NFTs and Decentralized Finance (Part II)

By Shane Shin

The NFT market’s rapid growth, owing to innovation in the cryptocurrency ecosystem and expansion of blockchain networks, is paving the way for a new phase in the web’s evolution, commonly referred to as Web 3.0. Thanks to smart-contract-enabled blockchain platforms, like Ethereum, that are programmed to self-execute, control and document transactions when predefined conditions are met, NFTs represent more than tamper-proof digital assets that are individually unique, traceable, and verifiable. Though it may take a while for non-fungible tokens to prove their true efficacies in everyday life beyond their evident appeals as certificates of ownership and authenticity, the opportunities they present seem boundless.

Peer-to-Peer Transactions in Decentralized Finance

Decentralized finance (DeFi) is an evolving financial infrastructure built on blockchain technology. DeFi provides financial services without the supervision of centralized intermediaries such as a bank or government agency, and non-fungible tokens have become suitable instruments for a variety of financial applications like borrowing, lending, trading and saving.

An NFT’s contribution to the growth of decentralized finance comes from its ability to enable instant peer-to-peer transactions using smart contracts. Two or more parties can engage in direct trades without an intermediary’s involvement and review, using cryptocurrencies or NFTs as a token of exchange on decentralized apps. By a way of closing transactions, if and when certain conditions are met, NFTs also allow consumers to choose better interest rates and sidestep a lot of risks and inefficiencies involved with the traditional banking system. DeFi NFT accounts have the potential to replace savings accounts at traditional banks while generating higher, more frequent interest. With time, the possibilities of what you can do with DeFi and NFTs continue to grow.

As NFTs have opened the gateway for tokenizing assets, they could also remove complexities involved with collateralization between traditional lenders and borrowers. Through Defi lending, people can lend their savings or assets directly to others. NFTs as collateral could facilitate borrowing without disclosures of private information, all the while extending collateral-suitable assets to include music, game items and other collectibles in the digital space. This offers huge promise for those without access to a bank or credit.

Fractional ownership of NFTs and other illiquid assets could further unlock the values of assets that were previously difficult to mobilize and divide, bringing liquidity to the marketplace and making NFTs a favorable option for flexible transfers and verified representation of ownership through a decentralized network. Likewise, NFTs could offer a variant by enabling royalty sharing, licensing and ownership sharing to address limitations with the traditional lending system.

The evolution of NFTs as an instrumental tool in decentralized finance, especially as collateral in DeFi lending, comes as no surprise considering how physical assets have been commonly used as collateral in the real world, but imagine if our social presence on social network sites like Instagram and Twitter accounts could be tokenized as an NFT and be assigned a specific value beyond what could be captured as advertising revenue per number of followers. After all, the allure of NFTs lies in the way they take power away from the middlemen and empower those who create and own them, drawing the NFT owner to the center of the next socioeconomic system. Using a social media account as an NFT collateral would be a perfect example of users gaining complete control of their identity and privacy in a decentralized way.

The Risks and Concerns

Everything in life is a trade-off, however, and DeFi has its risks. Sure, DeFi provides a convenient infrastructure for financial transactions using blockchain technology, but engaging in any financial transaction without the middleman as a reliable overseer can be a double-edged sword. There have been many cyber-attacks on DeFi exchanges, as well as general fraud attempts aimed at decentralized blockchain networks, not to mention issues that could arise from flash loans without collateral, high leverage, liquidity mismatches, and rug pulls from evil minds. Also, like all other financial instruments in the world, non-fungible tokens are volatile assets. There’s a chance that those assets could surge in value, but there’s also the chance that they could depreciate beyond the point of no return. Do the benefits outweigh the risks of having no regulatory authorities and therefore no regulation at the moment? How much would you be willing to trade off security for privacy?

Decentralized finance using cryptocurrencies and NFTs is still an extremely nascent infrastructure - so nascent that the existing regulatory and legal environment does not accommodate digital assets. While the question remains if authorities can or should enforce regulations on a decentralized system at all, governments and regulators are paying very close attention to their impact. There are also concerns regarding whether cryptocurrencies and NFTs will be categorized as commodities, though most regulators and governments seem to be on the fence. While we at Shorooq are very optimistic about the future applications that NFTs bring to decentralized finance and the greater metaverse, we will be on the lookout for any regulatory certainty that is thrown our way.

There is perhaps an appropriate level of regulation to make DeFi a safer, fraud-resistant platform enabling credit to everyone while addressing cybersecurity concerns. Without regulation, are decentralized autonomous organizations (DAOs), governed not by a single authority but by members with voting rights (i.e. members with tokens), enough to guide us into the next phase of web evolution for the benefit of everyone?

Can DeFi maintain its position as a fair, transparent market that is equally accessible to all 8 billion people in the world?

We hope so.

Will DeFi eventually be a centralized entity with a different label?

We hope not.

Will NFTs enjoy the current freedom of mobility across dozens of different marketplace platforms?

We hope so, but would love to see some consolidation in the marketplace.

While this writing does not intend to serve as a comprehensive overview on NFTs and their applications, we feel DeFi deserves some attention as it can potentially redefine financial solutions and processes for every business regardless of industry. We would love to hear your opinions and insights - Amid all the buzz and hype, are you excited about the latest crypto technology or concerned about challenges and implications of disruptive innovation?