Understanding the value of Non-Fungible Tokens (NFT)
Definition of NFTs
In the crypto world, there are two types of tokens, fungible and non-fungible. Fungible tokens are like currency. One dollar is always one dollar regardless of the serial number on the specific dollar bill. A one-dollar bill can be replaced by any other one-dollar bill. On the other hand, non-fungible tokens (NFT) are unique and cannot be replaced by any other token. NFTs can be used to represent unique digital assets, such as CryptoKitties and virtual buildings on Decentraland. NFTs are interesting because their uniqueness and ownership can be verified, they can be utilized across applications developed by different companies, and they can be traded easily through secondary markets. These features open up possibilities for new use cases and business models.
NFTs has been widely discussed since it was standardized by Dapper Labs in 2017. However, adoption is disappointing. NonFungible.com estimated there are around 20,000 NFT users per month, which is 40% of the estimated number of DeFi users. The primary reason is that not all NFT features are fully utilized. I would like to explain how NFT can be valued as a function of four components, and how value can be increased.
NFT value framework and opportunities
Value of an NFT = Utility + Ownership History + Future Value + Liquidity Premium
Depending on the asset that the NFT represents, value is weighted differently across these four components. This framework can be used by investors to evaluate if an NFT is worth investing, and by NFTs developers to think of ways to increase the value of NFTs to attract users and investors. The key takeaway is that NFTs creates many new ways for values to be created for both developers and asset owners.
Utility — Utility value is depended on how the NFT can be used. Two major categories that have high utility value are game assets and tickets. For example, a rare and powerful Crypto Space Commander battleship was sold for $45,250 in 2019, and the value of an NFT ticket is the price of an event ticket. Another dimension of utility is the ability to use the NFT in a different application. Imagine if you can use the same battleship in a different game, the value would definitely be even higher.
However, it’s very challenging to realize interoperability. Currently, 90% of NFT game players play only one game. That’s because developers need to first build a massive ecosystem of games and provide attractive use cases. Dapper Labs and Engin are both working towards that direction. Although there are many unknowns and require huge amount of time and effort, that’s exciting for the whole industry.
Another way to increase utility value that is easier to achieve is to form partnerships with other businesses to provide benefits to people who hold your NFT. For example, Dapper Labs can co-operate with NFT event organizers to negotiate a discount for CryptoKitties owners. With technologies such as AlphaWallet’s tokenScript, it’s very efficient to authenticate the issuer and owner of NFTs, so event organizers who want more participants don’t need to do much to implement the partnership. It’s a win-win for all parties involved.
Ownership history — Value depends on the identity of the issuer and previous owners of the NFT. NFTs with a high ownership history value are often created or issued by famous artists or companies with a strong brand. There are two ways to increase value. First is to co-operate with companies or individuals with a strong brand to issue NFT tokens. That naturally brings traffic and users to the ecosystem. For example, the first authorized NFT that represents a Formula 1 car was sold for $113,124. The second way is to resell NFTs that were previously owned by people who are influential. Currently, it’s challenging to find out who are the previous owners, although that’s valuable on-data data. Marketplaces and sellers can provide easy-to-use tracking interface to increase the value of NFTs. For example, OpenSea can highlight addresses of investors who make the most money from trading NFTs and list other NFTs they own.
Future value — The future value of an NFT is derived both from valuation changes and future cash flow. Valuation is driven by speculation and can sometimes be the main driver behind price appreciation. For example, the price of CryptoKitty #18 jumped from 9ETH to 253ETH in just three days in December 2017. Some may argue price movement that is driven by valuation is negative to NFTs, but speculation is human nature and is a non-trivial part of the current financial system. If the right balance is made, developers can increase NFT value and attract new users. Valuation is driven by scarcity of supply and speculation. Speculation can be guided by including price performance charts of NFT items or by highlighting NFTs that appreciate in value. The sneaker marketplace, StockX, achieves its $1 billion valuations partly because it creates a rare sneaker market by encouraging people to speculate on the price of sneakers.
Future cash flow is the interest or royalties earned by the original owner of the NFT. For example, SuperRare allows creators of NFT artworks to receive 3% royalty every time their artworks are sold subsequently on the secondary market. In the future, companies can borrow concepts from DeFi innovations. NFTs are assets and can be leased and collateralized to create additional cash flow. In a game, there is demand from players who want a specific game asset for one day to complete a mission.
Liquidity premium — High liquidity translates to a higher value of NFT. The liquidity premium is the primary reason why tokens that are created on-chain should have a higher value than off-chain assets. ERC standard NFTs can be traded easily without friction on secondary markets with anyone who holds ETH, which increases the number of potential buyers. Investors prefer to invest in NFT categories that have a high trading volume because liquidity lowers the risk of holding the NFTs. In an extreme scenario where the NFT loses its utility value after the associated platform is closed, a highly liquid NFTs still has value as long as there are people willing to buy and sell. On the other hand, NFT standards that are not based on Ethereum suffer from lack of liquidity, and the value of NFT created on those platforms is often discounted.
Companies need to design token economics that encourages users to trade to increase engagement and NFT liquidity. For example, games can force players to swap assets to remain competitive in the game and can depreciate NFT assets if they are idle for too long.
Application of the NFT value framework
Decentraland and My Crypto Heroes (MCH) have the highest value according to the framework, and their values are confirmed by on-chain data compiled by NonFungile.com. In 2019, the active market value, calculated by multiplying average active users by the average price per asset, for Decentraland and MCH were 350,000 ETH and 331,260 respectively, while the active market value for CryptoKitties was around 2,500 ETH.
