A market in which the assets coveted by investors for use as profile pictures or digital avatars are branded as Crypto-Punks, members of the Bored Ape Yacht or Kennel Club, or as Pudgy Penguins, is redolent of the Pokemon card craze of the 1990s. As it happens, the popularity of these Non-Fungible Token (NFT) collections with gameified nomenclatures has sparked a rediscovery of Pokemon cards, which are enjoying a nostalgia boom. That incidental side-impact is not a surprising one, because the scale of the NFT market is increasingly hard to ignore. In 2021 investors sank at least US$44.2 billion into NFTs, according to Chainalysis. Transaction volumes, total value invested and average transaction size all rose sharply by comparison with 2020. The blockchain data platform bases its estimate on the amount of crypto-currency sent to the ERC-721 and ERC-1155 contracts, the two types of Ethereum smart contract associated with NFT marketplaces and collections.
NFT marketplaces offer art, collectibles, videos, music and sports
The fact that most NFTs are built on Ethereum is a major factor behind the surging transaction costs (“gas fees”) on Ethereum, and the associated interest in the low-to-zero transaction cost alternative of the Solana blockchain protocol. Most of the purchases made are intermediated by a newish breed of commission-based NFT marketplaces of which the biggest, OpenSea, is also built on Ethereum. The NFT marketplaces are akin to crypto-currency exchanges such as Coinbase but minus the custody function (unlike the crypto-currency exchanges, most NFT marketplaces expect investors to own and operate their own digital wallet) and plus (in the case of the most successful NFT marketplaces) a genuinely decentralised model. OpenSea, which currently lists more than 6,000 NFT collections, is the generalist option. Other NFT marketplaces (such as art marketplace Nifty Gateway, which is owned by cryptocurrency exchange Gemini, a parentage that enables provision of a custody service) focus on niches.
The NFTs available are not confined to unique digital collectibles such as Bored Apes (there are only 10,000 available) or Pudgy Penguins (8,888). Fine art, videos, music and physical objects are also available as NFTs. Artist Damien Hirst has sold 9,000 of 10,000 unique, hand-painted, dot-covered works on paper at a price of US$2,000 each. He has given buyers 12 months to decide if they wish to take ownership of the physical work or own the NFT instead. If they choose the NFT, the physical work will be destroyed. Secondary market trades have raised the total market value of the Hirst collection to more than US$500 million. The traditional art auctioneers, whose nose for anything that smells of money is as finely tuned as the most shameless investment bank, have moved into the market. Christie’s made US$150 million from NFT sales in 2021 (US$69.3 million of it from Everydays: The First 5,000 Days, a digital art collage by artist Mike Winklelmann, better known as Beeple). Sotheby’s made US$100 million from NFT sales in 2021, including from sales of Bored Apes.
Artists of the kind long parodied by the British satirical magazine Private Eye have joined the frenzy, extending the NFT art boom to video clips too. Popular musicians have followed their example, issuing NFTs that give buyers exclusive rights over unique musical compositions. Kings of Leon, a rock band, sold limited edition digital copies of an album as an NFT. A large part of the appeal for musicians, as for artists, is the ability to sell work directly to fans and (importantly) collect a royalty payment every time their NFT is sold. Sports stars have opened a video clip sub-genre to sell sporting “moments.” An entire NFT marketplace, NBA Top Shot, has emerged to sell short clips of basketball games to fans. Its richest sale to date, a 15 second clip of a famous basketball player putting the ball through the basket, fetched US$230,023. Former South African cricketer Dale Steyn, a fast bowler, is selling video clips of his wicket-taking feats. The US Open tennis championship has issued NFTs that offer ownership of tennis art works, trading cards and opportunities to meet the stars or play tennis in the hallowed stadium.
Gaming is the finem as well as the fons et origo of NFTs
Another factor at work in the NFT market is the new industry of GameFi. Blockchain-based Play to Earn games such as Axie Infinity put gamers in the same position as artists issuing NFTs. Instead of paying intermediaries such as large corporations and distribution platforms such as Steam to play video games, Play to Earn enables players to generate an income from turning NFTs into crypto-currency that can be exchanged for fiat currency. The gamers acquire the NFTs by playing the game for NFTs which they can sell. Games players have for years earned in-game digital rewards they can exchange for new weapons or wearables or properties. Games such as Axie Infinity take this to a new level by enabling players to buy, breed (and battle) digital creatures called Axies as NFTs on the Ethereum blockchain. Because the Axies are NFTs, they can be bought and sold using crypto-currency. Crypto-currency can then be sold for fiat currency. Playing the video game, in other words, can secure assets which can be turned into cash in the secondary market. Crypto-currency can also of course be staked to earn blockchain validation fees or lent in the Decentralised Finance (DeFi) market to earn yield. This is where NFTs meet crypto-currency meet DeFi and, increasingly, meet the Metaverse. All four are part of the same network of networks.
Signs of speculation and signs of durability
Are NFTs a bubble then? Considered it isolation, they certainly feel like one, though NFTs have yet to earn the ultimate accolade of being denounced by senior bankers as “worthless.” In an era of record low interest rates, now strangely coupled with rising inflation, speculative hunts for yield are bound to occur. Importantly, unlike crypto-currency, where institutional investors are increasingly dominant, NFT activity is also driven mainly by less-informed retail investors reading Discord channels – which have also become a new playground for scammers. Nine tenths of NFT transactions are worth less than US$10,000. What retail investors want is obvious: large and rapid returns on relatively small investments. What NFT issuers want is equally obvious: to recruit a group of dedicated followers that give them money in return for digital assets sold to them at an initial discount plus the opportunity to sell them more by offering them more in the future – partly in the form of dividends in cash or kind, but also in the form of other discounted products. Kings of Leon, for example, gave buyers of its NFT privileged access to tickets for future concerts. This is now a common feature of NFTs.
