Understanding the absurdity and promise of Non-fungible Tokens (NFTs)
Since leaving Palantir and while gearing up for business school, I've spent a fair amount of time digging into the wonderfully intricate world of cryptocurrencies. I remain largely ambivalent on whether the world of crypto represents a promising new development for society or a pure waste of talent, energy, and money. Nonetheless, however you feel about crypto and NFTs, you should understand NFTs (Non-fungible Tokens), if only to refute their advocates.
NFTs are essentially digital certificates of ownership – they assert that some individual owns a piece of digital art. Individuals can buy an NFT to "own" a digital asset. To those that believe in the promise of NFTs, the technology represents a core building block of a "metaverse", a digital world with its own economy, value creation, and social systems.
I've spent three weeks immersing myself in the world of NFTs to try to understand what bears are missing and bulls are overlooking about the NFT world. I remain wildly mixed on what I've discovered, but I will say that the world of NFTs is more complex than what I imagined based on my first impressions. Here's what I've found.
The Absurdity of NFTs: the Bear Theses
An irrational, speculative market?
Let's get the bearish thesis out of the way: "There is something very wrong with a market in which an individual will pay 69 million dollars for a jpeg image." Well, possibly. It is perhaps equally absurd that a pixellated crypto punk would sell for over 7 million dollars.
But perhaps these are the exceptions – the few NFTs that somehow have uniquely high value?
Surprisingly, that is not the case. Take a look at all of the NFTs currently listed for over 5 Ethereum on opensea.io, a popular NFT store. In USD, at time of writing, that is roughly $10,000 or more. In other words, the multi-million dollar sales are certainly the outliers, but they're far from the only sales of digital assets that are garnering significant real world money.
Essentially, these people are buying certificates of ownership for digital assets. If it stopped there, perhaps it's easy to sympathize with the narrative that buying a digital asset for vast amounts of money is truly irrational. But people buy them – they pay significant amounts of money to purchase a certificate of ownership to a cartoon drawing.
It's really easy to dismiss that as irrational. Maybe it is. But we need to ask ourselves – what value is this actually delivering?
Another issue with NFTs is that the actual thing you are buying into isn't something you typically have in a hard copy. You're buying a certificate of ownership, not necessarily the art itself. That means the art needs to live somewhere on the web. Simplest solution: someone hosts the image for you. But who? What happens if that person goes out of business or doesn't pay their hosting bill?
I validated the absurdity of this by minting an NFT on the Avalanche blockchain and hosting it myself on natmeurer.com. How did I do it? Well, I copied the image over to my website host and served it through my proxy service. In other words, the NFT is only valid so long as I keep my website running. Not...great.
In most scenarios, though, NFTs are hosted on IPFS (Inter Planetary File Service). This means the digital art is stored on a number of different computers. As long as one computer is running to serve the art, it's still around. This is still fairly brittle, though. Computers in the IPFS network don't serve all of the content, so it is still possible that your art could disappear.
Another option is to store the art embedded on the blockchain itself. This is definitely a better approach, but it only works with small data. For example, the Forgotten Runes Wizards Cult just launched with an entirely blockchain-based asset system. The wizards sold out in a mere 30 minutes. They had this to say about their approach:
Most NFT projects merely store their images on IPFS, and the owners of such NFTs only hold a pointer to that image. Not so with us.
Our Wizards are fully encoded on-chain. The provenance of the Wizard images and data are recorded wholly within the Ethereum blockchain, attached to our custom contract. Which means ownership of a Wizard, and the image itself, is fully on-chain.
This on-chain provenance puts Wizards in a small cohort of on-chain NFTs including 0xmons and Mooncats.
In short, your Wizard is 100% decentralized and will live forever on the Ethereum blockchain.
The limitation of this approach, though, is that you can only really do pixel art in this context or something comparatively small. That's a significant limitation that doesn't apply to most of these NFT collections.
In other words, a fair critique of NFTs is that what you own isn't actually something you necessarily...own.
But it's bad for the environment!
