Let’s face it: NFT interest and trading volumes have declined significantly in 2023. However, lending against NFTs remains an important option for investors seeking liquidity.

To make the most out of the opportunities available to us in a bear market, it’s important to determine appropriate lending terms. This requires carefully calculating recovery rates–i.e., the percentage of collateral value recovered in default. This is essential for assessing your risks, even if fewer deals are being written.

In this blog post, we’ll dive into the calculation, usage, and adjustment of recovery rates for NFT lending.

Understanding this process provides key insights, regardless of market conditions.

## The Complex Calculations Behind NFT Recovery Rates

Determining appropriate NFT lending terms requires estimating recovery rates. But how exactly are these rates calculated for different NFT collections?

We use some robust calculations. To start:

![recovery rate formula](//images.ctfassets.net/lhkcghnr8ql4/6QgOJuwa1bveSxX05fbhhT/8a1981885ff88c14aa7b91f3da98a94e/recovery_rate_formula.png)

In this calculation, recovery rate R serves as a forecast of the change in an NFT's appraised value over a fixed time horizon. This rate is expressed as a relative change, where R < 1 signifies a decline in asset value, while R > 1 indicates an increase.

Recovery rates are inherently uncertain, and 
therefore, we treat R as a random variable following a skew-normal distribution.

To estimate the parameters of this distribution, we utilize the daily relative changes in floor prices based on Upshot appraisals, considering them as realizations of R.

It's important to note that when using floor prices, the resulting distribution applies to an entire collection, assuming that recovery rates remain consistent across assets within the same collection.

For point forecasting purposes, the mean of each skew-normal distribution serves as an estimate of the expected recovery rate for a given collection and time horizon.

Additionally, the default probability of a loan for a specific time horizon is determined by the probability that an asset's value depreciates below its appraised value at the loan's inception.

This probability can be derived from the cumulative distribution function (CDF) of R, specifically:

![recovery rate formula 2](//images.ctfassets.net/lhkcghnr8ql4/3I5eRhdRUz3u4W2q6sA6qD/fbe7a62a783cf32bed27601120346fda/recovery_rate_formula_2.png)

While these calculations provide valuable insights, it's crucial to acknowledge that they assume rational investor behavior.

It can be challenging to model and account for irrational behavioral patterns, which may impact the accuracy of these estimates.

To address this uncertainty, lenders must validate and adjust recovery rate forecasts to account for real-world irrationalities.

One approach is to compare projected returns to actual market performance over time. The gaps between projections and reality can then be used to refine your recovery rate estimates.

## Adjusting Recovery Rates for Forecasting Uncertainty

To assess forecast performance, we compare forward-looking returns based on floor prices with the forecast distribution means over rolling windows of 60 days. By calculating the mean absolute percentage error for each time horizon, we can adjust the recovery rate downward to account for forecasting uncertainty.

This adjustment, known as the "uncertainty margin," is calculated as the uncertainty-adjusted recovery rate equals the recovery rate multiplied by (1 - uncertainty margin) for each collection and time horizon.

With rigorously validated recovery rate estimates, lenders can incorporate these projections into competitive lending terms.

## Utilizing Recovery Rates in the Lending Process

The recovery rate model's output serves as a critical component in determining two key aspects of the lending terms: the loan amount and the interest rate.

### Loan Amount Determination

The uncertainty-adjusted recovery rate plays a pivotal role in determining the loan amount. For each collection, the loan amount is calculated as the maximum of the uncertainty-adjusted recovery rate multiplied by the appraised value of the asset.

The maximum uncertainty-adjusted recovery rate corresponds to the time horizon selected as the loan duration.

However, to prevent concentration risk and ensure a diversified lending strategy, the loan amount is capped at twice the collection-level loan median.

### Interest Rate Calculation

The interest rate for each asset is calculated at the collection level using the formula:

![Interest rate formula](//images.ctfassets.net/lhkcghnr8ql4/5txevxMsgxShLHHhNbNBUl/2963beaaf68539c981312403bb135ecc/Interest_rate_formula.png)

The risk-free rate is set at 4.3%, reflecting the long-term average of the 10-year US Government bond.

The premium, set at 0%, 2.5% and 5% depending on each NFT’s value bucket, is added to compensate for the additional risk associated with NFT lending.

The default probability utilized in this calculation corresponds to the default probability associated with the best recovery rate. The term (1 - default probability) increases the overall interest rate as the default probability rises, effectively compensating for default risk in the loan portfolio.

Our methodology offers various levers that can be adjusted to tailor the lending terms and enhance competitiveness.

### Interest Rates

The premium contributes to the interest rate formula and can be adjusted to make the rates offered more competitive.

### Loan Duration

Currently, loan durations range from 14 to 30 days. Depending on demand and risk considerations, this range can be extended to accommodate different lending preferences.

### Loan Amount

The loan amount is based on the adjusted recovery rate at a specific time horizon. The adjustment is determined using the mean absolute percentage error. The adjustment can be increased or decreased to align with market conditions, allowing for flexibility in loan amounts.

### Range of Collections

Currently, we generate lending terms for a range of liquid blue chip NFT collections. This selection of collections provides a competitive advantage as many other NFT lenders cover a smaller number of projects.

To further enhance our offerings, we have the option to selectively add more collections to the terms provided, catering to a wider range of investor preferences.

## Building Sustainable NFT Lending with Recovery Rates

Recovery rates are indispensable for structuring competitive, risk-aware NFT lending. Thoroughly understanding rate calculations lets lenders estimate collateral value retention across time horizons. Validating projections and adjusting for uncertainty creates actionable forecasts to inform loan terms.

