NFT Liquidity Protocols
FINE#8385
0x1552
January 17th, 2023

Table of Contents:

  • Introduction

  • NFT Liquidity Pool Protocols

  • Use cases

  • Other liquidity solutions

  • Closing thoughts


Author(s): hamzat_iii#1111

Editor(s): FINE#8385

Last updated: 17th Jan 2023


Introduction
One of the most prominent trends in the crypto ecosystem is NFTs. NFTs are usually considered as just digital collectibles or art that can accrue high price values in auctions. NFTs however, provide substantial contributions to DeFi’s growth. NFTs are unique ways to store value; this value is stored in the form of an asset and DeFi offers mechanisms to unlock this value.

Before the advent of DeFi, tokenized assets could only be amassed through ICOs or other centralized exchanges; thus making the market in the ICO boom mostly illiquid. However, DeFi and its protocols came around and easily facilitated the exchange, trading, lending and staking of tokenized assets.

NFTs traded over $25 billion in 2021 alone and have since gained tremendous traction. However, one of the most pressing issues with NFTs is the liquidity problem. Unlike crypto tokens, NFT markets are usually highly illiquid. NFT users are usually forced to undercut the NFT floor prices to be able to buy or sell NFT assets. This liquidity issue undermines the ability of NFT users to earn ROI on their NFTs. Since NFTs are value-based tokenized assets, they help provide growth possibilities in an asset’s value and thus help the owners of these assets to acquire income or wealth from these assets. Thus, DeFi protocols help users unlock value and liquidity from their NFTs.

How exactly do DeFi protocols help in bringing liquidity to NFTs?

This article aims to highlight some of these methods and explains NFT liquidity protocols as one of the most effective solutions to the NFT liquidity problem; but first, let’s discuss what liquidity is.

Understanding Liquidity

Liquidity in cryptocurrency markets describes the ease with which tokens can be swapped to fiat currency or other tokens without affecting their price. It generally describes how easily and quickly an asset can be bought or sold.

Digital assets are generally more liquid than tangible assets. This goes without saying that some tokenized assets are also way more liquid than others; this is usually due to trading volumes and market efficiency.

For NFTs, existing liquidity methods include marketplaces like OpenSea, auctions, aggregators, collateralized lending, fractionalization, and NFT liquidity pools. This article will focus on NFT liquidity pool protocols.

NFT Liquidity Pool Protocols

To understand, one needs a basic understanding of liquidity providers, liquidity tokens, and automated market makers. Liquidity pools enable trading, borrowing, and lending of tokenized assets.

NFT liquidity pool protocols are built on top of liquidity pools and are thus effective marketplaces for NFTs. These protocols allow users to deposit similar NFTs into a liquidity pool. Any asset in the pool can be redeemed by minting a derivable fungible token.

They open the pool to buyers that want to acquire NFTs of the same class, instead of sellers having to find buyers for a specific NFT; thus providing greater liquidity than ordinary NFT marketplaces.

Use Cases

Most NFT liquidity pooling protocols utilize NFT-FT pools to allow users to mint fungible tokens, redeem, exchange, buy and sell NFTs.

  • NFT Liquidity Pools: Liquidity pools are smart contracts where tokens are locked for the purpose of providing liquidity. Liquidity pools are made up of pairs of liquid assets. A set of non-fungible tokens are paired with another pair of fungible tokens. NFTs from the same collection or with similar properties are usually stored in the same liquidity pool. NFT floor prices are determined by a defined amount of fungible tokens.

  • Minting NFTs: This involves exchanging NFTs for fungible tokens. Here, NFT users relinquish ownership of their NFTs in exchange for a defined amount of fungible tokens. Users do this by depositing their NFT into a liquidity pool; fungible tokens are then minted by the smart contract corresponding to the price ratio. This ratio is predetermined at the deployment of the liquidity pool smart contract. Changes to this price ratio can only be effected if proposed and approved through some form of governance measure, usually some form of DAO governance process.

  • Redeeming NFTs: This is the opposite use case of minting NFTs in NFT liquidity pools. NFT users exchange their desired amount of fungible tokens for an unclaimed NFT that is available in the liquidity pool.

  • Exchanging NFTs: NFT exchange is the combination of the minting and redemption of NFTs to swap an NFT with another one in the same collection.

