The real value and potential of Non-Fungible Tokens (NFTs)
This is the third article in a series about blockchain, NFT marketplaces and the metaverse. For earlier articles, see here and here.
NFTs have been driving much of the current blockchain hype cycle with the massive value of transactions going through marketplace platforms such as OpenSea, for assets ranging from collectible artworks to digital rocks. But what exactly are people trading here?
NFTs are tokenised forms of assets encoded (i.e. written) onto a blockchain. They can represent (or be linked to) existing real world assets such as physical items, intellectual property rights, real estate, equities, derivatives, access rights (e.g. tickets) or purely digital assets like digital collectibles. Their value can derive from being pure collectibles (including some incremental resale value, but mostly derived from fan support of the brand/franchise), speculative asset appreciation, utility (providing valuable access, benefits or rights), or license to commercially exploit the underlying asset.
While we’re hearing a lot about JPG files of digital rocks as the oft-made-fun-of exemplars of NFTs, the key innovations that I think NFTs bring to the table are (1) verifiable ownership of the asset (which is central to any valuable asset) and (this part is sometimes neglected amidst the collectible hype) (2) the ability to encode (and therefore automatically enforce) rights to revenue streams generated by the asset through smart contracts, similar to the concept of royalties but potentially including subsequent sales, secondary transactions and beyond.1
Based on this, I think the potential of NFTs is under-utilised and underestimated as long as attention is focused on collectibles and speculative asset-type NFTs that rely on a shared belief in the asset’s appreciation, sustained by the inflow of new buyers who are willing to pay a higher price (believing that they can sell to the next buyer at an even higher price), making many digital collectibles feel ponzi-like to me. While there’s a place for speculative price appreciation in markets like wine, art and rare collectibles, these relatively mature markets have taken time to develop price discovery mechanisms, as opposed to the current wave of digital collectible NFTs where pure speculation fuels short-term unsustainabubbles.
So how would I differentiate between valuable and non-valuable NFTs (or “meaningfully valuable” vs “not meaningfully valuable”, for those who believe that monetary value is purely determined by what the market is willing to pay) and what would I look out for in an investible NFT-related proposition?
I think the real potential of NFTs is in the securitisation of revenue streams generated by an asset, so I’d look for propositions involving NFTs that represent ownership of an asset and the accompanying right to a revenue stream that the asset generates inherently (through rental, licensing or other forms of commercial exploitation of the asset) and/or through subsequent sales, automatically enforced through a smart contract (as long as the commercial exploitation/sale can be verified digitally). An example would be an NFT linked to an intellectual property right (song, film or article) which pays revenue shares to the creator (musician, filmmaker or writer) and NFT owner (or potentially even chain of current and previous owners) out of revenue generated from the commercial exploitation or subsequent sales of the IP right, each time the IP right is used or sold, enabling a chain of ownership and revenue sharing back to the original creator. Services and platforms that enable this for various types of valuable revenue-generating assets seem like very interesting propositions to me.
One type of such platforms is a marketplace. While there may still be a need for big liquid marketplaces like OpenSea in order to realise the potential of valuable NFTs, even if most of the stuff being traded on them are tulips and rocks, I think there’s space for dedicated NFT marketplaces that trade licenses to use valuable revenue-generating assets, e.g. actors/singers licensing their deepfake rights (or other commercialisable IP) - things that can actually generate revenue streams separately from their own price appreciation. NFTs make it easy to encapsulate the license and decentralised NFT marketplaces enable trustless transactions.
As for collectibles, I’d lean on the old adage from wine investment2 - “buy wine that you’d actually like to drink.” In this case, I think a collectible NFT should have real world value (even if subjective) beyond asset appreciation (e.g. wine that you like to drink, or art that you like to look at) so that the value (and subsequent price) of the collectible can be measured against criteria other than “is the price of this likely to go up?” This would avoid everything becoming speculative, encourage more reasonable price discovery for collectibles (like we see in the physical trading card and sneaker markets today) - those “reasonable prices” set by a more rational rather than speculative market, and enable NFT art and other collectibles to grow at a more sustainable rate.
As for the long game, a general form that I think might play out is fractionalised NFTs as a share of equity for community members’ contributions to or support for an artist, product (including aforementioned IP rights above), service or platform that they like, consume, use, or are helping to build, providing ownership (and the rewards of ownership) not just for creators but also consumers/supporters.3 This could extend further to community-based investment vehicles and NFT-based Patreon-like supporter reward mechanisms.
In general, I believe we’re just beginning to get a glimpse of the potential of NFTs but need to cut through the chaff of hype and speculation. In the near future, enterprising individuals may come up with new forms of revenue generation for a tokenised asset that we haven’t seen today, e.g. renting weapons in games, loaning artworks to a digital gallery in the metaverse, creating new direct revenue streams that we haven't accounted for. While this suggests that some NFTs may be valuable even if we don't yet know what revenue streams they generate, I do think that for many, this still doesn't justify the bubble prices we’re seeing now, and many of these new and as-yet-unheard-of revenue streams may be linked to the development and evolution of the metaverse (more on that in a coming deep dive).
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I think an interesting economic mechanic here is that this de-risks future appreciation or loss of opportunity revenue and allows for lower and more rational early prices, but we have yet to see this play out.
Despite the irony that wine is a rather illiquid investment.
Admittedly, this leans towards the DAO or Decentralised Autonomous Organisation, the first iterations of which went down with the first ICO boom/bust.