How NFTs Can Be Used in Decentralized Finance
While NFTs and DeFi (two of the most innovative blockchain-based concepts) may have seen tough times of late, they remain critical topics in the crypto space with the biggest potential for transforming the world of finance as we know it.
Decentralized Finance (or DeFi) is a term used to describe the shift from traditional financial systems to peer-to-peer finance. This shift is made possible by decentralized technologies built on blockchains like Ethereum.
This nascent industry has seen explosive growth over the past year, with the total value locked in DeFi protocols reaching an all-time high of over $250 billion. DeFi represents the promise of an open financial system that anyone with an Internet connection can access. And because traditional centralized systems are prone to censorship, fraud, and third-party interference, DeFi promises to be a more resilient and decentralized alternative.
One of DeFi’s key benefits is that it allows users to interact with protocols and platforms without having to go through a middleman or centralized entity. This makes transactions more efficient to carry out and reduces the chances of fraud or censorship.
NFTs (or non-fungible tokens) have been praised for their ability to represent digital assets in a unique and immutable way. This has led to their use case in various industries, from gaming and collectibles to art and music. Over the past few years, NFTs have contributed value in various spheres, leading to an explosive market capitalization estimated to be worth over $20 billion.
But how can NFTs be used in DeFi to make it more effective in offering new use cases?
After all, using NFTs in DeFi can help create more trustless and decentralized systems. The use of NFTs in DeFi is capable of unlocking a whole new world of possibilities and helping take DeFi to the next level.
DeFi: An Overview
Before we look at ways that we can incorporate NFTs into the world of decentralized finance, let’s first have a brief overview of DeFi in its entirety.
As mentioned before, DeFi is a term used to describe the shift from traditional financial systems to peer-to-peer finance enabled by decentralized technologies built on blockchains.
This nascent industry allows for speedy and efficient financial operations ranging from lending and borrowing to trading and investments without needing a centralized entity or middleman.
DeFi services are enabled mainly by decentralized applications that run on smart contracts, which are self-executing contracts written on a blockchain (often referred to as “DApps”).
The use of smart contracts in DeFi allows for the automation of financial processes and transactions, making the process more efficient and reducing the chances of fraud or error.
The lack of a centralized governing body also means that no one entity can control or censor the DeFi ecosystem or the DApp. This makes it a more open and trustless system that is available to anyone with an Internet connection.
The use of blockchain technology in DeFi also allows for greater transparency because all the data and information related to a transaction is stored on a public ledger that anyone can access.
This allows users to track their transactions and verify the authenticity of data. Interoperability with other DApps is an additional advantage of DeFi, allowing for greater flexibility.
Through interoperability, users from different DApps can interact with each other without restrictions. This helps create a more cohesive ecosystem where the user has complete control over their assets.
NFTs: An Overview
NFTs have had a good run in the past few years, extending their use case to various industries. NFTs live on the blockchain just like a cryptocurrency would, while at the same time featuring several properties that make them unique and more valuable.
The most important property of an NFT is the fact that it is non-fungible. This means each NFT is unique and irreplaceable by another token (in contrast to cryptocurrencies, which are fungible and easy to interchange).
The non-fungibility of NFTs allows them to represent digital assets more uniquely. This element has made NFTs popular in the gaming and collectibles industry, as they can easily be used to represent one-of-a-kind items, such as virtual land or a rare in-game piece.
Using NFTs in these industries helps create a more immersive and realistic experience for users.
However, the use of NFTs is undoubtedly not restricted to just the gaming and collectibles industry. Indeed, they have also found use cases in several other sectors, such as art, music, and social media.
NFTs have helped establish provenance, as an NFT allows for the tracking of an asset from its creation to its current owner. Only the NFT’s owner can view and manage its associated data, which helps reduce the chances of fraud, as they can verify the provenance of an asset.
It also enables greater transparency because the user knows exactly where the asset has been and who has owned it before.
NFTs additionally allow for the easy transfer of ownership because the process is automated and does not require the involvement of a third party or transfer of any physical assets.
