The NFT Frenzy
And the value capture in the NFT markets, upcoming use cases& the dark side of the ecosystem.
Visa bought CryptoPunk for $150k, pumping the Punk floor price to 115 ETH in less than 3 days. A week later, BAYC’s floor price was up ~300%. Subsequently, every major collectible saw an increase in its price floor — Meebits, Pudgy Penguins, AutoGlyphs, Art Blocks Curated, Degen Ape Academy etc.
Despite being called a bubble, overvalued jpegs, random art etc. — their communities are undeniable. The value of these collectibles comes from consensus — the same philosophy that drives crypto at its root. Consensus and en masse fascination for a collection come from several parameters — look of the artwork and scarcity.
What is causing the frenzy?
There are several theories on what entices people into spending millions on NFTs — the one I like to subscribe to is the thesis of sense of community, status and identity.
Owning a punk conveys social status and acts as a symbol of wealth (similar to owning a Rembrandt). It creates a sense of community and belonging — similar to how the early $BTC and $ETH believers continue to feel a strong kinship with their communities. Of course, there are those who are FOMO-ed into a purchase just to acquire the status symbol. This, however, largely applies to the latecomers.
The early adopters of a collection identify with their NFTs differently — some appreciate the art and the rarity while others like to use (avatar) NFTs as an identity layer. This has translated into pseudo-anonymous social media accounts dedicated to Punks & BAYC cropping up — each collector embracing their Web3.0 native avatar. They wear this symbol of their early insight and conviction as a badge of honor.
NFT Sales Recap
NFTs have existed since 2017 and flew under the radar until the end of 2020. Projections suggest annual sales worth $80.8B by the end of 2021 and $252B by the end of 2022. On average, market size for minting new NFTs (aka primary markets) is 3.39x times greater than the trading of NFTs (aka secondary market). The first half of 2021 saw $13.7B in NFT sales.
The NFT market exploded in late 2020 and early 2021. Q1 and Q2 of 2021 saw $5B and $8B worth of sales with a primary to secondary market ratio of 1.51x and 3.00x. Regardless of crypto market conditions, we expect the NFT market to continue to thrive. It will likely be driven by web2.0 consumer brands, digital artists and crypto games. August 2021 alone saw ~US$3.6B in trading volume on the top 3 marketplaces.
Curation attracts top dollar but permissionless-ness captures the value of long tail assets.
Curated NFT marketplaces sell high-end art work and hence accrue a greater average price per sale compared to permissionless marketplaces. Curated platforms also see better retention rate per user. However, curated platforms see lower volumes and offset this by imposing higher fees. For instance, Foundation & Nifty Gateway charge 15% and 5% respectively to mint NFTs on their platform whereas Opensea and Rarible charge their users a 2.5% tx fees.
Why the inflated prices of NFTs?
Crucially, it benefits the primary marketplaces to subscribe to an auction model which ensures high bids and keeps low liquidity in the marketplace. Secondary markets (and P2C models) are responsible for market’s price correction.
The disconnect (and lack of liquidity in P2C platforms) lies in failing to understand that curated & primary issuance platforms are selling premium assets with a high value associated with their listings — they are optimizing for a high bid price instead of high trading volume.
As the frenzy continues, NFT owners are looking to “flip” the NFT for a quick buck and overall this has greatly benefited secondary marketplaces like Opensea & Rarible. Their order book implementation works great for popular NFTs that have a decent turnover and demand in the market, but the auction mechanism fails to scale to the long tail NFT assets. Lack of liquidity, interest and active demand in the market poses a challenge for P2P marketplaces to service all other NFTs.
Collectors and market participants are however catching on that low liquidity hinders growth of the ecosystem. With an influx of traders entering the NFT markets, indexing and fractionalizing platforms have seen a rise in their TVLs as well.
Since my previous article, the TVLs of indexing and fractionalizing protocols have doubled if not 10x-ed. Although net off the liquidity on fungibility protocols is still low compared to DeFi, there is certainly an improvement.
Another positive sign of the long term growth and sustainability of the ecosystem is the sight of arbitrageurs and actively managed funds entering the NFT space exclusively. Blackpool is an actively managed NFT fund & DAO which essentially arbs between different primary & secondary markets. Genie is an NFT aggregator platform that will act as the 1inch or Matcha of NFTs. Projects like Metahood & Parcel are aggregating metaverse NFT land parcels & positioning themselves as the “Zillow of Metaverses”.
The process of market correction may hurt the NFT owners buying at inflated price points in the short term but is indicative of a long term sustainable market through price correction.
