Introduction
For several years now, Non-Fungible Tokens (“NFT”) have been growing in popularity. These scarce and unique blockchain-recorded crypto assets have already seen many use cases ranging from collectibles, gaming experiences, to licenses. Recently, the list has been expanded by another category: NFTs used as collateral in lending transactions. In February 2022, an anonymous person borrowed an $8.32 million secured by their collection of 104 CryptoPunks. It was the largest NFT-backed loan to date and illustrated a new way of leveraging NFT assets. While several peer-to-peer platforms started advertising these loans, there is not enough clarity around the benefits and risks for each of the parties involved - borrowers, lenders, and lending platforms. Let’s take a closer look at how one can engage in NFT-backed lending and what are some of the key benefits and risks the parties should be aware of.
How does NFT-backed lending work?
Typically, an NFT holder (“borrower”) connects the borrower’s digital wallet to the platform’s application and identifies the NFT the borrower would like to list as collateral. Next, the borrower specifies a preferred loan amount, interest rate and duration of the loan. Once the NFT is listed, lenders can make loan offers against it. When the borrower accepts a lender’s offer, a contract is created. The NFT is sent to the platform to be held in an escrow, loan funds are transferred to the borrower, and a promissory note is issued by the platform to the lender. If the borrower repays the loan with interest as scheduled, the platform returns the NFT from the escrow to the borrower’s wallet. If the borrower defaults on the loan, the lender has the opportunity to foreclose on the loan and acquire the NFT.
Benefits
Borrowers There are many benefits in using NFTs as collateral. If an NFT holder has no intention to sell the NFT, the asset would normally just idly sit in the holder’s wallet. Meanwhile, the holder/borrower can put the NFT to work by borrowing cryptocurrency against the NFT through a peer-to-peer platform without the need of selling the NFT. Those borrowed funds can be used to buy cryptocurrencies via DeFi protocols or deployed otherwise. NFT-backed loans typically involve short-term funding that range from several days to a couple of months, generally not exceeding six months. In contrast to traditional lending, crypto exchanges and lending platforms do not pull a credit report on the borrower to evaluate the borrower’s creditworthiness. Instead, the NFT value which generally significantly exceeds the loan amount serves as the main protection of the lender, as further described below. Another benefit of NFT-backed lending for borrowers is that crypto platforms disburse the funds quickly, in a matter of hours rather than days or weeks.
Lenders Lenders who agree to provide liquidity to borrowers may earn attractive returns that are greater than traditional loans. The interest rate depends on the loan amount, the duration of the loan, and other factors, but APR exceeding 40% is not unusual. However, to many lenders, the key benefit of this type of lending represents the opportunity to acquire the NFT at a discount if a borrower defaults on its loan. Some of the peer-to-peer platforms emphasize the benefit of obtaining an NFT through foreclosure rather than interest returns and advise lenders on acquisition strategies. In terms of lender participation, in most cases, lenders can manually select an NFT they want to lend against, such as a pixelated print or digital land. In other lending models, lenders deposit funds in a lending pool where the peer-to-peer platform chooses which NFTs will be used as collateral.
Platforms Peer-to-peer platforms typically charge a service fee between 2% and 5%, sometimes called a success or platform fee. Sometimes this fee is charged to lenders and is calculated based on the interest paid by the borrower, while other platforms may charge borrowers on the principal at the point of origination or even later when the borrowers make installments. Additional benefits that are often not used in the crypto space today but could become more prominent in the future could include, for example, advertisements of third-party products on the platform’s website, charging a fee for featured NFT listings, and/or fee-based subscriptions.
Risks
Borrowers Borrowers should be aware that the interest they pay on these short-term loans can be very high and failure to pay the loan will most likely result in the loss of their NFT. Most of the advertising disclosures used by peer-to-peer platforms do not clearly explain the rights and obligations of the borrowers including what fees the borrowers pay, when a gas fee gets paid and by whom (i.e., the cost of conducting a transaction on a blockchain), whether multiple installments are acceptable, whether a full interest rate will be charged to the borrower for early repayment of the loan, etc. It would be fair to assume that many of the borrowers who put their NFT to work will be unsophisticated individuals who may not fully understand the risks associated with these lending transactions. Furthermore, as the recent hacks of OpenSea revealed, peer-to-peer digital marketplaces are not immune to malicious attacks or smart contract risks. A security vulnerability may lead to a loss of the borrower’s NFT or an accidental sale of the NFT at a deep discount, leaving the borrower at the mercy of the platform. All in all, borrowers may either end up paying more for the loan than expected had the terms been disclosed in a clear and prominent way, or they may lose their NFT asset altogether.
