Update on Aug 22, 2022:

BendDAO has issued a new governance proposal to “BIP#9 Adjusting Liquidation Threshold, Auction Period, and Interest Base Rate & Removing the first bid limitation”.

There are a few parameter improvements suggested and it appears that the proposal will pass as a majority of voters have voted yes. The parameter changes proposed are:

Adjust the Liquidation Threshold to 70% as follows (it is 90% currently):
- update to 85% August 30th, 12 pm UTC
- update to 80% September 6th, 12 pm UTC
- update to 75% September 13th, 12 pm UTC
- update to 70% September 20th, 12 pm UTC
Adjust the Auction Period to 4 hours (It is 48 hours currently). The 48-hour window is designed to protect NFT holders to avoid liquidation without waking up and losing their PFP. But right now we have TWAP protection of Oracle on-chain which means floor price attack would be very difficult. So we would like to reduce the period from 48 hours to 4 hours to improve liquidity for auctions.
Remove the first bid limitation of 95% of the floor price
It will limit the auction competitors.
Adjust Interest Base Rate to 20%
It would help more ETH depositors earn more interest and prompt more NFT holders to repay ETH.

BendDAO Interests are skyrocketing:

Due to mass liquidation and slump in NFT prices, BendDAO is unable to auction off the liquidated NFTs. There is also a bank run on the reserves of the project. This led to increase in borrowing rates to 100% and simultaneously rewarded the ETH pool with over 80% interest. Depositing ETH in the pool right now can yield over 80% APR, but this is not a financial advise. If BendDAO runs out of reserves, they may be holding NFTs but they won’t have any ETH to pay the debt. So be careful.

Original Letter:

Bored Ape Yacht Club and Mutant Ape Yacht Club are quite possibly some of the most popular NFT projects in the history of non-fungible tokens. The digital property gives its owner access to special airdrops, new NFT mints, exclusive events around the world, commercial license of the artwork, and a lot more.

But what if one needs to borrow some quick cash against their blue-chip NFTs? BendDAO allows holders to collateralise their NFTs and borrow Ethereum against it on interest. Pay back the loan plus interest and the NFT is yours again.

What could go wrong? We may find out very soon. And that is today’s story.

BendDAO and NFT Liquidation

BendDAO operates on a peer-to-pool model for NFT lending. Users deposit ETH in the BendDAO pools to earn interest from it and subsequently, these pools are used to fulfil the loan requirements of NFT holders.

When an NFT holder collateralises their NFT, they can borrow ETH worth 30-40% of the floor price of said NFT at good interest rates. These funds are lent from the pool, hence the interest earned is distributed amongst the Liquidity Providers.

But what happens if the locked NFT prices slump and reach the point of liquidation?

Let us say that an NFT was collateralized when the floor price of the collection was 10 ETH. The user at the time borrowed 4 ETH against it. Assuming that the interest that the user has to pay is 10%, the user can get back their NFT after paying 4.4 ETH, which is their current total accumulated debt.

BendDAO uses a health factor metric to determine when an NFT should be liquidated.

Health Factor = (Floor price * liquidation Threshold)/ Debt + Interest

If the floor price of the above NFT were to reach 4.4 ETH, the Health factor will be

HF = (4.4 * 90%)/4.4 = 0.9 (or <1)

As soon the Health factor goes below 1, BendDAO will put the NFT up for a 48-hour auction, that starts after the first bid. Bidders can bid for the NFT in the auction. The debtor has an opportunity to pay the debt and claim back their NFT too, until 48 hours after the auction begins. Of course, there is a fine for that which will be rewarded to the bidder as a consolation prize.

The Liquidation threshold is the amount of loan to value. So a 4 ETH loan when the floor was 10 ETH, means the threshold is 40%, while at floor 4.4, it is 90%.

What is the NFT Liquidation Fear?

There is $57 million (30,430 ETH) worth of NFTs being used as collateral on BendDAO. At the same time, the floor price for BAYC and MAYC are falling.

