“Media lego” non-fungible tokens have surged in popularity in the Ethereum community this year, and among the NFT economy’s various sectors the digital fine art arena has been an early star.
Why’s that? Because NFTs give artists new programmable revenue avenues, and early innovators have taken notice. NFTs can have royalties automatically caked in, so that whenever a given piece sells in secondary markets, the creator instantly gets a 10% cut or so forth. There’s no traditional parallel to this in the traditional art world, and it’s unquestionably great for creators.
Accordingly, we’ve seen a lot of buzz kick up around the NFT assets ecosystem in recent months, which has brought in lots of new eyes. That’s awesome! But there’s a learning curve and risk involved, just as with all things crypto.
That said, one of my various professional goals is to help newcomers wrap their heads around NFTs shrewdly, like an expert would. So today, with a mind toward approaching risk in this space realistically, I wanted to introduce a concept that clicks as obvious once you think about it, but that I haven’t seen put forth in this way before: Impermanent NFT Loss.
First, What’s Impermanent Loss?
Another one of Ethererum’s major hits this year has been decentralized exchanges, and among the DEX genre automated market makers (AMMs) like Uniswap have been stealing the show lately.
Structurally, AMMs work via liquidity pools. Let’s take a Uniswap trading pool, ETH / DAI, for example. Users can provide liquidity to this pool by depositing equivalent portions of both assets, say 1 ETH and 380 Dai at today’s prices. Liquidity providers receive LP tokens (which can be redeemed for the underlying tokens at any time) and have the potential upside of earning trading fees from folks trading in and out of the ETH / DAI pool.
The risk of providing liquidity to AMMs, then? Impermanent loss, or the acute loss of funds from serving as an LP for a trading pair whose tokens’ prices diverge. Simply put, the grand IL question is this: would you have been better off simply holding ETH rather than providing liquidity to, say, the ETH / DAI Uniswap pool over a given span of time?
This same kind of assessment can be applied to NFT investing, even though AMMs and art NFTs are apples and oranges. Here’s what I mean.
Would you have been better off holding ETH rather than investing it into a particular NFT over a given time span?
For example, let’s consider a hypothetical involving Delphi Digital, the crypto research firm that made waves for picking up 5 rare Axies — the digital pets of the rising NFT game Axie Infinity — for a small trove of ETH back in September. The firm purchased Venom, a “triple mystic” Axie, for 104.25 ETH (which were roughly ~$345 each at the time).
— artic.eth (@Axie44) September 24, 2020
So think about this: let’s say crypto stays steady for the next 5 years and the ETH price stays in the $300-$400 range, while in that same span Axie Infinity continues to explode in popularity and mystics like Venom become much more desirable. In this case, Delphi Digital could easily flip the NFT for a significant profit.
Yet what if the opposite happens, i.e. the NFT ecosystem stays steady and the ETH price rockets up to something like $2,000 each indefinitely? The firm would would face impermanent NFT IL, since they would’ve made more USD-denominated returns if they’d simply stayed in ETH rather than bet on Venom.
Of course, the growth of stablecoin usage and active, revenue-generating activities like NFT staking can be used to mitigate NFT IL, so we’ll see how things continue to shake out from here.
The NFT economy is very promising and pulling in a lot of new attention lately accordingly. With that excitement brings FOMO (“Fear on missing out”), as new investors look to join in on the buzz.
That said, it’s important for newcomers to learn the ropes and understand what kind of risks they face in a sector they’re not yet familiar with.
There are no guaranteed returns in life, so spending ETH on a bunch of NFTs is far from a surefire get-rich strategy. The NFT IL concept illustrates just one of the basic layers of risk involved in this arena. But through better understanding, we can make more informed decisions and be better stewards for those who arrive to NFTs after us.
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