In-depth Analysis of How XCarnival Breaks Through the NFT Collateral Lending Market

Author: Waterdrip Capital

The recent continued popularity of the NFT market seems unaffected by the overall cryptocurrency market, instead exhibiting its unique local excitement. There are already 8 series on OpenSea with over 100,000 ETH in volume, including CryptoPunks, BAYC, Decentraland, MAYC, Art Blocks, SandBox, Clone X, and Azuki. The market trading volume of just these 8 NFT series is approaching 10 billion USD.

From the perspective of trading data, in 2021, people traded NFTs worth over 40 billion USD. Although the vast majority were punk avatars and "art form" collectibles, the trading volume of NFTs has seen geometric growth compared to previous years. The trading categories have also expanded to include cyberpunk, music, painting and other art collectibles, as well as ticketing, bonds, and other asset on-chain tracks, covering various fields such as gaming, social, and the metaverse. NFTs have become the fastest and strongest tool for breaking out in the blockchain field.

However, in stark contrast to the rapid growth of NFTs and the enormous transaction volume, there are currently only a few NFT collateral lending platforms that are lukewarmly serving this market with huge potential, which makes us want to explore the reasons behind it.

Why has the NFT collateral lending market, with such huge potential, not formed a scale?

Through preliminary research and analysis, we believe that the relatively small scale of the NFT collateral lending market mainly comes from the following two factors:

Liquidity of NFTs

Price Discovery of NFTs

To use NFTs as collateral for lending, they need to be viewed as a financial asset. However, financial assets with insufficient liquidity or even a lack of liquidity require a foundation of liquidity for the growth of their derivative collateral lending market.
The lack of liquidity in NFTs also leads to several common phenomena:

• Most NFTs have a low turnover rate, primarily relying on peer-to-peer trading methods. Sellers may list their NFTs on platforms like OpenSea and wait a long time without any buyers, ultimately failing to complete a transaction.
• A few series of NFTs are highly sought after but are expensive, purchased and collected by a small number of large holders who do not resell them, leaving ordinary NFT users shut out.
• More generally, there is an oversaturation of NFTs. Anyone can generate and create their own NFTs on platforms like OpenSea. Currently, there are over 29 million NFT projects listed on OpenSea. While users can purchase NFTs based on their preferences, the reality is that users have no ability to discern which NFTs hold real value among the tens of millions created. The massive creation of NFTs also signals their demise, drowning in the continuous wave of new NFTs.

Another key factor hindering the development of the NFT collateral lending market is: Price Discovery

Price discovery is the result of interactions between sellers and buyers. In other words, the price discovery of NFTs is the result of interactions between NFT suppliers and demanders. This behavior occurs millions of times daily in traditional markets and even in the DeFi market, but it seems to malfunction in the NFT market. This has been a long-standing issue that needs to be addressed: how to fairly price NFTs.

In our portfolio, Pawnhouse is a comprehensive platform dedicated to providing price discovery for non-standard assets (including NFTs). Its proposed Synchronous Multi-Round Auction (SMRA) system can help NFT market participants better obtain pricing services and incentivize bidders to provide price information. The SMRA system is currently in internal testing, and interested readers can stay tuned.

The lack of a consensus mechanism for the value of NFTs makes it difficult for both parties in a lending transaction to reach a basic agreement on the value of the NFT in question. This explains why a large number of NFTs can be actively traded on platforms like OpenSea but cannot be included by platforms supporting NFT collateral lending.

As NFTs have shown a definitive growth trend, looking to the future, NFT collateral lending is a significant issue that must and will be resolved.

Currently, the mainstream solutions mainly include P2P models and liquidity pool models.

Although these two solutions do not completely solve all the problems of NFT collateral lending, they are widely accepted and have, to some extent, activated the vitality of the NFT lending market, reflecting the market's choice.

P2P Model

The P2P model is applicable to all NFTs and can reflect the unique value attributes of NFTs, such as scarcity. It is currently the most familiar and widely used solution.

For example, six months ago, the XCarnival 1.0 version operated a P2P lending method on BSC. Leveraging the project ecosystem, it successfully addressed the pain points of imbalance between lenders and borrowers.