Ultimately, recovery rates provide the foundation for sustainable NFT lending. Rather than reacting irrationally, lenders can rely on data-driven forecasts to confidently support investors long-term.

Careful rate analysis transforms lending from speculation to discipline. As NFT markets progress, recovery-focused strategies separate resilient programs from short-lived trends.


Learn how carefully calculating, validating, and incorporating NFT recovery rates into lending terms enables sustainable programs that withstand bear markets.

How to Calculate Recovery Rates for NFT Lending (Even in a Bear Market)

Sotheby’s Auction House recently hosted an [auction](https://www.sothebys.com/en/buy/auction/2021/ape-in/101-bored-ape-yacht-club) of 101 Bored Ape Yacht Club NFTs in another milestone for crypto collectibles. Prior to the auction, Sotheby’s estimated the value of the collection at \$12–18m. We ran our machine learning models to value the Bored Apes on offer and stored the [estimate on the blockchain](https://polygonscan.com/tx/0xee199bdb3686d9972632ec4eaa71aec87c4cd8ace8462021046e2eeba1e52b26) before the auction ended. We arrived at a valuation of \$25.3m for the bundle. The winning bid? \$24.4m.

![sothebys ape auction](//images.ctfassets.net/lhkcghnr8ql4/2kXFD5cyHzubhr5cauMOr9/c9ef4033792c577a7293407e6d82f0a1/sothebys_ape_auction.webp)

At Upshot, part of what we do is leverage machine learning models, which are trained on market data, appraisals, and other relevant information, to generate valuations for NFTs. We’ve found that a machine learning approach can be used at scale to generate accurate valuations for large-sets of NFTs, taking into account the unique attributes of different NFTs and the time dynamics of the market.

For the Sotheby’s ape auction, our model did not use any data from the bids in the auction itself, but rather data from on-chain sales of the BAYC collection. Interestingly, 99% of the apes in the auction had no sales history whatsoever. Nevertheless, the model was able to predict that the winning bid would far exceed Sotheby’s own $18m maximum value and reach an estimate that was very close to the ending price of the auction.

How was our model able to get so close? Our model was able to infer valuations for these apes based on the sales of apes with similar attributes, taking into account the rapidly increasing price trend in the market over the past few weeks. The graph below shows our model’s ability to track actual sale prices over time and pick up the increasing valuations using only historical data.

![model response to variance](//images.ctfassets.net/lhkcghnr8ql4/5VfZ9sExvdlXKZ79ylqBqa/1f0d9ad68dcc7df922c6e3d5e5f176ad/model_response_to_variance.webp)

How did we arrive at our final estimate? We trained our machine learning models to predict transaction prices based on variables constructed from Bored Apes metadata and proxies for the state of the market at different levels of granularity. We then validated the predictions by examining their accuracy on data not used in the training process, while preserving the time-ordering of the data. In the case of Bored Apes, we applied a machine learning model with limited “memory” of the past to account for how quickly valuations can change over time.

Which features of the Bored Apes ended up being the most relevant? Fur type and hats. Buyers are willing to pay far more for apes with rare attributes along these dimensions. However, time dynamics were by far the most important feature in this context given the dynamism of NFT markets over the past few weeks.

![two apes](//images.ctfassets.net/lhkcghnr8ql4/2JpkZtsMwegIKT8tHqoMI0/2db59d1be85623989445e5d90122f1c5/two_apes.webp)

To conclude, we found that our machine learning approach is able to generate reasonably accurate valuations for portfolios of NFTs in a volatile market, taking into account the attributes of different assets and the time dynamics of the market. These types of approaches can help establish accurate valuations for future high-profile events, such as Sotheby’s and Christie’s auctions. They can also be used at scale to generate near real-time valuations for large sets of NFTs — increasing transparency in NFT markets and making it easier to utilize NFTs in the DeFi space.

__Stay in the loop!__

Join us on [Discord](https://discord.gg/xNeh7vzXTQ)

Follow us on [Twitter](https://twitter.com/UpshotHQ)

Sotheby’s Auction House recently hosted an auction of 101 Bored Ape Yacht Club NFTs in another milestone for crypto collectibles. Prior to the auction, Sotheby’s estimated the value of the collection at $12–18m. We ran our machine learning models to value the Bored Apes on offer and stored the estimate on the blockchain before the auction ended. We arrived at a valuation of $25.3m for the bundle. The winning bid? $24.4m.

The Sotheby’s Ape Auction: How Upshot’s Appraisal Performed

Decentralized finance (DeFi) is a rapidly growing financial model that enables cryptocurrency holders to buy and sell assets without the need for an intermediary or financial middleman.

The fundamental tenet of any DeFi system is that no centralized authority can govern, impose rules on, or regulate any financial transaction–unlike in traditional centralized systems. Using this approach, DeFi models create a secure yet permissionless, trustless ecosystem for digital asset users to execute peer-to-peer transactions.

DeFi technology is transforming the blockchain system, changing how people borrow, invest, and [lend digital assets such as NFTs](https://upshot.xyz/post/nft-lending-101). This article will provide an introduction to decentralized finance, review how DeFi systems work, and why they are becoming a preferred alternative to [centralized finance systems](https://www.analyticssteps.com/blogs/introduction-centralized-finance-cefi).

