Bored Ape Yacht Club: not boring

A lot has been happening in the cryptoasset space recently, but for present purposes we focus on the non-fungible tokens (“NFT”) market and specifically the Bored Ape Yacht Club (“BAYC”) NFTs. As you may be aware, BAYC NFTs proved extremely popular and valuable for a period. Bend DAO is a 'decentralised peer-to-pool NFT liquidity protocol'. In other words, it lends cryptocurrency to holders of NFTs who deposit their NFTs as collateral. This has been very popular with 'members' of the BAYC.

Bend DAO’s FAQs and Terms of Service helpfully are in Chinese, although as one can see from the update in the link, there is a liquidity crunch at Bend DAO.

What this means is that:

• the NFTs deposited as collateral for loans have fallen in value;
• the loan to value ratio set by the protocol has been breached (or is likely to be breached);
• the loan defaults and the protocol 'seizes' (and presumably then tries to sell the NFT to recoup some/all of the defaulted loan);
• the prices of the NFTs are too low to recoup the loss meaning:
  • Bend DAO suffers a loss (although it will own NFTs which might, perhaps, maybe one day be more valuable;
  • the protocol loses liquidity; and
  • those individuals who deposited cash in the protocol lose their money.

It is the last point which is important here: the protocol cannot lend money against collateral without someone having deposited it. The deposit would have been made in the hope of a certain return – certain because 'line goes up' – and if depositors get wary about the likelihood of mass default on loans and a liquidity crunch, then depositors will seek to withdraw their deposits.

Let us be clear, there is nothing whatsoever new here: TradFi fund managers having been dealing with redemption runs and illiquid pools of assets for years and standard fund documentation (commonly) deals with these circumstances; and in DeFi, we do not need to mention names as those names are (and will remain) in the news headlines. Would a depositor be happy to receive a return of deposit in specie (i.e. to receive a NFT instead of cash)? TradFi managers reserve this right in many cases.

What is new and of note is the myriad new ways in which retail (and mostly it is retail) can lose their money. Just a few years ago, who would have thought that an individual, in the hunt for better-than-base rate returns on an investment, would lose money by lending their money in return for a link to an internet address at which a cryptographic asset is stored?

In the author's humble opinion, the current proposal by Bend DAO (to change the loan to value ratio so that the NFT can become significantly less valuable before a default is triggered) stores up future problems. If (when) the loan to value ratios become worse than they are currently, the chances of recouping meaningful value in the collateral are even lower and depositors' risks even higher.

More importantly, who knows who is a depositor and a borrower and how far into which markets will go a liquidity crunch at a NFT lender. Will there be a point at which any regulator or government treats this industry in the same way as it does 'shadow banking'? That is very likely to be the case.

Rather than leave this post on a low, let's point out a silver lining: as the global economy stumbles, base rates will go up, which may mean that those with spare cash can find tradfi investment returns sufficiently high to take advantage of them and not seek out risky and opaque investments.