The NFT market has been the engine of the crypto industry for months. With Coca-Cola, Visa, Dolce & Gabbana, and many giant brands from various industries creating their own NFTs, this trend also took place in the mainstream media. The production of 10,000 avatars, which has become almost traditional, and NFT based ‘play to earn’ kind games can also be defined as other factors contributing to the continuation of this trend. It is now a fact spoken by everyone that NFTs represent a cultural transformation. Admitted or not by everyone, the culture of the digital world attracts similar attention to the high valuations given to paintings by famous painters. Most importantly, no artist no longer has to make an intermediary like their idea in order to perform their art and they also have the opportunity to receive the full reward of their labor without sharing the income from performing their art with anyone else. The point that the NFT market has reached and the transformation it expresses (CultureFi, in a new term) can be summarized very roughly with the main headings above.
The subject of this article is, unlike the traditional content about why NFT is or should not be valuable, are the NFT-based Perpetual Contracts (abbreviated as ‘Perp.’) system shared by Paradigm, a San Francisco-based investment firm. Many people who actually open leveraged trading in the crypto market are quite accustomed to the Perp. system. Perpetual Contracts can be summarized as the type of market where users can open positions for both directions of the price.
Before moving on to the NFT part of the Perp.’s, it would be beneficial to briefly explain how the system normally works. Perpetual Contracts, as the name suggests, are actually the buying and selling of contracts. For instance, if you buy a BTC-Perp at 40,000 USD, this means that you expect an increase in price, so you open a long position. As the price rises, your position starts to increase in value gradually. When you want to sell the BTC-Perp contract you have after making enough profit, the users who have opened a short position, that is, the users who have opened a position that the BTC-Perp price will decrease, pay the difference. If the price decreases, on the contrary, long traders pay short traders. If there is an intensity in long or short transactions on Perp, the type of position that is heavily traded will pay an additional commission to the less intense position. For instance, if there are too many long transactions on BTC-Perp, those who open long transactions pay a commission to those who open short transactions. As can be seen from this example, the market needs quite a lot of users and volumes for users to be able to pay each other.
So How Will NFTs Be Used?
Before going directly to how the system works, let’s talk about why such an initiative is needed. NFTs have become a very useful market for making high profits in a short time. Users can sell an NFT they purchased to another user in a short time at a price of x2 — x3. The purpose of the user who buys NFT at x2-x3 price is to sell that NFT to someone else at a higher price. This does not mean that the NFT market is exaggerated and will not be used in the future. However, when users are unable to sell the NFT they purchased, their investment may suffer a significant loss of value. Moreover, in cases where the user does not want to sell his NFTs but has an urgent need for cash, NFT-based Perps may appear frequently in the future as an ideal solution to both quickly access cash and protect investments.
The NFT-based Perp system starts with the user locking their NFTs into the system as collateral. In return for collateral, the market maker pays the NFT holder in ETH, based on the NFT’s floor price. Then, the market maker uses NFT collateral to create Perp to create a parity to be traded by traders. Investors can open long or short positions in accordance with their predictions that the floor price of the collection will increase or decrease. In order for the owner of the NFTs given as collateral to get their collection back, the market maker must pay the NFTs equivalent to that day’s floor price. After the payment, the user can get their NFT back again.
Let’s explain the process through an example:
Since the average value of George’s collection is 150 ETH, it will not be difficult for George to find a loan of 50 ETH. When NFT-based Perp systems become widespread, such credit systems can be expected to become widespread in both centralized and decentralized platforms. For instance, George borrows 50 ETH to repay 55 ETH to buy back his collection. After the loan, George has a balance of 100 ETH and can get his NFT collection back. After the collection is reclaimed, George pays back 55 ETH of NFT (in NFT or in cash after NFT sale) to the platform from which he borrowed. As a result, a collection worth 150 ETH — 55 ETH = 95 ETH remains in George’s balance.
Thanks to the NFT-based Perp system, George has secured himself against the decrease in the price of his ASD collection. In return, he forfeited a portion of the profit he would have received had the floor price risen even higher.
NFT Perp System For Traders
We briefly explained how the Perp. system works at the beginning of the article. When you want to open a leveraged transaction on any exchange, it is usually required to have a stablecoin like USDT in your balance. Paradigm is also stated that Perp products created in exchange for NFT collateral can operate in a similar way, however, users who want to open short positions can open it with NFT collateral instead of stablecoin, provided that they are from the collection represented by Perp.. Although long positions are transactions that can be opened by directly purchasing Perp., you actually borrow from the market maker as there is no contract in your balance when opening a short position. For instance, if you want to open a short position of 1000 USD, it is sold by borrowing 1000 USD worth of Perp from the market maker. When the Perp. value drops by 5%, if the user wants to close their short position, they pay 995 USD to the market maker and make a profit of 5 USD. So, how does this system, which normally operates on stablecoins, work with NFT collateral?