The P2P model for NFT collateral lending operates approximately as follows:

User Alice has some NFTs worth about 1000 USD, but she wants to use them as collateral to borrow funds for investing in other projects. She can set her NFT on the XCarnival platform:

Loan Amount: 800 USD
Loan Interest: Annual 15%
Loan Duration: One month

Meanwhile, user Bob wants to invest some tokens worth 5000 USD to purchase his favorite NFTs and earn reasonable returns. He can operate on the platform as follows:

Put Token into Megabox to mint 2000 USD
If he likes Alice's NFT, he can bid, for example, 400 USD, and earn an annualized return of 12% on the loan.

One month later, Alice repays the principal and pays interest to redeem her NFT. Bob earns the corresponding borrower’s return, or if Alice fails to repay the principal and interest, the NFT worth 1000 USD becomes Bob's.

Advantages and Disadvantages of the P2P Model

While the P2P model can effectively address the issue of varying NFT prices, especially for high-value and rare NFTs, it also has many problems, such as long transaction times (NFT owners can only wait for others to place orders or bids and need to check periodically), low capital utilization efficiency, and high interest rates. For NFT owners in urgent need of funds, this uncertainty can lead to a relatively poor user experience.

For general users, especially those who have used the P2P model for NFT collateral lending, it is evident that there is considerable room for improvement in the user experience of the P2P model. Therefore, another solution has recently emerged in the market—the liquidity pool model.

Liquidity Pool Model

The liquidity pool model for NFT collateral lending draws on the liquidity pool model of DeFi. NFT owners can immediately borrow funds after over-collateralizing their NFTs into the pool, and the entire process is similar to using AAVE/Compound. This is also a mainstream exploratory direction for the combination of NFTs and DeFi, with some projects currently exploring this area.

In the liquidity pool model, the NFT lending process is similar to that of DeFi. Capital providers can deposit their stablecoins or ETH into the liquidity pool to earn stable interest. The interest paid by NFT owners depends on the amount of lending funds in the pool and the supply of NFTs. If an NFT owner cannot repay or if the NFT price falls below the liquidation line, the NFT will be auctioned on trading platforms like OpenSea, and the funds will be returned to the capital providers.

Compared to the P2P model, the liquidity pool model has several advantages:

• Rapid transaction process with a short cycle
• Clear loan amounts
• Larger loan scales with lower participation thresholds
• Stable and relatively low interest rates

Users holding large blue-chip NFTs, such as Punks/BAYC, can obtain a clear loan amount immediately by collateralizing their NFTs in the liquidity pool model without waiting for price discovery, and they hardly need to worry about losses due to price manipulation. This is because the profits gained from price manipulation may be far less than the costs incurred.

Taking CryptoPunks as an example, as shown in the figure above, the average transaction price of Punks in the last 30 days is 109 ETH, with a floor price of about 68.5 ETH. Assuming that only 20% of Punks are used as collateral, 20 ETH can be borrowed at a floor price of 68 ETH (assuming a loan of 30% of 68 ETH).

If one wants to profit by raising the floor price for borrowing, even if large holders collude, they still need to raise it above 204 ETH to make a profit. A 20% collateral rate would require a trading volume of 408,000 ETH. If the collateral rate is 30%, it would require over 600,000 ETH in trading volume. This is also based on the premise that the intrinsic value of Punks remains at 68 ETH and does not increase, making the cost far exceed the profit.

The liquidity pool model also has certain drawbacks and cannot match all NFT series. For NFTs with specific rare attributes, it cannot provide a fair loan amount exceeding the floor price. The NFT series suitable for the liquidity pool model are relatively few, concentrated in blue-chip NFT series like CryptoPunks/BAYC. For long-tail NFT series, the risks of the liquidity pool model are higher, as the prices of NFTs may be manipulated by large funds, leading to liquidation and inability to sell in time, resulting in losses for borrowers. Additionally, the liquidity pool model is relatively complex, and despite most logic being similar to AAVE, there are still risks associated with smart contracts.
The drawbacks of the liquidity pool model can be summarized as follows:

• Not applicable to all NFTs, only suitable for mainstream NFT series
• Long-tail NFT assets face price manipulation risks
• Risks inherent in smart contracts

Summary of P2P Model and Liquidity Pool Model

Theoretically, the P2P model is applicable to all NFTs. Users list their NFTs on lending websites, and both parties choose independently. The downside of this method is that users cannot assess whether the NFT price deviates from the market price, and both parties bear high risks. If the borrower defaults, the liquidation process for the NFT is also unclear, making it difficult to guarantee the rights of the lender.

