Are NFTs and Cryptocurrencies Collateral?
Can cryptocurrencies and other digital assets, such as Non-Fungible Tokens (NFTs) be used as collateral? The answer is complicated and ever-evolving. Some companies will accept cryptocurrencies and NFTs as collateral, however, because they are not backed by a national currency or tangible asset, there is significant financial risk involved. Lending against digital assets is still a fairly new practice and because there is nothing tangible associated with them, valuations are subjective and not guaranteed. As a result, the perceived value of digital assets can fluctuate wildly or even be erased by the bankruptcy of your given host exchange.
Cryptocurrencies are unbacked digital currencies—also called coins—with all transactions recorded on a secure electronic ledger called a blockchain. An NFT is a unique digital asset recorded on a blockchain. These two types of digital assets can be used to back loans that are given in either digital or fiat currency.
Your digital assets are bought, sold, and traded on privately owned unregulated exchanges. While these exchanges are required to comply with federal corporate laws, they are not subject to government oversight regarding the exchanges themselves because they are not considered financial institutions.
The US government is still defining regulations for cryptocurrencies. Unlike more traditional assets, cryptocurrencies and NFTs can be highly volatile and their value can even crash to zero as the LUNA coin did in 2022. A recent US court ruling in favor of Ripple Labs and their XRP coin—and against the Securities and Exchange Commission (SEC)—has left it unclear if digital assets are considered securities under federal law. For now, they’re unregulated which means they lack legal protection. Owners or traders must rely on the security and transparency of blockchains.
One facet of using digital assets to guarantee a loan is that the borrower doesn’t need a credit check and keeps their crypto holdings once the loan is repaid. If the value of the asset goes up, the Loan To Value (LTV) ratio falls. This allows the borrower to secure additional funds against the asset or pay off the loan sooner. However, if the value of the asset falls, then the LTV ratio rises in the lender’s favor and the borrower must pay off a portion of the loan or use additional digital assets to secure the loan. Not unlike a margin call, there is the need to keep liquid assets at the ready and the costs can be significant.
If an NFT is used as collateral, both the lender and borrower must agree on the value. The asset is locked up in a “smart contract” escrow account on a blockchain until the loan is repaid. If the borrower defaults, ownership of the NFT is transferred to the lender.
There is still a risk for borrowers, and occasionally for lenders, in using digital assets to back fiat loans—especially more volatile coins. While the cryptocurrency market has stabilized recently and is once again rising, digital assets continue to be vulnerable to price instability.
Without global oversight of digital currencies and standardized regulation, the use of cryptocurrencies and NFTs remains a risky investment, as well as a volatile form of collateral. Most traditional and alternative lenders prefer to deal with tangible and government-backed assets, both of which provide a considerably greater level of security to you and your loan. When it comes to funding your business, it’s important to understand your options and risk tolerance.
If you’re a CFO or business owner overseeing your company’s finances, then register for our free upcoming Funding Strategies webinar, “Major Changes to SBA Financing: What You Need to Know.” The webinar takes place Thursday, September 7th at 2 pm ET and is part of our ongoing series of online discussions with leading financial experts to help companies find smart ways to finance their businesses.