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Traders are consistently seeking new ways to beat the market. Short selling NFTs in adverse macro conditions could be incredibly lucrative. But is this beneficial for the long term health of the NFT market?
This article will focus on the the Traditional Finance (“TradFi”) concept of Short Selling (“Shorting”) the Non Fungible Token (“NFT”) asset class.
Background
Traditional Finance (“TradFi”) Short Selling (“Shorting”)
NFT Shorting: How would it work?
Real World Case Studies
Benefits of Shorting NFTs
Risk Considerations
Closing Remarks
Short selling is betting that the price of the underlying asset will fall. If the asset price does fall, the short seller subsequently buys it back at a lower price and returns it to the person lending the asset. The short seller’s profit is the difference between the asset sale price and the repurchase price.
Shorting in tradFi typically involves speculative trading strategies, however it can be used to hedge risk by portfolio managers. The speculation is linked to the market risk around the price action of the stock/asset.
Michael Burry entered into a short position with the sub prime mortgage fiasco. His review of lending practices led him to believe that the real estate, and associated bonds related to the mortgages, were overpriced. A deeper dive into the underlying tranches led to a downgrade on these bonds and subsequent housing market collapse. There was even a film made about it… “The Big Short” with Christian Bale:
Shorting is a perfectly legitimate practice in free capital markets. It’s taking a bearish stance on a stock or asset, perhaps because it has seen astronomical gains over a recent time period. Price corrections are normal and capitalizing on these can be perfectly healthy by realigning the asset price with what fair value should be, once all information is priced in.
It is worth noting, however, that regulators have been known to step in to prevent further adverse cascading effects and aid recovery.
If we follow the typical method of short selling and apply it to NFTs, it can be executed in several ways. Albeit rather crudely now, given the lack of infrastructure.
The following four illustrations will help you visualize how this is currently done, and how it is anticipated to be executed as the NFT market matures.
i/ Current State 1:
1/ Borrow NFT from lender or broker.
2/ Sell NFT on open market.
3/ Purchase NFT back at later date.
4/ Return NFT to lender or broker to extinguish liability.
The issue with this is there is not much in the way of infrastructure to facilitate this trade, minimal brokers available and the ability to repurchase the exact same NFT may cause delays or require the short seller to pay a premium/ negotiate to obtain this again.
ii/ Current State 2:
1/ Enter into a contract to borrow the “floor” NFT within a collection, and be able to return another floor NFT within the same collection of equivalent value.
2/ Sell NFT on open market.
3/ Purchase NFT back at later date.
4/ Return an equivalent NFT to lender or broker to extinguish liability.
iii/ Future State 1:
1/ A lending platform offers a loan that’s pegged to the floor price of a collection. With the following key conditions (not exclusive):
The short seller takes on the exposure of the underlying NFT having entered into a contract with the lending platform.
The short seller has the ability to close out the position at any point, therefore taking on the risk associated with the price fluctuations.
The lending platform can request the short seller to deposit collateral in the event that the NFT collection increases in value by a specified amount. This is akin to a margin call. If this is not executed then the position is liquidated and the short seller is required to repay the loan.
2/ The short seller extinguishes the loan by repaying it at the current floor price of the collection and closes out their position with the lender.
iv/ Future State 2:
A put option (“put”) is a contract giving the option buyer the right, but not the obligation, to sell a specified asset at a predetermined price within a specified time frame. This predetermined price at which the buyer of the put option can sell the underlying security is called the strike price.
Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. This will likely be a product being offering for NFTs in the coming months/year. The buyer will open a position by paying the option premium to have the ability to sell the underlying asset at the strike price.
Official short selling NFT products, platforms and protocols are not yet established. The infrastructure isn’t developed to allow a market ready solution. However these can be indirectly executed through over the counter transactions and breaking it down into several steps. Some interesting protocols are being implemented, let’s take a look.
To caveat that including these protocols within this article does not constitute me recommending their use, it is purely for information purposes only.
Lending platforms are a good starting point when looking at the possibility of short selling NFTs.
1/ Cardinal Labs
We are starting to see conditional ownership of NFTs coming through on several platforms. Cardinal labs has launched an NFT rental service which allows owners to earn a passive yield lending their NFTs to others who are unable to afford the purchase price.
