Jacob wants to invest in and try out a new DeFi protocol but does not have enough liquidity on hand to do so. He is no longer comfortable taking out loans on AAVE as it would put his Health Factor in danger. Jacob however has some Decentraland Real Estate that he owns. He knows that his NFT real estate is really valuable and wants to keep ownership of it long term and hence cannot afford to sell it in the open market.
Jacob decides to use PawnSpace and list his NFT as collateral for a valuation & interest rate he deems is fair. Luckily, Belle an NFT & Decentraland Enthusiast sees Jacob's listing and feels that the valuation of the NFT is fair/undervalued and is willing to risk giving her funds to Jacob with the NFT as collateral in case of default. Belle agrees to an "Instant Loan" for Jacob's Loan Order, and the loan takes place smoothly.
Jacob receives his funds and tries to make profits on the new DeFi protocol he wanted to try out. He uses some of the gains to pay back the interest, gives back the principal and keeps the rest as profit. Jacob is happy as he receives his NFT back from escrow when he closes the loan. Belle is happy to get back her principal + interest from lending the loan.
From the previous example, everything went well for Jacob, and he was able to pay back the loan in time. But what if it didn't? In this scenatio, Jacob borrows funds from Belle with his NFT as collateral. However, the new DeFi yield farming protocol that Jacob invested in crashed significantly overnight which resulted in him losing his borrowed funds. Jacob knows he has to pay back his loan so that he doesn't incure further losses from the NFT that he collateralized and decides to get rid of his debt. He knows he will lose his NFT nevertheless, because he is no longer able to pay back the loan, and wnats to minimize his losses and sell his collateralized NFT. Jacob does this by trying to sell his obligation to repay the loan or otherwise known as the 'Debt Token'. The Debt Token being a representation/derivative of his debt for the underlying collateral has the valuation of the underlying debt. Anyone who sees potential in the growth of the collateralized NFT could buy this Debt Token and repay the loan to gain the NFT.
Bob sees Jacob's DebtToken listing on Opensea at a valuation of 2 wETH while the loan to be repayed with interest was 3 wETH. Bob knows that during the duration of the loan, the floor price of the collateralized NFT had increased to about 6 wETH. He realizes that by buying the debt from Jacob and repaying it, he is still able to get that piece of land at about 4 wETH, and still get a profit of 1 wETH if he sells that land at the current floor price of that NFT collection (6 wETH).
This ensure that Jacob minimizes his loss from the loan even though he loses his NFT worth atleast double the loan price at the time. Bob is ecstatic that he was able to make a couple of trades that allowed him to technically arbritrage his way to owning an NFT at lower than its actual floor price. Belle still comes out as a happy lender as she gets back her capital with interest.
Let's take similar scenarios from Example 1 & 2, Jacob takes out a loan against his collateralized NFT, and receives a Debt Token; while Belle, provides him with liquidity and lends him the funds for the mutually accepted loan duration (hence receives a Credit Token). Now Belle - the Lender - wants some instant access to liquidity, or she feels like the value of the NFT collateral will go down and wants to exit her lending position. Belle can always dispatch her rights to a loan or 'the obligation/right to get repayed', by transferring the ownership of the Debt Token to someone else, or by selling it in the open market, or even collateralizing it on PawnSpace (hence, creating a derivative).
Belle can potentially take the following approaches to gain access to liquidity:
- Sell 'Credit Token' on a marketplace such as OpenSea: Since the Credit Token has a clear valuation due to its financial nature, Belle can easily find a suitable valuation for her NFT and sell her "potential" credit to someone in return for instant access to funds. Someone else in the market, say Alice, decides to buy Belle's Credit Token and is now the owner of the loan, and any repayment done by Jacob at this point will be redirected to Alice's wallet. Alice also now has the right to claim collateral incase Jacob defaults on the loan.
- Collateralize Credit Token on PawnSpace: Again, since the Credit Token has a clear valuation (due to its financial nature), Belle can list her Credit Token on PawnSpace for a loan. This NFT collateral would essentially become a derivative since its value is derived from the underlying collateral within the Credit Token itself. If Belle ever defaults on her derivative loan, the lender would be able to claim the original Credit Token. A scenario could arise where Jacob - the borrower of the original loan - defaults on the original loan which could prompt Belle to also default on her loan. In this case, the lender (e.g. Alice), can now claim the original Credit Token (collateral of derivative loan), and then use the claimed (original) Credit Token to claim the underlying original NFT collateral that was defaulted on. If Belle does not default, but repays the derivative loan to Alice, then Belle can claim the original NFT collateral while also gaining some additional yield/profits from her borrowed funds from the derivative loan.
Note: Users can get creative on how they interact with the Debt and Credit Tokens, and their derivatives. We also see the potential of Credit-Farming with these derivative loans, but however caution users that they understand the underlying collateral before lending or Borrowing against it.