NFTs also serve as a good investment alternative because most are priced just as much as the physical good or commodity and have the potential to generate good returns.
How NFTs Can Be Used in DeFi
NFTs and DeFi make up a good use case because they can be used to represent a variety of assets on the blockchain. The use of NFTs in DeFi can help create a more efficient and trustless financial ecosystem. Here are some of the vital areas where NFTs can make a difference in DeFi.
Loan Collateralization
One primary way to use NFTs in DeFi is as a collateral asset. Just like you could use your house or car as collateral for a loan from a bank, you can now use NFTs as collateral for loans from decentralized protocols.
This helps reduce the risk for the lenders on the protocol, as they can now offer loans to a broader range of users with NFTs as collateral. This method also allows for more efficient use of capital, because you can use the NFT as collateral for multiple loans.
The process of loan collateralization using NFTs is relatively simple. First, the user deposits their NFTs into a smart contract. The lender then evaluates the NFTs and decides the loan-to-value ratio to assign. Next, the smart contract mints a new ERC-20 token pegged to the value of the deposited NFT.
You can then use this new token as collateral for a loan. If the user cannot repay the loan, the lender can take ownership of the NFT.
Asset Tokenization
Another way you can use NFTs in DeFi is asset tokenization, which is the process of creating a digital representation of a physical asset on the blockchain using an NFT.
This allows for easy, secure transfer of ownership of the asset and tracking it on the blockchain. For instance, an NFT might represent a derivative contract used in options trading.
Because of this, traders on DeFi platforms such as Uniswap can trade derivative products on a peer-to-peer basis, just like they would on a centralized exchange.
For instance, a trader can buy an NFT representing a call option on Ethereum. If the price of Ethereum goes up, the trader will make a profit; if the price of Ethereum goes down, the trader will lose money.
The use of NFTs also allows for the creation of synthetic assets. Synthetic assets are assets that do not have a physical counterpart, but are instead a representation of another asset.
For instance, an NFT representing a company’s share of stock can be created, with these synthetic assets then being traded on decentralized exchanges.
The use of NFTs in DeFi enables easy, secure transfer of asset ownership and tracking on the blockchain.
This helps reduce the chances of fraud and the need for a third party to facilitate the transfer of ownership.
Compliance and KYT
Another useful area for NFTs in DeFi is compliance and KYT (“know your transaction”). This is the process of verifying the identity of the parties involved in a transaction. To do this, compliance and KYT verify the funds’ source and other relevant information about the involved parties. This helps reduce the chances of fraud and money laundering.
Because the identity of the parties can be stored on the blockchain, the use of NFTs can help automate this process. You can then use the resulting information to verify the identity of the parties involved in a transaction.
This helps reduce the chances of fraud and the need for a third party to facilitate the verification process. Moreover, users won’t need to verify their identity each time they want to transact.
This is because the blockchain will already have their identity stored. In this way, NFTs can help improve the efficiency of compliance and KYT processes in the realm of DeFi.
Fractional Ownership
Another area where you can NFTs are being used in DeFi is fractional ownership (the process of allowing multiple parties to own a piece of an asset).
With the skyrocketing prices of NFT collectibles, some NFTs are just too expensive to be bought by a single person.
With fractional ownership, however, multiple parties can own an NFT. Each party will own a percentage of the NFT based on their invested amount.
This allows more people to own a piece of an NFT without paying the full price. And because there is now a larger pool of potential buyers, the NFT can be sold at a higher price.
What’s more, fractional ownership can help improve liquidity, as the NFT can be sold more easily – thereby increasing the market efficiency of the entire DeFi space.
Debt Management
Debt management is the act of managing and tracking debts on the blockchain. With NFTs, however, this process can be streamlined so that an NFT represents each debt.
This allows for easy, secure transfer of debt ownership and tracking on the blockchain.
You can implement smart contracts to automate the entire debt management process while also eliminating human error and fraud. This is because with NFTs and smart contracts, you can track debt from creation to repayment on the blockchain.
What’s more, if the borrower cannot repay the debt, the lender can take ownership of the NFT representing the debt. That NFT would then transfer to the lender on the blockchain.