  • Buying and Selling NFTs: This feature allows NFT users to buy and sell NFTs directly from the liquidity pools using cryptocurrency. This feature is enabled by the fact that minted fungible tokens are paired with mainstream cryptocurrencies and listed on third-party Automated Market Makers (AMMs).


Comparing NFT Liquidity Pool Protocols to other liquidity solutions

NFTs are known to be unique, and this uniqueness poses unique challenges to sourcing liquidity for NFTs. With unique and varied NFT properties like classes or tiers of a rarity within an NFT collection, it is important to define properties under which different NFTs will be grouped and then the best liquidity mechanism for the NFT will be evaluated. Different liquidity mechanisms feature accommodations that make them more effective in providing NFT liquidity over other mechanisms.

NFT liquidity pool protocols seek to improve NFT liquidity by utilizing trading markets of fungible tokens. They define, indicate, and aggregate the value of NFTs of the same class or NFTs that belong in the same collection. Briefly, let’s compare liquidity pool protocols to the other most common liquidity solutions.

1. NFT liquidity pool protocols versus NFT fractionalization protocols

Fractionalization involves splitting an NFT into multiple fractions that can be traded as fungible tokens. NFT liquidity pool protocols sometimes fail to preserve the value of collectors’ NFTs and NFT fractionalization protocols solve this problem by allowing NFT holders to fractionalize their NFTs and sell the shards to other investors in exchange for liquid cryptocurrency. However, unlike NFT liquidity pool protocols, the limitation of NFT fractionalization is that this liquidity method involves the need to create new markets on AMM trading markets per individual NFT or shard. This ultimately makes ownership complex. NFT liquidity protocols are thus more useful for low-value or floor assets than NFT fractionalization protocols which are more useful for high-value pieces.

2. NFT liquidity pool protocols versus NFT lending protocols

NFT lending protocols allow users to lend out their NFTs for a defined fee. NFT lending offers NFT owners only a fraction of the value of their NFTs, the owners however do not have to part ways with ownership of their assets and can effectively earn yield on their idle NFTs. Liquidity pool-based NFT lending protocols like the Zumer protocol, Pine Loans and JPEGd however, are building automated lending pools. Lenders can deposit NFTs into pools and set lending terms; if potential borrowers find the terms attractive, they can take out permissionless loans. These NFT liquidity protocols provide novel credit and liquidity risk management mechanisms to permit permissionless loan origination for NFT assets by segregating different risks to different liquidity providers. These models provide lending and borrowing flexibility.

3. NFT liquidity pool protocols versus NFT marketplaces

NFT marketplaces allow users to find buyers of their NFT assets via auction or simple sale mechanisms. NFT marketplaces are the most congenital mechanisms to buy or sell NFTs; however unlike NFT liquidity pool protocols, they require active marketing, else the market ends up illiquid. NFT marketplace auctions also require prior negotiations with other potential buyers or other marketing efforts to garner attention. Without gathering the attention of potential buyers to the sale, liquidity time might end up being longer. Also, most NFT marketplaces like OpenSea are generalized rather than specialized like NFT liquidity pool protocols.

Closing thoughts

Comparing the advantages and disadvantages of the above alternative solutions with NFT liquidity pool protocols, the NFT fractionalization mechanism has few users and adoptions due to the risk of irreversible recovery. NFT collateralized lending is a better solution than fractionalization presently. However, the peer-to-peer marketplace mechanism is more common in terms of adaptation and its number of users. Both general projects and blue-chip projects may be successfully matched, but its response speed is slow in terms of user experience and provision of liquidity. The auction system makes it impossible for lenders to match orders after quotations. causing problems with funding. In contrast, the NFT liquidity pool mechanism can provide token rewards for both parties and resultantly provide liquidity. However, these protocols force the consolidation of the prices of different NFTs and thus enable arbitrage opportunities. This resultantly pushes the prices of the NFTs too close to the floor price. Low-priced NFT owners will be prompted to sell their NFTs at the average price and arbitrageurs can snap deposited high-priced NFTs at low prices. As the liquidity pool price edges closer to the floor price, liquidity may start to diminish. This means that NFT liquidity pool protocols are more beneficial to NFT collections with stable demand and similar prices. On the whole, the NFT liquidity protocol that is seen to provide more value to the development of the NFT ecosystem while solving the NFT liquidity issue will definitely see more adoptions.


~Web 3 Series #17

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