lend and borrow crypto in a peer-to-peer fashion. The protocol does not take custody of the funds - it facilitates the transactions between the lenders & borrowers through smart contracts. The protocol enforces different collateralization ratios for each asset and allows liquidators to freely liquidate debt positions for a discount if these debt positions drop below a predetermined liquidation threshold. MMPs earn a percentage of the interest, often called the reserve factor, generated from the borrowing position. Different MMPs use their reserve factors for different purposes - AAVE, for example, uses this revenue to sustain the protocol’s operating costs, while also functioning as a risk premium per asset (higher reserve factor for higher risk coin, lower reserve factor for low-risk coin), and a source for token reward distribution to incentivize lending/borrowing markets. Similarly, Venus Protocol uses its reserve factor to cover operating expenses, as well as being a source for its token reward distribution. Compound uses the same methodology as AAVE for its reserves.
Staking/Token Reward Claiming
Much like Proof of Stake consensus, staking involves the act of ‘pledging your digital assets’, but where the two differ, is that staking does not serve the consensus mechanism of a specific blockchain. Instead, this form of staking involves assets (most commonly being the LP tokens representing the main trading pair for the protocol’s governance token) that the protocol must incentivize via staking reward, as these assets are essential for the protocol to work efficiently. The protocol cannot directly control or manage the staked assets, which is why incentive mechanisms are put in place to ensure that stakeholders act in their self-interest while simultaneously benefitting the protocol.
For example, protocol ‘A’ has a governance token ‘X’. ‘A’ requires a liquid market for token ‘X’ to both ensure as many people as possible have access to ‘X’, so they can all participate in the governance process, and to allow price discovery. ‘A’ will create the X/USDC trading pair on Uniswap with an initial $200k value locked in this pool. To achieve greater liquidity which results in less slippage for larger trade sizes, Protocol ‘A’ will incentivize users with governance tokens to provide liquidity in Uniswap. This is the easiest option for Protocol A, as it cannot control Uniswap, nor the trading pair and its associated pool liquidity. Protocol A creates a staking smart contract that will reward governance token X to users staking the LP token in the X/USDC pool described above.
Stakeholders and reward mechanism
Each protocol has different stakeholders, who are incentivized to work together by focusing on their self-interest. In this section, we’ll analyze the stakeholders that receive revenue or rewards by interacting with these protocols. Such information is crucial to understanding which stakeholder a user needs to be to generate yield in DeFi.
To function in a permissionless manner without an order book, AMM protocols need to incentivize liquidity providers to “make the various markets”. These liquidity providers are providing liquidity to a specific trading pair to allow price discovery and traders to exchange between the two cryptocurrencies with minimum slippage. The liquidity provider receives LP tokens in exchange for depositing their crypto in the pool to trade, which functions like a receipt, or proof on the blockchain, that a specific address deposited a determined amount of two or more tokens in a pool at a certain time. The pool’s (trading pair) smart contract will incur trading fees every time a trade happens between the token pair. Those fees are automatically distributed to liquidity providers as revenue for making the market. In summary, LP token holders earn the trading fees from each underlying pool.
In the case of money market protocols, these networks need to incentivize lenders and borrowers to use the network. The demand for the credit can come from the attractive interest rate curve, which depends on the utilization of the lent crypto. Low utilization rates imply low borrowing rates and vice versa. MMPs can also incentivize usage of the network with token rewards. Indeed, decentralized applications often issue tokens that can have governance rights, hence they are most of the time integrated into the economic model of the protocol itself. As a result, a fraction of the total token supply is typically allocated to incentivize the usage of the platform in the form of a reward added on top of interest earned normally by lenders and paid by borrowers. Certain protocols also reward users with fee revenue from the protocol itself.
Lastly, for staking protocols, the crypto asset that can be staked will vary based on the protocol’s value derived from crypto staking, as explained in the section above. Indeed in the example, we derived, a protocol needs to incentivize the trading of its governance token in AMMs, otherwise, it becomes difficult to scale the user adoption and achieve good price discovery. As such a specific LP token representing a share of this token pair will be of value to this protocol, as it is a proof of deposit that allows trading of the governance in a more liquid manner. On the other hand, for a protocol issuing a stablecoin, LP tokens are not the only type that the protocol needs to incentivize. The protocol issuing the stablecoin has a crucial need to have a healthy money market for its stablecoin to be borrowed and lent; hence it can incentivize those behaviors by the distribution of its governance token to those agents. Staking can happen in a separate protocol from the first you interacted with (LP token from Uniswap staked in Protocol A) or can occur in the same protocol where we first interact with (LP token from Sushiswap can be staked in Sushiswap farms).
In the following sections of the report, we’ll analyze three NFT-centric protocols that follow the same structure as the DeFi protocols mentioned above and the associated risks with using each protocol. Those protocols effectively will function in the same way as the broker or asset manager in Traditional Finance which enables fine art holders to make use of it as a capital asset.
