Are NFTs just hype or is there more?

Containers are a very simple concept and yet they have revolutionized physical world trade. Due to the standardization of size and the possibility to put in almost all goods, the global logistics chains have been greatly optimized. Blockchain-based tokens are similar: They allow physical and digital goods to be represented digitally, as well as a standardized form of digital delivery – both with and without an intermediary.

So the promises are great, but blockchain technology and tokens have not yet really revolutionized digital commerce. Was it just the right use case that was missing? And could non-fungible tokens (NFT) be that use case, or is it just hype that will soon fade?

What are NFTs?

So far, most blockchain-based tokens have been fungible, i.e. interchangeable. For example, one BTC or one stablecoin is 1:1 interchangeable with another. Non-fungible tokens, on the other hand, represent non-interchangeable physical or digital objects, such as a painting or even just a specific pixel of a digital work of art. Due to their uniqueness, these tokens have a value that goes beyond the pure material value. In relation to the analog world, this would be, for example, works with artistic or historical significance or trading cards.

In the digital world, on the other hand, the trading and auctioning of such goods was and is only possible to a limited extent, since copies of digital objects could not be effectively ruled out. Here, the blockchain technology acts as a kind of copy protection: Although copies of NFTs can be created, they can then be distinguished from the original – similar to a reprint of the Mona Lisa. NFTs are therefore tokens that represent a unique digital or physical object or, to stay with the image of the container, contain it and can be sent digitally.

New markets around NFTs

Markets for NFTs have experienced exponential growth. These are primarily digital art, collectibles, music rights, in-game items, and metaverses. The artist Beeple, who sold a digital work of art for the equivalent of 69.3 million dollars at an auction at Christie’s, attracted particular media attention (Christie’s 2021) and Twitter CEO Jack Dorsey, who auctioned the NFT of the first tweet ever (“just setting up my twttr”) for $2.9 million (Valuables 2021). Sports greats such as NFL Quarterback Patrick Mahomes or UFC Champion Khabib Nurmagomedov also sell NFT collections and football clubs such as FC Bayern Munich or Paris Saint-Germain participate in digital “NFT trading cards”. In a recent development, NFTs play a special role as digital property in a metaverse. The Decentraland and Sandbox projects are particularly worth mentioning here.

At present, digital property rights (still) lie with platforms and their operators. In perspective, NFTs can shift these ownership rights from the platform to the creators, which can result in a corresponding paradigm shift. As a result of enabling the trading of in-demand goods and their subsequent monetization, the market for the creation of digital goods can be transformed. This creates markets for the sale of digital goods, which represent new sales channels for artists and creative people and thus open up new opportunities in the industry that has been severely affected by the corona pandemic.

In addition to primary markets, secondary markets are also possible, which enable buyers of NFTs to resell the (digital) objects. This is particularly interesting for investors, but also for speculators. The importance of speculation for the NFTs market can be appreciated by looking at the daily sales volume (see chart). This is shown logarithmically due to the strong exponential growth. The small-seeming increase at the end of the time series represents growth from $86.7 million to $780.4 million – this was the sale of digital land in the Bored Apes Yacht Club (BAYC) metaverse.

If you compare the number of active NFT wallets with this, there is also strong exponential growth here, but with two differences to the sales volume: (1) the daily values ​​are less volatile and 2) there has been a clear flattening of the active wallets in the past few months , which even BAYC’s land sale could not compensate for.

Challenges: speculation, money laundering, fraud

Despite the high innovation potential of NFTs, the rapid market growth is surprising and it is easy to assume that this could be a speculative bubble. Another reason for the exorbitant growth could also be money laundering. For example, organized crime could “whitewash” crypto assets acquired through illicit deals by posing as an anonymous acquirer to purchase an NFT of their own creation. The income from the sale thus flows into the legal economic cycle – and as a side effect, the markets for NFTs are artificially inflated.

Another challenge surrounding NFTs is fraud in proving the uniqueness of the object or ownership rights to that exact object. While tokens can be seamlessly tracked on the blockchain and misuse within the blockchain system can be ruled out, this does not apply to the creators of NFTs or, in the case of representations of physical objects, by those who keep the objects. They must provide credible assurance that the item in question actually exists in the specified form. So there is a need for trust here, and with it the potential for betrayal of that trust.

Outlook

Although the rapid growth of the NFT market suggests a bubble, NFTs offer great potential for innovation. On the one hand, they can support the digitization of existing markets, for example for art. However, the even greater potential lies in the creation of new markets for digital objects, which until now have only been able to develop to a limited extent due to the lack of an opportunity to ensure uniqueness or at least rarity.

Along with a certificate of authenticity, NFTs creators can share future sales proceeds, include voting rights, or be broken down into fractions that can in turn be traded on their own. For example, it would be conceivable for investors to acquire small amounts of a (digital) work of art and for museums, exhibitions or associations to finance themselves from this.

The current challenges of NFTs are expected to be solved step by step as they reach market maturity. For example, the potential for fraud could be reduced by tokenizing not only the object itself but also the process of its creation as proof.

At the moment, however, the market for NFTs is still hanging heavily on the skirts of the crypto markets. The Blockchain Research Lab was able to show that NFT sales are positively related to the development of the BTC price, while a rising ETH price has a negative effect on the number of active NFT wallets (Ante, 2021). The latter is probably due to the sometimes exorbitant transaction costs of the ETH network.

Overall, however, it can be said that NFTs are developing into a new asset class. However, it should be borne in mind that this will be enormously heterogeneous and that it makes sense to distinguish between NFT types.

About the author

Prof. Dr. Ingo Fiedler studied business administration and economics at the University of Hamburg and received his doctorate. He is an affiliate professor at Concordia University, Montréal, and co-founder of the non-profit non-university research institute Blockchain Research Lab.04