Correlations and Risks of Borrowing Against NFT's

We explore the correlations between floor prices of top NFT collections such as Bored Ape Yacht Club versus the prices of ETH, BTC, and APE coin against the US Dollar.
Crypto investors tend to be risk-seekers relative to investors in more traditional markets, but that hardly means they can ignore risks altogether. And one of the key risk parameters in any investment portfolio is cross-asset price correlations. All else equal, low or even negative correlations between different crypto assets can provide diversification benefits and potentially lower volatility for the same level of returns.
Beyond the general case, ParaSpace is especially interested in implications of cross-crypto fungible token correlations with NFT’s. As a decentralized borrowing and lending platform we seek to provide much higher capital efficiency for users who hold NFT, ETH, and ERC20 assets. To that end we look at potential cross-asset correlations represent specific risks or opportunities to borrowers, lenders, and the ParaSpace protocol.

Why Borrow Against NFT’s, and What are the Risks?

ParaSpace seeks to solve key NFT and Crypto investor pain points when it comes to NFT’s. And those center around capital inefficiency and illiquidity of a very fast-growing market in Art and Collectibles:
  1. 1.
    NFT holders without access to liquidity need to sell their valuable NFT’s in order to invest further into the market and pursue other opportunities—limiting capital efficiency.
  2. 2.
    Valuable fungible crypto tokens sit idle given inability to earn yield on the fastest growing NFT’s.
In a capital-efficient market the holders of valuable assets could use those as collateral for loans, and lenders could in turn earn yields on such asset-backed loans. To be clear there is significant overlap between these two groups and the protocol, but let’s think about their motivations for each side of the exchange:
  • Borrowers: Provide NFT’s as collateral in order to access fungible token liquidity. Implicitly the borrower believes the value of their collateral in NFT’s will at least hold steady if not appreciate against the fungible token.
  • Lenders: Provide fungible tokens against NFT assets in exchange for returns on investment—i.e. yields earned. They implicitly believe the underlying NFT’s used as collateral will retain enough value to cover debt denominated in the fungible token.
  • Protocol/facilitator: Wants to balance risks for Borrowers and Lenders and ultimately wants borrower’s assets to at least match liabilities such that lenders can earn stable yields without risk of loss.
For borrowers, lenders, and the protocol see that significant volatility in NFT and/or fungible token prices could be detrimental to both borrowers and lenders. And indeed Lenders will require protection against capital loss—in ParaSpace we use NFT auctions to cover any potential shortfalls in NFT values versus their fungible tokens.
We likewise need to consider the risk that both NFT’s and fungible tokens fall at the same time—clearly this would hurt those who hold both. While collateralized borrowers would likely remain solvent, both sets of users would be worse off if the value of their combined assets fell.

What do NFT and Fungible Token Prices Tell us About Risks?

For healthy borrowing we want to ensure NFT prices do not diverge too sharply from fungible tokens, and we likewise know users would be worse off if they fell in tandem—let’s take a look at their correlations against one another. We’ll start with the most valuable NFT collection by Market Capitalization against the price of Ether.

Is it Risky to Borrow ETH Against a Bored Ape Yacht Club Token?

If we would like to borrow ETH against the value of our Bored Ape Yacht Club token we want the price of the Bored Ape NFT to rise or at least remain stable in ETH terms. If we are lending ETH against an Ape as collateral we have a less-directional bias but ultimately want the value of the BAYC token to cover at least the value of the loan.

Correlation Between Price of ETHUSD and USD Floor Price of Bored Ape Yacht Club Tokens

Correlation between USD floor price of Bored Ape Yacht Club tokens and price of ETHUSD. Weekly percentage returns from Nov, 2021 to Sep, 2022.
Our data shows Bored Ape Yacht Club NFT floor prices are positively correlated to the USD price of ETH —the USD BAYC Floor Price tends to fall when ETHUSD falls and they both tend to rise together. Or in short, BAYC tokens have not historically provided much of a diversification benefit to crypto investors who hold ETH. Of course that isn’t the full picture as we are focused on risks/benefits to the borrowers and lenders in this market.
For Bored Ape Yacht Club NFT-collateralized ETH borrowers, lenders, and the ParaSpace protocol it is actually of non-trivial benefit to see the positive correlation between ETH prices and the BAYC floor price.
As borrower your preference is for the price of your Bored Ape NFT to rise or at least remain stable against the price of ETH, and motivations for the ETH lender are for relative stability. As the protocol, ParaSpace ultimately seeks to solve problems for both borrowers and lenders while limiting risk.
If a user borrows ETH against their Bored Ape NFT and the floor price declines because of a drop in ETHUSD, their loan’s Health Factor would remain unchanged. The same is true the value of ETHUSD goes higher: the USD Floor price of their BAYC NFT means their collateral will cover the increase.
The challenge comes if the price of ETHUSD advances faster than the change in USD floor price of their NFT collateral, though historical correlations suggest this remains less likely.

