NFT loan derivatives

The tokenization of both loan Orders (Debt Token) and active Offers (Credit Token) creates a new asset class of NFT loan derivatives. Debt Token and Credit Token holders will have the freedom to trade their derivative asset tied to the loan. Since collateral is locked within the PawnSpace contract, an Order is tokenized and tradeable the moment it is created. Orders that have not yet been accepted a loan should contain a value equal to the locked collateral, minus the host blockchain’s (in this case Polygon's) transaction fee for unlocking the collateral. When an Order enters a loan, its value will immediately change. Since an active Order (or Debt Token at this point) represents the obligation to repay a loan, its value should theoretically become negative (debt). The time remaining to repay the loan should also affect valuation of the Debt Token; potentially in a similar manner to expiration times in Options Markets.

Upon creation of a pending Offer, it exists only as a non-transferable record coupled with the corresponding order. Since value transfer does not occur prior to acceptance, the Offer’s intrinsic value would be zero while it is still pending. When an Offer is accepted and currency is loaned to the borrower, the value of the Offer should represent the total repayment amount (loan principal plus interest) minus risk factors and transaction fees and is tokenized (Credit Token). There exists a number of variables, both external and internal to pawnspace, which could be considered when evaluating risk factors for the Credit Token.

External risk factors could include the type/quality of the collateral and its associated project, as well as the potential for price volatility in that asset. Internal risk factors include PawnSpace features, such as smart contract security (just like any other DeFi protocol). A Credit Token whose corresponding Debt Token is not owned by the original loan receiver could also be considered riskier.

Other risks include Debt Farming - where a borrower borrows funds against an NFT, and then sells the Debt Token on the market for more money with no intention from the beginning to pay it back, and dispatches all repayment obligations to the new owner of the Debt Token. This could result in bad actors and could be restricted with the introduction of debt & demerit scores that signal the reputation of the borrower. However the team is still researching ways to create an algorithm that could defend against sybil-attacks for such a scoring or reputation mechanism (mentioned in the next page).

Overall, the loan derivatives market is going to be an experimental feature with truly unknown outcomes. As time progresses, data from the loan derivative market will be used to identify and develop new features and lending strategies to further improve the platform. There also exists potential for future protocols and developers to build on top of PawnSpace and its loan derivatives to utilize their secured value in unique ways. Some examples of financial instruments that could be thought of are, CDOs (Collateralized Debt Obligations) and CCOs (Collateralized Credit Obligations).