Non-fungible tokens: boom or bust? A glance at opportunities for institutional investors

The concept of non-fungible tokens has existed since 2012 (they were known as colored coins at that time), but it was not until March 2021 that a work of art called Everydays: The First 5000 days made the public’s ears prick up — and for good reason. The buyer of the artwork paid an astonishing US $69 million for a digital collage created by Beeple — an artist who until October 2020 had never sold a print for more than US $100. Many people were puzzled by how a digital picture could be worth millions of dollars even though anyone could just take a screenshot of it.

And yet, there’s an appealing rationale for the future of NFTs, with industries that struggled to directly monetize their work slowly but surely realizing the potential of this technology. For example, integrated royalty mechanisms allow creators (such as artists or musicians) to receive a percentage of revenue every time the NFT changes hands on secondary markets. Additionally, the financialization of NFTs is gaining huge traction these days, making it a hot topic for institutional investors as well.

We at Finoa have consolidated our market insights in an attempt to shed light on the subjects relevant to institutional investors, in particular:

  • What does it mean for a token to be non-fungible?
  • How did NFTs develop?
  • If there is value in NFTs, how does it materialize?
  • How will decentralized finance (DeFi) protocols benefit NFTs?
  • How do we expect NFTs to develop in the future?

As the very first step, we have to understand that non-fungibility is a characteristic that we have been familiar with since our childhood days — provided that childhood involved cherishing prized objects like the latest Barbie doll or Superman action figure. What we have not seen is ownership of those unique items being stored as tokens on a digital, decentralized, public ledger — a blockchain.

What does it mean for a token to be non-fungible?

Non-fungibility becomes very clear if we contrast it with fungibility. The term “fungibility” refers to the ability of a good or asset to be readily interchanged for another of like kind. Let us think of an example: Imagine your best friend lends you a one-dollar bill. Would he expect you to give him back that exact dollar bill? Probably not. Any bill would do because any US dollar is equal to any other US dollar. Therefore, currencies are fungible.

But how would we value the iconic 1939 Volkswagen Type 1, more commonly known as the “Bug” or “Beetle”? (For those of you unfamiliar with classic car collecting — this iconic car designed by Ferdinand Porsche was affordable and became the zeitgeist of the 1960s, symbolizing the “small is beautiful” ethos.) In contrast to an exchange of dollar bills, it would be an uneconomic decision to exchange your 1939 Beetle for your friend’s more modern Beetle because they “are both Beetles”. The value of your Beetle depends on variables such as condition, rarity, and popularity.

What does this have to do with NFTs? The revolution behind NFTs lies in the fact that they establish proof of ownership for digital assets. Such as the one-of-a-kind Beetle, each NFT is entirely unique and not interchangeable . A record of transactions on the blockchain offers unquestionable proof of when the original NFT was created, including every time it changed ownership.

If you are new to the digital asset space, you might wonder which use cases emerge from NFTs. Currently, the great majority of NFTs held for sale are digital artworks, rare videos and sports highlights, assets in games, collectibles, and virtual properties. However, the tokenization of tangible assets such as cars, real estate, and wills is highly anticipated in the future.

Attaching digital content to the blockchain as a nonfungible token is neither complex nor technical. Anyone can create — or, in crypto jargon, “mint” — an NFT. All you need to do is upload the high-quality representation of your digital item on the NFT marketplace of your choice — OpenSea being the largest, with 98.6% market share as of January 2022 — without having to write a line of code. The NFT creation process allows you to choose how many copies of a specific version you want to mint, making some tokens more exclusive than others.

As you might have noticed, global interest in NFTs has heavily increased in the past year. Worldwide Google search volume for the keyword “NFT” is currently making new highs, surpassing search volume for the word “crypto” for the first time ever.

Worldwide popularity of the search query “NFT” as of 10/01/2022. (Source: Google Trends)

However, it’s primarily in the marketing channels of Discord and Twitter that lively exchanges and distribution of information take place. In order to retrace the birth of NFTs, we have to step back in time.

How did NFTs develop?

If we look at NFTs from a high-level perspective, it makes sense to divide NFT history into three stages.