## What is Decentralized Finance?

Decentralized Finance refers to a financial system that operates on blockchain technology and smart contracts: computer programs that automatically execute the rules of a contract when specific conditions are met. A DeFi system allows individuals to access financial services through a decentralized network instead of relying on centralized intermediaries such as banks and financial institutions.

The main goal of DeFi is to provide a transparent and open financial system accessible to everyone, regardless of their location or social status. DeFi applications, which are built on top of decentralized networks such as Ethereum, allow users to lend, borrow, trade, and invest in a variety of financial instruments, including cryptocurrencies, stablecoins, and derivatives, in a trustless and permissionless environment.

Some of the popular DeFi applications include decentralized exchanges (DEXs) such as Uniswap and Sushiswap, [lending platforms](https://upshot.xyz/post/nft-lending-platforms) such as [Upshot](https://upshot.xyz/) and Aave, and yield farming protocols such as Yearn Finance and Curve Finance. These applications have gained significant traction in recent years due to their ability to offer high returns on investments (yield farming), low transaction fees, and fast settlement times.

### Centralized Finance vs. Decentralized Finance

Centralized Finance (CeFi) and Decentralized Finance are two contrasting models that define how financial systems operate.

CeFi is the traditional model of finance where financial transactions occur on a centralized platform, controlled and regulated by a single authority like a government, a bank, or a financial institution. CeFi relies on intermediaries, such as banks or brokers, to manage transactions, hold assets, and execute trades. 

DeFi is an emerging model that operates without intermediaries, using a decentralized platform like the blockchain. DeFi protocols are built with smart contracts that function as self-executing business rules on the blockchain. The key concept of DeFi is to automate financial transactions and eliminate intermediaries, reducing transaction costs and increasing access to financial services. DeFi is designed to provide faster and more transparent financial systems since it is auditable on the blockchain.

Therefore, the primary difference between CeFi and DeFi is the degree of centralization that exists. CeFi is centralized, controlled, and managed by a centralized authority with different levels of regulation. DeFi is decentralized and managed and governed by a network of participants that work together to create a self-sustaining financial system.

Since launching on the [Ethereum Blockchain in 2015](https://decrypt.co/resources/a-brief-history-of-defi-learn?amp=1), DeFi has transformed the financial system and created an easy way to harness digital finances. Soon, DeFi will be integrated with other financial solutions to create a fully efficient and secure financial platform founded on blockchain protocols 

### Defi vs. Crypto vs. NFTs

DeFi, crypto, and NFTs are distinct concepts in blockchain ecosystems. Although they all exist in the blockchain ecosystem and function together in many use cases, they have and serve different purposes.

[Cryptocurrency](https://www.forbes.com/advisor/investing/cryptocurrency/what-is-cryptocurrency/), or crypto for short, refers to any digital currency that operates independently of a bank. They refer to any digital currency and use cryptography to secure transactions. Popular virtual currencies or assets like Bitcoin, Ethereum, and Tether are all examples of cryptocurrencies, as they are designed to be secure, anonymous, and verified through cryptography.

DeFi, conversely, does not represent any virtual asset but a system on the large expanse of the blockchain’s ecosystem. It represents or refers to a digital financial application (or dApp) built on the blockchain to eliminate the need for third-party to verify or approve transactions involving cryptocurrencies and other types of digital assets. DeFi applications enable the execution of financial activities such as buying, selling, and lending on the blockchain. Without them, cryptocurrencies would be useless.

NFTs or Non-fungible Tokens also exist on blockchain networks. However, they represent digital assets that convey ownership of distinctive goods like digital artwork, music, or other collectibles.

Like cryptocurrencies, NFTs exist on the blockchain, function using smart contracts, and are executed in financial activities using DeFi systems. However, unlike cryptocurrencies, NFTs are unique and not interchangeable. 

Overall, while there are distinct similarities between DeFi systems, cryptocurrencies, and NFTs (such as being functional within the blockchain ecosystem), they all represent different use cases in the digital ecosystem. 

### Benefits of DeFi

DeFi provides many useful use cases, many of which are inaccessible to traditional [fiat-based](https://corporatefinanceinstitute.com/resources/economics/fiat-money-currency/) financial systems. With the ability of asset-holders to execute a transaction without having to ask permission from a third party, users can unlock a world of benefits beyond what they can within the constraints and limitations of centralized finance. Some benefits of DeFi  systems include the following:

### Worldwide Access

One major benefit of DeFi systems is that they are permissionless, thereby creating opportunities for anyone with internet access to gain access to and use the services offered on DeFi apps. DeFi systems promote financial inclusion by enabling people to gain access to financial services regardless of their geographical location or socio-economic status.

This is essential because traditional financial services are typically limited to those who have access to physical banks, credit cards, or debit cards. However, DeFi systems are not restricted by any of these factors and make financial services available to anyone with a working internet connection. 

### Fast & Flexible

The use of blockchain technology enables DeFi to process transactions without the need for intermediaries like banks, which can slow the process. DeFi transactions can be completed within seconds or minutes from almost anywhere in the world. 

Additionally, DeFi is incredibly flexible. With traditional finance, there are strict rules and regulations that you need to follow to access specific services. This can be limiting, especially for those who don't meet the strict requirements.

Alternatively, has no minimum deposit requirements, and you don't even need to provide your name or personal information to access DeFi services. This makes DeFi incredibly accessible and flexible for those who may not have been able to access traditional financial services in the past.

### Pseudonymous

DeFi systems are considered pseudonymous since users don’t need to provide their names or other personal identification to execute financial services. Although transactions are recorded on a public blockchain ledger, the users' identities are not disclosed. Transactions may be publicly recorded but users can be assured their identities are not being revealed.