NFTs as Collateral Assets
NFT lending is becoming an increasingly competitive space as developers attempt to make NFTs a good collateral to borrow against. Aave announced its plans to accept NFTs as collateral, Ruler Protocol uses NFTX‘s Index Tokens as a collateral and several projects are building specialized lending modules for Uni V3 NFT lending like Themis Exchange.
NFT lending is ideal for NFTs that represent game assets, virtual real estate, and financial NFTs; but it is not ideal for digital art NFTs as the value of the art is subjective.
Leasing of gaming assets has been popularized by Axie Infinity and Yield Guild Games’s Scholarship systems where the leaser accrues % of the profit from the lessee’s gameplay. Leasing may become popular on Metaverses too, where brands would lease land for their launch events, making purchase of “prime virtual real estate” valuable.
How do you know NFTs are going mainstream? They are the new rewards system in enterprise marketing.
NBA Topshot was conceived by a JV between NBA and Dapper Labs in 2019. The project has seen high trading volumes and revenues by tokenizing iconic moments of NBA Seasons and renowned athletes. This demonstrates another instance of NFTs becoming mainstream as a means of user engagement and an alternate revenue source for organizations.
Platforms like Rabbit Hole and Project Galaxy are using NFTs to educate crypto rookies on how to interact with crypto and dApps. These campaigns also double as marketing for the projects as they directly reward participants with NFTs.
Matrix focuses on working with consumer and Web2.0 brands to increase engagement with their users and followers through NFTs and further gamification of their marketing campaigns. Recur is a licensing play and works closely with brands in designing and distributing brand-oriented NFTs and other user experiences.
Battle of white-labelled platforms vs. secondary marketplaces
As consumer brands jump on the NFT bandwagon, they aim to diversify their revenue channels without compromising on their brand identity. For consumer brands like Gucci and Taco Bell, NFTs have become a medium for marketing as they can interact directly with their fans and followers.
As more enterprises and SMEs join the NFT party, the ecosystem will see a rise in white-label or Shopify for NFTs projects. Opensea offers a white-label SDK to its trading engine but requires brands to set up their front-ends. Bitski, Sweet and Origin Protocol offer alternatives to this by providing a full-suite platform catering to creators, creative studios and agencies. Ventures in the space like Async Art are helping creators with limited coding background to create more programmable art and novel pieces like the Bitcoin NFT which changes its form based on the hourly changes of $BTC price.
Dark Side of NFTs
While NFTs brought mainstream audiences into crypto better than $BTC could, the ecosystem is facing serious challenges. Those in DeFi are familiar with some and some are completely new.
- Fraudulent NFT minting — consumers are not always taught “DYOR” but it’s the lifeblood of crypto. Apeing into imposter NFTs leaves the buyer with a valueless JPEG with no secondary market or resale value.
- Weak digital rights management — while many primary marketplaces boast about creator rights and embedded royalty features, in practice this may not mean much. If a user decides to sell the NFT on OpenSea which is well within their rights, the creator can lose rights to their royalties.
- Front Running & Floor Sweeps — Recently, many hotly anticipated NFT drops met the fate of bots who would frontrun other buyers and subsequently drive the price floors eventually dumping back into the market.
- Centralized marketplaces — Opensea, SuperRare, Foundation are centralized and operate as Web2.0 companies with a Web3.0 product offering. This leaves user’s NFT storage at the hands of the company’s servers. Opensea recently saw a bug which caused a wipeout of apx US$100k. The affected NFTs were sent to the burn contract and holders lost their assets forever through no fault of their own.
- No capital efficiency — Lack of fair valuations and pricing oracles = no way to financialize the illiquid assets. While I’m hopeful that financial NFTs (FNFTs) will be used in DeFi in the near future, we’re still a long way to go before the ecosystem can use NFTs as a whole as collateral.
In the long term we expect to see some or all of the following features in the next generation of NFT projects:
- front-running resistant NFT infrastructure and marketplaces
- conscious decisions by primary NFT sellers to improve liquidity in secondary marketplaces
- rise of NFT price oracles enabling NFTs to participate in DeFi
- rise of application-specific NFT sidechains
As the NFT ecosystem is growing, it is of utmost importance that secondary markets find liquidity. A well-liquid secondary market is necessary for future growth of the ecosystem — without which the last 8 months would have just been a big bubble bringing back bad connotations to the crypto as a whole. That said, I believe there are several protocols championing the mission and we’re all excited to see them grow as more smart capital pours into the space.