Can NFTs Revitalize this DeFi cycle?
The most (un)likely of Partnerships
The DeFi and NFT communities have kept to themselves for the most part in recent history. However, in this current bear/crab market, the DeFi community may see the biggest innovations coming from the adoption of NFTs into DeFi protocols.
DeFi 1.0 → 2.0 → 3.0?
The DeFi ecosystem currently exudes a sense of boredom and is desperately waiting for the next advancement that can finally be coined as DeFi 3.0. Solidly appeared to be the next great trend, and while certain aspects have been quite innovative, Andre Cronje’s departure paired with a glitchy roll out disappointed the masses. With NFT hype dropping since late January and DeFi desperately looking for its next popular trend, I propose increasing the synergy between the two most popular blockchain use cases, for what could potentially be the long awaited DeFi 3.0. In no way am I saying that NFT use cases in DeFi will be as groundbreaking as the creation of Aave or as engaging as the Curve Wars, but it may arouse some much-needed hype for the ecosystem that is crying out for something to cycle into it. Certain protocols have already incorporated NFT use cases, but for this trend to truly become DeFi 3.0 there needs to be widespread adoption.
I know the DeFi chads and NFT clout chasers have not always been the best of friends, with opposing communities looking to the other with disdain. Obviously, there is massive overlap between populations who use DeFi and buy NFTs, but realistically there is also a massive divide (as seen below) between the people who are investing in perpetual futures and those that are buying the 100th derivative of Bored Apes. While there may be a sense of intellectual supremacy on the DeFi side, there are many potential applications of NFTs in DeFi that I feel have been lacking widespread adoption due to this unfounded apprehension.
What makes NFTs so applicable to DeFi?
Most obviously, NFTs are non-fungible, which means they are inherently unique and thus can offer more personalized and specific positions in DeFi.
Secondly, NFTs have natural value derived from their utility and scarcity. DeFi protocols can fine tune the scarcity and utility of specific NFT releases to have greater control over what they imagine the initial value should be, then leaving the rest up to the free market to decide.
Thirdly, incorporating NFTs can untangle the price of governance power from the native protocol token. Imagine Protocol X releases a collection of NFTs that are required for voting on governance proposals. The X token could still earn 80% of protocol fees, while the NFT holders get to vote on governance proposals and earn 20% of protocol fees. This allows for a fully diluted value of native protocol tokens, creating a more accurate valuation of the tokens. Staking regular tokens for veTokens artificially inflates the price by taking tokens off the market, which may excite people who are holding bags of the token, but it creates a marketplace that can be heavily affected by the amount staked. Since it is difficult to predict in many cases how long tokens are staked for, separating this governance process with NFTs allows for greater transparency of the value of the token. Additionally, this can separate the markets for those that simply want to interact with a given protocol from those who have an active interest in improving the mechanisms behind the protocol. This idea can be expanded to create a hybrid form of governance using both NFTs and veTokens. Imagine if theoretically Curve released NFTs that were required for voting on governance proposals and also received 25% of protocol generated swap fees divided equally amongst NFT holders. As you can see by incorporating NFTs there’s massive amounts of creativity that can be applied to DeFi protocols, rather than sticking with the handful of existing mechanisms that are recycled through every new protocol.
Additionally, NFTs are easily tradable, removing the illiquidity that develops from having to lock up protocol tokens for veTokens. Using NFTs, rather than locking tokens for the utility that veTokens serve, can remove the need for liquid versions of veTokens. This could potentially remove the need for Convex-like protocols, whose sole role is to create a liquid version of veTokens, such as cvxCRV.
Lastly, NFTs allow for the game-ification of protocols. Typical DeFi protocols can add a gaming aspect that benefits the main use case of the protocol by incorporating NFTs, without having to go full GameFi and develop a video game. Nacho Finance is a great example, which I will touch on later.
What does the intersection of NFTs and DeFi actually look like?
While doing research for this article, all I could find written about NFT use cases in DeFi were examples of loans collateralized by valuable NFTs, such as the recent $8M loan taken out on NFTI backed by 101 CryptoPunks. While that’s a super interesting use case, I want to specifically focus on NFTs whose sole purpose and value arise from its use within DeFi protocols, rather than collectible NFTs that derive value from the image or community. For this reason, I’m also going to exclude NFTs that act as access passes to investment DAOs or access to discord channels for alpha. Given that pretense, here are some of my favorite use cases I came across from my research:
No article looking at the intersection of NFTs and DeFi would be respectable without mentioning the use of NFTs in UniSwap v3. Following the update from v2 to v3, UniSwap introduced concentrated liquidity, allowing liquidity providers to choose the price range they wish to provide for. Previously, liquidity providers all provided liquidity to the entire price curve, which made most of the liquidity unused, except for a small range. However, given that these new positions are unique to each provider, UniSwap had to pivot from their model of issuing ERC-20 LP tokens to represent the providers position to a model of issuing NFTs that represented the unique position of each provider. While these NFTs are not fungible like the previous LP tokens, meaning that positions cannot be pooled together, the positions are still easily tradeable. There are already protocols, such as Duality Finance, who are accepting the NFT LP positions as collateral for loans. The improved liquidity utilization would not be possible without the introduction of NFTs into the protocol, and while there was some initial pushback from certain people who were mad at losing the fungibility of their LP position, it has been a great success for both UniSwap, whose TVL has grown since, and for liquidity providers who are seeing greater fee revenue from their concentrated positions.
