Primer on a Synthetic Lending Market for NFTs

We are JPGMorgan, a proprietary fund specializing in lending against NFTs on platforms such as NFTFI, Arcade, Gondi, and Blur for over a year and a half. Our operations have involved originating over 2000 loans, amounting to more than 12,000 ETH in total, across 15 different collections. Our approach has been strongly rooted in quantitative analysis, aiming to tackle the lending market with a banking-grade methodology. This has given us deep insights into the challenges faced by the NFT market. In this article, we wish to share an idea, open for discussion, to help develop the industry further.

Through our experience, several significant challenges have become apparent:

1. Lack of Organic Borrowing Demand: The current demand for loans on NFTs is insufficient to justify a substantial NFT finance industry.

2. Aggressive Lending Practices: Some lenders are offering unreasonably high loan-to-value (LTV) ratios and low annual percentage rates (APR), with some loans extending over multiple years. These offers can even remain unfilled for a large amount of time. This highlights the inefficiency and immaturity of the market.

3. Inexistent Derivative Market: There is no efficient, sizeable, and liquid market for buying insurance on an NFT portfolio or for shorting NFT collections, despite several attempts from different protocols.

To explore potential solutions, it’s essential to understand the payoff structure of the predominant loan instrument in the market: the bullet loan. In a bullet loan, the principal plus interest is paid in one lump sum at the maturity of the loan.

Such loans have the same payoff structure as a put option assuming that we are in an efficient market where in the following scenarios:

• If the price of the NFT falls below the notional value of the loan, the borrower has no economic incentive to repay the loan, resulting in a default where the lender becomes exposed to the NFT’s price.

• If the price of the NFT remains above the notional value, the borrower repays the loan with interest to the lender.

Thus, the lender is effectively selling a put option, while the borrower is buying a put option where the strike price is the principal of the loan.

As established, a bullet loan functions similarly to a put option. What if lending platforms would integrate the following mechanics?

1. Lender submits a loan offer on a given collection at a given APR / LTV / duration

2. The bid can be executed by either

   1. An organic borrower who is looking for a plain honest loan

   2. A derivative player looking for an insurance on his NFT portfolio or a speculator bearish on JPEGs. For the sake of clarity this result into a PUT agreement between the lender (on the short side) and the derivative player (on the long side)

From the lender perspective nothing has changed. If the loan performs, he gets the desired interest payment. If the loan defaults, he receives a negative payoff and doesn't even have to liquidate the underlying. We know some lenders actually care about fetching the NFT and holding the inventory as they are long term bulls. Well in that case they can just lift the floor price resulting in the same situation as an organic loan.

Obviously this can only be integrated within platforms providing bullet loans. This is therefore inapplicable to blur.io (closer to a credit line than a bullet loan). However we hope that our friends at nftfi.com, arcade.xyz and gondi.xyz will consider this proposal.

Benefits

1. Increased Market Volume: Lenders would have more participants willing to take their offers, including those willing to short the market or buy insurance, leading to a substantial increase in loan (organic + synthetic) origination.

2. Reduction in Irresponsible Lending: Irrational lending offers would be mitigated as counter-parties could take the opposing position without owning an NFT, provided they believe the bet to be favorable.

3. Enhanced Price Discovery for NFT Markets:

   • Improved mechanisms for discovering the true floor price of NFT collections through efficient shorting mechanics.

   • Better determination of appropriate LTV, APR, and loan durations due to increased data and the ability for rational actors to take opposing positions of lenders.

4. Complementary Nature: The synthetic market would complement the existing NFT lending infrastructure, rather than requiring a completely new product implementation.

We welcome feedback on this proposed synthetic instrument and are more than happy to consult and assist platforms in developing this instrument. Long live NFTs and god save the queen man!