Lenders Lenders include a variety of entities from unsophisticated individuals to professional investors and sometimes DAOs – decentralized, self-regulating entities. Since peer-to-peer platforms do not underwrite the loans themselves, the key question for every lender is how to price the loan. The price offered by the lender will depend on the perceived value of the NFT which is inherently subjective. A lender interested in lending against NFTs will most likely search NFT marketplaces like OpenSea or Rarible to assess the price of an NFT. While the market would indicate that the vast majority of NFTs have little value, a small subset of NFTs have made headlines as a premium store of value and utility. NFT projects such as Moonbirds, Bored Ape Yacht Club, or CryptoPunks have generated some of the most valued NFTs to date and, consequently, have become the most sought-after NFT collateral.
Lending against such “blue-chip” NFTs helps lenders solve the liquidity issue as they would be able to sell the NFT quickly if the borrower defaults. Because NFTs, just like cryptocurrencies, are inherently volatile, the loan-to-value (“LTV”) ratio is probably the most important component of NFT-backed lending from a lender’s standpoint. The LTV ratio is a measure comparing the amount of the loan to the market value of the NFT and it varies across peer-to-peer platforms. For example, publicly available information indicates that a typical loan with Nexo has an LTV between 10 to 20% LTV, with NFTfi around 50%, and Stater sets a cap on LTV at 60%. Another risk factor lenders need to consider is the duration of the loan. NFT-backed loans tend to be short-term loans repayable within weeks and not exceeding six months. The longer the term, the greater the risk that the NFT market will change and the lender will not be able to sell the NFT at the price envisioned at the point of loan origination.
The NFT-backed lending market is in its infancy stage so there are limited examples available to assess how bankruptcy of a borrower would impact the lender’s rights to the NFT collateral. In the US, one of the imperatives of secured lending transactions is the ability to obtain a valid security interest in the loan and to be able to “perfect” it, meaning to prevail over subsequent creditors including a bankruptcy trustee. Obtaining a security interest in a loan should not be confused with a loan instrument being viewed as a security under securities laws. A perfection of security interest means the lender gives public notice of its security interest to third parties. If a lender fails to perfect his interest in the collateral, he will not have priority over other general (unsecured) creditors. Under Article 9 of the Uniform Commercial Code (“UCC”) that governs secured transactions, an NFT could be treated as either “general intangible” or “investment property.” The former can be perfected by the lender by filing a UCC-1 financing statement with the Secretary of State in the borrower’s location. The latter can be perfected by control of the collateral through an execution of a control agreement between the borrower, the lender and an intermediary. There are many practical questions related to the perfection as well as the creation of the security interest in NFTs, including the borrower’s location and the authentication of a security agreement that are beyond the scope of this article. Suffice to say that many of the NFT lenders would be deemed unsecured under US laws.
Platforms Platforms should be aware of the laws and regulations that could be applied to their business model, including securities laws, anti-money laundering (“AML”), sanctions, and data breach regulations, all of which create regulatory and litigation risks.
The first question peer-to-peer platforms may want to consider is whether their relationship with lenders, and the underlying instruments issued to the lenders, may trigger applicable securities laws. In 2008, the US Securities and Exchange Commission (“SEC”) issued a cease-and-desist order against Prosper, a peer-to-peer lending platform, preventing Prosper from offering securities without an effective SEC registration or exemption. Prosper operated its peer-to-peer platform connecting borrowers with lenders and charged origination fees as well as servicing fees to the parties involved, it issued unsecured notes to the lenders for loans ranging from $1,000 to $25,000, and on their website it advertised superior returns generated by the notes. The SEC found Prosper-issued instruments to be securities under both the Howey and Reves tests established by the US Supreme Court.