2/ BendDAO
Many will have seen the recent news around BendDAO whereby several bored apes came close to liquidation. This protocol allows loans to be taken against the underlying NFT. Provided the loans are repaid with the associated interest, they will be returned to the borrower.
Could we see variable principle lending products being issued from these existing lending platforms? Or there could be new platforms offering similar lending products, tweaked for short selling opportunities as described in “Future State 1” above.
Similarly we saw the recent 1,000 Ether purchase of a mega mutant that was funded by a 90 day loan. Two other mega mutants were transferred as collateral in a loan on the Arcade.xyz platform. As the NFT market becomes more mature we will begin to see more complex financial products/arrangements arise.
3/ Hyksos
This platform will be intended solely for those NFT collections that have a utility token tied to the NFT. The NFT owner could receive a reduced up front allocation of the project token while the counter party receives the usual emissions from the asset, which equates to a slight premium to account for the time value.
The cashflows from the utility token typically mean the token is tied somewhat to the floor price of the NFT. Could we see simultaneous short selling associated with these tokens alongside the NFT itself?
As an example we can probably open up a short position on the $APE utility token if we were bearish on BAYC. It’s not a perfect correlation but would be relatively closely aligned to announcements associated with the NFT collection.
The lending protocols will likely struggle with the lack of fungibility of NFTs.
1/ Mimicry Protocol
This is where Mimicry protocol can assist. By tying a separate token to the floor price of an NFT this can then be traded, and short positions opened, on the associated token. This is currently under development, with the most recent update provided on 9/16/22.
2/ NFTures
NFTures has developed a Tinder style application that is east to use for retail investors. They can effectively bet on the direction of a floor price of a collection through this interface. The “X” button is effectively short selling, with the spot price established through Unic.ly.
To highlight betting with leverage is extremely risky and I do not recommend this, hence this is for information purposes only.
Traders are constantly looking for ways to profit. Short selling NFTs in adverse macro conditions could be incredibly lucrative, particularly for an incredibly illiquid, volatile asset class that can fall 90% in price within a day. Besides the typical speculative strategies there are other reasons that short sellers open positions.
If a trader believes the fundamentals of a project don’t stack up they could open a short position to indicate their bearish sentiment towards the current price of the NFT collection. In tradFi there is a disclosure requirement for a short selling position in excess of a certain threshold, which helps with pricing efficiency and market awareness for potential scams.
It realigns fair market value and reduces the opportunity of scam projects or “rug pulls” to continue further than necessary. For instance, the tradFi short selling positions opened on Wirecard helped bring to light the $2 billion of missing funds within the company. In these examples short sellers believe the asset is overpriced due to fraud and will eventually reduce.
If an NFT collection is reaching a ridiculously high floor price it could be seen as an overinflated valuation. Short selling helps realign this by returning it to fair value. If an NFT collection only had several hundred items in a collection then this could be artificially inflated through co-ordinated “HODLING”. A short position on these projects could better align the floor price to market value, or the price an active participant is willing to pay for the project.
Some assets are correlated. NFT are more volatile assets than your traditional stock, however there will be correlations traders can find. Opening a short position on a specific NFT collection can reduce their overall portfolio exposure if there is another collection that is relatively positively correlated.
This can also be done with the underlying blockchain currency. For instance short selling Ether while long on an Ethereum NFT collection can reduce the exposure during a hawkish macro environment.
NFTs are by definition unique from one to the next, hence the non fungibility. This means that could be difficulties when returning the borrowed asset to the owner. If the lender is ok with receiving a different “floor” NFT from the same collection, then this strategy can work. However, if the lender would require the original item back then this could mean that NFT may need to be purchased for a premium or over the counter to obtain and return. If the counter party realizes that the NFT purchased is part of a short selling arrangement they may charge a premium for this asset as they become aware of the downside risk of the short seller.
If the NFT continues to rise in value then the exposure for the loss can be significant and the downside risk can be uncapped. The lender of the NFT or broker may have concerns over the recovery of the loss and request the NFT to be returned even though short seller may want it to remain open. This is similar to a margin call - the short seller is required to post collateral or add to their position to prevent the position being closed.
