NFTs and DeFi

NFTs are digital collectibles that run on the Ethereum blockchain. But they’re more than just virtual trading cards or digital artworks: They’re cryptocurrencies, ones that can connect to a huge variety of decentralized financial protocols.

DeFi protocols let you, for instance, cut up an Andy Warhol NFT into a thousand pieces and trade shares in it online. You could use DeFi smart contracts to programme an NFT to do whatever you liked, creating an entire new market in the process. Or how about lending out your NFTs, then earning back interest in your favourite cryptocurrency?

All this and more is already possible on the blockchain, making the NFT industry highly attractive to a new generation of collectors. In this short explainer, we give a brief introduction to the wider economies that NFTs can create.

NFTs and DeFi: A brief primer

Don’t understand what any of this means? You’re not alone. The crypto market is steeped in neologisms and obscure terminology. We’ll do our best to break them down.

What are NFTs?

An NFT is an acronym for non-fungible token.

These are cryptocurrencies—virtual currencies that run on a decentralized, censorship-resistant, and immutable database called a blockchain. As cryptocurrencies, they promise ownership that can’t be taken away by banks or governments and so on. And since NFTs run on the blockchain, you can prove who owns them and easily access a trustworthy record of previous ownership.

The difference is that they are provably unique and, well, non-fungible. NFTs are non-fungible. You can’t split them up (without the help of some fancy protocols, which we shall discuss later). This feature makes NFTs very attractive for digital collectibles, art, in-game items and so on.

Conversely, Bitcoin and Ethereum are fungible; they can be cut up into a near-infinite amount of pieces. You can send 0.00001 of a Bitcoin, and each Bitcoin is worth the same as the next (just like how a $20 bill is interchangeable with the next).

NFTs were created in 2016. One of their first use cases was CryptoKitties, a blockchain game that linked a virtual cat to an NFT. Each cat is unique, and players can create new unique cats. This provable scarcity makes some of these tokens very valuable, and some sold for hundreds of thousands of dollars.

In late 2020, major digital artists started looking at NFTs as a way to trade their art. A million dollars for a single NFT token became the new norm. An American artist called Beeple made the most money; he sold an NFT for $69 million in March 2021. Environmental concerns, a crypto market crash and high transaction fees eventually slowed down the market.

What is decentralized finance?

Last August, way before Bitcoin began its rise to highs of $64,000 in April 2021, another industry began to swell in size. This is the crypto-powered world of decentralized finance, also known as DeFi.

DeFi, in a sentence, is an industry based around non-custodial financial smart contracts.

Let’s break that down.

Non-custodial means that DeFi protocols never relinquish your control over your money, unlike when you, say, entrust a bank with your deposits.

Smart contracts are bits of computer code that run on blockchains, usually Ethereum; they power these non-custodial applications.

Some of these non-custodial (or decentralized) applications are financial in nature. Decentralized exchanges or lending protocols or complex derivatives platforms are among the most popular.

The DeFi industry became very popular because traders worked out that you could earn lots of what were essentially loyalty tokens for using these protocols, and that these tokens could be sold for massive profits.

This created a virtuous, if entirely unsustainable, circle of innovation, and some of the smartest minds in crypto rushed to DeFi to take advantage. Last January, about $1 billion was locked up in the industry. In May, 2021, about $90 billion was locked into these protocols. (This figure fell shortly after peaking due to a market crash; as of early June, it’s shrunk to about $65 billion).

NFTs and DeFi

The genius of DeFi is that developers could create financial protocols around any type of cryptocurrency—even NFTs. And since most NFTs are based on Ethereum, the same blockchain that supports the vast majority of the DeFi industry, marrying the two industries together was the natural next step. In the following section, we’ll give a quick rundown on some of the ways that DeFi became a perfect match for NFTs.

Fractionalized NFTs

While the whole point of NFTs is that you can’t cut them up, that they remain whole and pure, each one representing one piece of digital art, the downside is that this makes the NFT market highly illiquid.

