Subprimate crisis: how monkey JPEGs pushed a crypto lender to the brink of insolvency

But for one of those lending platforms, BendDAO, that experiment turned sour over the past week, as the market value of BAYC and other top NFT collections—which skeptics view as little more than JPEG pictures—fell sharply. Today, the decentralized platform is holding a large stockpile of rapidly-depreciating NFTs that it is struggling to sell as owners default on their loans.

“I don’t think [NFT lending] was wrong – I just think the lending platform was set up horribly for a situation like this,” Cirrus, a pseudonymous NFT trader, told Fortune. He raised alarm bells on August 17 about a potential NFT liquidation cascade worth $59 million – the first of its kind for NFTs, but common for cryptocurrencies. “People are also less willing to splurge on JPEGs during times of macro uncertainty,” he said. 

The BAYC collapse also led to a bank run of sorts on Sunday as those supplying loans yanked their funds from the platform, leading the BendDAO’s total wallet holdings to drop from 10,000 ETH ($16.5 million) to 5 ETH ($8,000). Since then, the platform’s balance has bounced back to 7,479 ETH ($12.3 million), as borrowers rushed to rescue their NFT collaterals at risk of default and willing buyers eventually showed up to snag discounted NFTs. For now, the insolvency crisis has been averted.

But what led to the BendDAO collapse in the first place?

It’s helpful to know that, on the surface, BendDAO runs like an automated digital bank owned by a co-op. The platform accepts ether (ETH) deposits from lenders seeking interest and lends out ETH from that pool to borrowers. Borrowers must lock up an NFT as collateral in the platform’s digital vaults. If someone fails to pay back their loan, then the lending pool will automatically repossess the NFT, auction it off, and pay back its pool of depositors – or at least that’s how it’s supposed to work.

Since its inception in March, the platform has lent out 56,000 ETH (around $929 million) to NFT holders. It’s been especially popular among BAYC holders: 272 Bored Apes, or 3% of the collection of 10,000, has been collateralized through the platform. Some use the unlocked liquidity to buy real-world goods, while others make strategic crypto bets. Franklin, who holds 59 BAYC NFTs and only goes by his first name, told Fortune he’s used BendDAO to “flip more apes, essentially doubling down or leveraging.” He’s taken out 10,000 ETH ($16.5 million) in repeat loans from BendDAO, with no current outstanding debt.

The platform’s stringent set of rules—such as high minimum-bid requirements for those who wish to accept collateral as well as a 48-hour lock-up of bidders’ ETH—initially deterred prolific NFT traders like Cirrus participating. “[That] leaves you at risk of getting burned if the [market value of NFTs] continues to drop during that period,” he said.

BendDAO’s pseudonymous co-founder, CodeInCoffee, appeared to acknowledge problems with the site’s incentive structures on Monday, saying “We are sorry that we underestimated how illiquid NFTs could be in a bear market when setting the initial parameters.”

CodeInCoffee also introduced a successful proposal to increase liquidity on the platform by lowering bidding requirements and shortening lock-up periods.

Designing for fungible vs non-fungible

Although the situation has now been mostly contained—even if it left a bad taste in the mouth of its lenders and borrowers–the whole experience has highlighted a fundamental distinction in the crypto industry.

“NFTs are fundamentally different from fungible tokens [or cryptocurrencies], and financial products servicing NFTs need to capture the nuances of the underlying assets,” Conor Moore, co-founder of NFT liquidity scaling platform MetaStreet, told Fortune.

BendDAO’s peer-to-pool lending is a flawed model for NFTs, he explained, “because of the critical assumption that liquidations will happen quickly, and at a specified value – true for liquid markets, and false for illiquid markets.”

Moore pointed out that, at the height of the BAYC liquidation crisis on August 21, BendDAO held 241 Bored Apes in their debt pool, which translates into about $20 million in loan exposure. That’s equal to 2,000% of BAYC’s daily spot trading volume of $1 million. 

In stark contrast, he explained, the largest peer-to-pool ETH lender MakerDAO’s loan exposure on March 12, 2020, when the crypto market crashed due to Covid-19 fears, was less than 2% of the daily ETH volume.

“The correct base building block for NFT lending is in a peer-to-peer format, with borrower and lender agreeing on loan terms prior to creating the loan,” Moore concludes. “These building blocks can then be combined, abstracted, scaled and packaged into entirely new debt products.”

But peer-to-pool structure isn’t necessarily the problem, according to Alex Ho, head of product at NFT lending platform Pine, which operates segregated lending pools set up by lenders with their own lending terms. BendDAO, he said, operates a commingled pool that socializes losses across all depositors.

Gabe Frank, co-founder of peer-to-peer NFT lending platform Arcade, told Fortune that BendDAO “built a product market participants found useful: DeFi loans against NFTs. The design choice was just wrong. There was always this risk for lenders in a peer-to-pool model.”

“It was an experiment that didn’t end well,” he said.

Ekin Genç is a freelance journalist whose work has appeared in such publications as VICE, Decrypt, and CoinDesk.