NFTX (DEX - AMM)
Overview of the platform
NFTX is a protocol for making fungible ERC20 tokens from popular NFT collections that are backed by actual NFT tokens (from those respective collections). Eg. A user can deposit a specific CryptoPunk to the NFTX Punk pool and receive a PUNK token in exchange. These tokens are called vault tokens, and like all ERC20s, they are fungible and composable. This greatly improves liquidity as the vault tokens can be traded on decentralized exchanges like Uniswap, which themselves are not NFT markets, or could be traded on traditional cryptocurrency exchanges like Binance.
NFTX provides liquidity and allows NFT holders to stake their minted vTokens & earn yield rewards. In addition, the platform incentivizes better distribution and price discovery for NFT projects. Lastly, NFTX allows NFT holders to instantly sell any NFT by minting it as a fungible ERC-20 token and swapping it for ETH on Sushiswap or allowing indirect selling by user redeeming a specific NFT from the vault by burning their vToken and paying a fee.
NFTX is built by a decentralized autonomous organization (DAO) - a group of community members, contributors, and core members closely aligned to build the primary NFT liquidity hub. As NFTX is an open organization, anyone anywhere may join to provide expertise and/or additional resources with the goal to grow NFTXs' success. The long-term goal for the NFTX DAO is to develop a moat as the primary issuer of wrapped NFT funds.
The protocol is an AMM DEX and has the associated mechanisms to generate yield for users by participating as a liquidity provider as touched on in the sections above.
NFTX was launched on January 5, 2021. The founder, Alex Gausman, is based in Vancouver, Canada. The project was backed by investment fund Coinfund whose investment portfolio includes several large and successful companies & protocols such as Dfinity, Messari, and Polkadot. Aside from the founder, 0xKiwi has been the only other contributor for v2 of the protocol on GitHub. He also contributes to uwu-labs/uwucrew, prysmaticlabs/prysm. Alex Gausman has contributed exclusively to the NFTX repository for the past few years according to his Github page.
Unlike most cryptocurrency projects which use Chainlink oracles, NFTX is using Rari's Fuse pricing oracles. Of note, the protocol also uses subgraph nodes which enable scalable querying & responding by catching on-chain data and events. The NFTX platform does not use any bridges or other protocols. NFTX makes use of yarn.lock (with hardhat config) - according to an article by the 11sigma blog, “Lock is the main source of information about the current versions of dependencies in a project. Yarn uses that information to check if it needs to update anything – it compares dependency versions currently installed in a project (listed in yarn.lock ) to version restrictions in the package.”
Since the NFTX platform is run autonomously as a DAO, so the DAO members are rewarded with NFTX tokens. Liquidity providers are awarded fees from minting/redeeming NFT-backed fungible vault tokens. The NFTX token is currently purely used for governance votes. The project’s founder recently created a snapshot vote to pay himself a $140k / yr salary from treasury funds to work on the project full time.
Smart Contract and Technical Risk Factors
The protocol was officially launched on January 5, 2021. NFTX has a bug bounty section in their documentation with rewards decided based on Ethereum Bounty Program. A user recently reported an unusual smart contract behavior on their discord and three team members replied and looked into the issue on the same day. There was no confirmation on the discord channel if the issue was resolved or what steps were taken to get it fixed.
The protocol initially published an audit on their Github page by firm LevelK in November 2020. The audit included 1 critical vulnerability, 5 medium-level vulnerabilities, and 10 low-level vulnerabilities. There was no information if the vulnerabilities were corrected or patched, but the audit is publicly linked on their GitHub page. The audit was performed on private repo at commit: f80a9c1c65f75b433346196c1bcd12a5d1bbea9c primarily on XStore and NFTX.sol contracts.
NFTX ran a subsequent audit via a contest on code4rena between May 5th and 11th, 2021. The results were published on June 21, 2021, and the analysis yielded an aggregated total of 24 unique vulnerabilities. Of these vulnerabilities, 4 received a risk rating in the category of HIGH severity, 10 received a risk rating in the category of MEDIUM severity, and 10 received a risk rating in the category of LOW severity. All high-risk issues were closed by 0xKiwi, all medium-risk issues were closed, low risk finding L-01 (Front-running setFees() could avoid fees #72) was not closed. The protocol has had a second audit by C4 in December 2021 and has been completed on March 24th and found 3 High severity issues (2 of the High severity issues have been resolved and 1 partially resolved), 17 Medium severity (10 have been resolved so far and others have been acknowledged) and 38 with low severity.