NFT Collateralized Short Positions
The value of the NFT to be collateralized is calculated by the market maker over various parameters such as the floor price of the collection, the average value, and the amount of debt the user can borrow is determined. The users can open a short position on Perp. with the money they borrow. In the event that the users lose the money they borrowed, in other words, their position is liquidated, the NFT, which is given as collateral, is under the control of the market maker.
This is how the system works, however, there are various risks. For instance, let’s assume that the balance of the person who opens a short position by giving NFT collateral is 0. When the price of Perp. rises, users who open short positions have to pay those who open long trades. However, as their balance is 0, the market maker generates a Perp. for the user and transfers it to the long position user. In return, the position of the user who opens a short position increases and gets a little closer to liquidation.
There is an extra liquidation method against such situations. The user, who opens a short position in exchange for NFT collateral, can close their position by clicking on the ‘voluntary liquidation auction’ option when they approach liquidation, that is, losing their NFT. When the position is closed, the NFT as collateral is put up for sale by the market maker. The debt of the user is paid with the earnings from the sale. If an extra balance remains, this balance is returned to the user. In other words, instead of going bankrupt by keeping their position open, the borrower can also consider the possibility of closing their position with some balance after paying their debt, with his NFT sold above the average price.
The examples are given so far included scenarios that were built without leverage. The most common reasons for using Perp.’s are that they allow opening positions with leverage. Thus, it is unthinkable not to have leverage in the NFT-collateralized Perp. system. It is possible for NFT-based Perp. products to have problems in this sense since Perp.’s are generally healthy markets in case of high volume and number of users. In order to take precautions against such a situation, the amount of leverage is proportioned according to the volume of the market.
If we take a look at what has been said so far, we see that NFT prices will not continue to increase forever and the Perpetual Contract system can be a very logical move as a hedge against declines. The biggest problem that the system may encounter is the low number of traders and low volume. Although there are preventive mechanisms developed for these situations, it is essential that the volume is high for the healthy functioning of the market.
NFT-collateralized Perp.’s will most likely merely be available to NFT collections, which find buyers at high prices such as CryptoPunks or Bored Ape Yacht Club, and which now have a serious investor base. Otherwise, it would not be an ideal situation for any trader if a Perpetual contracts market opened as a result of NFT collateral closes after 1 week due to the withdrawal of this collateral.
If NFT-collateralized Perp.s become widespread, it is possible that relatively smaller-scale NFT collections will be accepted as collateral. Whether the system will be open to every user in the first place is a significant debate. Because, as just mentioned, the collateral should not be withdrawn after a short time so that the market can continue to operate. Therefore, the system can be implemented either by contracting directly with professional investors or by stipulating a specific lock-in period for each user.
Leveraged transactions cause high profits as well as high losses as they involve very high risk. However, until the Perp market has enough users and volume, it may not be possible for the market to offer high leverage ratios. Despite this, since the NFT market is already subject to fairly steep rises frequently, low leverage will not reduce the attractiveness of NFT-collateralized Perp. products.
As for the evaluation of NFTs, nowadays NFT collections, in addition to whether the users find the collection nice or not, attracts investors by being evaluated according to many parameters such as whether it donates to any charity, etc., whether it promises a passive income by using DeFi systems, how active it is in Discord-Twitter-Tiktok channels. There are serious increases in the base price of the collection depending on the social media campaigns, the size of the donations, and whether the DeFi system works properly and provides passive income. Perp. system can make this evaluation highly manipulative. Perp. users who trade large sums can buy NFTs at high prices in line with their positions, or they can lower the base price by selling them at prices below their value. While this seems unlikely for collections like CryptoPunk, it is a viable possibility for smaller collections.
Consequently, NFTs are making great strides in cultural finance. Ideas about whether the market is exaggerating or not, it seems that the current market is constantly finding new areas to grow by developing new branches. Along with the emergence of cryptocurrencies, many people who are not normally interested in the bourse learned the market and became novice or professional traders, thanks to NFTs, many people became interested in art. With Perpetual Contracts, we may encounter an interesting market in the future where both artistic valuation and market analysis should be used together.
Prepared by: Berkay Aybey
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