This can be exacerbated by other traders, who may artificially inflate the price through co-ordinated bids to drive the price above the short sellers liquidation threshold. This happened with Gamestop in 2020 when retail investors took on the Wall Street Hedge Funds by purchasing the company stock while the hedge funds shorted.
We see this frequently in crypto. Leverage is washed out of the market, causing cascading liquidations amplifying price volatility.
There is additional risk when short selling given the liability incurred with the requirement to repay the asset to the lender/broker. There may also be additional broker or interest costs to compensate the counter party for the risk taken on with lending their asset. This would be the cost of borrowing the NFT.
There may be artificial price action on collections to capitalize on short selling arrangements. The smaller collections may be more susceptible to this manipulation and as such lending protocols should be wary about the types of collections that the products are offered to.
There may be regulatory restrictions over when and where short selling can take place. If the short selling is harmful for the market this may be banned, and penalties incurred for executing these types of trades on decentralized platforms or over the counter. Alternatively centralized platforms may not offer the ability to borrow NFTs or may impose restrictions around selling borrowed assets.
Dollar cost averaging into a position or NFT project has historically been the least volatile way of profiting or mitigating losses. Timing the market can be incredibly hard to do, speculative in nature and attributed to luck to execute this perfectly most of the time. The speculative nature of short selling can expose the trader to untimely price fluctuations that can cause the position to be liquidated.
The SEC has specific requirements for assets to be classified as a security. The HOWIE test is used to establish whether a product is a security.
The infrastructure is primitive for derivative trading with NFTs. Lending platforms are relatively novel concepts that are being developed as the NFT market matures. Current state protocols being developed will offer spread betting style solutions on a token that will be tied to the underlying floor price of an NFT collection.
As these product offerings come into fruition the market will become more interconnected, with increased systemic risk. We see leverage flushed out in the crypto/fungible token market with cascading liquidations causing increased volatility. It’s important that we take the lessons learned from tradFi and ensure that any knock on effects from short selling.
As crypto becomes more regulated, there could be bans on short selling also as a method of stemming any contagion. It will certainly be interesting to see how this is executed given the decentralized nature of the NFT market.
Traders are consistently seeking new ways to beat the market. Short selling NFTs in adverse macro conditions could be incredibly lucrative. But is this beneficial for the long term health of the NFT market?
This article will focus on the the Traditional Finance (“TradFi”) concept of Short Selling (“Shorting”) the Non Fungible Token (“NFT”) asset class.
Background
Traditional Finance (“TradFi”) Short Selling (“Shorting”)
NFT Shorting: How would it work?
Real World Case Studies
Benefits of Shorting NFTs
Risk Considerations
Closing Remarks
Short selling is betting that the price of the underlying asset will fall. If the asset price does fall, the short seller subsequently buys it back at a lower price and returns it to the person lending the asset. The short seller’s profit is the difference between the asset sale price and the repurchase price.
Shorting in tradFi typically involves speculative trading strategies, however it can be used to hedge risk by portfolio managers. The speculation is linked to the market risk around the price action of the stock/asset.
Michael Burry entered into a short position with the sub prime mortgage fiasco. His review of lending practices led him to believe that the real estate, and associated bonds related to the mortgages, were overpriced. A deeper dive into the underlying tranches led to a downgrade on these bonds and subsequent housing market collapse. There was even a film made about it… “The Big Short” with Christian Bale:
Shorting is a perfectly legitimate practice in free capital markets. It’s taking a bearish stance on a stock or asset, perhaps because it has seen astronomical gains over a recent time period. Price corrections are normal and capitalizing on these can be perfectly healthy by realigning the asset price with what fair value should be, once all information is priced in.
It is worth noting, however, that regulators have been known to step in to prevent further adverse cascading effects and aid recovery.
If we follow the typical method of short selling and apply it to NFTs, it can be executed in several ways. Albeit rather crudely now, given the lack of infrastructure.
The following four illustrations will help you visualize how this is currently done, and how it is anticipated to be executed as the NFT market matures.
i/ Current State 1:
1/ Borrow NFT from lender or broker.
2/ Sell NFT on open market.
3/ Purchase NFT back at later date.
4/ Return NFT to lender or broker to extinguish liability.