### Financial Autonomy

DeFi systems offer users full control over their own digital financial assets and investments without the need for intermediaries such as banks or other financial institutions. Users can retain custody of their assets using non-custodial crypto wallets while also lending, buying, and purchasing digital assets without having to rely on a third party’s approval. 

### Composability

Composability refers to the ability to interrelate with other components in the blockchain ecosystem. [Composability in DeFi](https://medium.com/coinmonks/the-true-power-of-defi-composability-14fe8355e0d0) is the ability of decentralized apps and other protocols to interact with each other in a permissionless and non-centralized manner.  DeFi apps and other protocols can leverage each other’s codes and utility in tandem, thereby continuously creating a more beneficial outcome of improved financial solutions.

By being able to integrate with other financial protocols on the blockchain seamlessly, DeFi systems can facilitate the creation of complex financial instruments and services that were previously unattainable with traditional financial systems. 

### Transparency

DeFi systems are built on public blockchains, offering full transparency for all transactions on that blockchain. Every transaction executed by DeFi systems on the blockchain is broadcast and made public, making it easier for other users to track and audit them. Centralized finance organizations rarely offer this feature in their protocols.

## DeFi Limitations

DeFi systems are undoubtedly revolutionizing the digital finance sector. However, they also come with limitations that challenge their potential.

### Higher Complexity

DeFi systems are built on the blockchain network, a protocol that is not fully user-intuitive and can be difficult to understand. This can make it difficult for individuals not particularly tech-savvy to navigate DeFi apps and utilize DeFi services. 

Couple this with the fact that DeFi technology and the blockchain are continuously evolving and adding new features to the ecosystem, and it’s easy to see how the complexity of DeFi systems can be a user limitation. 

### Potential Volatility

The cryptocurrency market is notorious for its volatility which can increase the fragility of the DeFi market. Price fluctuations can lead to a bumpy financial market, and DeFi users may risk losing assets when this happens.

### Scam & Fraud Risks 

Although DeFi technology runs on immutable public blockchains that cannot be altered, they are not immune to malicious intent. DeFi systems can be prone to online hacks that may lead to the loss of funds or assets and data breaches. According to a report, [over $10 billion was lost to DeFi scams in 2021 alone.](https://www.cnbc.com/2021/11/19/over-10-billion-lost-to-defi-scams-and-thefts-in-2021.html) 

### Scalability 

The current DeFi structure has limited scalability due to its reliance on expensive computation power. As the market grows, DeFi systems may struggle with a high volume of transactions and the inability to keep up with transaction-processing demands without performance degradation. 

However, Ethereum is working on building out [ETH 2.0](https://www.forbes.com/advisor/investing/cryptocurrency/what-is-ethereum-2-merge/) to help improve the throughput of DeFi networks on the blockchain and reduce the scalability limitations. 

#### Regulatory Uncertainty

Although the lack of a governing regulatory authority is what makes DeFi a unique financial solution, it can also make it vulnerable. DeFi systems are established and operated in unregulated environments, making them a breeding ground for illegal activities. 

Without a financial authority that imposes regulatory requirements, there is an uncontrolled risk of financial crimes such as money laundering and terrorist financing.

## DeFi Projects & Protocols

Although this list is nowhere near exhaustive, here are some of the most popular ways DeFi technology is used on the blockchain.

### DAOs & Governance

A [Decentralized Autonomous Organization](https://cointelegraph.com/learn/what-is-a-dao#:~:text=The%20decentralized%20finance%20(DeFi)%20space,have%20never%20met%20each%20other.) or DAO is an organization with no central authority that runs fully on the blockchain. The organization does not have any leading authority; instead, it’s guided by the rules encoded into the organization’s smart contract. 

DAOs are trustless systems created as a decision-making framework to enable members to reach decisions concerning projects relating to that specific DAO. Because there is no hierarchical power within these organizations, members must reach decisions unanimously by casting votes. To do this, they employ the use of governance tokens.

Governance tokens are designed to give holders the right to vote on and shape the future of a protocol. These tokens have value and can be traded on decentralized exchange platforms, but their values are usually determined by the success of the project or protocol they are tied to.

The efficiency of DeFi operations is largely dependent on DAO governance concepts. DAOs manage DeFi apps by using governance to reach decisions and govern the Defi app’s development and operation. When a DeFi protocol is built on a DAO, DAO members can use governance tokens to propose and implement changes to the protocol.

Together, DAO, DeFi, and governance create a financial model that empowers token holders, reduces reliance on centralized authorities, and democratizes traditional finance.

### DeFi Analytics

[Analytics](https://upshot.xyz/post/best-nft-analytics-tools) refers to the process of identifying, analyzing, and sharing significant trends in data from DeFi protocols. It also refers to the process of applying these patterns for making more effective decisions on DeFi platforms. 

DeFi analytics are tools that pool information from DeFi blockchains to provide insight into what transactions occur on those platforms, making it easier for traders to make informed trading decisions.

### Lending & Borrowing

Lending and borrowing digital assets is one of the solutions DeFi platforms offer today. These solutions are similar to lending in centralized financial systems–but without a centralized authority or third party approving the process. On decentralized applications (dApps), users can utilize P2P lending solutions to secure loans while using digital assets as collateral quickly. 

Certain dApps also enable traders to rent NFTs temporarily while the borrowers earn interest on their holdings. [NFT lending](https://upshot.xyz/post/nft-lending-101) and borrowing on DeFi platforms has become popularized over the years and will undoubtedly become a staple financial option on all dApps in the nearest future.