Additionally Trail of Bits performed an audit on Version 2 of the protocol on April 15th, 2022. The audit uncovered flaws that could impact system confidentiality, integrity, or availability. The process of creating vaults in the NFTX protocol is trustless. This means that anyone can create a new vault and use any asset as the underlying vault NFT. After deploying the new vault, the contract sets the user as the vault manager. Vault managers can change the vault fees and disable certain vault features. Therefore, users must verify that vaults that they interact with have reliable managers or have had their managers disabled through verification. A possible exploit scenario could be where Eve, a malicious manager, creates a new vault for a popular NFT collection. After it gains some user traction, she unilaterally changes the vault fees to the maximum (0.5 ether), which forces users to either pay the high fee or relinquish their tokens. Ultimately, this risk is related to the trustless nature of vault creation, but the NFTX team can take certain measures to minimize the effects. One such measure, which is already in place, is “vault verification,” in which the vault manager calls the finalizeVault() function to pass her management rights to the zero address. This function then gives the “verified” status to the vault in the NFTX web application.
With regards to governance, there have been a total of 41 proposals so far. The protocol stopped having weekly governance calls in May 2021 and has since switched to monthly governance calls which are released on YouTube. The calls consist mainly of treasury proposals. Governance changes are outlined on their forum as protocol improvement proposals. A minimum of five token holder votes is required to pass a governance proposal. More than 50% must vote in agreement for the XIP to Pass. For changes to the NFTX contract, more than 70% must vote in agreement for the XIP to pass. Once the above threshold is met, then the improvement proposal is voted officially on Snapshot. Disclosure of smart contracts related to control of the protocol, DAO, and core contract was incomplete in their documentation.
Capacity / Liquidity Risks
The protocol TVL is reported as $29.13M on DeFiLlama and $43.68M on Dune Analytics, as of March 17, 2022. We tallied the TVL of all pools and we believe the discrepancy in the figures between DeFiLlama and Dune Analytics was caused by the DeFiLlama code, where they are only checking the value locked in the NFTX vaults, as opposed to Pool, Minted/Redeemed, & Inventory like the NFTX query from their Dune Analytics Dashboard.
The actual protocol volume is fairly low due to the current bear market. CryptoPunks is the largest NFT pool on the platform, but there have been no mints, targeted redemptions, or even swaps in the past seven days (as of Aug 16, 2022). Historical liquidity metrics for this pool are available on Dune Analytics, and we can see that the largest trading volume happened between July 30 - August 15, 2021. There have been a cumulative 596 mints, redemptions, and swaps since the inception of the pool in June 2021. This resulted in total fees of 7.620 cryptopunks or roughly 514.2 ETH as of Aug 16, 2022.
According to the sushiswap pool dashboard the PUNK/ETH pool on Sushiswap has had approximately $364k in volume over the past 7 days as opposed to $3.8M in volume in March 2022 over the same time frame. And has generated around $1,092.83 in fees in the past 7 days as opposed to $11,543 in March 2022. Current pool liquidity is approximately $10.3M so the past week has generated ~0.01% in net fees for liquidity providers. The PUNK/NFTX pool has had $0 of trading volume and generated $0 in fees in that same period.
Another area for significant liquidity risk is the fact that NFT metadata for collections on NFTX that either uses centralized storage or are not frozen can change over time as explained in the previous section of this report. An actual example of this situation is the Meebits collection which was analyzed as being both centralized and not frozen. If the NFT metadata changes, it has the potential to render the NFT worth less in a situation where holders are not satisfied with the changes issued by the LarvaLabs team, and decide to liquidate their Meebits. This could result in the floor price of Meebits dropping substantially on both NFTX and other NFT marketplaces, and as a result, would significantly affect the value of any MEEB tokens minted through the NFTX platform. In addition, institutions or other players who provide liquidity to earn a yield on both NFTX or Sushiswap vault token pools could have their positions become worthless overnight.
LooksRare (CEX / Marketplace)
A brief overview of the platform
OpenSea was the NFT marketplace that gained the lion’s share of the liquidity during the NFT boom of 2021, recording an all-time high trading volume of nearly $5 billion in January 2022. This platform was not without flaws as the trading fees were extremely high & there was no associated token. LooksRare was a competing NFT marketplace launched in January 2022 to steal some of the hype associated with the market via Vampire Attack. LooksRare airdropped their platform’s native LOOKS token to anyone who had previously used the OpenSea platform to buy or sell an NFT. The free tokens, combined with lower trading fees (2% on LooksRare vs 2.5% for OpenSea), and other standalone features like token staking, helped the LooksRare platform gain tremendous hype on social media platforms like Twitter. The marketplace is positioning itself to be the de facto competitor for OpenSea with attractive features for users and a near-equal daily trading volume since launch.
The staking mechanism allows users to generate yield by participating as a staker as touched on in the sections above.
LooksRare was launched by two anonymous co-founders, Zodd and Guts, on January 10, 2022. It also has a small team of nine, mostly made up of engineers. Zodd's Twitter references Guts but the link to his account no longer works showing that Guts deactivated his Twitter. The LooksRare team is completely anon. There is no information regarding why their Github is private and the code is not accessible to the public. In addition, there was no information publicly available regarding seed or early-stage investors of the platform.