NFTs are also issued and traded in a tightly concentrated and highly competitive market in which, as with any form of trading, the gains of the winners are equivalent to the losses of the losers. Discounting of initial prices has, so far, enabled early buyers that choose the best-performing NFTs in the primary market to make profits in the secondary market. Losses are common in the primary market, where initial interest is intense and prices high but most issues fail to take off into a self-sustaining form of secondary market liquidity and rising prices. Failed bids for NFTS in the primary market also incur transaction costs. According to Chainalysis, less than 100 NFTs on OpenSea (about 2½ per cent of the total) account for half of all sales and just one wallet in every 20 – the most active traders – trouser 80 per cent of the profits made. The successful traders almost certainly have the money to diversify and place large bets, as well as valuable trading experience and technology and the knowledge to make better judgments. So although NFTs attract retail investors with small sums to invest, the structure of the market is loaded against them.
What the value of NFTs ultimately rests upon
Accordingly, there remains a risk of regulatory intervention in the wake of retail investor losses which crushes the entrepreneurial and speculative energy driving the market today. This would be unfortunate, not just because the NFT experiment is intrinsically interesting, but because there are reasons to believe that NFTs – unlike crypto-currencies and counter-intuitively, given that digital technologies reduce the marginal cost of making copies virtually to zero – can represent genuine value. For a start, they are unique, and available purely in digital form (even in the case of Damien Hirst, the physical analogue of the digital alternative must be chosen or destroyed). Secondly, NFTs are ownable and provably owned, because the blockchain traces the transactions. Thirdly, NFTs are transferable across blockchain networks. Fourthly, they offer shareholder rights (NFTs can offer holders voting rights) and benefits (such as privileged access to the concert or the game or the store). Fifthly, NFTs pay dividends in cash or kind. Sixthly, NFTs pay royalties to their creators, who get a cut of the sale value every time their NFT is sold. Seventhly, NFTs extend the set of investable asset classes into new areas, such as sporting “moments.” Eighthly, NFT markets, like DeFi markets, provide an opportunity to invest crypto-currency that is otherwise hard to deploy
But the most valuable feature of NFTs of all may turn out to be the human collectives they create. NFT issuers work hard to attract investors in much the same way investment banks seek commitments from institutional investors to buy an IPO or a bond issue. The communities of the like-minded created by this process have to be nurtured beyond the initial issue. Which is why issuers offer investors governance rights that encourage participation in building the NFT by helping to decide what new features should be added. That is novel, but privileged access to new products, or events, is not. These are the basis of any commercial “membership” arrangement and of the sense of personal “identification” football fans have with the performance of the club they support. In this sense, the business strategy of NFTs is both comprehensible and old-fashioned. They are building “communities” of committed customers that they can sell goods and services to.
All that is needed to make NFTs universal is easier accessibility. At the moment, investors in NFTs need to open an Ethereum-compatible self-custody digital wallet; buy some Ether crypto-currency to transfer to it; connect the digital wallet to an NFT marketplace such as OpenSea; make choices among thousands of NFT collections; and, finally, pay Ethereum network fees from the digital wallet for the privilege of purchasing an NFT that can be held in the digital wallet. Apart from the complexity of this multi-step process, and the need to invest using crypto-currency, the risk and cost of failed bids, the volatility of NFT prices and a disquieting lack of legal certainty and regulation also conspire to deter all but the most enthusiastic. So the most significant development in NFTs of the last 12 months may turn out not to be the surge in activity but the fact that OpenSea is working with third party payment provider MoonPay to enable investors to buy crypto-currencies with debit and credit cards.
Future of Finance will host a NFT webinar on March 17 which will review the history and recent performance of the NFT markets, asking what threatens the markets and what will enable them to continue to grow, particularly through institutional involvement, infrastructural investment and regulatory engagement.
Among the topics to be discussed at this webinar are:
- Who invented NFTs?
- What explains the recent growth of the NFT markets?
- How can NFTs best be categorised?
- What are the sources of value of an NFT?
- What are the links between blockchain, crypto-currencies, tokenisation and DeFI?
- How will NFTs interact with traditional finance?
- What are the pros and cons of the NFT industry being based on Ethereum?
- Is the current infrastructure of the NFT markets adequate for sustained growth?
- How do NFT custody arrangements compare with crypto-currency and security token custody arrangements?
- NFT markets are concentrated, thinly traded and volatile, but used mainly by retail investors. Do you anticipate a regulatory backlash?
- Is the early domination of the NFT markets by modern artists an encouraging sign or a worrying sign?
- An NFT marketplace employee was accused of trading on inside information about NFT issues. How useful is the blockchain in detecting such behaviour?
- What will attract institutional investors to the NFT markets?
- NFT markets have attracted scammers. How useful is the blockchain in defeating them and what can be done to defeat them?
- Are NFTs, like crypto-currency markets, susceptible to accusations that money is being laundered and tax evaded?
- Having to obtain crypto-currency first is a barrier to entry for many potential NFT investors. How can it best be cleared?
- To what extent is lack of legal and regulatory certainty a barrier to entry to NFT markets?
- Are NFTs pioneering a new form of capitalism in which the principal incentive is not price but affiliation?
- How much difference would user-friendly entry points make to the NFT markets?
- Are NFTs a bubble or durable innovation?
- What will the NFT markets look like in five years’ time?
Written by Dominic Hobson, Co-Founder at Future of Finance
For more information and to apply to join the NFT panel please contact Wendy Gallagher at firstname.lastname@example.org