The issue with this is there is not much in the way of infrastructure to facilitate this trade, minimal brokers available and the ability to repurchase the exact same NFT may cause delays or require the short seller to pay a premium/ negotiate to obtain this again.
ii/ Current State 2:
1/ Enter into a contract to borrow the “floor” NFT within a collection, and be able to return another floor NFT within the same collection of equivalent value.
2/ Sell NFT on open market.
3/ Purchase NFT back at later date.
4/ Return an equivalent NFT to lender or broker to extinguish liability.
iii/ Future State 1:
1/ A lending platform offers a loan that’s pegged to the floor price of a collection. With the following key conditions (not exclusive):
The short seller takes on the exposure of the underlying NFT having entered into a contract with the lending platform.
The short seller has the ability to close out the position at any point, therefore taking on the risk associated with the price fluctuations.
The lending platform can request the short seller to deposit collateral in the event that the NFT collection increases in value by a specified amount. This is akin to a margin call. If this is not executed then the position is liquidated and the short seller is required to repay the loan.
2/ The short seller extinguishes the loan by repaying it at the current floor price of the collection and closes out their position with the lender.
iv/ Future State 2:
A put option (“put”) is a contract giving the option buyer the right, but not the obligation, to sell a specified asset at a predetermined price within a specified time frame. This predetermined price at which the buyer of the put option can sell the underlying security is called the strike price.
Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. This will likely be a product being offering for NFTs in the coming months/year. The buyer will open a position by paying the option premium to have the ability to sell the underlying asset at the strike price.
Official short selling NFT products, platforms and protocols are not yet established. The infrastructure isn’t developed to allow a market ready solution. However these can be indirectly executed through over the counter transactions and breaking it down into several steps. Some interesting protocols are being implemented, let’s take a look.
To caveat that including these protocols within this article does not constitute me recommending their use, it is purely for information purposes only.
Lending platforms are a good starting point when looking at the possibility of short selling NFTs.
1/ Cardinal Labs
We are starting to see conditional ownership of NFTs coming through on several platforms. Cardinal labs has launched an NFT rental service which allows owners to earn a passive yield lending their NFTs to others who are unable to afford the purchase price.
2/ BendDAO
Many will have seen the recent news around BendDAO whereby several bored apes came close to liquidation. This protocol allows loans to be taken against the underlying NFT. Provided the loans are repaid with the associated interest, they will be returned to the borrower.
Could we see variable principle lending products being issued from these existing lending platforms? Or there could be new platforms offering similar lending products, tweaked for short selling opportunities as described in “Future State 1” above.
Similarly we saw the recent 1,000 Ether purchase of a mega mutant that was funded by a 90 day loan. Two other mega mutants were transferred as collateral in a loan on the Arcade.xyz platform. As the NFT market becomes more mature we will begin to see more complex financial products/arrangements arise.
3/ Hyksos
This platform will be intended solely for those NFT collections that have a utility token tied to the NFT. The NFT owner could receive a reduced up front allocation of the project token while the counter party receives the usual emissions from the asset, which equates to a slight premium to account for the time value.
The cashflows from the utility token typically mean the token is tied somewhat to the floor price of the NFT. Could we see simultaneous short selling associated with these tokens alongside the NFT itself?
As an example we can probably open up a short position on the $APE utility token if we were bearish on BAYC. It’s not a perfect correlation but would be relatively closely aligned to announcements associated with the NFT collection.
The lending protocols will likely struggle with the lack of fungibility of NFTs.
1/ Mimicry Protocol
This is where Mimicry protocol can assist. By tying a separate token to the floor price of an NFT this can then be traded, and short positions opened, on the associated token. This is currently under development, with the most recent update provided on 9/16/22.
2/ NFTures
NFTures has developed a Tinder style application that is east to use for retail investors. They can effectively bet on the direction of a floor price of a collection through this interface. The “X” button is effectively short selling, with the spot price established through Unic.ly.
To highlight betting with leverage is extremely risky and I do not recommend this, hence this is for information purposes only.
Traders are constantly looking for ways to profit. Short selling NFTs in adverse macro conditions could be incredibly lucrative, particularly for an incredibly illiquid, volatile asset class that can fall 90% in price within a day. Besides the typical speculative strategies there are other reasons that short sellers open positions.