As the Github repositories for the platform are private, the Coinchange Research Team could not check the code to see if any oracles or other protocols are used. The chainlink GitHub repository has no link to LooksRare either. The LOOKS tokens are issued in the ubiquitous ERC-20 standard and are not centralized.
LooksRare charges a flat sales fee of 2% (in WETH) on all NFT transactions on the platform excluding private sales. All the WETH collected from these fees are consolidated at the end of each 24 hours (roughly 6,500 ETH blocks) and then distributed to LOOKS stakers in a linear format per block over the next 6,500 block period. LOOKS token stakers earn 100% of the trading fees on LooksRare, the team or protocol themselves do not take a predetermined fraction/cut, unlike OpenSea which keeps 100% of the fees. Staked LOOKS tokens are auto-compounded for users that wish to just leave their LOOKS tokens staked.
Users who trade any NFTs on LooksRare earn trading rewards in the form of LOOKS, LooksRare’s platform token. Both the buyer and seller of an item earn rewards for their trading volume (except for private sales). Trading rewards are calculated daily and rewarded to users 2 hours after the end of each day. The entire schedule of trading reward emissions will be over 4,686,250 Ethereum blocks (or approximately 721 days, using 6,500 blocks per day), at which point all LOOKS token emissions will come to an end as the ecosystem becomes fully self-sustaining. Rewards go down proportionately over time.
LooksRare had a short-lived liquidity provider program which was discontinued on 2022/02/15 and the tokens were reallocated to be used for long-lasting Uniswap V3 liquidity managed by the team.
Hildobby.eth created a custom dashboard on Dune Analytics showing supposed wash trading volume on the platform and explained his findings in a thorough Twitter thread.
Smart Contract and Technical Risk Factors
The platform is over seven months old, launching officially on Jan 10, 2022. The founding team offers a comprehensive bug bounty reward of up to $1M for any critical vulnerabilities found on the protocol.
LooksRare is built on the Ethereum network and was designed to be a vampire attack on OpenSea to “steal” their user base. As a result, we believe there is a high likelihood that the code is very similar to OpenSea and could be a big reason why GitHub is private as the key code infrastructure is probably almost identical. The Coinchange research team investigated a similar smart contract from both OpenSea and LooksRare and compared the code using diffchecker. The LooksRare code appeared to be much more efficient as the smart contract was only 557 lines as opposed to 1950 lines for OpenSea. As previously mentioned, the team’s Github repositories are all private.
LooksRare published an audit issued by PeckShield on January 30, 2022. However, the audit is not a fair representation of the code quality of the protocol as it only was performed on the staking smart contract. There was no coverage of the execution logic and signing methodology allowing for trade to happen on/off-chain. There is however a new Security Assessment by Trail of Bits, performed on March 29th, 2022. The audit did not uncover significant flaws that could result in the compromise of a smart contract, a loss of funds, or unexpected behavior.
Nonetheless, the code quality appeared to be very high as only two vulnerabilities were found (one medium risk, and one low risk). The low-risk issue was confirmed by the LooksRare team but not resolved as it was not a security vulnerability and had more to do with tokenomics. The medium risk issue (resolved) was a calculation error when calculating staking rewards that would cause the amount of LOOKS tokens distributed to be greater than the amount in the pool and thus locking all deposited funds. The protocol and smart contract were not listed on DefiSafety, DeFi Score, or Simetri. In addition, LooksRare was not rated on either CertiK or TokenInsight. As a result, we assessed the overall security score as LOW.
The smart contracts are coded in Solidity after examining developer documentation on their site. LooksRare has a Public API available. Their developer SDK was released on March 3rd, 2022. Their developer docs have detailed information regarding both how their publicly available smart contracts function and how to integrate with them.
Lastly, there is no democratized governance process for LooksRare similar to other DeFi protocols. The tokenomics are controlled entirely by the team. There is no mention of the Treasury and who it consists of anywhere on the platform’s site, documentation, blog, or another medium, so it’s reasonable to assume that it consists of the anon team members. There was no mention of governance on the LooksRare discord server.
Capacity / Liquidity Risks
Compared to decentralized automated market-making protocols like NFTX, centralized marketplace platforms like LooksRare offer significantly lower liquidity risks for users. The risk of an NFT collection creator changing the metadata, given it is not decentralized or frozen, is a standard risk that is not limited to any particular platform or protocol and could lead to NFT collections becoming worthless overnight.
There is also the risk of the LooksRare platform no longer being as popular which would result in lower trading fees. This leads to a positive feedback loop where market makers and wash traders, who currently make up a significant portion of the LooksRare trading volume, might not use the platform as much given the USD value of the LOOKS token would drop significantly. This would lead to the platform becoming even more illiquid.
