NFT as Collateral Part II — Developments in DeFi Lending | Ingram Yuzek Gainen Carroll & Bertolotti, LLP

Please fol­low and like us:
Pin Share

After a few weeks fol­low­ing the roll­out of its secured financ­ing fea­ture, Arcade, the decen­tral­ized finance (DeFi) mar­ket­place that allows bor­row­ers to obtain a loan and secure it with NFT(s), has facil­i­tat­ed $10 mil­lion in loans and expects the vol­ume to be ten­fold by the end of the year.

Accord­ing to the news, sev­er­al mid-sized loans have been gen­er­at­ed, includ­ing a $1.25 mil­lion loan secured by a set of $5 mil­lion-worth NFTs and an approx­i­mate­ly $4 mil­lion loan secured by “two rare zom­bie cryp­top­unk NFTs,” while Arcade grad­u­al­ly offers its NFT-as-col­lat­er­al fea­ture to the gen­er­al pub­lic. Arcade’s CEO indi­cat­ed that so far Arcade has more than $20 mil­lion of “blue chips NFTs” in escrow in exchange for loans and that the aver­age annu­al inter­est rate for loans gen­er­at­ed on Arcade is 20%, depend­ing on the dura­tion of a loan and the liq­uid­i­ty of pledged NFT(s). In gen­er­al, the platform’s secured financ­ing fea­ture is “com­pa­ra­ble to fine art lend­ing,” except that the term is gen­er­al­ly short­er (aver­aged three months) and the inter­est rate is higher.

Notwith­stand­ing the com­mon grounds shared by Arcade’s secured financ­ing fea­ture and con­ven­tion­al fine art lend­ing (or con­ven­tion­al secured financ­ing), cer­tain dif­fer­ences still exist in terms of risk allo­ca­tion and loan struc­ture, and it is worth observ­ing how such dif­fer­ences would pan out in the DeFi lend­ing setting.

As indi­cat­ed in our pre­vi­ous post, risk allo­ca­tion has been one of the core con­sid­er­a­tions under­ly­ing con­ven­tion­al financ­ing arrange­ment, and insur­ance cov­er­age is com­mon­ly obtained by a bor­row­er (and some­times a lender) as a risk mit­i­gat­ing mea­sure address­ing the poten­tial loss of col­lat­er­al. For instance, many insur­ance poli­cies are read­i­ly avail­able to cov­er the dam­age or loss of art col­lec­tions, and Bank of Amer­i­ca has iden­ti­fied “insur­ance cer­tifi­cate” as a req­ui­site doc­u­ment for the dis­burse­ment of a loan on its web­page des­ig­nat­ed for bor­row­ers using “art col­lec­tion as col­lat­er­al.” How­ev­er, when it comes to insur­ing against the loss of NFT(s), the mar­ket has not yet come across a com­pre­hen­sive insur­ance pol­i­cy that is specif­i­cal­ly offered for NFT(s) and the asso­ci­at­ed risks. S&P Glob­al report­ed in its arti­cle that such lack of insur­ance pol­i­cy might be due to cer­tain fac­tors, such as “the need for NFTs to hit ‘crit­i­cal mass’” and the “ever-chang­ing val­u­a­tions of cryp­tocur­ren­cies and thus NFTs.” Accord­ing­ly, for a loan that an insur­ance cov­er­age for col­lat­er­al is indis­pens­able due to the size of the loan or the under­ly­ing risks, a lender or a bor­row­er hav­ing NFT(s) as the col­lat­er­al might be required to resort to a smart con­tract audit ser­vice before the col­lat­er­al is put in escrow in the smart con­tract and the loan pro­ceed is dis­bursed. After all, when the rem­e­dy mit­i­gat­ing the occur­rence of cer­tain inci­dents is not avail­able, the best (and maybe the only) alter­na­tive would be the enhanced due dili­gence that aims to dis­cov­er any unde­sir­able inci­dents before their occurrence.

As to the loan struc­ture, the term and the inter­est rate of a DeFi loan might be fun­da­men­tal­ly dif­fer­ent from those in the con­ven­tion­al secured financ­ing set­ting, espe­cial­ly in terms of how such mate­r­i­al terms are struc­tured in rela­tion to oth­er key pro­vi­sions of a loan. In gen­er­al, the term of a con­ven­tion­al loan secured with col­lat­er­al would be in the range of mul­ti­ple years with cer­tain accel­er­a­tion claus­es embed­ded to mit­i­gate the lenders’ risk expo­sure. (For instance, a lender would have the con­trac­tu­al right to declare a loan default if the bor­row­er has 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 (e.g., a few months), and the need for an accel­er­a­tion clause (or event) might not even exist. Accord­ing­ly, the inter­est rate for such short-term loans (e.g., more than 20%, as indi­cat­ed by Arcade’s CEO) tends to be much high­er than con­ven­tion­al loans (e.g., below or around 10%). Such dif­fer­ence in the loan struc­ture would inevitably alter the risk allo­ca­tion between the lender and the bor­row­er, there­by result­ing in dif­fer­ent risk mit­i­gat­ing mea­sures adopt­ed by the lender and/or the borrower.

As the DeFi lend­ing and the use of NFT(s) as col­lat­er­al are still at their ear­ly stage of devel­op­ment, it is worth observ­ing how the mate­r­i­al terms and the loan struc­ture would evolve over time and whether wis­doms from con­ven­tion­al financ­ing set­tings can be lever­aged. Stay tuned to Ingram’s NFT News­room to learn more about the lat­est devel­op­ments with NFTs.

Source link

Please fol­low and like us:
Pin Share

Leave a Reply

Your email address will not be published. Required fields are marked *