### Payments

DeFi offers innovative solutions for settling payments of the blockchain network. dApps leverage blockchain technology and smart contracts to facilitate fast, secure, low-cost payment transactions without intermediaries. They offer better financial inclusion and payment accessibility while challenging centralized payment processes.

### Marketplaces

DeFi platforms are the basis of digital marketplaces as they improve the efficiency and transparency of transactions in the marketplace. Defi marketplaces leverage blockchain technology to enable peer-to-peer trading, which eliminates intermediaries, reduces trading time, and cuts trading costs.

### Stablecoin 

Stablecoins are fundamental building blocks of DeFi ecosystems. These coins are designed to maintain a stable value and are usually pegged to fiat currencies such as US dollars.

Stablecoins give DeFi platforms stability and alleviate the dangers of market volatility while also helping investors generate profit on their crypto assets. 

Examples of stablecoins include: 
- Tether (USDT)
- USD Coin (USDC)
- Binance USD (BUSD)

### Decentralized Exchanges

[Decentralized Exchanges](https://chain.link/education-hub/what-is-decentralized-exchange-dex) are a major component of DeFi platforms. They are blockchain-based exchanges that let users trade digital sets directly without centralized intermediary intervention. 

DeFi platforms depend on DEXs to enable P2P trading of cryptocurrencies, stablecoins, and NFTs. DEXs also serve as liquidity sources for DeFi platforms by letting traders swap tokens and earn rewards by providing liquidity in liquidity pools. These pools will be used as fund reserves to generate loans for traders looking to borrow or rent on DeFi exchanges.

## The Future of Decentralized Finance

DeFi technology opens a new world of limitless opportunities that are otherwise absent in the myopic and limited operations of centralized financial organizations. The future of decentralized finance is incredibly exciting, and Upshot offers a guide to helping you explore all the possibilities it offers.

Upshot is an industry-leading NFT appraisal and financial tool that provides deep insight into NFT markets. The collision of NFTs and DeFi means new opportunities for financial innovation–and billions of dollars of liquidity in this space. The Upshot API allows developers, collectors, and investors to take advantage of this new wave of DeFi possibilities. 

[Get started with Upshot.](https://upshot.xyz) 


Understand the decentralized finance model and why DeFi opportunities have become an increasingly attractive investment in the crypto and NFT economy. 

What is Decentralized Finance (DeFi)? How Does it Work?

It’s easy to get lost in the day-to-day fluctuations of a digital community’s:

- Social media engagement
- Website traffic
- And, in the case of NFT collections, floor prices

But as we always say: __floor price alone don’t tell the full story of a digital community’s value.__

Moreover, sometimes a dip in a key metric might look concerning on the surface, but may not actually signal impending doom like many assume.

To truly understand the health of a digital community, you must look beyond the standard metrics. In this post, we’ll break down how to do an in-depth community analysis—focusing on everything from network structure to engagement trends.

We’ll use a popular NFT collection ([Azuki](https://www.azuki.com/))  as a case study to showcase these techniques. But the insights apply to assessing any online community.

Analyzing how this community responded after the launch of a new collection uncovered some counterintuitive insights. Not least of which, their asset prices dropped but their community grew larger and stronger by many measures.

But we’re getting ahead of ourselves.

First, let's look at how to analyze a community's strength.

## Conducting Network Analysis
Most real world and digital communities can be thought of as networks: sets of people connected together.

Everything from social networks to metabolic networks fit this topology. Most networks have common properties. For example, they often follow a power law distribution, where a small number of nodes are highly connected hubs, but most nodes only have a few connections.

Analysis of network structure can reveal insights about the nature of the underlying community. For example, many networks follow a power law distribution, with a few highly connected hubs and most other nodes having just a few connections.

For NFT networks, this likely represents a few whale wallets transacting with many others, while most holders only interact with a small subgroup.

## Quantifying Subgroups Through Community Detection
One key technique used in network analysis is community detection. This involves identifying densely connected clusters of nodes, with sparser connections between clusters.

Intuitively, these clusters represent subgroups within the broader network - like friend groups within a social network. In an NFT collection, detected communities likely represent groups of closely linked collectors and holders.

The cohesion of communities can be quantified using modularity. Networks with high modularity have dense connections inside communities but sparse connections between them.

So when examining an NFT collection, detecting communities and calculating their modularity provides insights into the composition and connectivity of holder subgroups––going beyond just individual wallet links and floor price.

## Analyzing the Azuki NFT Network
To analyze the Azuki NFT community, and determine the strength of their network beyond the headlines and floor prices, we looked at transaction data over a 6 week period in mid-2023. The snapshots of the collection took place just before and after their Elementals mint on June 27th.

We extracted two key datasets:

1. __Ownership data__: how many Azuki NFTs each wallet held
2. __Transaction data__: a network showing Azuki sales and transfers between wallets

![azuki image](//images.ctfassets.net/lhkcghnr8ql4/HLjvxUMTU6zteB1M6qYtM/0b09f85247ce83e37eb1bf32dfebf536/azuki_image.jpeg)

# How Ownership Transformed
Now, many Azuki holders complained that they experienced technical issues with the mint. Some were unable to mint any NFTs from the new Elementals companion collection. Other holders complained that the art for the collection looked almost identical to the original collection. An egregious error for a hefty 2 ETH mint price.