If a trader believes the fundamentals of a project don’t stack up they could open a short position to indicate their bearish sentiment towards the current price of the NFT collection. In tradFi there is a disclosure requirement for a short selling position in excess of a certain threshold, which helps with pricing efficiency and market awareness for potential scams.
It realigns fair market value and reduces the opportunity of scam projects or “rug pulls” to continue further than necessary. For instance, the tradFi short selling positions opened on Wirecard helped bring to light the $2 billion of missing funds within the company. In these examples short sellers believe the asset is overpriced due to fraud and will eventually reduce.
If an NFT collection is reaching a ridiculously high floor price it could be seen as an overinflated valuation. Short selling helps realign this by returning it to fair value. If an NFT collection only had several hundred items in a collection then this could be artificially inflated through co-ordinated “HODLING”. A short position on these projects could better align the floor price to market value, or the price an active participant is willing to pay for the project.
Some assets are correlated. NFT are more volatile assets than your traditional stock, however there will be correlations traders can find. Opening a short position on a specific NFT collection can reduce their overall portfolio exposure if there is another collection that is relatively positively correlated.
This can also be done with the underlying blockchain currency. For instance short selling Ether while long on an Ethereum NFT collection can reduce the exposure during a hawkish macro environment.
NFTs are by definition unique from one to the next, hence the non fungibility. This means that could be difficulties when returning the borrowed asset to the owner. If the lender is ok with receiving a different “floor” NFT from the same collection, then this strategy can work. However, if the lender would require the original item back then this could mean that NFT may need to be purchased for a premium or over the counter to obtain and return. If the counter party realizes that the NFT purchased is part of a short selling arrangement they may charge a premium for this asset as they become aware of the downside risk of the short seller.
If the NFT continues to rise in value then the exposure for the loss can be significant and the downside risk can be uncapped. The lender of the NFT or broker may have concerns over the recovery of the loss and request the NFT to be returned even though short seller may want it to remain open. This is similar to a margin call - the short seller is required to post collateral or add to their position to prevent the position being closed.
This can be exacerbated by other traders, who may artificially inflate the price through co-ordinated bids to drive the price above the short sellers liquidation threshold. This happened with Gamestop in 2020 when retail investors took on the Wall Street Hedge Funds by purchasing the company stock while the hedge funds shorted.
We see this frequently in crypto. Leverage is washed out of the market, causing cascading liquidations amplifying price volatility.
There is additional risk when short selling given the liability incurred with the requirement to repay the asset to the lender/broker. There may also be additional broker or interest costs to compensate the counter party for the risk taken on with lending their asset. This would be the cost of borrowing the NFT.
There may be artificial price action on collections to capitalize on short selling arrangements. The smaller collections may be more susceptible to this manipulation and as such lending protocols should be wary about the types of collections that the products are offered to.
There may be regulatory restrictions over when and where short selling can take place. If the short selling is harmful for the market this may be banned, and penalties incurred for executing these types of trades on decentralized platforms or over the counter. Alternatively centralized platforms may not offer the ability to borrow NFTs or may impose restrictions around selling borrowed assets.
Dollar cost averaging into a position or NFT project has historically been the least volatile way of profiting or mitigating losses. Timing the market can be incredibly hard to do, speculative in nature and attributed to luck to execute this perfectly most of the time. The speculative nature of short selling can expose the trader to untimely price fluctuations that can cause the position to be liquidated.
The SEC has specific requirements for assets to be classified as a security. The HOWIE test is used to establish whether a product is a security.
The infrastructure is primitive for derivative trading with NFTs. Lending platforms are relatively novel concepts that are being developed as the NFT market matures. Current state protocols being developed will offer spread betting style solutions on a token that will be tied to the underlying floor price of an NFT collection.
As these product offerings come into fruition the market will become more interconnected, with increased systemic risk. We see leverage flushed out in the crypto/fungible token market with cascading liquidations causing increased volatility. It’s important that we take the lessons learned from tradFi and ensure that any knock on effects from short selling.
As crypto becomes more regulated, there could be bans on short selling also as a method of stemming any contagion. It will certainly be interesting to see how this is executed given the decentralized nature of the NFT market.
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