Blend gives NFT lending a risky yet lucrative makeover

The recent launch of a new NFT lending protocol called Blend by NFT marketplace giant Blur has sparked debate over its design and the potential risks to the NFT market.

Blend is the latest in an expanding cast of NFT finance protocols, which have processed $1 billion in cumulative loans. Lending protocols are part of an attempt to improve liquidity in the NFT market and make it easier to put a price on the hard-to-value asset.

NFT lending protocols allow users to borrow crypto against NFTs as collateral. These platforms either pool loans from lenders in a peer-to-pool arrangement or match lenders with borrowers in a peer-to-peer design. Blend employs the latter design but also combines elements of the former.

But what makes Blend special also makes it a threat to the broader NFT market, according to its competitors.

Stephen Young, founder and CEO of NFT lending protocol NFTfi, described Blend’s design as an “innovative mechanism that works in principle,” but said that it incentivises borrowers to take out highly leveraged loans that are “inappropriate for the nature of NFTs.”

Such apprehension arises from the fact that NFTs are characterised by illiquidity and volatility, rendering even marginal price movements capable of inducing colossal liquidations.

These loan liquidations will “flush NFTs into the hands of point farmers, and in consequence may lead to much higher market volatility”, Young said.

Point farmers are lenders trying to earn more airdrop points on the Blur marketplace in expectation of the platform’s next token distribution. These lenders are more likely to sell the NFTs to recover their funds loaned out to borrowers, thus leading to greater volatility in NFT prices.

Since its launch on May 1, Blend has recorded 19,249 Ether ($34.6 million) in loans during the period, as per data from crypto analytics platform Dune. Blend supports three blue-chip NFT collections – Azuki, CryptoPunks, and Milady.

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Blend in its first few days of operations has seen high loan-to-value loans at low to no interest rates. This means that borrowers have access to highly-leveraged loans with minimal interest rate burdens.

This trend does seem to offer some immediate benefits for borrowers but there are likely to be significant risks involved.

“Unchanged, the current incentive design will likely lead to bad outcomes for borrowers,” Young told DL News. This could come in the form of mass loan defaults and cascading liquidation of risky loans.

Such a scenario has previously played out before, involving NFT lending protocol BendDAO. A bear market for NFTs in August saw BendDAO in danger of massive loan liquidations as borrowers on the protocol racked up significant bad debt. BendDAO had to pass emergency changes to its protocols to reduce the risk of loan defaults.

Blur did not immediately respond to a request for comment.

Blur token farming driving Blend lending volume

“Most of the Blend volume is driven by token farming, evident by high LTVs and 0% APR loans rather than organic loan activity,” Gabe Frank, founder of NFT lending protocol Arcade, told DL News.

Lenders looking to earn airdrop points are offering these high LTV loans to borrowers at minimal interest rates. This is a form of token farming for the Blur airdrop.

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Blur, the NFT marketplace behind Blend, is one of the biggest challengers to OpenSea, as the dominant NFT marketplace. Launched in October, Blur quickly became popular among NFT traders with features like zero-fee trading, optional royalties for creators, and floor sweeping — buying several NFTs at or close to the floor price of the collection.

Blur’s position as a major NFT marketplace means its lending protocol is expected to have a significant impact on the NFT space. The protocol is already leading the way in weekly loan volume but still has a long way to go to reach the market size of NFTfi, the largest lender with $411 million in cumulative loans since inception.

Inappropriate loans for NFTs?

Cirrus, a prolific NFT trader who was the first to point out BendDAO liquidations last year, said that Blur’s design and “the fact that Blur is likely to incentivise loan offers is a huge benefit to borrowers and a huge hit to lenders.”

Blend’s design could trigger a leveraged-fueled run in NFTs, explained Cirrus. This is due to the fact that borrowers can acquire more NFTs on credit using limited liquidity.

The fear is that borrowers will become overexposed to risky loans which could easily be liquidated when market conditions turn marginally sour.

Tyler Reynolds, an angel investor in DeFi and former Google payments team manager, offered a different perspective.

“I don’t know why people would be worried about making NFT prices more volatile,” Reynolds told DL News. “It may happen, but why is this a worry?”

“I would be worried about unsophisticated lenders lending USD against illiquid collateral assets at terms that may make the lender in the red the moment the loan is originated,” Reynolds said.

Exit right for lenders

One of the unique aspects of Blur is the ability for lenders to exit their positions at any time. And that puts borrowers at a disadvantage, according to Alex Ho, head of product at Pine Protocol.

Lenders offering Blend loans have the flexibility to refinance these loans at any time, thanks to the absence of a fixed maturity. This unique feature of Blend loans allows for refinancing through a process known as Dutch auctions, where other lenders are invited to bid on loans offered to borrowers. During this auction process, the interest rate on the loan gradually increases until a new lender accepts the loan position.

This approach enables borrowers to conveniently roll over their loan positions, provided they repay the loan within 24 hours after the auction, which lasts six hours.

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Blend’s innovative use of Dutch auctions helps to reduce costs for borrowers who might otherwise need to manually roll over their positions. But the complexity of the system compounded by the high likelihood of liquidation raises concerns.

“Continuous loans where borrowers can be liquidated anytime are less suitable for retail borrowers,” Ho said. “The convenience or gas-saving that comes with continuous loans does not justify the higher risk of getting liquidated.”

Ho argued that fixed-term loans are more suitable for borrowers to manage their position. “The Dutch auction liquidation model is heavily dependent on the market being efficient for it to not be a rug-pull for borrowers, i.e., there are always lenders willing to bid on these auctions,” Ho said.

Secondary market for NFT loans

Blend’s Dutch auction system also creates a secondary market for NFT loans.

But the success of this secondary market depends on a healthy mix of participants in the system, pseudonymous BendDAO co-founder PirateCode told DL News. That requires more lenders than borrowers.

“In practice, refinancing becomes relevant only when the number of lenders exceeds that of borrowers,” PirateCode said. “In such situations, lenders can simply establish loans directly with borrowers, bypassing the refinancing process altogether.”

Liquidity and fair pricing

Another unique aspect of Blend that’s controversial is the fact that the protocol – unlike many others in DeFi – do not use price oracles, which are tools that provide information about the price of an asset.

While Blur lists this lack of oracle dependency as an advantage, critics point out issues around fair pricing for NFTs.

“The fact that the Blend protocol does not incorporate pricing into its protocol just pushes the responsibility to come up with a fair valuation to the borrowers and lenders,” said Ho.

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“It’s great for certain types of transactions, such as loans against a rare zombie CryptoPunk,” he said. But for most NFT collections, the majority of the pieces do trade at the floor price and a protocol that incorporates a robust pricing mechanism will still make things more transparent, fair, and convenient for the majority of borrowers and lenders.”

Despite these issues, Blend has a lot to offer for the burgeoning NFT market, according to PirateCode.

“By allowing NFT holders to use their assets as collateral for loans, NFT lending protocols increase the liquidity within the NFT market,” they told DL News.

And that could “encourage more trading and investment activities, making the NFT market more dynamic and accessible,” he said.