There is a total supply of 1 billion LOOKS tokens of which 120M (12%) went to users as part of the initial airdrop, 33M (3.3%) to their unknown seed investors, 17M (1.7%) for liquidity management, 441M (44%) towards trading rewards for users, 189M (19%) towards staking rewards, 100M (10%) towards the founding team, and 100M (10%) towards the treasury.
10% went towards the treasury to incentivize future development; however, there is no mention of the treasury team and who it consists of anywhere on the LooksRare site or their publicly available documentation, so it is safe to assume that those tokens are controlled by the team. According to the LooksRare discord server, the treasury will be governed by a DAO in the future; however, there was no mention of the associated tokens. As of Aug 16, 2022, all remaining LOOKS tokens from the trading rewards wallet have been transferred to a Multisig Wallet which is in charge of distributing the tokens to various fee-sharing smart contracts.
One potential liquidity risk is that almost all of the top LOOKS holders on etherscan, including the team Multisig and Vesting Contract, are owner-controlled wallets and exchanges wallets.
Arcade.xyz (Money Market)
A brief overview of the platform
Arcade is a peer-to-peer lending marketplace that allows NFT owners to unlock liquidity on baskets of Ethereum-based NFTs they own. Lenders that hold stablecoins or ERC20 tokens can participate in a new and growing source of yield by underwriting term loans collateralized by the borrowers' NFTs. Arcade is the end-user interface for the Pawn Finance protocol.
Arcade facilitates off-chain order matching using smart contracts to both settle and validates loan terms between borrowers and lenders. The loans and collateral themselves are settled on-chain and held in decentralized escrow.
Borrowers can request loans in any ERC20 token, with a bundle of NFTs as collateral, for a fixed interest rate with a set term. V2 of the protocol will allow borrowers to make periodic payments - currently, only one payment in full is supported. The lenders can offer various APYs from which the borrowers can choose thus creating a true lending marketplace. Lender funding takes place in the form of any ERC20 tokens, with ETH and USDC being the most popular. There are currently no auto-liquidation or margining features in Arcade. If a loan goes into default, the borrowers can still pay off the loan as long as the lender has not claimed the collateral.
Arcade is a money market and has the associated mechanisms to allow users to generate yield by participating as either a lender or borrower as explained in the stakeholder section of this research report.
Arcade was launched by CEO & Co-Founder Gabe Frank and Co-Founder Robert Masiello on January 31, 2022. Gabe worked previously in institutional sales at BitGo & was the Director of Sales at Curv. Robert worked previously as a director at Industry Capital. Mark Toda is currently a Technical Advisor at Arcade where he is the most active developer on the protocol’s Github In the past he committed to several BitGo repositories where he was the Lead Ethereum Software Engineer.
Arcade received $15 million in Series A funding. Some of the notable investors include Pantera Capital, Castle Island Ventures, Franklin Templeton, BlockFi CEO Zac Prince, and Quantstamp CEO Richard Ma. In addition, they are backed by NFTECH.
Arcade and the Pawn Finance protocol use the same yarn.lock with hardhat config as NFTX. There is no mention of pricing oracles (either Link or Rari) in their Github code. The protocol also does not use subgraph nodes. Arcade gets around the lack of pricing oracles by having the terms of their loans settled on an individual basis. It is up to the lender to determine if the collateral is worth the risk of default. Furthermore, this feature allows the Arcade market to potentially prove more resilient in an NFT winter or after NFT metadata changes, rendering the NFT collateral worthless as seen in section “Data storage problem - NFT aren’t all immutable” in Coinchange NFT Landscape General Report. (link to report here)
The protocol does not have a token and currently charges no fee to borrowers as part of the Arcade V2 launch fee holiday, although this fee structure and arrangement may be changed in the future.
Smart Contract and Technical Risk Factors
There is no information regarding protocol security or any bug bounties in both their protocol documentation and Github. In addition, there is no description of the control over the smart contract in their docs.
The Pawn Finance protocol uses AAVE flash loan code for its rollover functionality.
Users can report issues with the Pawn Finance protocol or code on their GitHub - one user-reported issue was submitted on March 11th ("To repay the loan, you need to judge whether it is due or not") and an Arcade team member has yet to respond or provide a comment regarding the issue.
Quantstamp audited Arcade on June 16 2022 and they found 9 issues of varying severity. All the high, medium, and low severity issues were resolved. Quantstamp is a Y Combinator-backed company with over 1000 Google scholar citations and numerous published papers. As of June 2022, Quantstamp has protected $5B in digital asset risk from hackers.