What are Correlations between NFT’s, ETH, and ER20 Fungible Tokens?

We use the Bored Ape Yacht Club and ETHUSD correlation as a key example, but our analysis remains largely unchanged if we expand our selection to all NFT collections and ERC20 tokens supported for borrowing and lending on Para.Space.

Correlations of Top NFT Collections’ Floor Prices versus ETHUSD, BTCUSD, and APEUSD Coins

Correlation between USD floor prices of Bored Ape Yacht Club, CryptoPunks, Mutant Ape Yacht Club, Otherdeed, Azuki, Clone X, Moonbirds, Doodles, and Meebits NFT Collections versus ETHUSD, BTCUSD, and APEUSD. Weekly percentage returns from Nov, 2021 to Sep, 2022.
Click on the chart above to see both the scatterplots of NFT Floor Price returns versus these top fungible tokens. Highlighted in Purple are the cross-asset scatterplots and correlation coefficients—i.e. NFT Floor Price versus fungible tokens. Highlighted in the Green rectangle are the correlations and scatterplots between these fungible tokens.
Our study of cross-market correlations between these top NFT Collections’ Floor Prices against ETHUSD, BTCUSD, and APEUSD largely reinforces what we saw for the Bored Ape Yacht Club versus ETHUSD. That is to say that correlations are positive—these top fungible tokens tend to move in tandem with the floor prices of these NFT collections.
Notably, however, there are meaningful divergences between the above combination of assets. For instance the floor prices of both Mutant Ape Yacht Club and Bored Ape Yacht Club tokens have a
τ\tau
ranked correlation coefficient of 0.69. Likewise each of these collections has a fairly high 0.49
τ\tau
correlation coefficient against APEUSD. This all makes intuitive sense—each of these NFT’s and token are creations of Yuga Labs and should be linked in value.
On the flipside we see relatively weak correlations between most NFT collection floor prices against BTCUSD and non-Yuga NFT floor prices versus APEUSD. This could in fact be desirable depending on the investor’s preference.

What about Correlations for NFT Floor Prices in ETH?

If we look solely at NFT collection floor prices in ETH terms we see an important difference in correlations between those collections themselves and other crypto coins. Namely we see a much weaker link between top collections--the correlation between ETH floor prices CryptoPunks and other top-tier collections show minimal or negative correlations.
NFT Collection Floor price correlations in ETH terms. Correlation between ETH floor prices of Bored Ape Yacht Club, CryptoPunks, Mutant Ape Yacht Club, Otherdeed, Azuki, Clone X, Moonbirds, Doodles, and Meebits NFT Collections versus BTCETH, and APEETH. Weekly percentage returns from Nov, 2021 to Sep, 2022.
The chart above shows scatterplots and correlation coefficients between NFT floor prices in the green rectangle. The correlations between those NFT floor prices and BTCETH, APEETH, AAVEETH, and CRVETH are within the purple rectangles.
If the investor has no intention or need to think of their assets in USD terms and focuses solely on ETH, BTC, and other coins, historical correlations suggest they may achieve some portfolio diversification benefits if they hold uncorrelated NFT collections.

Do NFT and Crypto Token Correlations Make Borrowing Risky?

Historical correlations between top NFT Collection floor prices and key fungible tokens suggest they should largely move in the same direction. For borrowers and lenders this is largely preferable—the price of the NFT used as collateral will largely move together with the price of ETHUSD or other crypto token liability.
It is important to note of course that borrowing stablecoins such as DAI or USDC may nonetheless magnify the risk given positive correlations between NFT floor prices and ETHUSD. In effect if we borrow USDC against our Mutant Ape Yacht Club NFT we could become insolvent given a simultaneous decline in both the NFT Collection floor price and ETHUSD leave our outstanding USDC debt worth more than the value of our NFT collateral.
If we focus solely on ETH assets and liabilities we see slightly negative correlations between NFT floor prices and major crypto coins. For true crypto-natives who have no need or desire to convert crypto to USD this indicates there has historically been a diversification benefit in holding both top-tier fungible tokens such as BTC and top-tier NFT's.
We institute a conservative liquidation auction mechanism to protect both borrowers and lenders in our protocol, but borrowers in particular should note how cross-asset correlations could affect their positions.
Of course with risk comes potential reward—an NFT holder could in fact take a leveraged position on NFT’s and ETH if they choose to do so. And indeed if the NFT floor price and ETHUSD trade higher this could be profitable.
Take a closer look at the charts above and the Appendix for full information on historical correlations of NFT Collection floor prices versus ETHUSD, BTCUSD, and APEUSD. And as always contact us at https://www.twitter.com/ParaSpace with any comments and questions.