Stage 1: Bitcoin-based NFTs

Timeframe: ~ 2012–2016

When tracing NFTs back to the original idea, we must acknowledge the Colored Coins whitepaper by Yoni Assia (co-founder of eToro) and Vitalik Buterin (creator of Ethereum). In 2012, this whitepaper introduced Colored Coins as the earliest NFT predecessor. These were very small denominations of Bitcoin “colored” with specific attributes coded into metadata using Bitcoin’s scripting language. Although colored coins created a solid basis for NFTs, Bitcoin’s scripting capabilities were limited. Given the fact that colored coins only represented small denominations of Bitcoin, the commissions for processing transactions were low compared to other more profitable cryptocurrencies, discouraging miners from participating.

Taken together, these factors left the door open for a programmable blockchain — namely Ethereum — to create a better implementation. In June 2018, the ERC-721 token standard was accepted, creating a revolutionary opportunity for anyone to easily create and transfer NFT tokens on the Ethereum blockchain.

Stage 2: Ethereum-based NFTs

Timeframe: ~ 2017 — today

In October 2017, the first popular example of NFTs called CryptoKitties — a collection of artistic images representing virtual cats — appeared on the Ethereum network, using the still experimental ERC-721 standard. The virtual cats carried different visual attributes of varying levels of rarity, and were breedable, allowing users to create new cats with unique features. The “crazy amount(s) of real money” spent in the game presumably appeared outlandish to the general public but did not bring the trend to a halt. One market participant went so far as paying 600 ETH (US$ 170,000 at the time) for the most expensive CryptoKitty ever.

Another NFT heavyweight has its origins in 2017: CryptoPunks, a collection of 10,000 algorithmically-generated characters with unique features, could be claimed for free at launch by any user with an Ethereum wallet. Fast forward to today, and the value of CryptoPunks has skyrocketed. The most expensive Punk ever, the only alien CryptoPunk with a medical face mask, was sold for a nail-biting US$ 11.75 million.

The Ethereum ERC-721 token standard was a major enabler of NFT adoption but also brought the Ethereum blockchain to its limits, as increasing NFT demand caused roaring transaction fees. That opened the door for NFTs on other blockchains, bringing us to the third and final stage of our three-part history lesson.

Stage 3: “Alternative blockchain” based NFTs

Timeframe: 2020 — today

Currently, other Layer 1 protocols, as shown in the table below, are developing capacities to solve the perceived shortcomings of Ethereum. These newer blockchains include Solana, Ronin, and Flow, to name a few.

Blockchains by all-time NFT Sales Volume on 04/01/2022. Protocols created specifically for NFT transactions (e.g. Ronin, Flow, and WAX) are gaining ground on Ethereum. Simultaneously, other “multiple use-case” blockchains (such as Solana) are increasingly used for NFT transactions. (Source: CryptoSlam.io)

For example, the iconic CryptoKitties announced its transition from Ethereum to the Flow blockchain which could get the ball rolling for other projects. While Ethereum can handle 13–15 transactions per second, Flow’s protocol achieves a throughput of 1,000 transactions per second — with the next objective to reach a reasonable 10,000 TPS capability. Flow achieves this by using a Proof of Stake consensus mechanism, designed for extensive scaling without the use of complex sharding techniques.

Aside from Flow, there are many blockchains now promoting scalable, low-fee infrastructure designed explicitly for NFTs. As shown in the table above, with over $12.6b in sales volume, Ethereum still remains the most widely used blockchain for NFTs, but the success of Axie Infinity has pushed Ronin to the number two spot, with Solana and Flow taking third and fourth place.

Where do NTFs derive their value, since they are just a record on a blockchain?

Here is proposed a framework of 5 variables that influence the value of an NFT.

Value of NFT = Rarity + Utility + Ownership History + Liquidity + Community

CryptoPunk #7523 aka the third rarest punk according to Rarity.tools (Source: Rarity.tools)

1. Rarity

Purchasing an NFT that is rare maximizes the likelihood of having a high-value NFT in your wallet. The importance of rarity becomes apparent when we look at collectibles, which have a limited quantity or varying scarcity of their attributes. For a given NFT in a collection, each trait can be assigned a rarity score based on the percentage of NFTs having that particular trait in the collection. The more unique these characteristics are, the higher the expectations of the NFT’s value. For example, CryptoPunks with a low circulation of traits are valued way higher than those with a mixture of common traits. For this reason, it should not be surprising that the above-mentioned CryptoPunk #7523 — in fact, the third rarest punk in the space — was traded for US$ 11.75 million.

Redeemable Bitcoin pillow in exchange for an NFT (Source: Rarible)

2. Utility

Is the NFT attached to a game, metaverse, or does owning it give a unique benefit? The present and expected future utility of an NFT is crucial when trying to understand a value composition.

