Introduction
Asset tokenization brings forward a very compelling use case of bridging the use of cryptocurrencies & blockchain with real assets. One such example is the possibility of tokenizing real world properties as NFTs on blockchains, with the goal of unlocking even more financial utility for property owners.
In this article, we will explore this topic with the following thought exercise:
Anon owns a brand new luxurious apartment in Los Angeles. Can he use his apartment as collateral for a loan on https://compound.finance/ ?
Possible but difficult
Yes, a luxury apartment can be used as a collateral for a loan on Compound, but not directly and it is relatively difficult currently.
Here is a general diagram of how the process would be like:
Let us break this process down further in detail.
A. Tokenizing the apartment as an NFT
The first step is to tokenise the apartment as an NFT, under the ERC-721 standard , as it is a unique property. The property owner can either create it through NFT platforms like Opensea or create & deploy his own ERC-721 smart contract directly to the blockchain.
B. Pegging NFT value to real world value
Now comes the toughest part — ensuring that the real world value of the apartment can be translated onto the NFT. Key questions that will have to be answered before the next steps can proceed:
- Legalities — how would the title deed & legal ownership of the property be tied to the NFT?
- Security risk — how comfortable is the property owner with the inherent risks of exploit attacks on blockchains?
- On-chain valuation & utility — how would the property owner ensure that the NFT will be valued on-chain correctly against its real world value? What are the intended utilities of the token/s, is composability important?
This topic is being explored by many projects currently; an example is CitaDAO , a platform acting as a real estate investment vehicle, allowing any interested member of the public to invest, own, and earn returns (primarily from rental) from properties bought through joint fundraising via CitaDAO. It uses a process termed “Introducing Real Estate On-chain (IRO)” where community members contribute USDC to an property purchase fundraising round, in exchange for a share of ownership of the property, in the form of ERC20 Real Estate Tokens (RET); RET holders will be rewarded pro-rata with rental yield in the form of USDC tokens; these RET tokens can also be used for DeFi applications like yield farming (e.g. providing liquidity with LPs). Each property is tokenised as an ERC-721 NFT that comes with a digital right to redeem the title deed of the property, and legal ownership of the title deed is held by a Special Purpose Vehicle (SPV) owned by the DAO.
C. NFT Lending
At this point in time, Compound does not accept NFT as collateral directly — it only supports a defined list of tokens . Instead, the property owner will first need to turn to NFT lending platforms to borrow tokens that are supported on Compound. NFT lending is still in relatively early stages, and currently only accounts for less than 6% of NFT trading volume . There are two primary types of NFT lending platforms:
- Peer-to-peer : following the traditional lending marketplace model, peer-to-peer platforms match lenders with borrowers. The most popular peer-to-peer platform currently is NFTFi , where borrowers use their NFTs as collateral to borrow wETH or DAI, while lenders earn interest from loan servicing; in a nutshell, the process involves direct back-and-forth negotiation of loan terms between the borrower and lender, until an acceptance of offer is received from both parties, which will create and deploy an escrow smart contract that executes the loan and holds the NFT collateral; a liquidation will only trigger when a borrower fails to replay the loan with interest after a set expiration date has passed.
- Peer-to-protocol : following a similar model to DeFi lending protocols, peer-to-protocol platforms rely on liquidity providers depositing tokens to a protocol pool to earn yield, thus allowing borrowers to access liquidity from the pool immediately after collateralising their NFTs via the protocol’s vault contracts. One such popular example is BendDAO , where users can borrow ETH using NFTs from BAYC, CryptoPunks, Azuki, MAYC, CloneX, and Doodles as collateral; it uses Chainlink oracles to monitor NFT floor prices, and will only liquidate collateralised NFTs 48 hours after the floor price of the NFT collection drops below a set health factor.
Peer-to-peer lending platforms are more popular, as they allow for customisable loan terms. Below is a summary comparison of popular NFT lending platforms (Source: Blockcrunch ):
- Three Actor Model (3AM) : The pertinent issue of how to justifiably value individual NFTs remains — both lending platform models only look at floor prices of the NFT collection, rather than individual NFTs. There is a new lending platform model based on peer-to-protocol being developed by Astaria , called the three actor model (3AM) where it involves an appraiser, a borrower and a lender: the radical difference is that a third-party (the appraiser) will evaluate individual NFTs and create loan term sheets. More details can be found in this Twitter thread .
D. Borrowing on Compound
After the property owner has successfully borrowed stablecoins like DAI from an NFT lending platform, he/she can now use these borrowed tokens as collateral on Compound. Such moves are akin to leverage trading, which are inherently very risky.
Conclusion
As explained above, it is currently possible to use a property as a collateral for a loan on money markets in DeFi, but it is with great difficulty and uncertainty. The current biggest challenge is finding a proper way to translate the exact property value from the physical world to on-chain, as well as currently not being able to use an NFT as collateral directly to borrow from money markets like Compound.
This necessitates a workaround via NFT lending platforms, however it is still very early days for this use case and as such, is still quite limited. Despite this, it is a space that is currently being explored by many projects, and we can be sure to see many exciting new developments in asset tokenization in the near term.