These factors led to a massive drop in floor price, and many criticizing the project.
![azuki price chart](//images.ctfassets.net/lhkcghnr8ql4/1KyLtbeJJqACKyuQkFVysE/4d278678eb353d4d79e93640d3b9336c/azuki_price_chart.jpeg)
*Image courtesy of [@mrjasonchoi](https://twitter.com/mrjasonchoi) on X.com*

But network analysis shows us that floor price, headlines, and twitter sentiment don’t tell the whole story. 

The data we analyzed showed a steady increase in unique holders––i.e., more community members––from 3,381 in the weeks preceding the mint to 4,372 just a couple weeks after the mint.

We also saw the number of wallets making transactions surged after the Elementals release, from 1,006 to over 6,500 weekly.
![Azuki ownership analysis](//images.ctfassets.net/lhkcghnr8ql4/73qTy1J9g3dwaN8NDPcVU1/81cb712fd4160eda54e6ea5cfb99ffe0/Azuki_ownership_analysis.png)

Also, analyzing the top 100 Azuki holders showed around 60% remained consistent holders before and after the release. So, despite the headlines, the "whales" were mostly staying put.

![Azuki whale analysis](//images.ctfassets.net/lhkcghnr8ql4/3Cp1tNMdrqou4jVczVYuiY/d972fd46602fd63a96161317a084072e/Azuki_whale_analysis.png)

# Insights on Azuki’s Transaction Network
In addition to ownership data, we also looked at the network of Azuki transactions between wallets each week. Studying patterns in these transactions revealed insights about the community’s structure and engagement over time.

One metric we examined was __assortativity__: the extent to which similar wallets connect to each other. High assortativity indicates wallets tend to connect to other similar wallets.

For NFTs, this could mean whales transacting with other whales, or collectors within the same community subgroup trading with each other.

To calculate assortativity, we first used community detection algorithms to identify subgroups of closely connected Azuki holders. We saw the number of communities increase over time as more new holders joined.

This image is a visual representation of the Azuki community’s connections before the Elementals launch (between June 19th and June 26th):
![Azuki community pre launch](//images.ctfassets.net/lhkcghnr8ql4/7nrgWXj4oc0sIzIfZfPfuD/fee05411e5bda44b7596e3d9bafe0471/Azuki_community_pre_launch.png)

This image is a visual representation of the network after the launch, from June 27th to July 3rd:
![azuki community post launch](//images.ctfassets.net/lhkcghnr8ql4/6TioWd0t1nepvOFxJL57tM/2d03a0b615082ab75fcbd82f5731880b/azuki_community_post_launch.png)

As you can see, the community grew significantly, and became more interconnected. This suggests a stronger, more resilient network.

We also saw shifts in the key buyers and sellers week to week. No single whale dominated - different wallets emerged as hubs each period. This was another positive indicator, which shows a diverse network not dominated by single nodes (so to speak).

__Back to the assortativity calculations:__

The lower the assortivity, the less alike each wallet is. Implying a robust, diverse community that’s part of many communities.

The assortivity dipped when Azuki Elementals launched.

![assoritivity ratings](//images.ctfassets.net/lhkcghnr8ql4/4z7xk5mxaXExH23PM0H7Js/1ba2d2f2f74f91446ba3a96f216d7e45/assoritivity_ratings.png)

In short, these network insights suggest the introduction of Elementals brought in new holders from across groups. Azuki's community was diversifying and strengthening despite price drops.

## Key Takeaways
While we focused on one specific community, these network analytics can be used to understand any digital community. Some key lessons:

- Look beyond surface metrics. Network structure better reflects engagement.
- Monitor changes around major events. This reveals if new members join or existing ones leave.
- Identify core members and influencers within detected communities. Engage these VIPs.
- Watch for new hubs emerging over time. Distributed activity is healthy.
- Consider incentivizing key members during volatility to prevent mass exodus.
- Establish network baseline metrics early on. Track how they evolve across milestones.

Of course, every community is unique. But network analysis provides a data-driven toolkit to gain actionable intelligence on your digital community’s health.


Floor price doesn't reveal the full health of a digital community. We break down techniques like network analysis, engagement trends, and community detection to gain deeper insights.

How to Quantify a Digital Community’s Strength

Despite ever-changing market conditions, the NFT lending space represents immense potential for traders, lenders, and developers.

Indeed, its propensity for transformation is part of what makes NFT lending so fruitful.

But with potential comes risk. You must have a strategy to protect yourself, your profits, and your assets.

- Lending on risky platforms with low collateralization ratios could lead to unnecessary losses for you.
- Failure to diversify your portfolio across platforms, collections, and [asset buckets](https://upshot.xyz/post/asset-buckets) could leave you overexposed.
- You might miss out on opportunities for more attractive yields.

This article provides strategic insights on evaluating lending platforms, setting prudent loan terms, diversifying NFT assets, managing liquidation risks, and more.

With these practical tips and risk management strategies, you can confidently maximize returns in NFT lending while minimizing downside risks.

We’ll start by breaking down the two main types of lending models:

__Peer-to-peer and peer-to-pool.__

## What Are the Differences Between Peer-to-Peer and Peer-to-Pool Lending?

- __Peer-to-Peer Lending__: This model facilitates direct transactions between individuals. A typical scenario involves a borrower using a platform like NFTfi or Arcade, offering an NFT as collateral to secure a loan (often in WETH or DAI), then the NFT collateral is safely stored in a vault, governed by the agreed-to terms.

