NFT-Secured Lending in the Metaverse

Though hints of a digital reality first surfaced as early as 2003 when Second Life made its debut, Facebook’s fall 2021 rebranding — to “Meta” — brought the metaverse to the center stage. That Facebook CEO Mark Zuckerberg would go so far as to change the iconic name of our favorite friend-finding app surely signaled a sense of inevitability that the metaverse would soon pervade our lives.

But what is “the metaverse”? Abstract by nature, the metaverse is not actually even “the” metaverse; it is, as Zuckerberg himself puts it, “the next chapter of the internet overall.” [1]

Despite the name change, the metaverse is not a Facebook concept; it is an evolving and shared concept shaped by several companies developing platforms (e.g., SANDBOX and Decentraland [2]) to access and grow it.

Users accessing the metaverse via Decentraland are first prompted to link a wallet with access to an accepted token and create an avatar. After that, the avatar enters and explores, at the user’s command, what looks like the latest iteration of The SIMs, with parcels of land peppered with buildings created and owned by other users. Since its inception, Decentraland has seen more than $220 million in sales of property generated from 178,000 unique sales. [3] To facilitate the sale of property, Decentraland offers “LAND Mortgages.” [4] According to the website, in order to finance the purchase of “land” in Decentraland, a borrower must (1) approve the smart contracts in order to conduct transactions using the correct tokens, (2) navigate to the parcel the borrower would like to purchase and request a mortgage, and (3) submit an application and a deposit of at least 10% of the price of the parcel. Once the mortgage application has been submitted, it is published to the network until a lender fulfills the mortgage and supplies the funds, at which point the parcel is taken off the market. The borrower repays the loan through the Decentraland Marketplace, which provides, “If you fail to fully repay the loan, you have 7 days after the expiration date to repay your loan.” If you fail to repay the loan, the lender can request “the mortgage back,” and borrowers will lose the tokens they have paid, along with any claim to the parcel.

Another metaverse finance company, NFTfi, tells users they can use the NFTs they own to access liquidity by listing the NFTs as collateral to get loans from other users. [5] The process mimics that described in Decentraland: Users’ NFTs are transferred into a double-audited escrow smart contract for the length of the loan. Once the loan is repaid, the NFT transfers back to the user. If the borrower defaults, the lender can foreclose on the NFT. [6] During the time the borrower repays the loan, the “technical owner of the NFT is the escrow smart contract,” thus borrowers are unable to use the NFT “in any way” while it is in escrow. [7] NFTfi’s platform offers users the opportunity to act as lenders, advertising that users can offer loans on assets they are “happy to back,” noting that the “best case” scenario yields “juicy APR” and in the “worst case” scenario, “the borrower defaults and you walk away with an NFT at a hefty discount.” [8]

TerraZero loans U.S. dollars to borrowers to buy NFT parcels in the metaverse; the parcels themselves secure the loans, and once the borrower has repaid TerraZero, the NFT parcel transfers to the borrower. Until the loan is fully repaid, TerraZero holds the NFT but gives the borrower “deployment rights,” which allow it to build, occupy and profit off the land in the meantime. If the borrower defaults on repayment of the loan, the deployment rights evaporate and the NFT reverts to TerraZero fully.

All three — Decentraland, NFTfi and TerraZero — use NFTs the same way: as collateral for loans. In July 2022, Article 12 of the UCC and amendments to existing UCC law debuted to address growing concerns regarding the treatment of certain digital assets in commercial transactions, termed by the Article’s namesake, “controllable electronic records.” Article 12 itself governs transactions of controllable electronic records, which are defined as records of information in electronic form that can be subjected to control. [9] In order to have control over a controllable electronic record, one must have the following: (1) the power to enjoy substantially all of the benefits of it; (2) the exclusive power to prevent others from enjoying those benefits; (3) the exclusive power to transfer control or to cause another person to control it; and (4) the controllable electronic record or a record attached to or logically associated with it, or the system in which it is recorded enables the person to readily identify herself as having the powers set forth in (1)–(3). [10]

The concept of control as it relates to what qualifies as a controllable electronic record has the potential for murkiness in scenarios where NFTs are collateral. What entity actually has control, as defined in Article 12, of the NFT for the duration of the loan? The very act of pledging an NFT as collateral may impact who controls it, and the terms of use of the cryptocurrency token and metaverse platform used may likewise impact a determination of control. Furthermore, what types of regulations or methods of contracting will emerge to protect both parties to a loan when the collateral is as highly volatile in value as NFTs? Because of the dramatic fluctuation in values of NFTs, lending platforms facilitating peer-to-peer lender-borrower relationships present opportunities for strategic and potentially predatory lending, borrowing and foreclosure practices. When a borrower defaults but the value of the NFT collateralizing the loan has plummeted, what rights, if any, will lender have to obtain a deficiency judgment or delay foreclosure until the value of the NFT recovers? Conversely, what happens when the value of the NFT skyrockets; does the lender recoup the entire value or just that of the initial loan? These are just a few of countless questions that arise as we navigate the uncharted territory that is lending in the metaverse. Until the terms of contracts governing these lending relationships are publicized, courts rule on disputes emerging from these transactions, or further regulations are promulgated, we can only speculate about what is already a highly speculative endeavor.