Before that, an anonymous whitehat Roku conducted an audit for Arcade V2 on June 02, 2022. The overview of the audit says “The codebase is very well documented and tested. The test suits achieved 100% statement coverage and 100% branch coverage on core functions, (98% in total). The test suite is also very well organized and covers various kinds of scenarios, which makes it very easy to understand how the system is supposed to behave, also gave me an ease while trying to write up some exploit scenarios. Overall, the codebase gave me a high confidence in the engineering team in terms of security process and expertise. I concluded the 6-day audit with 1 high severity, 1 medium severity and 2 low severity findings.” Upon checking the audit details, all major issues have been fixed as of June 14, 2022.
Additionally, two other audits have been performed, one of which is by multi-chain audit firm Least Authority dated August 2021, almost six months before the official launch of the platform. Least Authority has completed an audit for the Ethereum Foundation for EIP-3074, which is evidence of their reputability. Zooko Wilcox, the founder of Z-cash, is an advisor for the auditing firm.
The protocol’s code is well written as described on page 4 of the audit, "The Pawn Finance smart contract code is well written and organized, and adheres to widely accepted standards and security best practices. Additionally, the implementation demonstrates that the Pawn Finance team has minimized computational complexity and gas costs, which benefits user security and reduces transaction costs." Pawn Finance is built on Ethereum and coded in both Typescript and Solidity.
Page 8 of the above audit report explains that the smart contract called Loancore is controlled by an admin key and there is not sufficient disclosure as to what it does and why. At the time the issue was unresolved and acknowledged by the team during the process of verification. As of August, Arcade documentation has no clear mention of admin key and ownership of the smart contract but there is a mention of a multisig 2 out 6 in the Macro Audit Report.
Capacity / Liquidity Risks
Arcade currently has 11 active loans with a value of $281k as opposed to 23 active loans with a value of $7.9M in March 2022. One interesting statistic is that as of July 2022, the platform has a mere 3.26% default rate across 92 loans. This could be due to the incentive structure where lenders can be very selective with which loan requests they fill and borrowers run the risk of losing their collateral if the loan is not paid back on time in full.
A unique feature of Arcade, compared to other NFT-based lending protocols like NFTFi, is that Arcade allows the borrower to package multiple NFTs into a single wrapped bundle through the Pawn protocol instead of taking out multiple individual loans.
Arcade faces an unusual liquidity risk where borrowers might not be incentivized to repay their loan if the market value of the collateral drops below the agreed-upon principal and interest due at the repayment deadline. Lenders, as a result, are required to be responsible for the overall state of the cryptocurrency market and take measures to protect themselves when providing credit.
Usability & Some Ways To Earn Yield
Only one of the protocols currently has APIs or SDK, which means a user must interface with the other protocol’s native UI directly. As the industry is in its infancy, more advanced developer tools could be in the above protocols’ future pipeline, as usage continues to grow and the platforms generate more funds. LooksRare released its developer API in March 2022, which furthers the accessibility and composability of the protocol. In addition, the protocols’ documentation is still nowhere near as detailed or polished as other big, established DeFi protocols like AAVE.
Below we will analyze how the three NFT Financialization protocols discussed above can be used to earn yield in different ways and what role a user plays in each protocol as touched upon in the stakeholder section of the research report.
There are several different ways to generate yield using the NFTX platform, in this report we will take a look at the following three - by staking NFTs directly on NFTX, by providing liquidity on Sushiswap for minted Vault Token / ETH pools, and lastly by arbitraging price differences between the minted vault tokens and the floor price of the respective NFT on various marketplaces. NFTX is an AMM DEX and the user functions as a liquidity provider in the first two examples.
NFTX allows users to mint fungible vault tokens representing the collection for which a user wants to stake. For example, depositing any CryptoPunk, regardless of its unique rarity, market valuation, or features will generate a PUNK token (fungible representation of CryptoPunk NFTs on NFTX). These fungible vault tokens can be staked on the NFTX platform under each collection’s respective liquidity pools and a user will receive part of the running trading fees associated with that vault as yield.
There are two different interest rates on the NFTX dashboard for any pool, the first being the Inventory APR and the second being the Liquidity APR. The inventory APR represents the yield earned for staking an NFT on the platform and the higher liquidity APR represents the yield earned for staking an NFT with an equal amount of ETH (relative to the vault token market price). The difference between the two interest rates is equal to the yield earned by providing liquidity to the vault token / ETH pool on sushiswap as explained below. One important detail to note is that 20% of the vault token fees are distributed to inventory stakers (only provide their NFT to the pool) and 80% of the vault token fees are distributed to liquidity stakers to compensate them for the high probability of impermanent loss.
Once a user creates a minted vault token for any chosen NFT collection, they can also earn yield by providing liquidity to the respective Sushiswap pool. As explained in the stakeholder section, liquidity providers earn trading fees for making a specific market, in this case, the vault pool token / ETH liquidity pool. The PUNK token, for example, has a liquidity pool worth approximately $17.2M with a 7d trading volume of approximately $4,6M as of March 24, 2022. This generated fees worth approximately $13.8k in the 7-day period, which is distributed proportionally to liquidity providers given the amount of liquidity they deposit to the pool relative to the total amount.