- __Peer-to-Pool Lending__: This model operates a bit differently. In peer-to-pool lending, liquidity providers stake tokens into pools. Borrowers can then tap into this liquidity by placing their NFTs in vaults. BendDAO is an example of a platform that champions this lending approach.

Now that we have a cursory understanding of the different NFT lending types, let’s break down a few of the most popular lending platforms, what makes them unique, and the most common ways people earn money on them.

# Peer-to-Pool Lending
Peer-to-pool NFT lending utilizes pooled funds contributed by multiple lenders. Borrowers can access these funds by staking their NFTs as collateral into smart contract vaults.

__This provides easy liquidity without needing to sell your NFTs.__

For lenders, peer-to-pool lending offers a hands-off way to earn attractive yields. By supplying capital to lending pools, they can passively earn interest and platform fees based on pool activity.

In general, this model provides higher liquidity than direct peer-to-peer lending.

### Lending for Enhanced Yield on BendDAO
BendDAO in particular offers a lucrative proposition for lenders:

By simply depositing ETH, you can watch your investments grow as the platform lends it out to eager borrowers. But the benefits don't stop there.

Those who stake the platform’s BEND token (and possess veBEND) are entitled to an administrative fee. This fee is calculated based on the holder's [veBEND](https://docs.benddao.xyz/portal/governance/vote-escrowed-bend-vebend) balance in relation to the overall veBEND supply.

Remarkably, this [administrative fee](https://docs.benddao.xyz/portal/governance/fee-collection-and-distribution) constitutes about 30% of the total interest revenue amassed from all NFT loans. And for the cherry on top? All these fees, paid exclusively in ETH, are disbursed to veBEND token holders on a weekly cadence.

# Peer-to-Peer Lending
Peer-to-peer lending facilitates direct loans between individuals using NFTs as collateral. On platforms like NFTfi, X2Y2, and Arcade, borrowers and lenders connect directly to agree on loan terms, and the NFT acts as security if the borrower defaults.

A key advantage of peer-to-peer lending is lower fees, as there are no intermediaries taking a cut. Lenders can also potentially earn higher interest rates than on pooled lending platforms. However, liquidity on peer-to-peer platforms can be lower as loans require manual matching. There’s also higher risk without centralized oversight.

For borrowers, peer-to-peer lending unlocks liquidity from NFTs without having to sell them. They can leverage NFTs to obtain loans tailored to their needs. Likewise, lenders can earn yields on a decentralized market outside the traditional financial system.

Overall, peer-to-peer NFT lending provides a direct and decentralized way for borrowers to monetize their NFTs and for lenders to earn yields. But it comes with the risks of a nascent market lacking intermediaries or oversight.

### How People Maximize Returns with NFTfi
NFTfi, one of the most reputable peer-to-peer NFT lending platforms, supports over 150 NFT collections. The platform employs a multifaceted approach to appraise NFT collateral value, considering factors like:

1. Current floor prices
2. Project averages
3. And valuations from [NFTBank](https://nftbank.ai/)

Borrowers benefit from the platform's robust, tamper-proof permissionless smart contract infrastructure, accessing liquidity through wETH, USDC, and DAI loans. Notably, while NFTfi waives borrowing fees, lenders incur a [5% fee](https://nftfi.com/how-it-works/) on the interest accrued from successful loans.

*__1. Lending for yield__*

This strategy can be an enticing alternative to traditional liquidity provision on platforms like [Uniswap](https://uniswap.org/).

For optimal returns, lenders might diversify by proposing multiple loan offers, each crafted with a focus on risk-minimization, such as spreading offers across different collections, and structuring conservative loan terms. Prioritizing loans on liquid assets and collections—those that can be swiftly sold if necessary—might also be beneficial.

*__2. Lending to acquire__*

Proactive lenders can leverage this strategy to make offers on desired NFTs, often securing them for a cheaper price than through an open market purchase. A boon for NFT aficionados and collectors, this strategy facilitates cost-effective NFT acquisition over time. The principles of diversified loan offers and asset liquidity still remain crucial with this strategy.

# Perpetual Peer-to-Peer Lending with Blend
Blend, [Blur](https://blur.io/)’s NFT lending platform, quickly emerged as a leader in the NFT lending space. What sets Blend apart is its deviation from the norm:

It operates independently of oracles and imposes no constraints on loan durations.

This flexibility allows borrowers to maintain their positions indefinitely, either until they repay or face liquidation. The interest rates, rather than being fixed, are shaped by market dynamics.

By channeling ETH into Blend, users not only reap yields but also accumulate Lending Points on the Blur platform. These points empower lenders to make loan offers from their Blur Pool funds. The "Max Borrow" value, chosen by the lender, dictates the maximum ETH amount that can be borrowed against a single NFT, and in turn, amplifies their point earnings.

When a borrower greenlights a loan offer, their NFT is secured, and the lender's interest earnings, denominated in ETH, commence. The loan remains flexible, allowing closure at any point to retrieve the principal and interest. However, borrowers are bound by a 30-hour window to either repay or refinance their loan with a fresh offer.

### Blur Season 2
This gamified take on lending has led to much of Blur’s early success.

The $BLUR [Season 2 Airdrop](https://blur.io/airdrop) is designed to incentivize specific user behaviors, such as bidding, listing, and lending. By partaking in these activities, Blur liquidity providers can earn rewards.

Bidding has emerged as the favorite among farmers, primarily because it demands exposure solely to ETH—a relatively low-risk asset compared to NFTs. This exposure can be further hedged using short futures, theoretically rendering farming almost risk-free.