One of the most common critiques of crypto these days is that the current networks come with a significant environmental cost. That's because the underlying technology of the two most popular cryptocurrencies today, Bitcoin and Ethereum, rely on "proof of work" protocols. That basically means that computers around the world solve energy intensive math problems to secure the network.
For Bitcoin, this is unlikely to change. For Ethereum, though, where the vast majority of NFTs live, there are tangible plans to move the entire network to the much more energy-efficient proof of stake protocol. This will take some time, but that move will largely undermine the critique of NFTs that they are bad for the environment.
Today, we even have proof of stake protocols running, like Avalanche, which is currently the fastest cryptocurrency out there and no more impactful on the environment than centralized payment networks like Visa.
This is one bear thesis I don't think has any staying power for crypto in general and thus for NFTs.
Lots of bears
Honestly, it's pretty easy to be bearish on NFTs at first glance. They seem to offer no value to society, may be net harmful to the environment, and they appear to be a wildly speculative market. All of these things may be true, but let's explore what could be right about NFTs.
The Promise of NFTs: the Bull Thesis
The Digital Community
The thing I underestimated the most about the NFT space was the community elements. In the NFT world, virtually every collection of digital art has an attached discord or telegram channel where communities collaboratively share their digital art, brainstorm new ideas for the NFT collections.
These communities are not only passionate – they collaboratively contribute, psych each other up, and make sales to each other. People become incredibly passionate about the communities in which they participate, and some collections can catch on as celebrities like Jay-Z participate.
I've joined a number of these communities in the past few weeks. They're incredibly active, and it's the best way to hear about new projects. In other words, once you buy a few different NFTs, there is a tendency to roll into other collections as others recommend new NFT collections.
Because the market is seemingly growing so quickly, buying into new collections as they get going is a potential way to see massive returns. It's also a way to lose tons of money via "Rug Pulls," a term that is used to describe a situation in which a collection launches without any subsequent follow-through or in which the developers take their money and run without delivering actual digital assets.
Still, when communities grow, for example like the Bored Ape Yacht Club mentioned above, communities become self-reinforcing and grow organically. At its simplest, the more passionate a community, the more individuals buy up the "floor", or the lowest priced assets, and the price rises. That's one reason that the Bored Ape Yacht Club, or BAYC as it's known, has the cheapest NFTs going for multiple thousands of dollars.
Other communities can actually engage in buying back and "burning" (permanently removing from circulation) NFTs from their collections. For example, Dead Heads, which recently launched and sold out in 30 minutes, has vowed the following:
Our community will have its own voting structure which can determine secondary sale earnings and allocate them in ways that benefit holders, in the immediate term it will be used to buy the floor and fund the animated series. Floor DeadHeads will be used in giveaways and some will be sent to the cremation station and burned forever.
Community is obviously key – one major question that remains is whether these communities will retain their fervor long term.
Asymmetric Upside: Rarity
One aspect of some of the most popular NFT collections is rarity. When certain NFTs are generated, they may assign attributes of different rarities to individual entries. This is the case of most computer-generated collections. For example, you might create characters with unique clothing, hair, eyes, and mouths (think Mr. Potato Head). The rarer each element is on your NFT, the more valuable, theoretically, is your NFT.
Of course, rare features are...rare. To buy an NFT when it is first launched, in a process called "minting," you are often buying a lottery ticket in the hopes of getting a rare entity. Most will definitionally not be rare, and the most common features are referred to as "floor" tokens (because they sell at the floor price).
However, getting the rarest entities in an NFT "drop" (Release) means reselling your NFT for massive returns (i.e. buying for 50 dollars and selling for $10,000). This is one of the characteristics that makes buying NFT collections before they're revealed so compelling.
If one draws a floor NFT, the returns can still be massive based on Drops or a strong community, but rarity is an additional upside. Tools like rarity.tools exist solely to interpret the rarities of different features to determine price.
Asymmetric Upside: Drops
One thing that keeps communities alive is new features, and NFTs remain a place, like much of the cryptocurrency world, where there exists the possibility of outsized returns. Often this comes by having ownership of a single digital asset or a combination of assets that allows you to scale to more assets. Sometimes it's just winning a giveaway on Twitter.