Lastly, a user can generate yield on NFTX by arbitraging the difference between floor price NFTs on other platforms and the associated vault token on NFTX. Buying a CryptoPunk at the floor price from the LarvaLabs marketplace cost 62.25 ETH as of March 17th, 2022. PUNK tokens can currently be minted on NFTX for either a 5% fee, or for free if the zap function is used (Mint and stake SLP token with 48h timelock before withdrawal available). The vault token can be exchanged for ETH in the Sushiswap pool for 69.08 ETH as of March 24, 2022.
NFTX has a native governance token which can also be staked to earn yield as explained in the Staking / Token Reward subsection under “101 Overview of The Different Protocol’s Type Enabling Financial Innovation”.
Three ways to currently generate yield by using LooksRare are through trading fee rewards, staking the LOOKS token on their site, and arbitraging NFT price differences between LooksRare and OpenSea. LooksRare is a centralized exchange and the user can use it as a staking platform to generate yield.
LooksRare has about 44% of the total token supply set aside to be distributed on a fixed schedule proportionately to those who use the platform the most. On April 20, 2022, LooksRare released Listing Rewards and reallocated a one-time total of 250,000 LOOKS from the Trading Rewards program to the Listing Rewards program (to be distributed over approximately a month). And on June 14, 2022, an additional 100,000 LOOKS was reallocated from the Trading Rewards Program to the Listing Rewards program. The total LOOKS Per Day allocated to Trading Rewards became 437,468.75 LOOKS.
LooksRare currently charges a 2% fee for any NFT-related transaction on their platform (in ETH) and those fees are distributed to stakers of the LOOKS token. In addition, LooksRare also has approximately 19% of the total supply of LOOKS tokens set aside as staking liquidity incentives which are distributed on a fixed schedule. Both of these payouts, trading fees and staking rewards, are rewarded proportional to what percentage of the total staked amount a user represents for the previous calendar day. The current staking APY is approximately 53.58% as of Aug 16, 2022, of which ETH trading fees represent 32.38% of the staking APY, and the LOOKS staking incentive represents the remaining 16% APR. The staking reward APR is dynamic and changes over time according to many different factors, including token prices, trading volume, liquidity, the amount staked, and more.
Stakers run the risk of having the APY decrease substantially over time if usage of the protocol dwindles leading to significantly fewer users going forward. In addition, if the price of the LOOKS token decreases by a huge amount after purchase, the staking reward (provided as LOOKS tokens) might not make up for the USD value lost of the purchased tokens themselves.
Many popular NFT collections like Pudgy Penguins have a slightly different floor prices on both OpenSea and LooksRare (1.239 on OpenSea vs 1.29 on LooksRare as of March 21, 2022). This translates to an arbitrage opportunity of roughly 5% between the two platforms. In addition, if an NFT is purchased on OpenSea and resold on LooksRare, users will also be rewarded with LOOKS tokens for trading volume as explained above.
Two ways to generate yield with Arcade are by lending out to borrowers on the platform directly and by using your NFTs as collateral to take out a loan and yield farm with the liquidity. Arcade is a money market protocol and the users need to interact with the platform as a borrower or lenders to generate yield.
There are currently about 26 open loan requests on Arcade, ranging from 10 USD to over 300k USD, with the average loan size of ~$177k USD and an average annual interest rate being roughly 10-20%. Lenders can explore potential funding opportunities under the Loan Requests section of the platform. Funding is provided with ERC20 tokens, the most requested being wETH, or a stablecoin like USDC. NFTs are provided as collateral and the lender receives ownership of the NFTs if the predetermined loan and interest amount are not repaid on time. This is to the lenders' benefit as default typically results in lenders receiving NFTs worth substantially more than the agreed-upon principal and interest. Lenders must be aware that NFT prices are extremely volatile, and it could be in the best interest of the borrower to default if the value of the collateral has dropped below the total amount owed at the time of repayment.
Alternatively, if a user owns a valuable NFT, they might consider tapping into their “equity” by borrowing funds on Arcade using the NFT as collateral. Once a loan request is submitted and a lender provides capital, the liquid funds can be used to earn yield in other DeFi applications where they are earning more than the interest owed on their Arcade loan. This yield is in addition to the appreciation of the NFT over the term of the loan. Borrowers must ensure they repay the agreed-upon loan principal and interest on time, otherwise, they risk losing the NFTs they put up as collateral.
The Arcade protocol does not currently have a native governance token, and as a result, a user cannot earn yield by staking like the other two protocols discussed above.