### How Lenders Are Harvesting Blur Points
Blur Points serve as a testament to a user's engagement level, determined by the length and intensity of their participation in lending, bidding, and listing activities. In the case of lending, you earn Blur Points by loaning your NFTs to other users. Note that those points are on top of the yield you earn from the loan itself.

It’s a risky, high stakes yield strategy. Which is likely what has made it so popular. Which leads us to to the next section:

## NFT Lending Risks (and How to Manage Them)
In NFT lending, the key to maximizing your returns is effective risk management. There are several important aspects to creating a risk-resilient portfolio of NFT loans.

Let’s break some of them down here:

# 1. Setting Your Lending Parameters

Risk management in NFT lending relies heavily on the configuration of lending parameters. As a lender, you’re able to define the NFT collections you’re comfortable lending against, set the loan-to-value (LTV) ratio, determine the loan duration, and establish the interest rate. By carefully calibrating these parameters, you can ensure that your lending activities align with your risk tolerance.

For example, opting for a lower LTV ratio (e.g., 50% instead of 75%) provides a safety net in case the value of the collateral NFT experiences a sharp decline. Similarly, setting a higher interest rate can offset the risks associated with lending against NFTs.

You can also mitigate your risks by choosing shorter loan durations, such as 1-6 months, rather than longer 12-month loans. Diversifying your loans across multiple borrowers, collections, and even platforms can be prudent as well.

# 2. Navigating Loan Defaults

In the event of a default, the lender takes possession of the NFT the borrower used as collateral. At this point, as a lender you have the choice to keep the NFT, potentially benefiting from future value increase, or to liquidate it to recover their funds.

The decision of whether or not to take custody of an NFT can play a large role in your success as a lender. It may be tempting to hang onto the NFT, but if the price has dropped to the point that the borrower liquidated, you might be holding a depreciating asset.

When deciding, analyze the recovery potential of your new asset by looking at the collection's growth indicators:

- Check for positive community sentiment
- Upcoming catalysts like launches or events
- Recent sales trends

Also assess the liquidity of the collection to estimate how easily the NFT could be sold. More liquid collections generally have higher recovery rates if sold post-default.

If indicators point to potential near-term appreciation, holding the NFT may be worth your while. But if the value has dropped significantly, liquidating the asset quickly may maximize recovery.

# 3. Inadequate Appraisals
Loans are made based on a shared understanding of the appraised value of the collateralized asset. When the [valuation is inaccurate](https://upshot.xyz/post/asset-buckets), lenders risk financial loss, while borrowers risk receiving less than the actual value of their NFT asset.

It's important to benchmark your platform’s valuation models by backtesting accuracy across different market environments. Models relying solely on current floor prices aren’t enough. Sufficient out-of-sample data should be used to evaluate performance.

# 4. Concentration Risks
Diversification is an essential part of risk management for NFT lending. By lending across various NFT collections and platforms, lenders can spread their risk, thereby mitigating any negative impact if the value of a specific collection plummets significantly.

It’s also important to consider systemic risks such as cascading liquidations. If many loans from the same collection share the same liquidation price, drops in value can trigger sequential liquidations, amplifying price drops, liquidations, and more.

Furthermore, lenders can employ a risk overlay based on their current portfolio of active loans. This overlay can fine-tune the loan terms by considering various factors, such as:

- Collection-level concentration
- Ownership concentration
- The number of open NFT loans in the marketplace

Lenders can even employ more sophisticated techniques like quadratic programming to find the optimal asset weights that minimize portfolio volatility.

# 5. Market Volatility
NFT prices can fluctuate immensely in short periods of time. Regularly monitoring the market and adjusting your lending parameters accordingly can be an effective risk management strategy.

In the event of a specific collection’s value dropping, lenders might consider readjusting the LTV ratio or temporarily suspending lending against that collection until the market stabilizes.

# 6. Hedging Risks
NFT lending serves as a popular method for owners to hedge their long positions in NFTs. Essentially, taking out an NFT-collateralized loan functions similarly to purchasing a put option with an upfront payment.

If the market value of the NFT dips below the loan amount, the borrower might find it beneficial to default on the loan and surrender the NFT, thereby effectively utilizing it as a hedging tool.

However, NFT lending isn’t the sole strategy for risk mitigation. Financial instruments like perps and options offer alternative risk hedging avenues.

For example, borrowers concerned about a potential decline in [Bored Ape NFTs](https://app.upshot.xyz/indexes/yuga) could short $APE futures to counterbalance their long exposure. This provides downside protection if Ape prices decline, offsetting the impact of potential defaults on loans collateralized by the NFTs. Utilizing derivative instruments on correlated assets allows lenders to hedge risks beyond portfolio diversification.

## Future Prospects of NFT-Backed Lending
NFT-backed loans have emerged as a transformative tool, enabling asset owners to unlock liquidity in the NFT market and have been the go-to source for downside protection of NFTs. However, the journey isn’t without its challenges. Recent declines in NFT prices have cast shadows over the robustness of many NFT x DeFi protocols, as evidenced by dwindling user engagement.

There's a tendency among market participants to downplay the probability of adverse future events. Such an oversight can culminate in significant losses. It's imperative for investors to adopt a forward-thinking approach to risk management.

Despite the hurdles, the monetization and securitization of NFTs, a domain still in its nascent stages, brims with immense promise.

Learn strategies to maximize returns and minimize risks in NFT lending by understanding key differences between peer-to-peer and peer-to-pool models, setting prudent loan terms, diversifying, and more.