Redeemability, understood as the unique opportunity for an NFT holder to trade the NFT for physical goods unavailable to the public, adds utility to NFTs. For example, Redeemablenfts.com is a marketplace for crypto merchandise, such as “Hodl” pillows or Bitcoin bed sheets that can only be snagged in exchange for an NFT.

Another way to create utility value is to offer interoperability for users. Future innovations may lead to a world (or so-called metaverse) where users can transfer all of their non-fungible belongings from one game to another.

Moreover, holding a scarce NFT can grant you lifetime membership to closed communities, the best example being the “Bored Ape Yacht Club” — a troop of 10,000 cartoonish primates. Beyond showing off a prestigious ape as an avatar on Twitter, the club further enables exclusive NFT ownership rights before anyone else. For instance, each proud owner of a bored ape had the ability to mint a free Mutant Ape NFT, which currently trades for several hundred Ether on Opensea.

Finally, an interesting yield-bearing utility can be generated when NFT meets Decentralized Finance (DeFi). Especially from an institutional investor perspective, the DeFi use case is worth a closer look which follows later in this piece.

3. Ownership history

Value is heavily affected by the creator or previous owners of the NFT, which can be globally recognized artists, celebrities, or brands. Any object tied to a prominent figure or brand on the market affects the value perception of their work.

One practical example is featured in the documentary “Trader”, in which legendary hedge fund manager Paul Tudor Jones puts on his lucky sneakers, claiming that he bought them at a charity auction because they used to be Bruce Willis’ and “the man’s a stud”. It clearly underscores how ownership history can heavily influence an item’s appreciation potential. How can that be related to NFTs? In June 2021, the famous rapper Jay Z changed his Twitter profile picture to CryptoPunk NFT #6095, which he had purchased on OpenSea. According to DappRadar, a global app store for decentralized applications, Jay Z would generate a nice profit of 90% on #6095 if he would sell it today.

4. Liquidity

In general terms, the liquidity of NFTs is quite low compared to fungible tokens. Because there is a risk of being stuck with an NFT, those NFTs with high trading volumes command a premium. High trading volumes also prevent market manipulation and volatile pricing. That explains why investors may place greater value on NFTs that are deployed on the Ethereum blockchain, as chances are good that they can be traded on secondary markets.

CryptoPunk evolving into a digital identity worth more than US$ 9.5 million. (Source: one37pm)

5. Community

How strongly is the community engaged with the project? Since NFTs exist in a supply and demand-driven economy, if the community is not enthusiastic about the project but rather wants to make a quick flip, chances are high that it will not be worth much for long.

First, a strong community is one with a long-term view of the respective project. This is expressed, for example, in Telegram or Discord channels in which the members discuss potential use cases and further engagement with the project rather than disclosing primarily profit-driven motivations.

Second, strong community is emotionally attached to their NFTs. For example, the owner of CryptoPunk #6046 turned down a US $9.5 million offer, because he perceives the NFT as a crucial part of his identity. Or to phrase it in his words: “I am my jpeg, my jpeg is me.”

How will DeFi protocols benefit NFTs?

Let’s face it. NFTs constitute one of the hottest topics in the space at the moment, with internationally recognized newspapers such as “The Economist” and “Financial Times” lending their opinions. However, for many institutional investors, getting exposed to an unregulated, highly volatile asset class appears relatively speculative. As for most NFT projects, historical time series of prices only go back as far as early 2021, making it fairly unsuitable for long-term or quantitative analyses.

What the future holds is anyone’s guess, and it doesn’t help when Coinbase founder Fred Ehrsam states that 90% of NFTs produced today “will have little to no value in three to five years”. And yet, only recently (14/12/2021) Mike Novogratz, an ex-hedge fund manager and founder of Galaxy Investment Partners , referred to NFTs as “the most important thing that happened this year”.

Visa’s purchase of a CryptoPunk demonstrates a bullish attitude and chances are looking good that other players will follow suit. To give you another example, Kevin Rose just announced on behalf of True Ventures, a venture capital firm that invests in early-stage technology start-ups, that the firm is pursuing to “hold bluechip NFTs on their books”.

Although we find ourselves in the early NFT stages, we have been wondering what would actually make it worthwhile for an institutional investor to be exposed to the non-fungible world? NFTs in their basic form do not earn any yield, unlike fungible tokens, which can be lent out, staked, or otherwise put to work.