Other Notable NFT Financialization Protocols:
NFTFi, similar to Arcade.xyz, allows NFT owners to use their assets as collateral to access secured wETH and DAI loans from liquidity providers in a completely trustless & permissionless manner. Unlike Arcade, however, NFTs are assessed on an individual basis. Liquidity providers can earn attractive yields or rare NFTs at a steep discount to their market value, in the case of default. We would expect the NFTFi protocol to have better documentation than what we were able to find given the success of the protocol - they have reached close to $120M in total loans and generated over $4.7M in interest payments and $250K fees according to the protocol’s official Dune Analytics dashboard.
JPEG’d is a new and comprehensive lending protocol that will enable owners of NFT tokens the opportunity to obtain loans against their assets, while still retaining complete ownership of them. In other words, JPEG’d is combining the tried-and-true Collateral Debt Position (CDP) model, with NFTs being used as collateral, to enable a new DeFi primitive called Non-Fungible Debt Positions (NFDPs). In addition to being a completely decentralized protocol, the network itself is governed by token holders of the native platform. JPEG’d is also forming multiple synergistic relationships with other tangential DeFi protocols to increase both the value generated by users and the features available to users of the platform. Most importantly, JPEG’d has developed a creative insurance mechanism that will allow depositors to repurchase their NFTs back from the DAO in the event of a liquidation. What sets JPEG’d apart from other NFT-based lending platforms is its native stablecoin - pUSD and the integration of this stablecoin in the wider DeFi ecosystem. Investors include famous Twitter users Tetranode, DeFiGod1, & DegenSpartan.
Trava Finance is attempting to incentivize more liquidity to the NFT world and allowing owners to earn a yield for holding their NFTs through their innovative auction pricing model. Once an auction (for an NFT) is complete, users can borrow against their NFT by using it as collateral. The auction mechanism is divided into two parts - auction-to-sell and auction-for-buy-right. In the former, the purchaser receives the NFT right after the auction is complete. The latter does not allow the owner to immediately buy the NFT, instead, they function more as a liquidator. If the owner of the NFT cannot repay the loan they originated, the auction-for-buy-right winner can gain ownership at a much lower price.
Revest Finance - The Revest Protocol uses a different form of NFT called the semi-fungible token (FNFT) which allows users to create programmable wrappers which can hold assets and give up control/ownership of these assets until a particular set of conditions are met. In addition, the FNFT is agnostic in terms of what it wraps. This allows a whole new set of possibilities and use cases - eg. you can lock an ETH token until your son’s 21st birthday upon which he is given access to the wrapped contents.
Bakery Swap is a Decentralized Exchange built on Binance Smart Chain where users can stake & bake their NFTs. Includes several features in addition to DEX features including NFT supermarket which functions as an NFT marketplace. The benefit is that you can purchase NFT projects which are just launching (Initial Dex Offering) similar to Binance LaunchPad for tokens. The first Initial Dex Offering (IDO) sale was for an NFT project called Battle Pets, a blockchain-based game where players can breed, exchange, and battle NFT pets with the metadata stored on the Binance Smart Chain. BakerySwap also allows users to mint NFT Combos which require you to lock up their native BAKE token. The more BAKE you lock up the higher tier NFT combo you can create.
NFTrade is the first decentralized, fully cross-chain compatible NFT trading protocol. Users can now access a platform that will connect the entire NFT marketplace, aggregating every available NFT from almost every blockchain, bringing increased liquidity and access to a fractured market that currently necessitates the use of multiple applications and additional fees. This launch introduces the creation, buying, selling, and escrowed peer-to-peer swapping of NFTs, as well as NFT farming, allowing users to stake idle tokens from a variety of projects to earn exclusive utility-based or collectible NFTs, bringing added benefits to both end-users and project developers.
The NFT sector spanning different categories (see our NFT landscape report) is currently taking shape toward a more efficient market enabled by the usage of the underlying NFT value. The key stakeholders are NFT financialization protocols, which are building the same overall structure (money markets, dexes, staking) and interoperability as traditional DeFi protocols. Hence, approaching this sector with the same angle as when trying to find out how to generate yield in DeFi protocol is possible as evidenced in the report.
Although yield strategies are not without risk especially due to the infancy of these markets and protocols, there is still a lot of innovation to come which will help improve liquidity and create innovative earning mechanisms that leverage stakeholder participation. Most importantly, composability, which has already started, will enable these NFT financial protocols to further grow and integrate with other DeFi protocols like money legos. In doing so the NFT sector will effectively garner true liquidity for digital assets which are currently for the most part used in isolation from each other and function in specific ecosystems.
Current protocols enabling enhanced liquidity for NFTs like NFTX, LooksRare, and OpenSea as well as Arcade and NFTFi will have the first mover advantage compared to newer protocols. These will either leverage the existing features and use cases or build new ones, which will likely create new user behaviors together with unlocking new mechanisms around ownership, transfer, and valuation of NFTs.
Download the research paper "NFT Financialization Report" as a PDF.