Insurance
Insurance is yet another area where NFTs are being used in DeFi. This is because NFTs can help automate the entire insurance process while reducing the chances of fraud.
NFTs can represent each insurance policy. This allows for easy, secure transfer of ownership and tracking the policy on the blockchain.
It is possible to automate this process so that all the user needs to do is purchase the NFT representing the policy. Because of this, they can bypass most of the tedious process of collecting the relevant paperwork and meeting the specified requirements of every insurance cover.
Moreover, in case of a claim, the smart contract associated with the policy can automatically verify and pay it out. This would help reduce the chances of fraud and the time taken to process a claim.
Risks Involved
NFTs in the DeFi space are beneficial, but are there any risks involved?
The answer is yes. One such risk is that because NFTs are still a new technology, the lack of regulation could lead to scams and fraud.
Furthermore, because NFTs are on the blockchain, they are also subject to the same risks as other similarly-stored assets. These include hacks and 51% attacks.
NFT transactions can also be pricey, as they often involve gas fees that are known to skyrocket when popular NFT blockchains like Ethereum get congested.
Smart contract security breaches are also a significant concern in the DeFi space, because a lot of money is often locked up in smart contracts as either NFTs or cryptocurrencies.
If a hacker were to breach a smart contract, they could make off with a large sum of money in the form of NFTs. Not only would this lead to financial loss, it would also lead to loss of trust in the DeFi space.
Examples of DeFi Projects Using NFTs
There are a few DeFi projects out there that are currently using NFTs.
Opyn
One such project is Opyn. Opyn is a decentralized insurance platform that allows users to buy and sell options contracts on Ethereum.
ERC-721 tokens represent options contracts, which are stored on the Ethereum blockchain. This allows for easy, secure transfer of contract ownership and tracking contracts on the blockchain.
With Opyn, users can bypass most of the tedious activity of buying and selling options contracts, as they can complete the entire process on the decentralized platform.
ImmutableX
Another DeFi project using NFTs is Immutable, a decentralized marketplace that allows users to buy, sell, and trade digital collectibles.
Like in the case of Opyn, digital collectibles on Immutable are represented by ERC-721 tokens stored on the Ethereum blockchain, which enables easy, secure transfer of ownership and tracking collectibles on the blockchain.
Because the decentralized platform can handle the whole process, users can also use Immutable to save time buying and selling digital collectibles.
NFTfi
NFTfi is a DeFi project allowing people to use their NFTs as collateral to borrow fiat or cryptocurrency.
With NFTfi, people will be able to use their NFTs as collateral to borrow against them. This allows for easy, secure transfer of NFT ownership and the ability to track them on the blockchain.
NFTfi also works to enable NFT lovers to maintain ownership of the NFTs, while at the same time being able to extract value from those NFTs.
Uniswap3
As one of the most popular decentralized exchanges, Uniswap3 solves the issues of impermanent loss (which were prevalent on the older Uniswap version) through the introduction of non-fungible liquidity pools. This is a new application for NFTs where they are used to represent liquidity, thus giving liquidity providers a specific range to allocate their capital and allowing them to achieve higher levels of capital allocation without downside risks.
CoverCompared
This platform combines NFTs and DeFi in insurance management. With CoverCompared, users can access lower premium insurance policies by staking their NFTs as collateral.
What’s more, with CoverCompared, users can compare over 100 insurance plans from seven major insurance categories. They can also buy coverage from these policies using cryptocurrencies. CoverCompared is also working on granting access to multinational insurance providers using crypto and NFTs.
Conclusion
NFTs in the DeFi space are highly beneficial, offering a wide range of advantages such as the ability to automate processes, reduce fraud, and improve security. However, some risks are also involved, like the lack of regulation and the possibility of scams – not to mention the security vulnerabilities of smart contracts. Despite the risks, NFTs still have an enormous degree of potential in the DeFi space. NFTs can bridge the gap between traditional finance with DeFi by enabling the digitalization of various assets in the world of finance. And based on what we’ve seen, we will likely see even more projects utilizing them soon.