The liquidity pool model focuses on the mainstream NFT lending market, and the key to NFT collateral lending projects adopting this model lies in the ability to integrate mainstream NFT resources. Since mainstream/blue-chip NFT series represent a stock market, obtaining more mainstream/blue-chip NFT series supply can quickly capture market share, attract and drive lending funds, forming a positive cycle, thereby establishing an advantage and truly attracting blue-chip NFTs and capital supply into the NFT collateral lending market.

XCarnival—How to Break the NFT Collateral Lending Market

Recognizing this, XCarnival, after operating the P2P model on BSC for half a year, is about to launch its NFT lending pool on the ETH chain, with plans to officially land on the ETH chain in mid to late March this year. It is believed that the launch of the NFT lending pool on the Ethereum chain will inject a strong boost into the NFT collateral lending track.

From the information currently disclosed by the project party, many useful insights can be gleaned. First, the XCarnival lending pool is significantly different from existing products on the market. The Pool to C (Customer) liquidity pool model on the Ethereum chain can be broken down into three main parts.

(Image from internal testing)

First is the source of funds for the pool. Users will deposit Ethereum and stablecoins into XCarnival's pool, and the project party will reward these users. This can be simply understood as the project party providing a new investment channel for stablecoin users.

(Image from internal testing)

Second is the NFT holders. Users holding NFTs can place their NFT assets into the lending pool and directly receive stablecoins. Users can quickly collateralize their mainstream NFTs into different pools using the lending pool and borrow corresponding mainstream tokens like ETH, USDT, etc., with the ability to borrow and repay at any time.

Finally, how to ensure the rights of both lending parties. How to ensure that the lender's stablecoins are not misappropriated while ensuring that the borrower can repay the loan? XCarnival maximizes transaction security through an oracle mechanism to ensure smooth completion.

The new product will build multiple loan pools to release NFT assets on the Ethereum chain. The initial product release will be limited to common NFT assets.

(Image from internal testing)

Regarding the oracle mechanism, the project party has not yet disclosed details. Current solutions generally use on-chain data to perform TWAP (time-weighted average price), using multiple time dimensions as data sampling sources while excluding extreme values to create a comprehensive floor price. The same NFT can only be assessed once during multiple transactions over a period to avoid attacks, and this method also prevents price manipulation.

Through the Pool to C model, the use cases of the lending pool have improved asset utilization and transaction efficiency. XCarnival is expected to truly release NFT liquidity and empower the NFT collateral lending market.

Competitive Analysis

Stani Kulechov, the founder of the decentralized lending protocol Aave, tweeted last July that Aave was experimenting with using NFTs as collateral and hoped to release a protocol suitable for various NFT use cases. Six months later, Aave's NFT lending pool has still not officially launched, so it is worth keeping an eye on.

Currently, there are very few projects adopting the liquidity pool model to support NFT collateral lending. Besides XCarnival, which is set to launch this model in March, Drops has also claimed it will launch a liquidity pool model, but currently, the Lending Pool is still in the "coming soon" stage, so it is worth monitoring.

Market Outlook

It is evident that the current adoption of the liquidity pool model to support NFT collateral lending is still in a very early stage. It requires not only a keen business sense but also strong resource integration and product development capabilities.

With XCarnival set to launch on Ethereum this year, in addition to the existing P2P model, the official launch of the Pool to C model could potentially be the first NFT collateral lending platform to formally support the liquidity pool model, and it is expected to become a breakthrough player in the NFT collateral lending market.