What are NFTs? - Their Role in DeFi

By definition, a fungible asset is a type of asset that is interchangeable with other assets of the same type. Currency is a fungible asset. After borrowing a $100 bill, the borrower can return the amount either in a combination of bills of different denominations or in a different $100 bill. The value of the dollar $100 remains the same in both cases.

Non-fungible assets are not mutually substitutable in the way fungible assets are. Examples of non-fungible assets in the conventional world of finance can be houses, cars, etc.

A non-fungible token in the world of blockchain technology and decentralized finance has been developed similarly. An NFT is the tokenized version of a non-fungible asset. Instead of a fiat currency like USD, AUD, or GBP, these tokens may represent an artwork, real estate, or collectibles. Popular digital games, such as Decentraland and CryptoKitties, frequently leverage these tokens.

NFTs are developed on the ERC-721 protocol. ERC 20 represents a class of tokens that are identical. Whereas, ERC-721 represents a class of unique tokens.

There are a few features that make a token non-fungible. To start with, the ownership of NFT is unique. It can not even be substituted by another matching NFT. These tokens are not separable. Every NFT has defined ownership and privileges.

NFT and DeFi — A Promising Union?

NFTs are being promoted as the next big thing in the world of decentralized finance. In the first week of September, NFTs witnessed sales amounting to US$1 million. In the first week of the next month, that is to say in October 2020, the sales of NFT went up to US$2 million.

According to experts, it is the DeFi paradigm that has helped NFTs to become liquid. It has freed NFTs from being seen as an expensive proposition.

NFTs also help to expand the market of collaterals in DeFi lending. A DeFi lending and borrowing platform require collaterals. These collaterals are generally the crypto-holdings. With the introduction of NFT, one can now put other types of assets as collateral. For example, an artwork or a real-estate property can be tokenized as NFTs and put up as collaterals.

The use of NFT goes beyond the realm of collaterals. It has the capability of representing more complex financial products. These products can be insurances, bonds, or options.

In insurance, each contract is converted into NFT. These NFTs can be traded on a secondary market.

Another DeFi model that has been adopted in the world of NFTs in the issuance of governance tokens. Many platforms and NFT marketplaces have started issuing and distributing their governance tokens.

Let’s have a look at some of the biggest sales of recent times that used NFTs as the medium of exchange.

In July 2020, Picasso’s Bull was put up for an NFT art auction sale. The price went as high as $55,000. After a few days, another sale broke this record. A digital artwork, titled “Right Place & Right Time” was sold for US$100,000. Async Art conducted the sale. On October 7, another artwork, “Portraits of a Mind”, surpassed both these records. The renowned auction house Christie’s sold it for $130,000.

More Usage of NFT

Using NFT as Digital Collectible

This started with the game CryptoKitties in 2017. The game mimics the economic model of asset appreciation. Here non-fungible tokens are sold as cryptoKitties. Users can buy these cryptoKitties and eventually trade them. To explain in a bit more detail, participants buy available cryptoKitties and then breed them to make a CryptoKitty which is rarer than the available CryptoKitties. The participant then sells this CryptoKitty in the secondary market. This game garnered huge attention from crypto-enthusiasts. Some CryptoKitties fetched as high a price as $170,000.

Personal Information Verification

The NFTs also help in digital identity verification. Since these tokens are not interchangeable and can not be mutually substituted by another NFT, they act as an efficient tool for running personal identity checks. An individual’s credentials such as driving license, academic credentials, passports, etc can be fed to an NFT. This works as a digital KYC. Since it negates the scope of paper documents, which often turn out to be fake, fraudulent, or erroneous, these NFTs are much more secure and transparent.

Licensing of Software

Any software uses a personal key as its license. This key is a long string of characters, alphabets, and numbers. Users often share or hack these keys to use the software wrongfully. This results in a decrease in revenue for the software company.

To stop such misuse, NFTs are used these days. The NFT works as the key in this case. One can keep the NFT in his crypto wallet and use it as and when required without having to share any other personal details. Using smart contract algorithms, companies can also specify the period for which the key is valid.

The democratization of High-Value Asset Classes

Asset classes like real-estate are expensive. Small value investors can not often enter the market because of the kind of money it involves. NFTs solve this problem by facilitating part-ownership of assets. Recently, a property worth 30 million US dollars was converted into NFTs and was put up for sale. The buyers of each NFT acquired ownership of a part of this asset as per their capability. For the real-estate segment, the deal is profitable because it brings liquidity to an asset-segment that is often constricted by illiquidity.

Use in Supply Chain Management

The use of blockchain technology to make a supply chain more efficient is not new. With its unique features, NFTs add more transparency to this process. Manufacturing companies use NFTs to help the NFT holders to track all the unique information about a process. The holder of the NFT gets to know the temperature of the meat in each section of the meat processing unit, the quality of the leather at a handbag manufacturing line, the quality of the paint used to paint the bag by holding an NFT.

The Future of NFT/DeFi

The total market of NFT reached $100 million by the end of July 2020. With the DeFi market currently standing at a size of $4 billion, the NFT space is also expected to grow in the days to come.

Some experts believe that as high as 4 in 10 new crypto-users will use NFT as an entry point. The important drivers that will fuel this growth are as follows:

The Fun Angle

NFTs are used to collect art, game rewards, and similar attractive items. The typical audience of NFT, therefore, does not need to have any specialized knowledge in Finance. The process of collecting NFT is interactive and fun. Therefore, a large chunk of people from outside of the world of finance is expected to get involved in NFT.

The Scarcity of Supply

The type of assets that are tokenized in an NFT does not go by the standard rule of supply and demand. Assets like painting and artwork increase in value because of their scarcity. For other tradable goods, an increase in demand is met with an increase in supply. But, an increase in demand for Picasso’s artwork will never lead to an increase in supply. This scarcity helps the underlying assets of NFT to grow in value.

Attractive to the Asian Market

Those who are aware of the crypto industry believe that for any crypto project to be successful, it needs to be successful in the Asian market. With its funny collectibles and gamified interfaces, NFTs have captured the cultural imagination in Asian countries like Japan and South Korea.

To conclude, NFT is going to grow in the future because it’s far more inclusive and exciting than the traditional realm of DeFi investments. In the DeFi market, the interest is towards only the financial return. Here, in NFT, the user expects a far deeper reward at the psychological level. With the world becoming full of digital-native objects, NFT is also expected to permanently settle the question of ownership.

Also published at https://medium.com/@zild/what-are-nfts-and-what-role-do-they-play-in-defi-2421b132dc43

Disclaimer: All opinions in this article belong to the author and do not reflect the opinions of Hacker Noon as a company.