Just like the real art world, only a handful of people are willing to pay millions of dollars for a single piece. This means that NFTs, just like regular art, have become a plaything for the rich, or simply a place to park money in the hopes that the value of the NFT will grow.

How dull! To make NFTs tradeable by the masses, DeFi protocols let NFT owners cut up these digital artworks into thousands of different pieces, ready for trading on decentralized (non-custodial) exchanges.

One platform, NIFTEX, does this by locking up the NFT token, also known as an ERC-721, in a decentralized protocol, and then minting fungible ERC-20 tokens (Ethereum-based tokens) in return.

If someone manages to buy back all of these tokens, they can redeem them for the NFT. It’s a cool bit of computer code that opens up the market, making the latest Banksy artwork as easily tradable as Bitcoin or Ethereum.

Decentralized NFT hosting

One of the biggest criticisms of NFT art is that the NFT token itself doesn’t contain the artwork whatsoever; it’s just a bit of code that redirects a user to a website that hosts an image or a video. Crypto critic David Gerard told the BBC in May, 2021, “NFTs are just a new form of magic beans,” he said. “All you’re buying is a receipt.” If that site goes down, the NFT will point to an error page and the token becomes worthless.

But what if you decentralized the entire internet? Decentralized web hosting, powered by crypto, is a real thing: It’s called IPFS, or the InterPlanetary Filing System. IPFS is created by Protocol Labs, the same company that’s building Filecoin, which kind of functions like a decentralized Dropbox that pays people that lend out spare harddrive space.

The advantage to decentralized web hosting is that governments can’t shut down websites, and hosting companies can’t restrict URLs. So, if you mint an NFT with IPFS, you can ensure that your digital artwork never goes offline. IPFS’s creators created a programme called Minty, a command-line application thatgmints an NFT and uploads it to IPFS using Pinata or nft.storage.

Lending out your NFTs

One drawback to physical art is that it’s very risky to lend it out. If you lend out a Monet or a Picasso, there’s always the chance that it will get damaged in storage or some tourist’s backpack will rip it to shreds. Unlikely, but possible.

This is a real pain for art collectors, since protecting and insuring against that risk is very expensive. And if they want to minimize as much risk as possible, they might just keep it in storage until it’s time to sell. This means that it could take a while before an investor makes a profit from the art.

Ah, but with digital art, based on NFTs, art investors can lend out their tokens at minimal risk. They can do this with decentralized NFT lending protocols, which let people borrow NFT tokens for a fee. This means that investors can earn money on their holdings without having to sell them for good (which comes with risk, since the new buyer might not want to sell them back).

Why might someone want to borrow NFTs? Well, they might want to display them in digital galleries, or, if they represent not digital art but, say, an in-game item or a season pass to a theme park, use them.

A videogame developer might, for instance, turn a rare sword into an NFT, then sell that NFT on an NFT marketplace. A videogame might let you rent that NFT for the purpose of a single mission, without having to buy it and store it in your inventory forever. (Interestingly, a separate videogame could reinterpret that sword as, say, a racecar or a suit of armor).

Programmable NFTs

This brings us neatly to our final stop: programmable NFTs. All NFTs are based on a smart contract, and these smart contracts can alter when certain conditions are met, irrevocably changing the nature of an NFT.

One of the best examples of this is CryptoKitties, one of the first NFT projects. Each CryptoKitty has its own unique “DNA”, bits of code that changed the appearance or characteristics of the cat. And you can “breed” two different cats together to mint a new NFT.

Another example is Beeple’s first artwork. Beeple had created two animations of Donald Trump, and his NFT would irrevocably mutate into one of the animations depending on the outcome of the US general election. If Trump lost the election, the NFT would turn into a heap of trash; if he won, the NFT would turn into a raging Trump charging through a dystopian city. Trump lost, of course, and is forever consigned to the trash.