How to leverage NFTs in DeFi Protocols?

NFTs and DeFi are hot topics in the crypto world these days. As carriers of equities, NFTs are used to represent ownership of unique assets such as artworks, collectibles, and in-game items, etc., with the powerful ability to describe the rich information of these assets. The circulation of NFTs is not possible without the financial services of DeFi, such as trading, lending, splitting, and ETFs, etc. With its powerful descriptive nature, NFTs could also express complex contractual relationships in finance as financial vouchers, representing the user’s right to withdraw funds from the DeFi platform.

As a practitioner in DeFi, I’m very excited about the prospect of NFTs being used as financial vouchers. In fact, I’m a firm believer that the volume of assets represented by such NFT vouchers will soon surpass that of all DeFi ERC-20 tokens on Coingecko as well as the total value of NFT art and collectibles there are.

I am deeply convinced that future DeFi products will embrace NFTs, rather than generic ERC-20 tokens, for their asset certificates.

But why NFTs? This is usually the first question investors ask me. Why bother using NFTs (specifically, ones that use ERC-721 and ERC-1155 standards) to build DeFi protocols, when ERC-20 tokens are better in terms of fungibility and liquidity? To answer this important question, we need to back up a little and talk about a decentralized protocol by the name of Uniswap.

Uniswap’s non-fungible liquidity pool is an innovation by leaps and bounds

Uniswap V3 is innovative in many respects, but one innovation that has always stuck with me is the upgrade from a Fungible Liquidity Pool to a Non-fungible Liquidity Pool. This fundamental change has significantly improved the utilization rate of funds, by allowing for a customizable fund allocation. I believe that eventually, this will be the case for all products that have liquidity pools, because the demand for sophistication and maneuverability around risk and position management of users’ funds growing stronger, as, in the long run, more institutional users and professionals will gradually join in. As a result, future DeFi protocols will be hugely incentivized to follow Uniswap V3’s pattern and committed to empowering users with the ability to customize their fund allocations[1].

Let’s take a closer look.

As the figure below shows, Uniswap V2’s liquidity pools are, typically, fungible. Here, the liquidity is distributed evenly along an x*y=k price curve, with assets being reserved for prices between zero and infinity. When Uniswap adopts NFTs to implement more flexible, concentrated positions with custom price ranges, non-fungible liquidity[2] pools are created. And the result? Significantly improved fund utilization rate.

The key difference between V2 and V3 is clear. V3 improved the compatibility of the liquidy pools and made funds more “customizable,” whereas V2’s liquidity pool funds are still fungible like ERC-20 tokens. When they are deposited into V2’s liquidity pools, they are indiscriminately used (or, in some cases, managed). But when kept in V3’s liquidity pools, those assets would be handled in a highly customizable manner to each user’s needs. The assets in V3 are not only distinguishable by amount, but also by the specified original ownership as well as cumulative transaction fees that correspond to the market-maker price ranges.

Thanks to these “quirks,” Uniswap V3 users now have more comprehensive control over their assets. Currently, the V3 users as market-makers are inclined to maximize profit by compressing their funds. Take ETH/USDC pool (as of July 15th, 2021. See liquidity distribution in the figure below) as an example. Most of the LPs are concentrating their funds at the price of “1 ETH = 2,104.8933 USDC,” while the liquidity distribution in Uniswap V2 shows an even distribution.

A liquidity pool is said to be “fungible” when its portfolio is operated under a unity of rules set forth by the DeFi protocol. We call such a liquidity pool a “fungible liquidity pool.” That means that funds managed in such a pool are meaningful by virtue of their quantity. This is similar to the concept of fungibility of bitcoins (“fungible” because they interchangeable): the only meaningful difference between your bitcoins and mine is quantity — no more, no less.

In contrast, a liquidity pool is said to be “non-fungible” when there are more definitive characteristics to the assets in the pool than mere quantity. We call it a “non-fungible liquidity pool.” Therefore, V3 featuring non-fungible liquidity pools has a clear edge over V2 with fungible liquidity pools[3]. This is the case due, again, to the non-fungible liquidity pool’s unique capability to allow users to preserve distinctive characteristics of funds when these funds enter the liquidity pool.

Non-fungible Liquidity Pools are the only path for DeFi products

Here are some existing products with non-fungible liquidity pools.

Armor — A decentralized brokerage for cover underwritten by Nexus Mutual. As a broker, Armor’s main task is dealing with orders from their applicants and provide them with corresponding insurance products. Armor also has built a smart contract for its asset pool to manage all insurance applications. The uniqueness is its various projects for different applicants and the corresponding period (any time from 30 to 365 days) of each insurance. The personalized demands of insurance funds make the asset pool non-fungible.