Moving from one dex to another, Curve has its own governance issue that could be solved by implementing NFTs. While Andre Cronje has left the DeFi community saddened by his departure, one of the best innovations from his Solidly protocol was the introduction of tokenizing the lock position for governance, which solved the issue of illiquidity from Curve’s veCRV. On Curve, when you lock CRV tokens for veCRV, you can choose how long you wish to lock them for, ranging from 1 week to 4 years. However, if you already locked 100 CRV tokens for 4 years, you are unable to lock any number of tokens for a time period shorter than 4 years. Solidly’s ve locks as NFTs solve this locking issue by issuing NFTs as a receipt for the tokens locked each time. The lock positions are cumulative, which means that a user could have 3 different lock positions, each with its own unique number of tokens and lock time duration contributing to the total lock position. The tokenization of lock positions allows for tradability on secondary markets, as well as the ability to borrow against the lock position. I can’t stress this enough, but Curve needs to adopt this model ASAP to allow for greater flexibility amongst users.
While on the topic of Curve, for those that are not aware, liquidity providers earn boosted rewards if they hold veCRV. BinaryDAO, on Metis, has reimagined the idea of boosted rewards by incorporating NFT use. Prior to the ICO and official release of the protocol, BinaryDAO released a collection of 2,500 NFTS that grant owners who stake at least 25% APR. Additionally, the NFT holders will be airdropped 100 $BYTE tokens/NFT, the protocol’s native token. I personally love BinaryDAO’s rollout of an NFT collection, given that the sale gave them liquidity that is useful for bootstrapping the protocol, and it reimagines how rewards can be boosted. This method is much different to UniSwap and Solidly’s implementation of NFTs, given that those protocols mint NFTs on per use case, while BinaryDAO released a more typical NFT collection with a set amount. Clearly, I’m not the only one who is bullish on BinaryDAO’s boosted rewards strategy, given that the collection sold out in under a minute. Staking an NFT for boosted rewards allows for greater flexibility and freedom, given that I could go out and buy a BinaryDAO NFT to receive max boosted rewards. On Curve if I want the max boosted rewards, I need to lock my tokens for the full 4 years, making my bags illiquid for 4 years. Given how fast DeFi moves it is a huge risk to lock tokens for 4 years for the purpose of boosted rewards. NFTs completely solve this issue and allows liquidity providers to earn boosted rewards for as long or short as they want, since whenever they want to abandon the protocol, they can easily sell the NFT rather than being locked in for years.
Arguably the most fun implementation of NFTs in DeFi is the upcoming release of Nacho NFTs from Nacho Finance. Nacho Finance’s main product is an algorithmic stable coin platform that aims to be pegged 1 wETH: 1000 $NACHO, which may make you ask how the heck they are implementing NFTs. Well, their ultimate goal with the collection is to build value for the holders of the protocol token, $NACHO, by seamlessly plugging into the existing Nacho ecosystem. To do this, they have developed a Nacho Universe, where NFTs of Luchadors can be leveled up and wrestle against other Luchadors in their weight class through head-to-head battles, as well as tag-team and royal rumble battles with up to 30 Luchadors in the ring at once. Luchador owners and spectators can wager on the winners of the battles. Luchadors can be “staked in the gym to train” where they earn $BOOZ as they train. $BOOZ can be staked in the cantina to earn $CHIPs, which can be used to increase the Luchador’s weight, since heavier Luchadors earn more $BOOZ during training. To increase the abilities of the Luchadors, giving them a better chance at winning in the battles, owners can use $NACHO to level up properties such as speed, strength, spirit, style, and stench. This not only creates a fun betting experience on chain, but it also benefits current and future Nacho holders, as well as strengthening Nacho Finance’s ability to maintain peg by allowing for the protocol to become deflationary as the NFTs act as a black hole for $NACHO.
Will it stick?
NFTs created on a per use case, like UniSwap v3 and Solidly, are wildly different from NFT collections with set amounts that are released, like BinaryDAO and Nacho Finance, but both styles have one thing in common: improving the experience for protocol users. I am extremely bullish on the integration of NFTs within the DeFi ecosystem, specifically for boosted rewards and solving the Curve token locking conundrum. While I personally think the UniSwap v3 and Solidly approaches are more effective at changing the way we create DeFi protocols, the creativity and value added from set NFT collections should not be overlooked either. I’m not sure if NFT integration within DeFi is too broad of a topic to coin as DeFi 3.0, but whether you like it or not, widespread integration is coming sooner than later.
Author is a Decentralized Finance (DeFi) intern at Polygon, highly interested in accelerating the adoption of DeFi and NFTs in a sustainable manner. Also, currently studying finance and business analytics at Boston College - Carroll School of Management, while being actively involved in the BC Blockchain Club. Can be reached on twitter @offdeblockchain