The most recent example of value creation is the Bored Ape Yacht Club's "Bored Ape Kennel Club."
Essentially, the owners of the Bored Ape Yacht Club decided that they would issue entirely new NFTs to all current owners. Because of the way the blockchain works, identifying all owners of an asset is trivial. They gifted these new dog NFTs to all current owners. The lowest price of one of these dogs currently on the market is .65 ETH, or a bit over $1000.
In other words, NFTs allowed them to simply create money for their community. One reason that NFTs are so compelling is that initial value creation is so decentralized. If you have a sufficiently strong community and market price, creating more value for holders becomes trivial. It's also fun to participate.
Other communities, for example the PxinGxng, do raffles as part of the Ghxsts collection. Entries in the raffle are based on owning NFTs from the collection. Winning a raffle means earning a super-rare NFT from the core artist.
In some cases, you can even get something for free. Twitter recently dropped a collection of NFTs called "The 140 Collection". They were largely gifted to individuals on Twitter:
These were largely gifted to individuals who then resold them for an average price (at time of writing) of 20.49 Ethereum. That is $40,000. What's crazier is that individuals active in the community got these initially for free. It's hard to ignore the potential for an investor in situations where picking the right horse (literally or figuratively) can lead to massive returns. Very few other asset classes outside of cryptocurrency can simply duplicate themselves and retain their value.
NFTs for Artists
Perhaps the most compelling aspect of NFTs are their potential to give artists a real, persistent revenue stream from selling their art.
One aspect of the NFT specification is that it can allow resales of art to send some funds back to the original artists. This is to say, you can encode in the contract a particular cut for the artist – this is something that wasn't possible in the old days of art and is unquestionably good for artists.
However, NFTs that do the best are often these rarity-driven, profitable collections or even memes. It's easy to see why some are cynical:
The reality for many artists is that they are edged out by memes and cartoon collectibles with little value beyond rarity. This can be understandably frustrating.
The Metaverse and Gaming
The last element that is important to understand about NFTs is how they relate to the concept of a metaverse / digital world. NFTs offer a clear track record of ownership in a "metaverse." For example, you could be the only player in a video game to own a particular weapon or piece of gear.
Alternately, digital art could be something that you could uniquely display in your digital home. This sounds, on its face, absurd at first glance. However, games like Decentraland treat virtual land as a commodity that can be bought and sold. People pay real money for these virtual tracts of land, in part because virtual land can be used to generate outsized returns through other revenue-generating activities.
Even more interestingly, the interaction between virtual and real worlds is a space of growing experimentation. For example, the Metakey project creates an NFT that is intended to offer opportunities to its holder. It is, in some ways, a way to opt into future drops and in others an exclusive pass to virtual experiences.
A separate approach that brings the real world into the virtual world is the Proof of Attendance Protocol. In that approach, it grants NFTs to individuals that attend particular events as proof of their attendance.
In theory, NFTs can provide all sorts of benefits to holders that interact with the real and virtual worlds. In the vision of a metaverse, a record of ownership is essential to virtually any digital economy.
Still, should we be abandoning the real world in favor of a metaverse even more?
What does any of this mean for the world?
After immersing myself in NFTs, I find the space more interesting, but it's difficult to pinpoint whether the effort spent on it is worthwhile for humanity at large.
As you'll see above, most of the "promises" of NFTs are largely financial. They are, in many respects, another fun form of gambling and game playing, not dissimilar to the stock market.
For some artists and creators, however, NFTs offer a way to draw more revenue than ever before, especially for those willing to gamify their art with tools like rarity or other incentives.
Still, one can't help but feel that we need our best engineers to be solving bigger problems than how to sell "rare" cartoons on the web, regardless of how fun that may be. This is one reason I'm excited about many projects like the Untamed Elephant Crew, which is designed to raise awareness of a particular cause and donate some proceeds to that cause.
Regardless, I'm convinced NFTs are here to stay. They're too compelling, too profitable, and too fun to go away any time soon. So, the question becomes, how do we make NFTs a tool for good – for the independent artists and not just those wealthy enough to afford a $69 million jpeg? I leave this question as an exercise for the reader.