88mph — A fixed interest rate lending protocol. Like Armor, 88mph focuses on lending scenarios with non-fungible liquidity pools, which helps users obtain a fixed deposit rate through tranches. 88mph has built various pools for different projects to provide users with various options on deposit terms, and that results in non-fungible liquidity pools to represent complicated ownerships of users’ funds.

In the endgames of DeFi, organizations with financial needs must be serviced with liquidity pools that allow these organizations to customize fund allocation. This necessity rings true for all financial tracks including trading, lending, insurance, futures, and options: In trading, the fund utilization can be improved by there being more choices for asset allocation needs (as was done in Uniswap); in lending, as more low-liquidity collaterals get involved and the need for more flexible maturity dates grows, fixed-term lending will prevail; and for insurance providers, the void remains to be filled for their need to modify contract terms for the sake of risk management. The list goes on and on.

NFT as the only path for equity vouchers in non-fungible liquidity pools

Every DeFi product featuring non-fungible liquidity pools, including Uniswap, Armor, and 88mph, adopts NFTs as certificates for equities. As such, providers of these liquidity pools will receive an NFT that represents their rights to withdraw funds from the pool. The handling of higher dimension variables beyond quantity into things like maturity, rates, etc., could only be made possible by virtue of the descriptive ability of NFTs. This is why Uniswap V3’s NFTs easily outplay ERC-20 tokens.

Now, back to our original question. In building DeFi protocols, why bother using NFTs when ERC-20 tokens are superior in terms of fungibility and liquidity? True, fungible tokens have a predominant presence in the existing scenarios of liquidity pools. ERC-20 fungible tokens may also be good for building non-fungible liquidity pools — by a slightly awkward process of separating and making funds from a non-fungible liquidity pool into a bunch of fractional fungible liquidity pools, and then creating a multitude of ERC-20 contracts accomodating each of these pools.

There are just two small problems with this.

First, the cost of product development is simply too high. Similar to Uniswap V3’s concentrated-liquidity scenario, once the users are permitted to choose market-maker price ranges, there will be hundreds of thousands of market-maker price ranges. It is both unrealistic and impractical to mint a multitude of ERC20 tokens with varying ranges.

The second issue is the cognitive barrier. (Okay, I admit that sounds a little pretentious!) What I’m talking about here is that when DeFi products mark — and they do — their ERC-20 tokens with ambiguous labels such as “2020–10–31-Borrow-5%,” it leaves too much room for misinterpreting, and for this reason, it’s fundamentally counterproductive.

So, as a compromise, some products simply opt to limit users’ choices. That includes offering fewer loan choices (e.g. Ruler, Yield) or insurance periods (e.g. Cover). Although this approach does have some advantages (a subject worthy of a separate blog post), it deprives users of their freedom to choose, which is often too expensive a cost.

Ergo, NFTs are the only sensible path for the implementation of fund ownerships in the context of non-fungible liquidity pools. And this is true even factoring in a few advantages fungible tokens have.

Solv Protocol

Right now, the DeFi world is undergoing a massive NFTization campaign, and the motivation is simple: More flexibility in fund allocation leads to allocations for funds with more unique demands. These funds in turn lead to a demand for non-fungible liquidity pools. And more demand for non-fungible liquidity pools will finally incentivize projects to adopt NFTs to certify fund ownerships in a more sophisticated way.

As NFTs become predominant in DeFi, products that feature non-fungible liquidity pools will allow asset holders to have more freedom and choices with their asset allocation and risk management. With DeFi’s decentralizing nature having effectively eliminated barriers to entry, the next mission for DeFi projects is to excel at meeting liquidity providers’ needs and to enrich users’ choices for keeping risks and profits in balance.

Compared with NFTs associated with digital art or collectibles, we define “financial NFTs” as non-fungible tokens representing and certifying any type of financial equity. To achieve that, enter Solv Protocol — a DeFi project dedicated to bringing financial NFTs into the DeFi world. With the financial NFTs and the token standard Solv created in-house, challenging issues (including split and merge) may be tackled at last.

More on the infrastructures and standards of financial NFTs will be discussed in our next blog post.

We thank Mike, Jason, James whose comments and suggestions helped improve and clarify this article.

Reference:

[1] Introducing Uniswap V3, https://uniswap.org/blog/uniswap-v3/

[2] How Does Visor Integrate With Uniswap V3? https://medium.com/visorfinance/how-does-visor-integrate-with-uniswap-v3-f8a648d343ad

[3] Some people pointed out that V3’s market-making mechanism poses a challenge to retail liquidity providers (LPs) on account of higher expensive gas fees induced by price range adjustment, and a higher risk. I believe this mechanism will equip DeFi’s future with specialized asset management. As more institutional users join in to grab a share of the growing volume, retail LPs will use specialized intermediaries to implement their market-making.