In a previous blog post, we discussed DeFi and its promising nature for institutional investors to participate in decentralized lending, borrowing, and trading using fungible tokens. As we have already pointed out in the utility section of this article, what we expect to see in the future is an attractive fusion of both worlds — DeFi and NFT. Let us draw up the current DeFi market offering for NFTs:

1. Liquidity Pools & Fractionalization

Within the NFT market, NFTX and NFT20 have emerged as the leading platforms to solve the lack of liquidity. Holders of NFTs that do not trade frequently are able to place their NFTs into a so-called “vault” or “pool”, which functions as a repository for holding many NFTs of the same value. The great majority of vaults are “floor” vaults, meaning that they contain the lowest valued NFTs from a collection. As soon as the NFT is deposited in the vault, the user receives a token representing a claim on any single NFT in the vault. This token can be used throughout the whole DeFi space, including in ways that generate yield.

CryptoPunk Vault on NFTX with floor-priced NFTs. (Source: NFTX)

The classic way to generate yield on DeFi tokens is to provide liquidity on a decentralized exchange such as Uniswap, which enables trading activities on that exchange and earns transaction fees in the process. By way of background, decentralized exchanges — like Sushiswap and Uniswap, which hold the largest market shares — allow for on-chain trading without the necessity of a traditional order book. Instead, these pools motivate liquidity providers to lock their assets in exchange for an incentive, proportional to their share of the total liquidity available for trading in that pool.

The innovation of NFTX and NFT20 is in the transformation of a non-fungible item into something fungible that can be easily traded or used to generate passive yield on decentralized exchanges.

As an alternative to liquidity pools, fractionalization protocols such as Fractional and Unicly are gaining ground. Using these protocols to split an ERC-721 token into multiple ERC-20 tokens has become increasingly popular, as it allows the broader public to acquire small parts of the most coveted, otherwise too expensive NFTs. Especially in the light of a highly volatile and illiquid NFT market, fractionalization also enables the investor to minimize risk by obtaining portfolio diversification instead of relying on a small number of expensive NFTs. Similar to NFTX and NFT20, Unicly and Fractional decompose non-fungible ERC-721 tokens into fungible and liquid ERC-20 tokens which allows the tokens to be used for DeFi applications like trading and lending. Besides Ethereum, it is likely that DeFi functionality will be enabled for other blockchains as well.

2. Lending

Since DeFi applications do not require any central authority as an intermediary in the lending process, investors have the opportunity to borrow other cryptocurrencies against their NFTs as collateral. Especially for investors who do not want to part with their NFT, but require cash, lending can be the perfect solution. In the case that the value of the collateral becomes less than the value of the loan, the collateral is liquidated in order to pay back the loan before the borrower goes bust.

On the leading NFT lending platform, NFTfi, lenders grant borrowers up to 50% of their NFT value as the loan principal. The interest rates, however, vary depending on both the lender and the desirability of the NFT. But as discussed previously, we have to consider the NFT market as highly illiquid, which makes it difficult to establish the real-time value of an NFT. As a proxy for the fair value of the collateral, lenders can pay attention to the recent sales history or the floor price of similar assets.

It is exciting to see the ball rolling for lending platforms being created explicitly for institutional investors and high-net-worth retail investors. Take for example Arcade (formerly Pawn.fi), a platform that raised a US$ 15 million Series A fund in late December 2021 to facilitate loans against NFTs for institutional investors. With the marriage of DeFi and NFTs, we are entering an exciting new chapter in the crypto world. The existing landscape of DeFi/NFT projects (shown in image 6) continues to build and capture peoples’ interest and imagination.

Mapping the NFT landscape within decentralized finance (Source: Messari)

How do we expect NFTs to develop in the future?

NFT trading volume exploded in 2021, increasing 38,060% year-over-year in Q3 of 2021, as shown in the graph below. That trend has continued to pick up momentum in 2022 with daily trading volume surpassing US$ 231 million two days into 2022, the highest level since the initial explosion in August of 2021.

NFT trading volume experienced strong growth in 2021 (Source: The Block)

What this trend does not disclose is the rate at which non-fungible tokens are being adopted across different groups of the population. According to research conducted by Finder.com, we have not yet reached the “early majority” stage of the adoption bell curve. As of November 2021, we find primarily early adopters invested in NFTs: Just 2.8% of American internet users currently own an NFT with an additional 3.9% planning to buy NFTs in the near future. NFT adoption rate here in Germany paints a similar picture: While 4% of Germans hold NFTs in their wallets, an additional 3.4% plan to do so in the future.

