NFT as Collateral Part II – DeFi Lending Developments | Ingram Yuzek Gainen Carroll & Bertolotti, LLP
Weeks after rolling out its secure funding feature, Arcade, the decentralized finance (DeFi) marketplace that allows borrowers to get a loan and secure it with NFT(s), facilitated $10 million in loans and expects the volume to increase tenfold by the end of the year.
According to the news, several medium-sized loans have been generated, including a loan of $1.25 million secured by a set of NFTs worth $5 million and a loan of approximately $4 million secured by “two rare cryptopunk zombie NFTs”, while Arcade is gradually rolling out its NFT-as-collateral functionality to the general public. Arcade’s CEO reported that to date, Arcade is holding over $20 million of NFT blue chips in escrow in exchange for loans and the average annual interest rate for loans generated on Arcade is 20%, depending on the term of a loan and liquidity. pledged NFT(s). In general, the secure finance feature of the platform is “comparable to art lending”, except that the duration is usually shorter (on average three months) and the interest rate is higher .
Notwithstanding the commonalities shared by Arcade’s secured finance feature and conventional art lending (or conventional secured finance), some differences still exist in terms of risk allocation and loan structure, and it should be to observe how these differences would translate into DeFi lending. setting.
As noted in our previous article, risk allocation has been one of the primary considerations underlying conventional finance arrangements, and insurance coverage is typically obtained by a borrower (and sometimes a lender) as a measure risk mitigation against potential loss of warranty. For example, many insurance policies are readily available to cover damage or loss to art collections, and Bank of America has identified “Certificate of Insurance” as a required document for loan disbursement on its web page for borrowers using “art collection as collateral.” However, when it comes to insuring against the loss of NFT(s), the market has yet to encounter a police global insurance specifically offered for NFT(s) and associated risks. S&P Global reported in its article that such a lack of insurance policy could be due to certain factors, such as “the need for NFTs to reach a “critical mass”‘” and the “constantly changing valuations of cryptocurrencies and therefore of NFTs.” Accordingly, for a loan for which insurance coverage for collateral is essential due to the size of the loan or the underlying risks, a lender or borrower with NFTs as collateral might be required to use a service smart contract audit before collateral is escrow in the smart contract and loan proceeds are disbursed. After all, when the remedy mitigating the occurrence of certain incidents is not available, the best (and perhaps the only) alternative would be enhanced due diligence which aims to discover any undesirable incident before it occurs.
When it comes to loan structure, the term and interest rate of a DeFi loan can be fundamentally different than conventional secured financing, especially in terms of how those material terms are structured versus other key provisions of a loan. Typically, the term of a conventional loan secured by collateral would be in the order of several years with certain built-in acceleration clauses to mitigate lenders’ risk exposure. (For example, a lender would have the contractual right to declare a default if the borrower breached its representations and warranties or certain covenants stipulated in the loan documents.) In the world of DeFi lending, however, the term of a loan is relatively short (eg, a few months), and the need for an acceleration clause (or event) may not even exist. As a result, the interest rate on these short-term loans (e.g., over 20%, as Arcade’s CEO pointed out) tends to be much higher than conventional loans (e.g., lower or around 10%). Such a difference in loan structure would inevitably alter the allocation of risk between lender and borrower, resulting in different risk mitigation measures adopted by the lender and/or borrower.
Since DeFi lending and the use of NFT(s) as collateral are still in their early stages of development, it is worth observing how the material terms and structure of the loan would evolve over time and whether wisdoms conventional financing parameters can be exploited. Stay tuned to Ingram’s NFT Newsroom for more on the latest developments with NFTs.