At the time of writing BAYC floor price is 72. A large number of BAYC NFTs were collateralized when the floor price was 125 ETH. Hence, at 72 ETH, the health factor of the locked NFTs is dangerously closed to 1. If they go below that, let us say, if the floor drops to 65 ETH, many NFTs could risk liquidation.

BAYC NFT dangerously close to liquidation on BendDAO — Several BAYC and MAYC NFTs are Health Factor 1.01. Source: BendDAO

There is currently one BAYC #533 available in the auction, however, it has received no bids yet. What happens if no one buys the auctioned NFTs? That is a question we will answer shortly. Read on.

The risk may be high due to the sheer volume of NFTs held on BendDAO. By some accounts, ~3% of BAYC is actually collateralized on the platform. A sharp drop in floor price may lead to several liquidations abruptly.

Cirrus @CirrusNFT

5. Well surely there aren't THAT many collateralized apes right? Wrong. 2.8% of BAYC supply and 1.6% of MAYC supply are currently in the BendDAO wallet There are other platforms like NFTfi that also have a sizable amount of outstanding loans

That is the fear of liquidation. But we must also ask, how crucial or dangerous it truly is. To get an answer for that, we have to start by understanding how feasible are these liquidations actually.

What if no one buys the Auctioned NFTs?

Numbers do not lie. If BAYC and MAYC floor prices were to drop, it may lead to several liquidations. But the question is, what if no one actually bids for these NFTs?

Let us take break question into two parts,

If there are bidders, how do you ensure that BendDAO doesn’t lose money whilst the NFT prices are falling?
The expectation is that these Blue chip NFTs never go too down or to zero. At any point, the bid has to be more than the debt. So as long as there is a bidder, the bid will be above floor price and above total debt, so in theory - BendDAO will not lose money.
Practically, however, what if there is no bidder and the auction is over?
This is where things sound problematic. Here’s what BendDAO says,

In this case, the platform only has a temporary floating loss and no actual losses. Either the borrower will repay the debt at some point in the future, or after the market price recovers, some liquidators emerge to take part in auctioning off the debt.

BendDAO is betting on the market’s recovery in case no one buys the liquidated NFTs.

And the entire NFT collateralisation market’s issue boils down to this very point. What if no one buys it?

Non-Fungible tokens aren’t particularly famous for their liquidity. Especially in NFTs that cost thousands of dollars, the demand is almost always driven by belief or a quick arbitrage opportunity.

There isn’t always going to be much incentive for anyone to buy or bid on these NFTs in the auction.

Reason: Your bid has to be more than 95% of the floor value and higher than the debt amount. Between these two values, what if there isn’t much room for making money from arbitrage?

Hence, it seems entirely plausible that while there will be many auctions, they are very likely to end without any bids. The auctions don’t begin until the first bid is placed, so there may be several NFTs in limbo at a given point in time if the prices are unfavourable. And that should scare the Liquidity providers. At the end of the day, the funds lent out against the NFTs that won’t sell belong to the LPs.

Having a mere belief that the markets will recover is not a good bet to take in my opinion.

There is no denying that BendDAO has created a beautiful product. Users can even pay a partial amount as a Down Payment and own an NFT of their choice. Essentially, BendDAO allows you to borrow the remaining amount from its pools against the NFT as collateral. So, you can be the proud owner of an NFT of your liking without having to pay the full amount immediately.

In the coming days, we have to monitor such instances carefully and learn from them to build better products for the future. While I wish that we never see these liquidations, it seems like it is going to be an interesting week ahead.

P.s - I have made a friend bid on an Azuki NFT auction, that will now end on Sunday. Will share updates on it later. Make sure you subscribe so you don’t miss it.

In Other News:

A South Korean town has been successfully running an experimental trial allowing police to seize crypto from the individual's exchange accounts for traffic charges. Read more.
Canada-based Bitbuy and Newton are imposing a 30k Canadian dollars annual buy limit for restricted coins for their Ontario-based users to protect consumers amidst screwed-up regulations. Read more.
The European Central Bank states that the launch of central bank digital currencies can be the sole solution to assure a smooth continuation of the current monetary system. Read more.

Thought Provoking:

The Coin Crunch

Massive Liquidation Risk may crash BAYC and…