NFT adoption curve in late 2021 in Germany

As shown, we are still in the very early days of NFTs, which might explain the lack of regulation and continuing volatility.

But let us look into the future: How will the investment perspective of institutional investors adapt once an early or even late majority of the worlds’ populations have some of their savings tied up in NFTs? And especially: What role should a digital asset custodian play in the NFT ecosystem?

Fred Ehrsam’s notion that 90% of NFTs produced today “will have little to no value in three to five years” is speculative, but it draws our attention to the fact that only a handful of NFTs will produce steady value retention or appreciation in the long run. These are likely to be today’s “blue chip” projects such as CryptoPunks, Bored Ape Yacht Club, and NBA TopShots, and indeed these are being sought after by institutional NFT investors striving to minimize their risk.

Shortly before the New Year of 2022, Bitwise Asset Management, a leading index fund manager with more than US$ 1.7 billion assets under management (AUM), announced the Bitwise Blue-Chip NFT Index Fund — the “world’s 1st NFT index fund”.

Bitwise’s chief information officer Matt Hougan announced the NFT index fund launch (Source: Twitter)

The index fund is designed to make it easier for accredited investors to gain market-cap-weighted exposure to the top 10 most valuable and established NFT collections. The product, which is similar to equity index funds, rebalances quarterly and is composed of the holdings shown in image 10 below.

Index constituents of the Bitwise Blue-Chip NFT Index Fund as of 14/12/2021 (Source: Bitwise)

Although the fund removes the complexities around the purchase and custody of NFTs, the investor gives up the unique opportunity to generate additional yield via DeFi products, instead of paying a 3% management fee to Bitwise for the administration of the fund. A direct NFT investment currently constitutes the only way for an institutional investor to gain access to DeFi’s yield-bearing nature and prevent an otherwise “mostly static state.” This was pointed out by Brandon Buchanan, CEO of a Miami-based Web3 focused investment management firm called Meta4 Capital:

“NFTs that would otherwise be in a mostly static state are now being put to work and we’re able to financially engineer returns in excess of the interest rate for our investors either by buying additional NFTs or earning yield through DeFi protocols.”

Similar to conventional crypto-currencies, institutional investors are likely to rely on trustworthy custody solutions for their NFTs. At Finoa, we are curiously exploring NFT-custody across multiple chains, and already enable custody of both Ethereum ERC20 tokens and the native tokens of the Flow blockchain, giving investors a way to make an indirect bet on NFTs. (As indicated in the table at the beginning of this piece, the Ethereum and Flow blockchains have enabled 72% of the historical trading of NFTs.)

The exciting integration of NFTs and DeFi only began within the last year and is still in its infancy. However, in the future, digital asset custodians could enable institutional investors to achieve both the highest levels of security as well as the opportunity to generate a passive, stable yield on their NFT investments.

Conclusion

In summary, this piece presented the concept of proving ownership of a non-fungible item on a blockchain. It was shown that while Ethereum is the underlying blockchain behind most NFTs, several other blockchains are gaining significance in the quest for a low transaction cost, scalable infrastructure.

While assessing five key value drivers for NFTs, we also established that the NFT market is still highly volatile and illiquid, with investors often struggling to determine the value of an NFT. We also took a look at “vault” solutions which increase the fungibility of “floor” NFTs, improving their liquidity and also providing an opportunity to earn yield via DeFi applications. Conversely, fractionalization mechanisms enable a single NFT to be broken down into multiple tokens.

We are still in the early stages of NFT-based DeFi products and are looking forward to seeing more protocols in that innovative field. When it comes down to selecting a custodian for NFTs, there will potentially be a rising demand for both security and the potential to earn a return on the assets over the long term.

About Finoa

Finoa is a regulated custodian for digital assets, servicing professional investors with custody and staking. The platform enables its users to securely store and manage their crypto-assets, while providing a directly accessible, highly intuitive, and unique user experience, enabling seamless access to the ecosystem of Decentralized Finance (DeFi). Reference customers include the world’s most renowned Venture Capital firms, large corporations, and financial institutions. Finoa was founded in Berlin in 2018, has received a preliminary crypto custody license (§64y Para. 1 KWG), and is supervised by the German Federal Financial Supervisory Authority (BaFin).

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