Earlier this year, the SEC and US state regulators charged BlockFi, a crypto lending platform, a $100 million penalty for failing to register BlockFi’s product, BlockFi Interest Accounts, as a security and for failing to register as an investment company. The crux of the issue was that BlockFi took crypto assets from various investors in exchange for promised returns, pooled the assets, and lent them to institutional investors while making inaccurate statements about collateralization of these loans. These cases, coupled with the SEC’s priorities announced earlier this month, underscore the SEC’s appetite to apply the securities regulatory framework aggressively to crypto lending platforms, whether centralized or decentralized.
Another potentially high-risk area where crypto lending platforms may run short of compliance is AML. Regulators around the world would likely expect any lending platform to identify and prevent transactions that facilitate money laundering or financing of terrorism. As indicated in February 2022 by the US Department of the Treasury’s Study of the Facilitation of Money Laundering and Terror Financing, platforms offering NFTs may be considered virtual asset service providers by the international Financial Action Task Force and may come under FinCEN’s regulations, depending on the nature and characteristics of the NFT offered. It would be fair to assume that most of the NFT peer-to-peer lending platforms do not identify their customers for AML purposes. If a borrower purchased an NFT with proceeds from a criminal activity and later put the NFT down as collateral against a crypto loan, the borrower could easily default on the loan, get rid of the “tainted” NFT asset and keep the borrowed amount seemingly without any strings attached. It would seem highly unlikely that a regulator would let a lending platform get away with facilitation of such a transaction.
Another question is how platforms approach compliance with financial sanctions. The Office of Foreign Assets Control of the US Department of the Treasury (“OFAC”) applies sanctions regulations to digital transactions including those that involve NFTs. If an NFT owner who is listed on the OFAC list of blocked persons with his virtual currency address wants to borrow funds against the NFT, sanctions regulations would most likely prohibit any US person from engaging in transactions with such a borrower. Recent announcements of Uniswap and Tornado Cash about screening and blocking wallets subject to OFAC sanctions are good signs that the crypto industry started paying more attention to sanctions compliance. Whether you are a decentralized trading protocol, coin mixer or a blockchain-as-a-service company, sanctions regulations will apply to your business.
Finally, if a platform becomes a victim of a data breach, local laws may require a prompt notice to authorities and/or the impacted customers. For example, platforms subject to the European General Data Protection Regulation (“GDPR”) will, in their role as data controllers, have 72 hours after becoming aware of a data breach to notify the supervisory authority. In some instances, controllers would also be required to notify the customers. In the US, data breach regulations are creatures of state law and every one of the 50 states has enacted data breach notification laws. A data breach would signal that the platform’s data security is presumably not at the appropriate level. This may create litigation and regulatory risk, as shown in the recent lawsuit against OpenSea.
Conclusion
NFT-backed lending is an ingenious way of using NFTs. However, as has been indicated, this use case presents multiple risks to the parties involved, particularly to crypto platforms. Before a platform embarks on a customer acquisition journey, it may consider the following ‘dos and don’ts’ gleaned from general lending practices and the past enforcement actions:
DO:
Educate both the borrowers and lenders and help them understand all the risks of this type of lending. Include comprehensive FAQs and provide a contact where customers can connect with you. Providing a disabled “help” button on your website or an access to a Discord channel through which customer questions may not be answered will not help.
Clearly and prominently display the terms and conditions including the interest rate payable by the borrower and each and every fee charged by the platform. If you do not make your service transparent, transparency may be forced upon you.
Conduct a legal assessment of the applicable laws based on your jurisdiction as well as the location of your customers. Next, closely monitor these laws for new developments.
Pay close attention to customer complaints and look for any emerging patterns. Customer complaints can draw regulatory attention and be an early indicator of future disputes.
DO NOT:
Overpromise returns lenders can make on loans available through your platform, especially not through any public statements. In your advertisement do not exaggerate or compare your platform to other investment tools, especially if the claims cannot be substantiated.
Change any terms and conditions without giving an advanced notice to both the borrowers and lenders. Avoid any “rug pulls” without an ample opportunity for the participants to opt out.
Underestimate compliance and the willingness of regulators to press charges. AML, sanctions, and info-security issues tend to generate enforcement actions that may not be defensible from a PR standpoint.
About the author:
David Mikulecky is a product and regulatory counsel with 15 years of experience in three jurisdictions - the United States, the United Kingdom, and the Czech Republic.
Disclaimer: This article is for educational purposes only and is intended only to provide general information about the legal areas mentioned. It is not meant to provide specific legal advice.